**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**Quarterly Report Pursuant to Section 13or 15(d) of the SecuritiesExchange Act of 1934**

 

**For thequarterly period ended March 31, 2008**

 

**CommissionFile Number: 000-51444**

 

**KapStone Paper and PackagingCorporation**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                     | ** ** | **20-2699372**      |
|----------------------------------|------------|---------------------|
| (State or Other  Jurisdiction of |       | (I.R.S. Employer    |
| Incorporation or  Organization)  |       | Identification No.) |

 

**KapStonePaper and Packaging Corporation, 1101 Skokie Blvd., Suite 300**

**Northbrook,IL 60062**

(Address of Principal Executive Officesincluding zip code)

 

**(847)239-8800**

(Registrant’s Telephone Number, IncludingArea Code)

 

Indicateby check mark whether the Registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Exchange Act during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yesx  No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large  accelerated filer o                     |   | Accelerated  filer x         |
|------------------------------------------------|--------|-----------------------------------|
|                                           |   |                              |
| Non-accelerated  filer o                       |   | Smaller  reporting company o |
| (Do  not check if a smaller reporting company) |   |                              |

 

IIndicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).Yes o  No x

 

Therewere 25,283,897 shares of the Registrant’s Common Stock, $0.0001 par value,outstanding at April 30, 2008, excluding 40,000 shares held as treasuryshares.

 

 

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**KapStone Paper and Packaging Corporation Index to Form 10-Q**

 

**TABLE OF CONTENTS**

 
| PART I. — FINANCIAL INFORMATION |                                                                                                                              |
|-------------------------------------------|-----------------------------------------------------------------------------------------------------------------------------------|
|                                      |                                                                                                                              |
|                                      | Item 1. — Condensed  Consolidated Financial Statements (Unaudited) and Notes to Condensed  Consolidated Financial Statements | 1 |
|                                      |                                                                                                                              |   |
|                                      | Item 2. —  Management’s Discussion and Analysis of Financial Condition and Results of  Operations                       | 11 |
|                                      |                                                                                                                              |   |
|                                      | Item 3. —  Quantitative and Qualitative Disclosures about Market Risk                                                        | 18 |
|                                      |                                                                                                                              |   |
|                                      | Item 4. —  Controls and Procedures                                                                                           | 19 |
|                                      |                                                                                                                              |
| PART II.  — OTHER INFORMATION   |                                                                                                                              |
|                                      |                                                                                                                              |
|                                      | Item 1. — Legal  Proceedings                                                                                                 | 19 |
|                                      |                                                                                                                              |   |
|                                      | Item 1A. — Risk Factors                                                                                                      | 19 |
|                                      |                                                                                                                              |   |
|                                      | Item 2. —  Unregistered Sales of Equity Securities and Use of Proceeds                                                       | 22 |
|                                      |                                                                                                                              |   |
|                                      | Item 3. —  Defaults Upon Senior Securities                                                                                   | 22 |
|                                      |                                                                                                                              |   |
|                                      | Item 4. —  Submission of Matters to a Vote of Security Holders                                                               | 22 |
|                                      |                                                                                                                              |   |
|                                      | Item 5. — Other  Information                                                                                                 | 22 |
|                                      |                                                                                                                              |   |
|                                      | Item 6. — Exhibits                                                                                                           | 22 |
|                                      |                                                                                                                              |
| SIGNATURES                                | 23                                                                                                                                |

 

i

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** **

**Part 1. Financial Information**

 

**Item 1.Financial Statements**

 

**KapStonePaper and Packaging Corporation**

**CondensedConsolidated Balance Sheets**

**(Inthousands, except share and per share amounts)**

** **
| ** **                                                                                                                                                                                                                                                                           | ** ** | **March 31,** | ** ** | **December 31****,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|---------------------------|------------|
| ** **                                                                                                                                                                                                                                                                           | ** ** | **2008**           | ** ** | **2007**                  | ** ** |
| ** **                                                                                                                                                                                                                                                                           | ** ** | **(Unaudited)**    | ** ** | ** **                | ** ** |
| **Assets**                                                                                                                                                                                                                                                                           | ** ** | ** **         | ** ** | ** **                | ** ** |
| Current assets:                                                                                                                                                                                                                                                                      | ** ** | ** **         | ** ** | ** **                | ** ** |
| Cash and cash equivalents                                                                                                                                                                                                                                                            |       | $                  | 60,260     |                      | $          | 56,635 |   |
| Trade accounts receivable                                                                                                                                                                                                                                                            |       | 29,419             |       | 30,208                    |       |
| Inventories                                                                                                                                                                                                                                                                          |       | 14,458             |       | 16,358                    |       |
| Inventories consigned to third parties                                                                                                                                                                                                                                               |       | 3,516              |       | 3,488                     |       |
| Deferred income taxes                                                                                                                                                                                                                                                                |       | 1,155              |       | 1,263                     |       |
| Prepaid expenses and other current assets                                                                                                                                                                                                                                            |       | 2,948              |       | 735                       |       |
| Total current assets                                                                                                                                                                                                                                                                 |       | 111,756            |       | 108,687                   |       |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| Plant, property and equipment, net                                                                                                                                                                                                                                                   |       | 104,612            |       | 104,858                   |       |
| Other assets                                                                                                                                                                                                                                                                         |       | 5,243              |       | 3,735                     |       |
| Intangible assets, net                                                                                                                                                                                                                                                               |       | 5,829              |       | 5,875                     |       |
| Goodwill                                                                                                                                                                                                                                                                             |       | 2,295              |       | 2,295                     |       |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| Total assets                                                                                                                                                                                                                                                                         |       | $                  | 229,735    |                      | $          | 225,450 |   |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| **Liabilities and Stockholders’ Equity**                                                                                                                                                                                                                                        | ** ** | ** **         | ** ** | ** **                | ** ** |
| Current liabilities:                                                                                                                                                                                                                                                                 | ** ** | ** **         | ** ** | ** **                | ** ** |
| Current portion of long-term debt                                                                                                                                                                                                                                                    |       | $                  | 17,611     |                      | $          | 19,578 |   |
| Accounts payable                                                                                                                                                                                                                                                                     |       | 11,498             |       | 11,050                    |       |
| Accrued expenses                                                                                                                                                                                                                                                                     |       | 4,407              |       | 4,867                     |       |
| Accrued compensation costs                                                                                                                                                                                                                                                           |       | 4,754              |       | 6,625                     |       |
| Accrued income taxes                                                                                                                                                                                                                                                                 |       | 2,045              |       | 1,477                     |       |
| Total current liabilities                                                                                                                                                                                                                                                            |       | 40,315             |       | 43,597                    |       |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| ** **                                                                                                                                                                                                                                                                           |       |               |       |                      |       |
| Other liabilities:                                                                                                                                                                                                                                                                   |       |               |       |                      |       |
| Long-term debt                                                                                                                                                                                                                                                                       |       | 31,350             |       | 32,922                    |       |
| Pension and post-retirement benefits                                                                                                                                                                                                                                                 |       | 3,769              |       | 3,420                     |       |
| Deferred income taxes                                                                                                                                                                                                                                                                |       | 2,350              |       | 1,047                     |       |
| Other liabilities                                                                                                                                                                                                                                                                    |       | 282                |       | 279                       |       |
| Total other liabilities                                                                                                                                                                                                                                                              |       | 37,751             |       | 37,668                    |       |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| Commitments and contingencies                                                                                                                                                                                                                                                        |       |               |       |                      |       |
| Stockholders’ equity:                                                                                                                                                                                                                                                           |       |               |       |                      |       |
| Preferred stock $.0001 par value; 1,000,000 shares authorized;  no shares issued and outstanding                                                                                                                                                                                |       | —             |       | —                    |       |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| Common stock $.0001 par value, 175,000,000 shares authorized;  25,283,897 shares issued and outstanding (40,000 treasury shares  outstanding) at March 31, 2008 and 25,280,197 issued and outstanding  (40,000 treasury shares outstanding) at December 31, 2007 |       | 3                  |       | 3                         |       |
| Additional paid-in capital                                                                                                                                                                                                                                                           |       | 115,256            |       | 115,002                   |       |
| Retained earnings                                                                                                                                                                                                                                                                    |       | 36,331             |       | 29,101                    |       |
| Accumulated other comprehensive income                                                                                                                                                                                                                                               |       | 79                 |       | 79                        |       |
| Total stockholders’ equity                                                                                                                                                                                                                                                      |       | 151,669            |       | 144,185                   |       |
|                                                                                                                                                                                                                                                                                 |       |               |       |                      |       |
| Total liabilities and stockholders’ equity                                                                                                                                                                                                                                      |       | $                  | 229,735    |                      | $          | 225,450 |   |

 

See notes tocondensed consolidated financial statements

 

1

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**KapStonePaper and Packaging Corporation**

**CondensedConsolidated Statements of Income**

**(Inthousands, except share and per share amounts)**

 

**(unaudited)**

** **
| ** **                                     | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                     | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
|                                           |       |                                                 |       |   |   |
| Net sales                                      |       | $                                                    | 67,129     |   | $ | 65,427 |   |
| Cost of sales, excluding depreciation          |       | 41,558                                               |       | 42,436 |   |
| Freight and distribution                       |       | 6,587                                                |       | 5,686 |   |
| Selling, general and administrative expenses   |       | 4,930                                                |       | 3,720 |   |
| Depreciation and amortization                  |       | 2,593                                                |       | 2,181 |   |
| Other operating income                         |       | 184                                                  |       | 461 |   |
| Operating income                               |       | 11,645                                               |       | 11,865 |   |
| Interest income                                |       | 547                                                  |       | 397 |   |
| Interest expense                               |       | 753                                                  |       | 1,156 |   |
| Income before provision for income taxes       |       | 11,439                                               |       | 11,106 |   |
| Provision for income taxes                     |       | 4,209                                                |       | 4,028 |   |
|                                           |       |                                                 |       |   |   |
| Net income                                     |       | $                                                    | 7,230      |   | $ | 7,078 |   |
|                                           |       |                                                 |       |   |   |
| Weighted-average number of shares outstanding: |       |                                                 |       |   |   |
| Basic                                          |       | 25,282,047                                           |       | 24,973,333 |   |
| Diluted                                        |       | 34,557,324                                           |       | 33,868,933 |   |
| Net income per share:                          |       |                                                 |       |   |   |
| Basic                                          |       | $                                                    | 0.29       |   | $ | 0.28 |   |
| Diluted                                        |       | $                                                    | 0.21       |   | $ | 0.21 |   |

 

See notes to condensed consolidated financial statements

 

2

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**KapStone Paper and PackagingCorporation**

**Condensed Consolidated Statements ofCash Flows**

**(In thousands)**

 

**(unaudited)**

 
| ** **                                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                          | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| **Operating activities**                            |       |                                                 |       |   |   |
| Net income                                          |       | $                                                    | 7,230      |   | $ | 7,078 |   |
| Depreciation and amortization                       |       | 2,593                                                |       | 2,181 |   |
| Stock based compensation expense                    |       | 236                                                  |       | — |   |
| Amortization of debt issuance costs                 |       | 59                                                   |       | 64 |   |
| Deferred income taxes                               |       | 1,411                                                |       | 958 |   |
|                                                |       |                                                 |       |   |   |
| Changes in operating assets and liabilities:        |       |                                                 |       |   |   |
| Trade accounts receivable                           |       | 789                                                  |       | (5,929 | ) |
| Inventories                                         |       | 1,872                                                |       | 3,660 |   |
| Prepaid expenses and other current assets           |       | (2,213                                               | )          | (711 | ) |
| Accounts payable                                    |       | 448                                                  |       | 2,116 |   |
| Accrued expenses                                    |       | (1,206                                               | )          | (2,439 | ) |
| Accrued compensation costs                          |       | (1,871                                               | )          | 4,893 |   |
| Accrued income taxes                                |       | 568                                                  |       | 2,976 |   |
| Net cash provided by operating activities           |       | 9,916                                                |       | 14,847 |   |
|                                                |       |                                                 |       |   |   |
| **Investing activities**                            |       |                                                 |       |   |   |
| Acquisition costs paid                              |       | (469                                                 | )          | (187 | ) |
| KPB acquisition                                     |       | —                                               |       | (150,303 | ) |
| Receipt of cash held in trust                       |       | —                                               |       | 115,239 |   |
| Capital expenditures                                |       | (2,301                                               | )          | (2,078 | ) |
| Net cash used in investing activities               |       | (2,770                                               | )          | (37,329 | ) |
|                                                |       |                                                 |       |   |   |
| **Financing activities**                            |       |                                                 |       |   |   |
| Proceeds from long-term debt                        |       | —                                               |       | 60,000 |   |
| Debit issuance costs paid                           |       | —                                               |       | (855 | ) |
| Repayment of long-term debt                         |       | (3,539                                               | )          | — |   |
| Redemption of shares                                |       | —                                               |       | (230 | ) |
| Proceeds from the exercise of common stock warrants |       | 18                                                   |       | — |   |
| Investment banking fee paid                         |       | —                                               |       | (1,200 | ) |
| Net cash provided by (used in) financing activities |       | (3,521                                               | )          | 57,715 |   |
|                                                |       |                                                 |       |   |   |
| Net increase in cash and cash equivalents           |       | 3,625                                                |       | 35,233 |   |
| Cash and cash equivalents-beginning of period       |       | 56,635                                               |       | — |   |
| Cash and cash equivalents-end of period             |       | $                                                    | 60,260     |   | $ | 35,233 |   |

 

See notes tocondensed consolidated financial statements

 

3

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**KAPSTONE PAPER AND PACKAGING CORPORATION NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**(In thousands, except share and per share amounts)**

 

**(unaudited)**

 

# **1.**                                      FinancialStatements

# ** **

The accompanying unauditedcondensed consolidated financial statements of KapStone Paper and PackagingCorporation (the “Company,” “we,” “us,” “our” or “KapStone”) have been preparedin accordance with U.S. generally accepted accounting principles for interimfinancial information, the instructions to Form 10-Q and Article 10of Regulation S-X. Accordingly, they do not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements. In the opinion of management, all adjustments (consistingof a normal recurring nature) considered necessary for a fair presentation havebeen included. Operating results for the three months ended March 31, 2008are not necessarily indicative of the results that may be expected for the yearending December 31, 2008. For further information, refer to theconsolidated financial statements and related footnotes included in our AnnualReport on Form 10-K/A for the year ended December 31, 2007.

 

KapStone Paper and PackagingCorporation (formerly Stone Arcade Acquisition Corporation) or the “Company”was incorporated in Delaware on April 15, 2005.  On May 25, 2006, the Company formed awholly-owned subsidiary, KapStone Kraft Paper Corporation, or KapStoneKraft.  The Company was formed to serveas a vehicle for the acquisition through a merger, capital stock exchange,asset acquisition, or other similar business combination (“Business Combination”)of an operating business in the paper, packaging, forest products and relatedindustries.

 

On January 2, 2007, theCompany acquired substantially all of the assets and assumed certainliabilities of the Kraft Papers Business (KPB) from International Paper Company(IP). The accompanying condensed consolidated financial statements include theresults of KPB since this date. Prior to the acquisition of KPB, the Companyhad no operations and was considered a development stage company.

 

# **2**.                                      Reclassification

# ** **

Otherincome related to commissions the Company received from IP in the 2007 periodhas been reclassified to other operating income to conform to the currentperiod presentation. The reclassification had no effect on net income.  In addition, the change in deferred incometaxes of $1.0 million reported in the statement of cash flows in the 2007period has been reclassified from accrued expenses to conform to the currentperiod presentation.

 

# **3.**                                      AccountingPronouncements

# ** **

In September 2006, theFinancial Accounting Standards Board (“FASB”) issued Statement of Financial AccountingStandards (“SFAS”) No. 157, *Fair ValueMeasurements*. SFAS No. 157 defines fair value, establishes aframework for measuring fair value and expands disclosures about fair valuemeasurements but does not change existing guidance as to whether or not aninstrument is carried at fair value.  InFebruary 2008, the FASB released a FASB Staff Position, which delayed theeffective date of SFAS No. 157 for all nonfinancial assets and liabilities,except those that are recognized or disclosed at fair value in the condensedconsolidated financial statements on a recurring basis. SFAS No. 157 was firsteffective for the Company on January 1, 2008. 

4

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# ** **

The impact of the adoption of SFAS No. 157 on our financial assets andliabilities, which are principally comprised of cash equivalents, did not havea significant impact on their fair value measurements or require expandeddisclosures.

 

# **4.**                                      Stockholder’sequity

# ** **

Inconnection with the Company’s initial public offering, on August 19, 2005,the Company sold 20,000,000 units (“Units”) for a gross price of $6.00 perUnit. Each Unit consists of one share of the company’s common stock, $0.0001par value, and two warrants. Each warrant entitles the holder to purchase fromthe Company one share of common stock at an exercise price of $5.00 and expireson August 15, 2009. The warrants are redeemable by the Company at a priceof $0.01 per warrant upon 30 days notice after the warrants becomeexercisable, only in the event that the last sale price of the common stock isat least $8.50 per share for any 20 trading days within a 30 day tradingperiod ending on the third day prior to the date on which notice of redemptionis given.

 

# **5.**                                      Inventories

# ** **

Inventoriesconsist of the following at March 31, 2008, and December 31, 2007,respectively ($000’s):

 
| ** **                     | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **2008**           | ** ** | **2007**              | ** ** |
| Raw materials                  |       | $                  | 5,255      |                  | $          | 5,351 |   |
| Work in process                |       | 559                |       | 655                   |       |
| Finished goods                 |       | 4,882              |       | 6,363                 |       |
| Replacement parts and supplies |       | 3,762              |       | 3,989                 |       |
|                           |       |               |       |                  |       |
| Inventories                    |       | $                  | 14,458     |                  | $          | 16,358 |   |

 

# **6.**                                      Incometaxes

# ** **

TheCompany’s U.S. federal statutory tax rate is 35% for 2008 and 2007. The Company’seffective tax rate for the three months ended March 31, 2008 and 2007 was36.8% and 36.3%, respectively. Differences between the effective tax rate and the federal statutory taxrate are due to the impact of state tax, net of federal benefit and the domesticmanufacturing deduction.

 

Inthe normal course of business, we are subject to examination by taxingauthorities. The Company’s open tax years are 2005 through 2007.

 

**7.**                                      **Net income per share**

 

Basicand diluted net income per share is calculated as follows ($ 000’s except forshare and per share data):

 

5

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| ** **                                                               | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                               | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| Net income as reported                                                   |       | $                                                    | 7,230      |   | $ | 7,078 |   |
| Weighted-average number of common shares for basic net income per  share |       | 25,282,047                                           |       | 24,973,333 |   |
| Incremental effect of dilutive common stock equivalents:                 |       |                                                 |       |   |   |
| Common stock warrants                                                    |       | 9,219,778                                            |       | 8,895,600 |   |
| Unvested restricted stock awards                                         |       | 55,499                                               |       | — |   |
|                                                                     |       |                                                 |       |   |   |
| Weighted-average number of shares for diluted                            |       | 34,557,324                                           |       | 33,868,933 |   |
|                                                                     |       |                                                 |       |   |   |
| Net income per share – basic                                        |       | $                                                    | 0.29       |   | $ | 0.28 |   |
|                                                                     |       |                                                 |       |   |   |
| Net income per share – diluted                                      |       | $                                                    | 0.21       |   | $ | 0.21 |   |

 

Stockoption grants totaling 631,050 were outstanding during the three month periodended March 31, 2008, but were not included in the computation of dilutedearnings per share because the effect of including the stock option grantswould be anti-dilutive.

 

Underwriter’spurchase option of 1,000,000 units were outstanding during the three monthperiod ended March 31, 2008 and 2007, but were not included in thecomputation of diluted earnings per share because the effect of including theunderwriter’s option would be anti-dilutive.

 

# **8.**                                      Pensionplan and post retirement benefits

# ** **

**DefinedBenefit Plan**

 

Aspart of the Company’s acquisition of the Kraft Papers Business (KPB) in January of2007, the Company established the KapStone Paper and Packaging CorporationDefined Benefit Plan (“Plan”) to provide benefits for approximately 560 unionrepresented employees.  This plan is part of the collective bargainingagreement between Kapstone and the United Steel, Paper and Forestry, Rubber,Manufacturing, Energy, Allied-Industrial, Chemical and Service Workers Union,AFL-CIO, CLC.  The assumed liability for the retroactive benefits providedfor prior service was $1.4 million at January 2, 2007, and employeesaccrue benefits under the Plan as of January 1, 2007.

 

Netpension cost recognized for the three months ended March 31, 2008 and 2007for the Company’s pension plan, is as follows ($ 000’s):

 
| ** **                                       | ** ** | **Three Months Ended March 31,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                       | ** ** | **2008**                                        | ** ** | **2007** | ** ** |
|                                             |       |                                            |       |   |   |
| Service cost for benefits earned during the year |       | $                                               | 306        |   | $ | 287 |   |
| Interest cost on projected benefit obligations   |       | 39                                              |       | 20 |   |
| Expected return on plan assets                   |       | (6                                              | )          | — |   |
| Amortization of prior service cost               |       | —                                          |       | 25 |   |
| Net pension cost                                 |       | $                                               | 339        |   | $ | 332 |   |

 

KapStonewill fund its pension plan according to IRS funding limitations. Based on thoselimitations, KapStone expects to contribute $1.1 million to the pension planduring the third quarter of 2008.

 

6

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**OtherPost-retirement Benefits**

 

As part of the KPB acquisition,the Company assumed certain liabilities for retiree medical/life obligationsfor employees not eligible to retire at December 31, 2006 of $0.9 million.Net postretirement cost recognized for the three months ended March 31,2008 and 2007 for the Company’s retiree medical and life insurance plan wasless than $0.1 million, respectively.

 

**DefinedContribution Plans**

 

In January 2007, theCompany established a defined contribution plan covering all eligibleemployees. Company contributions to the 401(k) plan are based on matchingof employee contributions, vest immediately for salaried employees and vestafter three years for union employees. For each of the three months ended March 31,2008 and 2007, the Company recognized expense of $0.4 million for matchingcontributions.

 

The Company’s RetirementSavings Plan, which covers all eligible salaried employees, provides forcontributions based on an employee’s salary and age.  The Company contributions vest 100% afterthree years. For the three months ended March 31, 2008 and 2007, theCompany recognized expense for contributions to the Retirement Savings Plan of$0.2 million. Retirement Savings Plan contributions are made to employees’ 401(k) accountsin January of each year.

 

**9.             Stock-Based Compensation**

 

On December 29, 2006,stockholders approved the 2006 Incentive Plan (“Plan”).  A maximum of3.0 million shares of our common stock, available for issuance pursuant tostock options, restricted stock awards or stock appreciation rights(collectively called “Awards”), may be granted under the Plan. If any Award isforfeited or expires without being exercised, or if restricted stock isrepurchased by the Company, the shares of stock subject to the Award shall beavailable for additional grants under the Plan. The number of shares availableunder the Plan is subject to adjustment in the event of any stock split, stockdividend, recapitalization, spin-off or other similar action. Awards may begranted to employees, officers and directors of, and consultants or advisorsto, the Company and any subsidiary corporations. Options intended to qualify,under the standards set forth in certain federal tax rules, as incentive stockoptions (“ISOs”) may be granted only to employees while actually employed theCompany. Non-employee directors, consultants and advisors are not entitled toreceive ISOs. Option Awards granted under the Plan are exercisable for a periodfixed by the administrator, but not longer than 10 years from the date ofgrant, at an exercise price which is not less than the fair market value of theshares on the date of the grant.

 

In April 2007, the Company’sCompensation Committee approved the issuance of 174,000 shares of restrictedstock and 631,050 stock options to directors, executive officers and employeesof the Company. KapStone accounts for these awards under SFAS No. 123(R), *Share-Based Payment*, which requires thatthe cost resulting from all share-based payment transactions be recognized ascompensation cost over the vesting period based on the fair value of theinstrument on the date of grant. The Company recognized $0.2 million ofcompensation cost for the three months ended March 31, 2008.

 

At March 31, 2008, theCompany reserved 3.0 million shares of common stock for stock option andrestricted stock awards.

 

7

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**StockOptions**

 

The stock options vest asfollows: 50% after two years and the remaining 50% after three years.  Thestock options have a contractual term of seven years. The stock options aresubject to forfeiture should these employees terminate their employment withthe Company for certain reasons prior to vesting in their awards, or theoccurrence of certain other events such as termination with cause. The exerciseprice of these stock options is based on closing market price of our commonstock on the date of grant and compensation expense is recorded on anaccelerated basis over the awards’ vesting periods.

 

A summary of informationrelated to stock options is as follows:

 
| ** **                              | ** ** | ** **  | ** ** | **Weighted** | ** ** | **Weighted**          | ** ** | **Intrinsic**        | ** ** |
|-----------------------------------------|------------|-------------|------------|--------------|------------|-----------------------|------------|----------------------|------------|
| ** **                              | ** ** | ** **  | ** ** | **Average**  | ** ** | **Average**           | ** ** | **Value**            | ** ** |
| ** **                              | ** ** | ** **  | ** ** | **Exercise** | ** ** | **Remaining**         | ** ** | **(dollars in** | ** ** |
| ** **                              | ** ** | **Options** | ** ** | **Price**    | ** ** | **Life (Years)** | ** ** | **Thousands)**       | ** ** |
| **Outstanding at January 1, 2008** |       | 631,050     |       | $            | 6.77       |                  | 6.3        |                 | $          | 147 |   |
| Granted                                 |       | —      |       | —       |       | —                |       | —               |       |
| Exercised                               |       | —      |       | —       |       | —                |       | —               |       |
| Lapsed (forfeited or canceled)          |       | —      |       | —       |       | —                |       | —               |       |
| **Outstanding at March 31, 2008**  |       | 631,050     |       | $            | 6.77       |                  | 6.0        |                 | $          | (92 | ) |
| **Exercisable at March 31, 2008**  |       | —      |       | —       |       | —                |       | —               |       |

 

Total stock-based compensationrecorded in the Condensed Consolidated Statement of Income related to the stockoption grants was $0.1 million for the three months ended March 31, 2008.

 

As of March 31, 2008,there was $0.8 million of total unrecognized compensation cost related tonon-vested stock options. That cost is expected to be recognized over aweighted average period of two years. No stock options were vested as of March 31,2008.

 

**RestrictedStock**

 

In April 2007, the Company’sCompensation Committee granted 174,000 restricted shares of common stock toexecutive officers and employees as compensation for service. These commonstock shares are restricted as to transferability until they vest three yearsfrom the grant date. These restricted shares are subject to forfeiture shouldthese employees terminate their employment with the Company for certain reasonsprior to vesting in their awards, or the occurrence of certain other events.The value of these restricted shares is based on the closing market price ofour common stock on the date of grant and compensation expense is recorded on astraight-line basis over the awards’ vesting periods.

 

The following table summarizesour restricted stock amounts and activity:

 
| ** **                              | ** ** | ** ** | ** ** | **Weighted** | ** ** |
|-----------------------------------------|------------|------------|------------|--------------|------------|
| ** **                              | ** ** | ** ** | ** ** | **Average**  | ** ** |
| ** **                              | ** ** | ** ** | ** ** | **Grant**    | ** ** |
| ** **                              | ** ** | **Shares** | ** ** | **Price**    | ** ** |
| **Outstanding at January 1, 2008** |       | 174,000    |       | $            | 6.76       |   |
| Granted                                 |       | —     |       | —       |       |
| Vested                                  |       | —     |       | —       |       |
| Forfeited                               |       | —     |       | —       |       |
| **Outstanding at March 31, 2008**  |       | 174,000    |       | $            | 6.76       |   |

 

8

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Total stock-based compensationrecorded in the Condensed Consolidated Statement of Income related to therestricted stock awards was $0.1 million for the three months ended March 31,2008. As of March 31, 2008, there was $0.7 million of total unrecognizedcompensation cost related to the restricted stock which will be recognized overthe remaining vesting period of two years.

 

**10.          Segment Information**

 

The Company operates in onegeographic segment, the United States. The Company operates in two operatingsegments: unbleached kraft and dunnage bags. The unbleached kraft segmentproduces a variety of unbleached kraft paper and linerboard products. Theseproducts are sold to customers who convert the paper into end-market finishedproducts. The dunnage bags segment converts unbleached Kraft paper and filminto inflatable dunnage products, which are used to secure freight to minimizemovement and potential damage of goods and products during transport. Theproducts are sold to distributors and on a direct basis for use bymanufacturers, less-than-trailer-load carriers and retail regional distributioncenters. Corporate expenses that benefit the entire organization are notcharged to the operating segments. Corporate assets represent mainly cash andcash equivalents, capitalized software for a new ERP system, deferred acquisitioncosts and deferred income taxes.

 
| ** **                                                                          | ** ** | **Three Months Ended March 31,** | ** ** |
|-------------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| **Operating Segment (in thousands of U.S. dollars):** | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| Net sales:                                                                          |       |                                                 |       |   |   |
| Unbleached kraft                                                                    |       | $                                                    | 60,360     |   | $ | 58,481 |   |
| Dunnage bags                                                                        |       | 7,892                                                |       | 7,768 |   |
| Elimination of intersegment sales to  Dunnage bags                                  |       | (1,123                                               | )          | (822 | ) |
|                                                                                |       |                                                 |       |   |   |
| Total                                                                               |       | $                                                    | 67,129     |   | $ | 65,427 |   |
|                                                                                |       |                                                 |       |   |   |
| Net sales to external customers:                                                    |       |                                                 |       |   |   |
| Unbleached kraft                                                                    |       | $                                                    | 59,237     |   | $ | 57,659 |   |
| Dunnage bags                                                                        |       | 7,892                                                |       | 7,768 |   |
|                                                                                |       |                                                 |       |   |   |
| Total                                                                               |       | $                                                    | 67,129     |   | $ | 65,427 |   |
|                                                                                |       |                                                 |       |   |   |
| Operating income / (loss):                                                          |       |                                                 |       |   |   |
| Unbleached kraft                                                                    |       | $                                                    | 14,550     |   | $ | 13,514 |   |
| Dunnage bags                                                                        |       | 1,331                                                |       | 1,495 |   |
| Corporate                                                                           |       | (4,236                                               | )          | (3,144 | ) |
|                                                                                |       |                                                 |       |   |   |
| Total                                                                               |       | $                                                    | 11,645     |   | $ | 11,865 |   |
|                                                                                |       |                                                 |       |   |   |
| Depreciation and amortization:                                                      |       |                                                 |       |   |   |
| Unbleached kraft                                                                    |       | $                                                    | 2,473      |   | $ | 2,133 |   |
| Dunnage bags                                                                        |       | 91                                                   |       | 40 |   |
| Corporate                                                                           |       | 29                                                   |       | 8 |   |
|                                                                                |       |                                                 |       |   |   |
| Total                                                                               |       | $                                                    | 2,593      |   | $ | 2,181 |   |

 

9

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| Total assets (at March 31, 2008 and  2007): |   |   |    |   |   |
|--------------------------------------------------|--------|--------|---------|--------|--------|
| Unbleached kraft                                 |   | $      | 143,524 |   | $      | 155,045 |   |
| Dunnage bags                                     |   | 16,862 |    | 11,394 |   |
| Corporate                                        |   | 69,349 |    | 40,627 |   |
|                                             |   |   |    |   |   |
| Total                                            |   | $      | 229,735 |   | $      | 207,066 |   |
|                                             |   |   |    |   |   |
| Capital spending:                                |   |   |    |   |   |
| Unbleached kraft                                 |   | $      | 775     |   | $      | 2,049 |   |
| Dunnage bags                                     |   | 121    |    | 29     |   |
| Corporate                                        |   | 1,405  |    | — |   |
|                                             |   |   |    |   |   |
| Total                                            |   | $      | 2,301   |   | $      | 2,078 |   |

 

**11.          Subsequent Events**

 

**AssetPurchase Agreement**

 

On April 4, 2008, theCompany signed an asset purchase agreement with MeadWestvaco Corporation topurchase substantially all the assets and assume certain liabilities of theNorth Charleston Kraft Division for $485 million, subject to certainpost-closing adjustments. The acquisition consists of an unbleached kraft papermanufacturing facility and electric cogeneration facility in North Charleston,South Carolina and a lumber business located in Summerville, South Carolina.KapStone expects to close the acquisition by September 30, 2008, subjectto customary closing conditions, including regulatory review and receipt offinancing.

 

Financing for the acquisitionis expected to be secured by a new five year credit facility of $585 million.

 

The Charleston Kraft Divisionbusiness was deemed an attractive acquisition candidate based on meeting theCompany’s objectives of being a North American based profitable company in thepaper and packaging industry and for its synergies with the Company’s business.

 

**Stock-BasedAwards**

 

On April 10, 2008, theCompany’s Compensation Committee approved the issuance of approximately 175,000shares of restricted stock units and 690,000 stock options to directors,executive officers and employees of the Company under the Company’s 2006Incentive Plan.

 

10

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**Item 2.****        MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

This Quarterly Report on Form 10-Qincludes forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. We have based these forward-lookingstatements on our current expectations and projections about future events.These forward-looking statements are subject to known and unknown risks,uncertainties and assumptions about us that may cause our actual results,levels of activity, performance or achievements to be materially different fromany future results, levels of activity, performance or achievements expressedor implied by such forward-looking statements. In some cases, you can identifyforward-looking statements by terminology such as “may,” “should,” “could,” “would,”“expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or thenegative of such terms or other similar expressions. Factors that might causeor contribute to such a discrepancy include, but are not limited to, thosedescribed in Item 1A in this Form 10-Q and in our other Securities andExchange Commission filings.  Theinformation contained in this form 10-Q represents our best judgment at thedate of this report based on information currently available.  In providing forward-looking statements,KapStone does not intend, and does not undertake any duty or obligations, toupdate their statements as a result of new information, future events orotherwise.

 

The following discussion shouldbe read in conjunction with our Condensed Consolidated Financial Statements andrelated Notes thereto included elsewhere in this report.

 

**Overview**

 

We were formed on April 15,2005 to serve as a vehicle to effect a merger, capital stock exchange, assetacquisition or other similar business combination (“Business Combination”) withan operating business in the paper, packaging, forest products and relatedindustries.

 

On January 2, 2007, theCompany purchased substantially all of the assets and  assumed certain liabilities of the KraftPapers Business, or KPB, a division of International Paper Company (IP),consisting of an unbleached kraft paper manufacturing facility in RoanokeRapids, North Carolina and Ride Rite® Converting, an inflatable dunnage bagmanufacturer located in Fordyce, Arkansas, for a cash purchase price of $155million in cash less certain post-closing adjustments of $7.8 million, plus twocontingent earn-out payments of up to $60 million (in aggregate), based on KPB’sannual earnings before interest, income taxes, depreciation and amortization,or EBITDA, during the five years immediately following the acquisition.  Any contingent earn-out payments will beaccounted for as additional purchase price consideration and recorded asgoodwill.  

 

The accompanying managementdiscussion and analysis include the results of KPB since January 2, 2007.Prior to the acquisition of KPB, the Company had no operations nor generatedoperating revenues and was considered a development stage company.

 

11

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On April 4, 2008, theCompany signed an asset purchase agreement with MeadWestvaco Corporation (MW)to purchase substantially all of the assets and assume certain liabilities ofMW’s Charleston Kraft Division (CKD) for $485 million, subject to certainpost-closing adjustments.  Theacquisition consists of an unbleached kraft paper manufacturing facility andelectric cogeneration facility in North Charleston, South Carolina and a lumberbusiness located in Summerville, South Carolina.  KapStone expects to close the acquisition by September 30,2008, subject to customary closing conditions, including regulatory review andreceipt of financing.  The resultsreported below do not reflect any actual or pro forma adjustments related tothe acquisition.  See Liquidity andCapital Resources – Future Cash Needs for discussion of the credit facilitythat is expected to be utilized for borrowings necessary to pay the purchaseprice and other related cash needs.

 

**Comparisonof Results of Operations for the Three Months Ended March 31, 2008 and theThree Months Ended March 31, 2007**

 

The Company’s management uses avariety of financial measurements to analyze its performance. Thesemeasurements include (1) Operating Income, (2) Productivity, (3) Selling,General & Administrative (“SG&A”) expenses and (4) Averagerevenue per ton (for unbleached kraft) and average revenue per dunnage bag (forRide Rite® Converting).

 

*Operating Income.*    Operatingincome is used by the Company’s management primarily as a measure of itssegments’ operating performance. The Company’s management defines operatingincome as sales minus costs associated with these sales. Sales include sales ofunbleached kraft paper products, linerboard and dunnage bags net of termallowances and discounts. For purposes of calculating operating income, costsinclude the cost of raw materials, labor, maintenance, depreciation andamortization, distribution expenses and selling, general and administrativeexpenses.

 

*Selling, General and Administrative Expenses.*   SG&Aexpenses include selling, customer service and corporate employee salaries andbenefits, professional fees, and information technology expenses, includingfees paid to IP for transitional services support.

 

*AverageRevenue per Ton/Dunnage Bag.*  Average revenue per ton/bag represents the grossrevenue divided by the tons of unbleached kraft paper or the number of dunnagebags sold, as applicable.

 
| ** **                                              | ** ** | **Three Months Ended March 31,** | ** ** | **Increase/** | ** ** |
|---------------------------------------------------------|------------|------------------------------------------------------|------------|---------------|------------|
| **(in thousands of U.S. dollars):** | ** ** | **2008**                                             | ** ** | **2007**      | ** ** | **(Decrease)** | ** ** |
| Net sales                                               |       | $                                                    | 67,129     |          | $          | 65,427 |   | $ | 1,702 |   |
| Cost of sales, excluding depreciation                   |       | 41,558                                               |       | 42,436        |       | (878 | ) |
| Freight and distribution                                |       | 6,587                                                |       | 5,686         |       | 901 |   |
| Selling, general and administrative  expenses           |       | 4,930                                                |       | 3,720         |       | 1,210 |   |
| Depreciation and amortization expenses                  |       | 2,593                                                |       | 2,181         |       | 412 |   |
| Other operating income                                  |       | 184                                                  |       | 461           |       | (277 | ) |
| Operating income                                        |       | 11,645                                               |       | 11,865        |       | (220 | ) |
| Interest income                                         |       | 547                                                  |       | 397           |       | 150 |   |
| Interest expense                                        |       | 753                                                  |       | 1,156         |       | (403 | ) |
| Income before provision for income taxes                |       | 11,439                                               |       | 11,106        |       | 333 |   |
| Provision for income taxes                              |       | 4,209                                                |       | 4,028         |       | 181 |   |
| Net income                                              |       | $                                                    | 7,230      |          | $          | 7,078 |   | $ | 152 |   |

 

12

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Net sales for the quarter endedMarch 31, 2008, were $67.1 million compared to $65.4 million for the firstquarter of 2007, an increase of 2.6%. The increase in net sales was driven byhigher prices in the unbleached kraft segment, partially offset by lowervolume. Dunnage bag sales were up 1.3%. Refer to the segment results below fordetailed sales information for each segment.

 

Cost of sales for the quarterended March 31, 2008, was $41.6 million compared to $42.4 million for thefirst quarter of 2007, a 1.9% decrease. The decrease in cost of sales wasmainly due to a $1.5 million non-cash purchase accounting charge to adjust acquiredinventory to fair value as part of the KPB acquisition that occurred in the2007 quarter and lower unbleached kraft volume of $0.7 million in the 2008quarter. Partially offsetting these decreases were inflation on energy and rawmaterial costs and lower production levels which increased cost of sales by$1.4 million and $0.6 million, respectively, for the three months ended March 31,2008.

 

Freight and distributionexpenses for the quarter ended March 31, 2008, totaled $6.6 millioncompared to $5.7 million for the quarter ended March 31, 2007. Theincrease of $0.9 million reflects higher transportation rates due to fuel oilsurcharges, a higher percentage of shipments by truck and customer mix.

 

Selling, general andadministrative expenses for the quarter ended March 31, 2008 totaled $4.9million compared to $3.7 million for the quarter ended March 31, 2007. Theincrease of $1.2 million is due to highercompensation costs of $0.7 million mainly for corporate employees hiredthroughout the second half of 2007 and early 2008. In addition,professional fees and occupancy costs were higher by $0.2 million in quarterended March 31, 2008.

 

Depreciation and amortizationfor the quarter ended March 31, 2008, totaled $2.6 million compared to$2.2 million for the quarter ended March 31, 2007. The increase of $0.4million reflects depreciation on 2007 capital expenditures and amortization ofintangible assets.

 

Other operating income for thequarters ended March 31, 2008 and 2007, totaled $0.2 million and $0.5million respectively. Other operating income includes commissions the Companyreceives from marketing bleached paper produced by IP and sold to KapStonecustomers.

 

Interestincome for the quarters ended March 31, 2008 and 2007 was $0.5 million and$0.4 million, respectively. Interest income represents earnings on the Company’scash and cash equivalents. The increase in interest income reflects a higheramount of cash being invested during the quarter ended March 31, 2008,partially offset by lower interest rates.

 

Interestexpense for the quarters ended March 31, 2008 and 2007, was $0.8 millionand $1.2 million, respectively. Interest expense reflects interest on theCompany’s long-term debt and amortization of deferred debt issuance costs.Interest expense was $0.4 million less in the quarter ended March 31,2008, due to a lower amount of outstanding debt and lower interest rates.

 

Provision forincome taxes for the quarter ended March 31, 2008, reflects an effectivetax rate of 36.8% compared to 36.3% for the similar period in 2007. The increasein the effective tax rate reflects a lower benefit from the manufacturingdeduction.

 

**Segment Results**

 

The followingtable presents a reconciliation of consolidated net sales and operating incometo amounts reported by operating segment:

 

13

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| ** **                                     | ** ** | **Three Months Ended March 31,** | ** ** |
|------------------------------------------------|------------|------------------------------------------------------|------------|
| **Operating Segment ($000’s):** | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| Consolidated net sales:                        |       |                                                 |       |   |   |
| Unbleached kraft                               |       | $                                                    | 60,360     |   | $ | 58,481 |   |
| Dunnage bags                                   |       | 7,892                                                |       | 7,768 |   |
| Elimination of intersegment sales              |       | (1,123                                               | )          | (822 | ) |
|                                           |       |                                                 |       |   |   |
| Total net sales                                |       | $                                                    | 67,129     |   | $ | 65,427 |   |
|                                           |       |                                                 |       |   |   |
| Operating income / (loss):                     |       |                                                 |       |   |   |
| Unbleached kraft                               |       | $                                                    | 14,550     |   | $ | 13,514 |   |
| Dunnage bags                                   |       | 1,331                                                |       | 1,495 |   |
| Corporate                                      |       | (4,236                                               | )          | (3,144 | ) |
|                                           |       |                                                 |       |   |   |
| Total operating income                         |       | $                                                    | 11,645     |   | $ | 11,865 |   |

 

The following representsanalysis and commentary for results of operations for the Company’s twooperating segments: Unbleached kraft and Dunnage bags.

 

***Unbleached Kraft***

 
| ** **                      | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                    | 60,360     |   | $ | 58,481 |   |
| Operating income ($000’s): |       | $                                                    | 14,550     |   | $ | 13,514 |   |
| Operating income % of net sales |       | 24.1                                                 | %          | 23.1 | % |
|                            |       |                                                 |       |   |   |
| Average revenue per ton         |       | $                                                    | 571        |   | $ | 537 |   |
| Tons of paper sold              |       | 105,650                                              |       | 108,953 |   |

 

For the threemonths ended March 31, 2008, unbleached kraft segment net sales increasedby $1.9 million, or 3.2%, to $60.4 million compared to$58.5 million for the three months ended March 31, 2007. Averagerevenue per ton increased $34/ton, approximately $3.6 million, due to the fullrealization of 2007 price increases. Volume of paper sold decreased by3,303 tons driven by greater 2007 inventory sales volumes and lightergrade mix partially offset by one additional operating day in 2008.  Intersegment sales to the dunnage bag segmentof $1.1 million increased by $0.3 million.

 

Unbleachedkraft segment operating income increased by $1.1 million, or 8.1%, to$14.6 million for the three months ended March 31, 2008 compared to$13.5 million for the three months ended March 31, 2007. Higheraverage revenue per ton contributed $3.6 million of the increasedoperating income. The impact of the pricing gains was partially offset by lowervolume of $1.4 million. Inflation on energy, chemicals, freight and other costsnegatively impacted operating income by $2.0 million for the quarter ended March 31,2008.  In addition, 2007 

 

14

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operating income included a$1.2 million non-cash purchase accounting charge adjusting acquired finishedgoods inventory to fair value. Operating income in the quarter ended March 31,2008, was also negatively impacted by production levels that were 2.5% belowthe similar period in 2007. Operating income as a percent of net sales improvedto 24.1%.

 

***Dunnage Bags***

* *
| ** **                      | ** ** | **Three Months Ended March 31,** | ** ** |
|---------------------------------|------------|------------------------------------------------------|------------|
| ** **                      | ** ** | **2008**                                             | ** ** | **2007** | ** ** |
| Net sales ($000’s):        |       | $                                                    | 7,892      |   | $ | 7,768 |   |
| Operating income ($000’s): |       | $                                                    | 1,331      |   | $ | 1,495 |   |
| Operating income % of net sales |       | 16.9                                                 | %          | 19.2 | % |
|                            |       |                                                 |       |   |   |
| Average revenue per bag         |       | $                                                    | 3.76       |   | $ | 3.80 |   |
| Bags sold (000’s)          |       | 2,101                                                |       | 2,044 |   |

 

For the threemonths ended March 31, 2008, net sales for the dunnage bag segmentincreased by $0.1 million, or 1.3%, to $7.9 million compared to$7.8 million for the three months ended March 31, 2007 mainly due toa 2.8% increase in unit sales. Average revenue per bag of $3.76 decreased by$0.04 or 1.1%, for the three months ended March 31, 2008 compared to thesimilar period in the prior year due to increased price competition in 2-plybags.

 

Dunnage bagsegment operating income decreased by $0.2 million, or 13.3%, to$1.3 million for the three months March 31, 2008 compared to$1.5 million for the three months ended March 31, 2007. Unfavorablevolume/mix, lower average revenue per bag, inflation on raw material costs andhigher amortization expenses contributed approximately $0.5 million of thereduction to operating income. Operating income for the quarter ended March 31,2007, included a $0.3 million non-cash purchase accounting charge adjustingacquired finished goods inventory to fair value as part of the KPB acquisition.Operating income as a percent of net sales declined to 16.9%.

 

***Corporate***

 

Corporateexpenses for the three months ended March 31, 2008 totaled$4.2 million compared to $3.1 million for the year three months March 31,2007. The increase of $1.1 million is due to higher compensation relatedcosts of $0.7 million reflecting the hiring of corporate employees which tookplace mainly during the second half of 2007 and early 2008. In addition,professional fees and occupancy costs were higher in quarter ended March 31,2008 by $0.2 million.

 

**Liquidityand Capital Resources**

 

***KPB Acquisition***

 

On January 2, 2007, weconsummated the purchase of substantially all of the assets and the assumptionof certain liabilities of KPB. The assets consist of an unbleached kraft papermanufacturing facility in Roanoke Rapids, North Carolina and Ride Rite®Converting, an inflatable dunnage bag manufacturer located in Fordyce,Arkansas. The liabilities assumed consist of trade accounts payable, accruedexpenses and certain long term liabilities. The purchase price for theacquisition was $155.0 million in cash less certain post-

 

15

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closing adjustments of $7.8million, plus contingent earn-out payments of up to $60.0 million (inaggregate) based on KPB’s annual earnings before interest, income taxes,depreciation and amortization (“EBITDA”) during the five year periodimmediately following the acquisition. The first contingent payment will beequal to 5.3 times KPB’s average annual EBITDA for the five year periodimmediately following the acquisition, less $165.0 million and subject to amaximum of $35.0 million. The second contingent payment is an “all ornothing” payment and is payable if, and only if, KPB’s average annual EBITDAfor the same five year period equals or exceeds $49.2 million. Generally, bothpayments, if earned, will be due and paid at the end of the five year period.

 

If these contingent earn-outpayments are made, they will be accounted for as additional purchase priceconsideration.

 

Funding for the acquisitioncame from restricted cash funds held in trust at December 31, 2006totaling $115.2 million and the establishment of a new credit facility for$60.0 million.

 

***Credit Facility***

 

In connection with the KPBacquisition, the Company’s subsidiary, KapStone Kraft, obtained a seniorsecured credit facility which provides us with the ability to borrow up to$95.0 million pursuant to a five year $35.0 million revolving loanand a five year $60.0 million term loan. Advances under the revolving line of credit are primarily based uponpercentages of eligible accounts receivable and inventories.  The facility expires on December 31,2011. At March 31, 2008, availability under revolving loan was $34.3million.

 

The term loan has remainingprincipal payments of:  $1.5 million on June 30,September 30 and December 31 of 2008; quarterly payments totaling$6.3 million in 2009 and 2010; $1.7 million on March 31, June 30and September 30 of 2011; and $15.2 million on December 31,2011.

 

We are also required to makeprepayments on the term loan under certain circumstances from the net cashproceeds of certain asset dispositions and issuances of securities or debt and,within 100 days after the end of December 31, 2007 and  2008, 50% of excess cash flow from suchfiscal year.  The Company paid the 2007excess cash prepayment of $11.6 million on April 8, 2008.

 

Borrowings under the revolvingloan accrue interest, at our option, at either: LIBOR plus 1.00% to 1.75% depending on KapStone Kraft’s total debt toEBITDA ratio; or the Base Rate (prime rate) plus 0% to .50% depending onKapStone Kraft’s total debt to EBITDA ratio. Borrowings under the term loan accrue interest, at our option, ateither:  LIBOR plus 1.25% to 2.00% dependingon KapStone Kraft’s total debt to EBITDA ratio; or the Base Rate (prime rate)plus 0% to .50% depending on KapStone Kraft’s total debt to EBITDA ratio. TheBase Rate margin and LIBOR margin shall adjust quarterly upon receipt ofquarterly financial statements.

 

The credit facility contains anumber of significant covenants that, among other things, restrict KapStone’sability to dispose of assets, incur additional indebtedness, prepay otherindebtedness, pay dividends, repurchase or redeem capital stock, enter intocertain investments, make certain acquisitions, engage in mergers andconsolidations, create liens, or engage in certain transactions with affiliatesand otherwise restrict KapStone’s corporate and business activities.  In addition, under the credit facility,KapStone is required to comply with a minimum EBITDA, fixed charge coverageratio and total debt to EBITDA ratio. The credit facility also restricts the aggregate amount of capitalexpenditures incurred by KapStone.

 

16

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Events of default under thesenior secured credit facility include, but are not limited to:  (a) failure to pay principal or interestwhen due; (b) material breach of any representation or warranty; (c) covenantdefaults; (d) default with respect to any other debt with an outstandingprincipal amount in excess of $2.5 million if the effect thereof is toaccelerate or permit the acceleration of such debt; and (e) events ofbankruptcy.

 

The credit facility is securedby all of KapStone’s tangible and intangible assets and a pledge of the capitalstock of KapStone Kraft.

 

***Cash flow***

 

Cash flow from all activitiesduring the quarter ended March 31, 2008, increased by $3.6 million from December 31,2007, reflecting cash generated from operations of $9.9 million, partiallyoffset by net cash outflow from investing activities of $2.8 million and netcash outflow from financing activities of $3.5 million.

 

Net cash inflow from operatingactivities was $9.9 million due to net income for the quarter of $7.2 millionand non-cash charges of $4.3 million. Changes in operating assets andliabilities used $1.6 million reflecting an annual payment of $1.2 million forinsurance premiums, incentive payments of $1.7 million and 401k plancontributions of $0.6 million, partially offset by lower inventories due tolower production levels and lower trade accounts receivables due to improvedcollections.

 

Net cash outflow from investingactivities was $2.8 million reflecting capital expenditures of $2.3 million.For the quarter ended March 31, 2008, capital expenditures mainly reflect$0.8 million for the unbleached kraft segment and include equipment upgradesand replacements at the paper mill in Roanoke Rapids, North Carolina and $1.3million for the Company’s new ERP system. Acquisition costs paid of $0.5 million includes costs incurred for theacquisition of the Charleston Kraft Division of MeadWestvaco.

 

Net cash outflow generated fromfinancing activities totaled $3.5 million during the quarter ended March 31,2008, and reflects a repayment of long-term debt.

 

***Future Cash Needs***

 

Excluding the impact of theanticipated completion of the acquisition of the Charleston Kraft Division(CKD) of MeadWestvaco, we believe that our existing cash, cash equivalents andshort-term investments and cash flow from operations, combined withavailability under our credit facility, will be sufficient to meet ourpresently anticipated future cash needs.

 

In connection with the proposedacquisition of CKD, KapStone entered into a debt commitment letter (the “DebtCommitment Letter”) with LaSalle Bank National Association and Banc of AmericaSecurities LLC with respect to a five year senior secured credit facility inthe aggregate amount of $585 million, consisting of a $100 million revolvingcredit facility and a $485 million term loan facility (the “Facilities”).

 

Such commitments are subject toa number of conditions including, among other, the negotiation, execution anddelivery of satisfactory documentation of the Facilities; the accuracy andcompleteness of certain representations made by KapStone and its affiliates;the absence of certain material adverse changes with respect to KapStone or theCKD business; and the concurrent consummation of the acquisition of CKD inaccordance with applicable law and on 

 

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satisfactory terms.  Certain subsidiaries of KapStone will provideguarantees of KapStone’s obligations under these new Facilities, and theFacilities will be secured by substantially all of KapStone’s and its guarantorsubsidiaries’ assets and capital stock of subsidiaries.  The Debt Commitment Letter contemplates thatthe Facilities will include various customary representation and warranties,affirmative and negative covenants, financial covenants and default provisions.

 

The Company intends to use theproceeds from the Facilities to finance the acquisition of CKD and related feesand expenses, to refinance certain liabilities, and for working capital andgeneral corporate purposes.  Unlessextended, the commitments expire on the earlier of August 29, 2008, or theclosing of the Facilities and related transactions contemplated by the DebtCommitment Letter.

 

**Off-BalanceSheet Arrangements**

 

We have not entered into anyoff-balance sheet financing arrangements and have not established any specialpurpose entities. We have not guaranteed any debt or commitments of otherentities or entered into any options on non-financial assets.

 

**Item 3.—    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKETRISK**

 

Market risk is the sensitivityof income to changes in interest rates, commodity prices, equity prices, andother market-driven rates or prices.

 

Under KapStone Kraft’s CreditFacility, we have a $60 million term loan and a revolving loan of $35 million.At March 31, 2008, the balance of the term loan was $49.0 million andthere were no amounts drawn on the revolving loan. We had two letters of creditoutstanding at March 31, 2008 totaling $0.7 million. Advances under therevolving line of credit are primarily based upon percentages of eligibleaccounts receivable and inventories.  Thefacility has a maturity date of December 31, 2011.

 

Borrowings under the term loanaccrue interest, at our option, at either: LIBOR plus 1.25% to 2.00% depending on the Company’s total debt toEBITDA ratio (as defined in the agreement); or the Base Rate (prime rate) plus0% to .50% depending on KapStone’s total debt to EBITDA ratio. The Base Ratemargin and LIBOR margin adjusts quarterly upon receipt of quarterly financialstatements.

 

Changes in market rates mayimpact the bank’s base rate. For instance, if the bank’s base rate was toincrease or decrease by one percentage point (1.0%), our annual interestexpense would change by approximately $0.4 million based upon our expectedfuture monthly loan balances per our existing repayment schedule.

 

The principal market risk towhich we are exposed is commodity and energy price risk. We are exposed toprice fluctuations of certain commodities used in production as well as fluctuationsin the price of its finished goods. Key raw materials and energy used in theproduction process include roundwood and woodchips, coal, electricity andcaustic soda. We purchase these raw materials and energy at the market prices,and do not use forward contracts or other financial instruments to hedge itsexposure to price risk related to these commodities. Prices for paper andrelated products are subject to market conditions. We have no long-termcontracts to purchase raw materials or energy at fixed prices.

 

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**Item 4. —CONTROLS AND PROCEDURES**

 

As of the end of the period covered by this report, our Chief ExecutiveOfficer and our Chief Financial Officer carried out an evaluation of theeffectiveness of the design and operation of our disclosure controls andprocedures, as required by Rule 13a-15(b) under the Securities ExchangeAct of 1934. Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that our disclosure controls and procedures weredesigned, and were effective, to give reasonable assurance that informationrequired to be disclosed about us and our subsidiary is recorded, processed,summarized and reported within the time periods specified by the rules andforms of the SEC and is accumulated and communicated to management asappropriate to allow timely decisions regarding required disclosure in ourfilings under the Securities Exchange Act of 1934.

 

There were no changes in our internal control over financial reportingduring the three months ended March 31, 2008 that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

**PART II. — OTHER INFORMATION**

 

**Item 1.—    LEGAL PROCEEDINGS**

 

None.

 

**Item 1A. —RISK FACTORS**

 

Except as for the followingupdate to the risk factors relating to the proposed acquisition of theCharleston Kraft Division (CKD) of MeadWestvaco Corporation, there have been nomaterial changes from the Risk Factors described in our Form 10-K for theyear ended December 31, 2007 (“Form 10-K”).  Each of the Risk Factors below should be readin conjunction with the Risk Factors and information disclosed in our Form 10-K.

 

***The anticipated benefits of the CKD acquisition may not be realized.***

 

We entered into the asset purchase agreementwith MeadWestvaco with the expectation that the acquisition of CKD will resultin various benefits including, among other things, benefits relating toenhanced revenues, a broader array of product offerings, the expansion of ourproduction capabilities, operational improvements and a diversification of ourcustomer base. The transaction will present challenges to management, includingthe integration of operations, properties and personnel of CKD and our existingoperations. Achieving the anticipated benefits of the transaction is subject toa number of uncertainties, including, but not limited to, whether we canintegrate our business and the CKD business in an efficient and effectivemanner. Failure to achieve these anticipated benefits could result in increasedcosts, decreases in the amount of expected revenues and diversion of management’stime and energy and could materially impact our business, financial conditionand operating results.

 

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***We may fail to realize theanticipated synergies and cost savings expected from the pending CKDacquisition.***

 

Our success after the CKD acquisition willdepend, in part, on our ability to realize the anticipated growth opportunitiesand cost savings from integrating our business with CKD.  To realize these anticipated benefits, wemust successfully integrate our business with CKD in a manner that permitsthese synergies to be realized.  If weare not able to successfully achieve these objectives, such anticipatedbenefits may not be realized fully, or at all, or may take longer to realizethan expected.

 

***We may have difficultyintegrating our business with the CKD business and may incur substantial costsin connection with the integration.***

 

Achieving the anticipated benefits of thetransaction will depend on the successful integration of our products,operations, personnel, and facilities with those of CKD in a timely andefficient manner.

 

Although we do not anticipate materialdifficulties in connection with such integration, the possibility exists thatsuch difficulties could be experienced in connection with the transaction,especially given the relatively large size of the transaction. The time andexpense associated with integrating our businesses and CKD may exceed ourexpectations and limit or delay the intended benefits of the transaction.Similarly, the process of integrating sales and marketing forces andadministrative functions and coordinating product offerings can take longer,cost more, and provide fewer benefits than initially projected. To the extentany of these events occurs, the benefits of the transaction may be reduced.

 

Integrating our business with CKD will be acomplex, time-consuming and expensive process. Before the transaction, KapStoneand CKD operated independently, each with its own business, products,customers, employees, culture and systems. We may face substantialdifficulties, costs and delays in integrating the two businesses. Thesedifficulties, costs and delays may include:

 

·                  Costs and delays in implementing commonsystems and procedures;

 

·                  Potential charges to earnings resulting fromthe application of purchase accounting to the transaction;

 

·                  Difficulty comparing financial reports due todiffering financial and/or internal reporting systems;

 

·                  Diversion of management resources from thebusiness;

 

·                  Challenges in retaining and integratingmanagement and other key employees of KapStone and CKD;

 

·                  Difficulties in coordinating infrastructureoperations in an effective and efficient manner; and

 

·                  The inability to achieve the synergiesanticipated to be realized from the transaction on the timeline presentlyanticipated, or at all.

 

After the transaction is consummated, we mayseek to combine certain operations and functions using common information andcommunication systems, operating procedures, financial controls and humanresource practices, including training, professional development and benefitprograms. We may be unsuccessful in implementing the integration of these systemsand processes in a timely and efficient manner. Any one or all of these factorsmay cause increased operating costs, worse than anticipated financialperformance and/or the loss of customers and employees. Many of these factorsare also outside of our control.

 

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***We may have difficultyintegrating our system of internal control over financial reporting with thatof CKD.***

 

The failure to integrate our system ofinternal control over financial reporting with that of CKD following thetransaction could affect adversely our ability to exercise effective internalcontrol over financial reporting. A failure to exercise effective internalcontrol over financial reporting could result in a material misstatement in ourannual or interim consolidated financial statements.

 

***As a result of the pending CKDacquisition, including the financing necessary to consummate the transaction,we will have substantial indebtedness.***

 

As a result of the transaction, we expect toincur substantial indebtedness, including the financing necessary to pay thecash consideration and transaction-related costs, in addition to debt assumedfrom CKD. Our substantial indebtedness could have the following consequences:

 

·      Our ability to obtain additional financingfor working capital, capital expenditures, acquisitions, general corporatepurposes or other purposes may be impaired in the future;

 

·      A substantial portion of our cash flow mustbe dedicated to the payment of principal and interest on our indebtedness;

 

·      We will be substantially more leveraged thancertain of our competitors, which might place us at a competitive disadvantage;

 

·      We will be subject to restrictive covenantsthat may negatively affect our operational or financial flexibility or ourability to pursue additional acquisitions;

 

·      We may be hindered in our ability to adjustrapidly to changing market conditions; and

 

·      Our high degree of leverage could make usmore vulnerable in the event of a downturn in general economic conditions orour business.

 

***If the conditions to thepending CKD acquisition are not satisfied or waived, the transaction may notoccur.***

 

Specified conditions set forth in the assetpurchase agreement must be satisfied or waived to complete the CKDacquisition.  If the conditions are notsatisfied or waived, to the extent waiver is permitted by law or the rules orregulations of NASDAQ, the transaction will not occur or will be delayed, andwe may lose some or all of the intended benefits of the CKD acquisition.

 

The following conditions, in addition toother customary closing conditions, must be satisfied or waived, ifpermissible, before we and CKD are obligated to complete the transaction:

 

·      The waiting period (and any extension thereof)applicable to the transaction pursuant to the Hart-Scott-Rodino AntitrustImprovements Act (“HSR Act”), or any other applicable competition, transaction,antitrust or similar law shall have expired or been terminated;

 

·      Specified governmental consents or certainother approvals shall have been obtained and be in full force and effect;

 

·      There must not be any judgment, injunction,decree or order issued by any court or other governmental entity or any otherstatute, law, rule, legal restraint or prohibition which prohibits, materiallyrestricts, makes illegal or enjoins consummation of the transaction; and

 

·      There must not be any action or proceedingpending by a governmental entity challenging or seeking to prevent theconsummation of the transaction.

 

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Except as described above, there have been noother material changes to our risk factors since December 31, 2007.

 

**Item 2.—    UNREGISTERED SALES OF EQUITY SECURITIES AND USE OFPROCEEDS**

 

None.

 

**Item 3.—    DEFAULTS UPON SENIOR SECURITIES**

 

None.

 

**Item 4.—    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS**

 

None.

 

**Item 5.—    OTHER INFORMATION**

 

None.

 

**PART II. — OTHER INFORMATION**

 

**Item 6.—    EXHIBITS**

 

The following Exhibits arefiled as part of this report.

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                        |
|------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                   |
| 2.3              |       | Asset  Purchase Agreement dated April 4, 2008 among MeadWestvaco South Carolina  LLC, MeadWestvaco Corporation, KapStone Paper and Packaging Corporation and  Oak Acquisition, LLC. (1)           |
|             |       |                                                                                                                                                                                                   |
| 3.1              |       | Amended  and Restated By-laws. (1)                                                                                                                                                                     |
|             |       |                                                                                                                                                                                                   |
| 10.12            |       | Debt  Commitment Letter dated April 4, 2008 by and among KapStone Paper and  Packaging Corporation, LaSalle National Bank Association and Banc of America  Securities LLC. (1)                    |
|             |       |                                                                                                                                                                                                   |
| 10.13            |       | Amendment  to the KapStone Paper and Packaging Corporation 2006 Incentive Plan. (2)                                                                                                                    |
|             |       |                                                                                                                                                                                                   |
| 10.14            |       | Performance  Incentive Plan of KapStone Paper and Packaging Corporation. (2)                                                                                                                           |
|             |       |                                                                                                                                                                                                   |
| 10.15            |       | Form of  Restricted Stock Unit Agreement. (2)                                                                                                                                                     |
|             |       |                                                                                                                                                                                                   |
| 31.1             |       | Certification  of Chief Executive Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                                                                   |
| 31.2             |       | Certification  of Chief Financial Officer Pursuant to Rule 13a-14(a) under the  Securities Exchange Act of 1934, as Adopted Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002. |
|             |       |                                                                                                                                                                                                   |
| 32.1             |       | Certification  of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                         |
|             |       |                                                                                                                                                                                                   |
| 32.2             |       | Certification  of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as  Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                         |

 

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| (1)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on April 4,  2008.  |
|--------|--------|--------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                               |
| (2)    |   | Incorporated  by reference to the Registrant’s Current Report filed on Form 8-K on April 10,  2008. |

 

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**SIGNATURES**

 

In accordancewith the requirements of the Exchange Act, the registrant caused this report tobe signed on its behalf by the undersigned, thereunto duly authorized.

 
|              |   | KAPSTONE  PAPER AND PACKAGING CORPORATION   |
|-------------------|--------|---------------------------------------------|
|              |   |                                        |
| May 5,  2008 |   | By:                               | /s/  Andrea K. Tarbox |
|              |   | Andrea  K. Tarbox                           |
|              |   | Vice  President and Chief Financial Officer |

 

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