**Management’s Discussion and Analysis of**

**Financial Condition and Results of Operations**

 

**Overview**

 

Chesapeake Corporation (“Chesapeake”) is aleading supplier of specialty value-added paperboard packaging products in Europe and a leading international supplier of plastic packaging products to niche end-use markets. We focus on specific end-use packaging markets, where customers demand creative designs,technical expertise and production capabilities that include broad geographic coverage and effective supply chain offerings. 

 

Cash flow in 2003 exceeded management’s expectations due to improved working capital utilization (see Liquidity and Capital Resources). We believethat cash generation is a good indicator of how we are managing the company. It is a clearer measure of our performance that is less subject to accounting interpretation. Generating cash receives top priority throughout Chesapeake. Our businessportfolio evaluations and incentive programs are based on cash flow performance as well as earnings performance. 

 

Chesapeake operates in three business segments: 

 

***Paperboard Packaging***

 

The Paperboard Packaging segment designs and manufactures folding cartons, leaflets, labels and other value-added packaging products. Our primary end-use markets arepharmaceutical and healthcare; international and branded products (such as alcoholic drinks, confectioneries, cosmetics and fragrances); tobacco; and food and household. 

 

***Plastic Packaging***

 

The Plastic Packaging segment designs and manufactures plastic containers, bottles, preforms and closures. The primary end-use markets are agrochemicals and otherspecialty chemicals, and food and beverages. 

 

***Land Development***

 

The Land Development segment holds approximately 500 acres of realestate in Virginia as of December 28, 2003. We expect that the liquidation of our land holdings will be substantially complete in the next three to six months. 

 

***Outlook***

 

Overall results achieved during 2003 met management’s expectations as favorable foreign currency translation rates, strong performance in the Plastic Packaging segment and internal growth in the pharmaceuticaland healthcare market sectors helped offset a competitive pricing environment and slower than expected demand for international and branded packaging. Record high summer temperatures in Europe and geopolitical events, including the outbreak of SARSand the Iraqi conflict, negatively affected demand for confectioneries and alcoholic drinks. 

 

Looking ahead, we believe that 2004 results will benefit from increased volume and manufacturing efficiencies from our investments in two new German facilities, which should be fully operational by the end of thefirst quarter of 2004, and capacity enhancements in the Plastic Packaging segment. Additionally, the facility rationalization in Scotland completed in late 2002 should lead to improved results as we expect that the international and branded marketwill recover during 2004. The expected increase in sales volumes should help mitigate the impact of a competitive pricing environment that we expect to continue in 2004. 

 

We continue to focus on innovative packaging design, including unique combinations of raw material substrates andidentification of new applications for existing production processes. In the fourth quarter of 2003, we incurred start-up costs for a significant product launch that included new applications for our existing production capabilities. We expect tocontinue to incur these costs into the first quarter of 2004, after which our sales volumes and margins should benefit. 

 

By the end of 2003, we liquidated most of the land in our Land Development segment. With approximately 500 acres remaining, we do not expect to havesignificant earnings in this segment in 2004. 

 

At December 28,2003, Chesapeake had significant debt maturities in the first half of 2005. We expect to refinance this debt before their maturity dates, which we anticipate will lengthen our maturity schedule and lower our overall cost of capital while enhancingour financial flexibility. In February 2004, the first phase of our refinancing was completed with an amended and restated senior credit facility maturing in 2009 (see Liquidity and Capital Resources). In December 2003, Chesapeake filed a universalshelf registration statement with the Securities and Exchange Commission (“SEC”), which will permit us to offer and sell, from time to time, various types of securities, including debt securities, preferred stock, depository shares, commonstock, warrants, stock purchase contracts and stock purchase units, having an aggregate offering price of up to $300 million, or the equivalent amount in one or more non-U.S. currencies. The use of proceeds from any offering under the shelf registration may include the repayment of indebtedness, financing acquisitions and the repurchase of outstanding Chesapeakesecurities. 

 

On March 1, 2004, we announced our plan topublicly offer 3.4 million shares of our common stock under the shelf registration. Chesapeake also intends to grant to the offering syndicate a 30-day option to purchaseup to 510,000 additional shares, solely to cover over-allotments, if any. We expect the net proceeds from the sale of these shares, after deducting estimated discounts, commissions and expenses, to be approximately$80.7 million (assuming an offering price of $25.21 per share, the last reported sales price of our common stock on February 26, 2004, and excluding the net proceeds from the sale of shares pursuant to the over-allotment option, if any). We expect to use the net proceeds to redeem up to£40.25 million principal amount of our outstanding 10-3/8 percent senior subordinated notes due 2011 at a redemption price equal to 110.375 percent of the principal amount plus accrued and unpaid interest and, to the extent there are excess net proceeds, to repay outstandingborrowings under our senior bank credit facility and to make open market purchases of our other debt securities. We expect the sale of these shares and the use of the net proceeds from such sales to be neutral to earnings per share in fiscal year2004 before one-time charges and slightly accretive to earnings per share in 2005 due to a reduction in high coupon interest expense and related tax benefits. We believe the proposed equity offering, and the expected use of the net proceeds thereof,will strengthen our balance sheet, improve our liquidity and move us closer towards achieving our longer-term goal of attaining an investment grade rating. 

 

Over the next few years, we plan to expand our network of value-added packaging capabilities, which is now located primarily in Europe, throughacquisitions, joint ventures, alliances, and/or internal development of complementary businesses primarily in North America and emerging markets such as the Asia-Pacific region. We believe such expansion would improve our geographical andproduct-line balance and satisfy multinational customers’ desire for broader geographic coverage from their packaging supplier. 

 

**Results of Operations**

 

The following consolidated results from continuing operations highlight major year-to-year changes in our income statement (see page 21 for a discussion of discontinued operations). More detail regarding these changesis found under the caption “Segment Review.” All per share amounts included in Management’s Discussion and Analysis are presented on a diluted basis. 

 

The consolidated financial statements were prepared in conformity with United States (“U.S.”) generally acceptedaccounting principles (“GAAP”) and require management to make extensive use of estimates and assumptions that affect the reported amounts and disclosures (see discussion of Critical Accounting Policies starting on page 26). Actual resultscould differ from these estimates. 

 

Income from continuingoperations before interest and taxes is abbreviated as “EBIT.” Segment EBIT excludes any restructuring charges and gains on sales of businesses. Excluding these amounts from our calculation of segment EBIT is consistent with how ourmanagement reviews segment performance and, we believe, affords the reader consistent measures of our operating performance.

 

***2003 vs. 2002***

 

**Net sales:**Chesapeake’s 2003 net sales of $899.3 million were up 9.4 percent compared to net sales in 2002 of $822.2 million. The increase was primarily due to the favorable effect of foreign currency exchange rates. Net sales decreased approximately3.4 percent excluding the effects of foreign currency translation, primarily reflecting $26.7 million of decreased land sales. Reduced sales volume in the international and branded market sector of the Paperboard Packaging segment, which wasprimarily the result of reduced demand in the travel-related sales channels and record high summer temperatures in Europe which reduced confectionery demand, was partly offset by increased sales volume in the Plastic Packaging segment. The salesincrease from our Plastic Packaging segment related primarily to the food and beverage market due to the heat in Europe and increased business from our investments in Africa. 

 

**Gross margin:**Gross margin, which is defined as net sales less cost of products sold, was $171.2 million in 2003, compared to $158.0million in 2002. Gross margin as a percentage of net sales for 2003 was approximately flat compared to 2002. 

 

**Selling, general and administrative (“SG&A”) expenses:** SG&A expenses as a percentage of net sales were 13.2 percent in 2003 compared to 11.4 percent in 2002. The increase was primarily aresult of increased insurance and pension costs across all segments totalling approximately $5.5 million and increased long-term incentive program costs of approximately $2.4 million. 

 

**Gain on sale of business:**The results for 2003 include the settlement of substantially all of ourindemnification obligations to St. Laurent Paperboard (U.S.) Inc. (“St. Laurent”) related to the 1997 sale of our former kraft products mill in West Point, Virginia. As a result of the settlement, we reduced our accrual for estimatedenvironmental liabilities by $22.2 million in 2003, which resulted in a gain of approximately $11.2 million ($7.7 million, net of income taxes). A settlement payment of $11.0 million was paid during 2003. See Note 14 for additional information onthe previous indemnification obligation and the settlement. 

 

**Restructuringcharges:**The 2002 results included a restructuring charge of $2.6 million ($1.8 million after taxes) for severance costs for approximately 120 employees related to the closure of a facility in Congleton, England, which produced packaging for thefood and household market, and the consolidation of two facilities in Scotland serving the international and branded packaging market of our Paperboard Packaging segment. Severance benefits have been paid to all affected employees, and the reservewas utilized by the end of 2003. 

 

**Other income:**Other income, net, was$11.5 million for 2003 compared to $10.0 million for 2002. The 2003 results included a $4.9 million gain from insurance claims related to equipment damaged in a fire and the 2002 results included a gain of approximately $3.1 million on the sale of afacility in the United Kingdom. 

 

**EBIT:**EBIT was $74.9 million for 2003compared to EBIT of $71.8 million for 2002. In addition to the items noted above, approximately 10.0 percent of the increase in EBIT was due to changes in foreign currency exchange rates. See Segment Review below for further details on segment EBIT.

 

**Interest expense, net:**Net interest expense for 2003 was $42.4 million,down $3.0 million from net interest expense in 2002. Our borrowings include amounts denominated in the local currencies of the countries in which we conduct substantial business, which serve as a partial natural hedge against currency fluctuations.Changes in foreign currency exchange rates increased net interest expense for 2003 by $2.5 million. The overall decrease in net interest expense in 2003 was primarily due to savings generated by lower interest rates, which were a result ofrefinancing fixed-rate debt maturities with lower variable rate borrowings under the senior credit facility and the impact of interest rate swaps (see Risk Management). Additionally, $1.0 million of interest expense related to the construction oftwo new plants in Germany was capitalized in 2003. 

 

**Tax expense:**Theeffective income tax rate for 2003 was approximately 18.5 percent compared to an effective income tax rate of approximately 22.3 percent in 2002. The decrease in our effective income tax rate for 2003 was due to a change in the mix of foreignearnings and the favorable settlement of foreign tax audits. 

 

**Income fromcontinuing operations:**Income from continuing operations for 2003 was $26.5 million, or $1.74 per diluted share, while income from continuing operations for 2002 was $20.5 million, or $1.35 per diluted share. 

 

***2002 vs. 2001***

 

**Net sales:**Chesapeake’s 2002 net sales of $822.2 million were up 4.0 percent compared to net sales in 2001 of $790.5 million.The increase was primarily due to the favorable effects of foreign currency exchange rates, increased land sales and greater sales volumes in the international and branded market sector and the African beverage market. These increases were partiallyoffset by competitive pricing pressure throughout the Paperboard Packaging segment and reduced sales volumes in certain market sectors, primarily technology, food and household, and tobacco. 

 

**Gross margin:**Gross margin for 2002 was $158.0 million compared to $161.2 million in2001. Gross margin as a percentage of net sales for 2002 decreased approximately 1.2 percent compared to 2001, primarily due to reduced margins in the Paperboard Packaging segment resulting from competitive pricing pressure and lower sales volumesin some markets. These reductions were offset, in part, by improved margins in the Plastic Packaging segment. 

 

**SG&A expenses:**SG&A expenses as a percentage of net sales decreased from 13.9 percent in 2001 to 11.4 percent in 2002. The decrease was primarily due to the discontinuation of goodwill amortization (seeNote 4) and reduced corporate headquarters’ costs. Goodwill amortization expense was $14.4 million in 2001. 

 

**Restructuring charges:**As noted above, the 2002 results included a restructuring charge of $2.6 million ($1.8 million after taxes). 

 

During 2001, Chesapeake recognized restructuring charges before income taxesof $14.6 million ($9.3 million after taxes). Approximately $9.2 million was recognized for costs associated with a salaried staff reduction at our corporate headquarters and in our Plastic Packaging segment of approximately 50 positions achieved primarily through a voluntary separation program. The voluntaryseparation program benefits were funded primarily by surplus assets of our U.S. defined benefit salaried pension plan. Approximately 70 percent of the staff reduction had occurred by December 30, 2001, and the remainder occurred during the firstquarter of 2002. Approximately $2.6 million was recognized for the elimination of two corporate office sites and the reduction of the carrying value of a corporate aircraft that was sold in January 2002. As of December 29, 2002, the reserve had beenutilized and approximately 50 employees had received severance benefits. Also during 2001, the Paperboard Packaging segment incurred approximately $2.8 million of severance costs for approximately 100 employees, primarily associated with theintegration of its recent acquisitions. As of December 28, 2003, severance benefits have been paid to all affected employees and the reserve was utilized (see Note 5). 

 

**Other income:**Other income, net, increased to $10.2 million in 2002 compared to $9.4 million in 2001. The increase is due to areduction in facility closure costs, offset, in part, by a reduction in gains on sales of fixed assets. 

 

**EBIT:**EBIT was $71.8 million for 2002 compared to EBIT of $46.0 million for 2001. The increase in EBIT was primarily due to the restructuring charge in 2001 for the reduction of the corporate headquartersstaff, the elimination of goodwill amortization expense in 2002, the benefit realized in 2002 from the staff reduction, the strong results in the Plastic Packaging segment and the favorable effects of foreign currency translation. These increaseswere partially offset by the reduced operating margins in the Paperboard Packaging segment and the 2002 restructuring charge. 

 

**Interest expense, net:**Net interest expense for 2002 was $45.4 million, up $14.1 million from net interest expense for 2001. The increase in interest expense wasprimarily due to a higher average cost of debt resulting from 2001’s fourth quarter issuance of subordinated notes and an amendment to our senior credit facility, changes in foreign currency exchange rates and the interest costs attributed todiscontinued operations in 2001, as well as the timing of the receipt of cash proceeds from discontinued operations in 2001 that were used to pay down debt. 

 

**Tax expense:**The effective income tax rate for 2002 was approximately 22.3 percent compared to a reported 28.6 percent for 2001. The decrease in the effectiveincome tax rate was due to the elimination of non-deductible goodwill amortization. Without goodwill amortization and restructuring charges, the 2001 income tax rate would have been approximately 22.0 percent. 

 

**Income from continuing operations:**Income from continuing operations for 2002 was$20.5 million, or $1.35 per share, up from 2001 income from continuing operations of $10.5 million, or $0.69 per share. The increase in income from continuing operations was primarily due to the elimination of goodwill amortization in 2002 (see Note4), a reduction in restructuring and corporate expenses, offset in part by increased interest expense and reduced operating margins in the Paperboard Packaging segment. 

 

**Segment Review**

 

***Paperboard Packaging***