**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

** **

**FORM 10-Q**

** **

x                                  Quarterly ReportPursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

o                                    Transition ReportPursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934.

 

ForQuarter Ended **June 30, 2006**

CommissionFile Number **1-3439**

 

 

| ** **                                              | **SMURFIT-STONE CONTAINER ENTERPRISES, INC.** | ** ** |
|---------------------------------------------------------|-----------------------------------------------|------------|
| (Exact name of  registrant as specified in its charter) |

 

| Delaware                         |                                                                                                                                     | 36-2041256                         |
|----------------------------------|------------------------------------------------------------------------------------------------------------------------------------------|------------------------------------|
| (State  or other jurisdiction of |                                                                                                                                     | (IRS  Employer Identification No.) |
| incorporation  or organization)  |                                                                                                                                     |                               |
|                             |
|                             | 150 North Michigan  Avenue, Chicago, Illinois       60601                                                  |                               |
|                             | (Address  of principal executive offices)              (Zip  Code) |                               |
|                             |                                                                                                                                     |                               |
|                             | (312)  346-6600                                                                                                                          |                               |
|                             | (Registrant’s  telephone number, including area code)                                                                               |                               |
|                             |                                                                                                                                     |                               |
|                             | Not Applicable                                                                                                                           |                               |
|                             | (Former name, former  address and former fiscal year, if                                                                                 |                               |
|                             | changed since last  report)                                                                                                              |                               |
|                                  |                                                                                                                                          |                                    |  |  |

 

 

Indicate by check mark whether the registrant (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.              Yes x  No o

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Large accelerated filer o   Acceleratedfiler o   Non-acceleratedfiler x

 

Indicate by check markif the registrant is a shell company (as defined in Rule 12b-2 of the Act).

Yes o   Nox

 

APPLICABLE ONLY TO CORPORATE ISSUERS:

 

As of August 3, 2006, the registrant hadoutstanding 770 shares of common stock, $.01 par value per share, all of whichare owned by Smurfit-Stone Container Corporation.

 

**The registrant meets the conditions set forth inGeneral Instruction (H) (1) (a) and (b) of Form 10-Q and is therefore filingthis form with the reduced disclosure format permitted thereby.**

 

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**PART I -FINANCIAL INFORMATION**

** **

**Item 1.    Financial Statements**

 

**SMURFIT-STONECONTAINER ENTERPRISES, INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

**(Unaudited)**

 
| ** **                                                                                                                                                                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                                                                        | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| **(In millions)**                                                                                                                                                                                 | ** ** | **2006**               | ** ** | **2005**             | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net sales                                                                                                                                                                                         | ** ** | **$**                  | **1,765**  | ** **           | $          | 1,760 |   | **$** | **3,494** | ** ** | $ | 3,469 |   |
| Costs and  expenses                                                                                                                                                                               |       | ** **             | ** ** |                 |       | ** ** | ** ** |   |   |
| Cost of goods  sold                                                                                                                                                                               | ** ** | **1,513**              | ** ** | 1,524                |       | **3,102** | ** ** | 3,023 |   |
| Selling and  administrative expenses                                                                                                                                                              | ** ** | **170**                | ** ** | 164                  |       | **343** | ** ** | 330 |   |
| Restructuring  charges                                                                                                                                                                            | ** ** | **13**                 | ** ** | 3                    |       | **22** | ** ** | 4 |   |
| Gain on sale of  assets                                                                                                                                                                           | ** ** | **(1**                 | **)**      |                 |       | **(24** | **)** |   |   |
| Income from  operations                                                                                                                                                                           | ** ** | **70**                 | ** ** | 69                   |       | **51** | ** ** | 112 |   |
| Other income  (expense)                                                                                                                                                                           |       | ** **             | ** ** |                 |       | ** ** | ** ** |   |   |
| Interest  expense, net                                                                                                                                                                            | ** ** | **(96**                | **)**      | (86                  | )          | **(188** | **)** | (172 | ) |
| Loss on early  extinguishment of debt                                                                                                                                                             | ** ** | **(28**                | **)**      |                 |       | **(28** | **)** |   |   |
| Other, net                                                                                                                                                                                        | ** ** | **(20**                | **)**      | 1                    |       | **(23** | **)** | (2 | ) |
| Loss from  continuing operations before income taxes                                                                                                                                              | ** ** | **(74**                | **)**      | (16                  | )          | **(188** | **)** | (62 | ) |
| Benefit from  income taxes                                                                                                                                                                        | ** ** | **30**                 | ** ** | 6                    |       | **73** | ** ** | 25 |   |
| Loss from  continuing operations                                                                                                                                                                  | ** ** | **(44**                | **)**      | (10                  | )          | **(115** | **)** | (37 | ) |
| Discontinued  operations                                                                                                                                                                          |       | ** **             | ** ** |                 |       | ** ** | ** ** |   |   |
| Income from  discontinued operations, net of income tax provision of $3 and $9 for the  three and six months ended June 30, 2006 and $9 and $16 for the three and six  months ended June 30, 2005 |       | **4**                  | ** ** | 14                   |       | **14** | ** ** | 25 |   |
| Loss on sale of  discontinued operations, net of income tax provision of $175                                                                                                                     | ** ** | **(1**                 | **)**      |                 |       | **(1** | **)** |   |   |
| Net income  (loss)                                                                                                                                                                                | ** ** | **$**                  | **(41**    | **)**                | $          | 4 |   | **$** | **(102** | **)** | $ | (12 | ) |

 

See notes toconsolidated financial statements.

 

1

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**SMURFIT-STONECONTAINER ENTERPRISES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

 
| ** **                                                                                                                   | ** ** | **June 30,**    | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------|------------|
| **(In millions, except share data)**                                                                                         | ** ** | **2006**        | ** ** | **2005**         | ** ** |
| ** **                                                                                                                   |       | **(Unaudited)** |       |             |       |
| **Assets**                                                                                                                   |       |            |       |             |       |
|                                                                                                                         |       |            |       |             |       |
| Current assets                                                                                                               |       |            |       |             |       |
| Cash and cash  equivalents                                                                                                   | ** ** | **$**           | **9**      |             | $          | 5 |   |
| Receivables,  less allowances of $11 in 2006 and $10 in 2005                                                                 | ** ** | **283**         |       | 224              |       |
| Retained  interest in receivables sold                                                                                       | ** ** | **132**         |       | 139              |       |
| Inventories,  including amounts valued under LIFO method                                                                     |       |            |       |             |       |
| Work-in-process  and finished goods                                                                                          | ** ** | **154**         |       | 234              |       |
| Materials and  supplies                                                                                                      | ** ** | **399**         |       | 500              |       |
|                                                                                                                         | ** ** | **553**         |       | 734              |       |
| Prepaid expenses  and other current assets                                                                                   | ** ** | **50**          |       | 82               |       |
| Total current  assets                                                                                                        | ** ** | **1,027**       |       | 1,184            |       |
| Net property,  plant and equipment                                                                                           | ** ** | **3,804**       |       | 4,245            |       |
| Timberland, less  timber depletion                                                                                           | ** ** | **43**          |       | 44               |       |
| Goodwill                                                                                                                     | ** ** | **2,873**       |       | 3,309            |       |
| Other assets                                                                                                                 | ** ** | **306**         |       | 332              |       |
|                                                                                                                         | ** ** | **$**           | **8,053**  |             | $          | 9,114 |   |
| **Liabilities  and Stockholder’s Equity**                                                                               | ** ** | ** **      | ** ** | ** **       | ** ** |
|                                                                                                                         |       |            |       |             |       |
| Current  liabilities                                                                                                         |       |            |       |             |       |
| Current  maturities of long-term debt                                                                                        | ** ** | **$**           | **30**     |             | $          | 35 |   |
| Accounts payable                                                                                                             | ** ** | **582**         |       | 654              |       |
| Accrued  compensation and payroll taxes                                                                                      | ** ** | **158**         |       | 186              |       |
| Interest payable                                                                                                             | ** ** | **79**          |       | 97               |       |
| Income taxes  payable                                                                                                        | ** ** | **14**          |       | 17               |       |
| Current deferred  income taxes                                                                                               | ** ** | **16**          |       | 15               |       |
| Other current  liabilities                                                                                                   | ** ** | **130**         |       | 183              |       |
| Total current  liabilities                                                                                                   | ** ** | **1,009**       |       | 1,187            |       |
| Long-term debt,  less current maturities                                                                                     | ** ** | **3,785**       |       | 4,536            |       |
| Other long-term  liabilities                                                                                                 | ** ** | **1,158**       |       | 1,123            |       |
| Deferred income  taxes                                                                                                       | ** ** | **462**         |       | 529              |       |
| Stockholder’s  equity                                                                                                   |       |            |       |             |       |
| Common stock,  par value $.01 per share; 1,000 shares authorized, 770 issued and outstanding  in 2006 and 2005, respectively |       |            |       |             |       |
| Additional  paid-in capital                                                                                                  | ** ** | **3,622**       |       | 3,604            |       |
| Retained  earnings (deficit)                                                                                                 | ** ** | **(1,598**      | )          | (1,492           | )          |
| Accumulated  other comprehensive income (loss)                                                                               | ** ** | **(385**        | )          | (373             | )          |
| Total stockholder’s  equity                                                                                             | ** ** | **1,639**       |       | 1,739            |       |
|                                                                                                                         | ** ** | **$**           | **8,053**  |             | $          | 9,114 |   |

 

 

2

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**SMURFIT-STONECONTAINER ENTERPRISES, INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

 
| **Six Months Ended June 30, (In millions)**                                                   | ** ** | **2006**   | ** ** | **2005**   |   |
|-----------------------------------------------------------------------------------------------|------------|------------|------------|------------|--------|
| **Cash  flows from operating activities**                                                     | ** ** | ** ** | ** ** |       |   |
| Net loss                                                                                      | ** ** | **$**      | **(102**   | **)**      | $      | (12 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used for) operating activities    |       | ** ** | ** ** |       |   |
| Gain on  disposition of discontinued operations                                               | ** ** | **(174**   | **)**      |       |   |
| Loss on early  extinguishment of debt                                                         | ** ** | **28**     | ** ** |       |   |
| Depreciation,  depletion and amortization                                                     | ** ** | **199**    | ** ** | 207        |   |
| Amortization of  deferred debt issuance costs                                                 | ** ** | **5**      | ** ** | 4          |   |
| Deferred income  taxes                                                                        | ** ** | **91**     | ** ** | (27        | )      |
| Pension and  postretirement benefits                                                          | ** ** | **17**     | ** ** | (20        | )      |
| Gain on sale of  assets                                                                       | ** ** | **(24**    | **)**      |       |   |
| Non-cash  restructuring charges                                                               | ** ** | **10**     | ** ** | 2          |   |
| Non-cash  stock-based compensation                                                            | ** ** | **12**     | ** ** | 5          |   |
| Non-cash foreign  currency (gains) losses                                                     | ** ** | **12**     | ** ** | (4         | )      |
| Change in  current assets and liabilities, net of effects from acquisitions and  dispositions |       | ** ** | ** ** |       |   |
| Receivables and  retained interest in receivables sold                                        | ** ** | **(61**    | **)**      | (44        | )      |
| Inventories                                                                                   | ** ** | **33**     | ** ** | (1         | )      |
| Prepaid expenses  and other current assets                                                    | ** ** | **(1**     | **)**      | 1          |   |
| Accounts payable  and accrued liabilities                                                     |       | **(62**    | **)**      | (45        | )      |
| Interest payable                                                                              | ** ** | **(18**    | **)**      | 1          |   |
| Other, net                                                                                    | ** ** | **11**     | ** ** | (2         | )      |
| Net cash  provided by (used for) operating activities                                         | ** ** | **(24**    | **)**      | 65         |   |
| **Cash  flows from investing activities**                                                     | ** ** | ** ** | ** ** |       |   |
| Expenditures for  property, plant and equipment                                               | ** ** | **(139**   | **)**      | (139       | )      |
| Proceeds from  property disposals and sale of businesses                                      | ** ** | **949**    | ** ** | 6          |   |
| Payments on  acquisitions                                                                     |       | ** ** | ** ** | (5         | )      |
| Net cash  provided by (used for) investing activities                                         | ** ** | **810**    | ** ** | (138       | )      |
| **Cash  flows from financing activities**                                                     | ** ** | ** ** | ** ** |       |   |
| Proceeds from  long-term debt                                                                 |       |       | ** ** | 72         |   |
| Net borrowings  (repayments) of debt                                                          | ** ** | **(756**   | **)**      | 7          |   |
| Debt repurchase  premiums                                                                     | ** ** | **(24**    | **)**      |       |   |
| Dividends paid                                                                                | ** ** | **(4**     | **)**      | (4         | )      |
| Capital  contribution from SSCC                                                               | ** ** | **2**      | ** ** | 1          |   |
| Deferred debt  issuance costs                                                                 |       | ** ** | ** ** | (2         | )      |
| Net cash  provided by (used for) financing activities                                         | ** ** | **(782**   | **)**      | 74         |   |
| **Increase  in cash and cash equivalents**                                                    | ** ** | **4**      | ** ** | 1          |   |
| Cash and cash  equivalents                                                                    |       | ** ** | ** ** |       |   |
| Beginning of  period                                                                          | ** ** | **5**      | ** ** | 6          |   |
| End of period                                                                                 | ** ** | **$**      | **9**      | ** ** | $      | 7 |   |

 

 

3

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**SMURFIT-STONE CONTAINERENTERPRISES, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

(Tabular amounts in millions)

 

**1.****             ****SignificantAccounting Policies**

 

**Basis of Presentation:**The accompanying consolidated financial statements and notes thereto ofSmurfit-Stone Container Enterprises, Inc. (“SSCE” or the “Company”) have beenprepared in accordance with the instructions to Form 10-Q and reflect alladjustments which management believes necessary (which include only normalrecurring accruals) to present fairly the Company’s financial position, resultsof operations and cash flows. These statements, however, do not include allinformation and footnotes necessary for a complete presentation of financialposition, results of operations and cash flows in conformity with U.S.generally accepted accounting principles. Interim results may not necessarilybe indicative of results that may be expected for any other interim period orfor the year as a whole. These financial statements should be read inconjunction with the audited consolidated financial statements and footnotesincluded in the SSCE Annual Report on Form 10-K for the year ended December 31,2005 (“2005 10-K”) filed March 6, 2006 with the Securities and ExchangeCommission.

 

SSCE is a wholly-owned subsidiary of Smurfit-StoneContainer Corporation (“SSCC”). SSCE has domestic and international operations.

 

**Recently Adopted AccountingStandards:**InSeptember 2005, the Emerging Issues Task Force (“EITF”) reached a consensus onIssue No. 04-13, “Accounting for Purchases and Sales of Inventory With the SameCounterparty,” effective for the Company April 1, 2006, for new arrangementsand modifications or renewals of existing arrangements. EITF No. 04-13 requirescertain inventory buy/sell transactions between counterparties within the sameline of business to be viewed as a single exchange transaction.The Companyadopted EITF No. 04-13 effective April 1, 2006. EITF No. 04-13 required theCompany to prospectively report certain inventory buy/sell transactions ofsimilar containerboard types in the Containerboard and Corrugated Containerssegment on a net basis in the consolidated statements of operations, therebyreducing net sales and cost of goods sold by $70 million for the three monthsended June 30, 2006. Had EITF No. 04-13 previously been in effect, net salesand cost of goods sold would have been reduced by an additional $58 million forthe six months ended June 30, 2006, and $81 million and $153 million,respectively, for the three and six months ended June 30, 2005.

 

**2.****             ****Reclassifications**

 

Certainprior year amounts have been reclassified to conform to the current yearpresentation.

 

**3.****             ****Discontinued Operations**

 

Duringthe second quarter of 2006, the Company entered into an agreement to sellsubstantially all of the assets of the Consumer Packaging division to a companyformed by Texas Pacific Group (“TPG”) for approximately $1.04 billion. On June30, 2006, the Company completed the sale transaction and received cash proceedsof $902 million, which excluded $126 million for certain accounts receivablepreviously sold to Stone Receivables Corporation (“SRC”) under the accountsreceivable securitization program and was net of sales transaction costs andother closing adjustments. The Company recorded a pretax gain of $174 million,offset by a $175 million income tax provision, resulting in a net loss on saleof discontinued operations of $1 million, subject to post-closing adjustmentsas provided in the sale agreement. The after-tax loss is the result of aprovision for income taxes that is higher than the statutory income tax ratedue to non-deductible goodwill of $273 million.

 

4

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TheConsumer Packaging division was a reportable segment of the Company comprisedof four coated recycled boxboard mills, 39 consumer packaging operations in theUnited States, including folding carton, multiwall and specialty bag, flexiblepackaging, label, contract packaging and lamination businesses and one consumerpackaging plant in Brampton, Ontario.           Netsales for these operations were $391 million and $787 million, respectively,for the three and six months ended June 30, 2006, and $393 million and $777million, respectively, for the three and six months ended June 30, 2005. Thesefacilities employed approximately 6,600 hourly and salaried employees. Theresults of operations from the Consumer Packaging segment have beenreclassified as discontinued operations for all periods presented.

 

Theassets and liabilities of the discontinued operations included in theaccompanying consolidated balance sheet as of December 31, 2005 consisted ofthe following:

 
| Receivables                               |   | $      | 10     |   |
|-------------------------------------------|--------|--------|--------|--------|
| Inventories                               |   | 150    |   |
| Prepaid expenses and other current assets |   | 3      |   |
| Net property, plant and equipment         |   | 356    |   |
| Goodwill                                  |   | 279    |   |
| Other assets                              |   | 9      |   |
|                                      |   | $      | 807    |   |
|                                      |   |   |   |
| Accounts payable                          |   | $      | 78     |   |
| Accrued compensation and payroll taxes    |   | 24     |   |
| Other current liabilities                 |   | 15     |   |
| Long-term debt                            |   | 16     |   |
| Other long-term liabilities               |   | 1      |   |
|                                      |   | $      | 134    |   |

 

 

**4.****             ****Strategic Initiatives and Restructuring Activities**

 

During the fourth quarter of 2005, the Company announced a strategicreassessment plan to improve performance and better position the Company forlong-term growth. The plan focuses on (i) cost reduction initiatives from whichthe Company expects to achieve $525 million in annual savings by the end of2008, (ii) revenue growth initiatives, and (iii) organizational changes toenable the cost reduction and revenue growth initiatives. As part of theinitiative plan, the Company completed the sale of its Consumer Packagingdivision on June 30, 2006 and used the proceeds to reduce debt. The originalcost reduction initiatives target included cost savings benefits to be derivedfrom the Consumer Packaging division and accordingly, the Company has adjustedthis target to exclude the impact of the Consumer Packaging division from boththe target and actual savings achieved.

 

For 2006, the Company is targeting $240 million of cost savings fromthe strategic initiatives. During the three and six months ended June 30, 2006,the Company realized cost savings of approximately $45 million and $78 million,respectively, from its strategic initiatives compared to levels prior to thecommencement of the initiatives.

 

In connection with this plan, during the second quarter of 2006, theCompany recorded restructuring charges of $13 million, including non-cashcharges of $5 million related to the write-down of assets, primarily property,plant and equipment, to estimated net realizable value. The Company announcedthe closure of three converting facilities and idled one corrugator, whichresulted in the termination of approximately 270 employees. The remainingcharges were primarily for severance and benefits.

 

For the six months ended June 30, 2006, the Company recordedrestructuring charges of $22 million, including non-cash charges of $10 millionrelated to the write-down of assets, primarily property, plant and equipment,to estimated net realizable value. The Company has shut-down or announced the

 

5

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closure of six converting facilities and idled two corrugators, whichresulted in the termination of approximately 480 employees. The net sales andoperating losses of these facilities in 2006 prior to closure were $30 millionand $8 million, respectively. The net sales and operating losses of thesefacilities for the year ended December 31, 2005 were $96 million and $12million, respectively. Additional charges of up to $10 million will be recordedin future periods for severance and benefits related to the closure of theseconverting facilities and for pension settlement costs.

 

The Company recorded restructuring charges of $3 million and $4 millionfor the three and six months ended June 30, 2005, respectively, including a $2million non-cash charge to write-down assets, primarily property, plant andequipment, to estimated net realizable value. The remaining charges wereprimarily for severance and benefits.

 

At December 31,2005, the Company had $55 million of accrued exit liabilities related to therestructuring of operations. For the three and six months ended June 30, 2006,the Company incurred $4 million and $16 million, respectively, of cashdisbursements related to these exit liabilities. In addition, for the three andsix months ended June 30, 2006, the Company incurred $4 million and $7 million,respectively, of cash disbursements related to exit liabilities establishedduring 2006.

 

**5.****             ****Stock-Based Compensation**

 

Certain officers and key managers of the Company participate in variousstock-based compensation plans sponsored by SSCC, which issues stock optionsand restricted stock units. In December 2004, the Financial Accounting StandardsBoard issued Statement of Financial Accounting Standards (“SFAS”) No. 123(R), “Shared-BasedPayment,” effective January 1, 2006, which is a revision of SFAS No. 123, “Accountingfor Stock-Based Compensation.” SFAS No. 123(R) requires all share-based paymentsto employees, including grants of employee stock options, to be recognized inthe financial statements based on their fair values. The Company adopted SFASNo. 123(R) on January 1, 2006, under the modified prospective method, in whichthe requirements of SFAS No. 123(R) must be applied to new awards and topreviously granted awards that are not fully vested on the effective date, butdoes not require a restatement of previous years’ financial statements. Uponadoption, the Company implemented a lattice option pricing model to estimatethe value of stock options granted after January 1, 2006.

 

The lattice option pricing model considers a range of assumptionsrelated to volatility, risk-free interest rate and historical employeebehavior. Expected volatility was based on historical volatility on SSCC’scommon stock and current implied volatilities from traded options on SSCC’scommon stock. The risk-free interest rate was based on U.S. Treasury securityyields at the time of grant. The dividend yield on SSCC’s common stock isassumed to be zero since SSCC has not paid dividends and has no current plansto do so in the future. The expected life was determined from the latticeoption pricing model. The lattice option pricing model incorporates exerciseand post-vesting forfeiture assumptions based on analysis of historical data. Thefollowing table provides the assumptions used in determining the fair value ofthe stock-based awards granted during the three and six months ended June 30,2006.

 
| ** **                      | ** ** | **Three months ended  June 30, 2006** | ** ** | **Six months ended  June 30, 2006** | ** ** |
|---------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| Weighted-average dividend yield |       | 0.00                                  | %          | 0.00                                | %          |
| Weighted-average volatility     |       | 36                                    | %          | 36                                  | %          |
| Risk-free interest rate         |       | 4.98                                  | %          | 4.60                                | %          |
| Weighted-average expected life  |       | 5                                     |       | 5                                   |       |

 

 

The impact of adopting SFAS No. 123(R) for the three and six monthsended June 30, 2006 was a $2 million and $3 million increase, respectively, inselling and administrative expenses due to recognizing expense on non-vested,outstanding shares issued prior to the adoption of SFAS No. 123 on January 1,2003. At June 30, 2006, the total compensation cost related to non-vestedawards not yet recognized

 

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was approximately $38 million to be recognized through March 31, 2009,with a weighted-average expense period of approximately 2 years.

 

During the first and second quarters of 2006, the Company grantedperformance-based stock options to management level employees responsible forimplementing the strategic initiative plan. Vesting is dependent upon thefinancial performance of the Company and the attainment of the strategicinitiative savings from 2006 to 2008. These performance-based stock optionsexpire no later than seven years from the date of grant. Compensation expenseis recorded over the three-year performance period based on the achievement ofthe performance criteria.

 

Prior to the adoption of SFAS No. 123(R), the Company accounted forstock-based compensation under SFAS No. 123. The Company selected theprospective transition method as allowed in SFAS No. 148, “Accounting forStock-Based Compensation-Transition and Disclosure,” which requires expensingoptions prospectively, beginning in the year of adoption, and utilized theBlack-Scholes formula to estimate the value of stock options granted toemployees. The assumptions used in the Black-Scholes formula are described inthe 2005 10-K. Because the prospective transition method was used and awardsvest over three to eight years, the expense for the three and six months endedJune 30, 2005 is less than what would have been recognized if the fairvalue-based method had been applied to all awards since the original effectivedate of SFAS No. 123. The following table illustrates the effect on net (loss)and earnings per share if the fair value based method had been applied to alloutstanding and unvested awards for the three and six month periods ended June30, 2005.

 
| ** **                                                                                                                                    | ** ** | **Three months ended  June 30, 2005** | ** ** | **Six months ended  June 30, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| Net income  (loss), as reported                                                                                                               |       | $                                     | 4          |                                | $          | (12 | ) |
| Add: Stock-based  employee compensation expense included in reported net income (loss), net of  related tax effects                           |       | 1                                     |       | 3                                   |       |
| Deduct: Total  stock-based employee compensation expense determined under fair value-based  method for all awards, net of related tax effects |       | (3                                    | )          | (6                                  | )          |
| Pro forma net  income (loss)                                                                                                                  |       | $                                     | 2          |                                | $          | (15 | ) |

 

 

**6.****             ****Gain on Sale of Assets**

 

The Company recorded a gain of $23 million in the first quarter of 2006related to the divestiture of its Port St. Joe, Florida joint venture interestand related real estate.

 

**7.****             ****Other, Net**

 

For the three and six months ended June 30, 2006, the Company recordednon-cash foreign currency losses of $14 million and $12 million, respectively,related to its operations in Canada. For the three and six months ended June30, 2005, the Company recorded non-cash foreign currency gains of $5 millionand $4 million, respectively, related to its operations in Canada.

 

**8. Accounts ReceivableSecuritization Programs**

 

At June 30, 2006 and December 31, 2005, $655million and $592 million, respectively, of receivables had been sold under twoaccounts receivable securitization programs, of which the Company retained asubordinated interest. The off-balance sheet SRC debt and funding received fromthe Canadian accounts receivable program totaled $527 million and $472 million,respectively, as of those dates.

 

7

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At June 30, 2006, the Consumer Packaging divisionreceivables sold under the accounts receivable securitization program were $126million. As these outstanding accounts receivable are collected, the cash willbe used to reduce the related off-balance sheet debt.

 

**9. Long-Term Debt**

 

On May 23, 2006, the Company commenced a cash tender offer to purchaseup to $400 million in unsecured senior notes, applicable to any and all of its$300 million aggregate principal amount of outstanding 9.25% unsecured seniornotes due 2008 and a portion of its $750 million aggregate principal amount ofoutstanding 9.75% unsecured senior notes due 2011. As of June 29, 2006, theexpiration date of the offer, approximately $298 million of the outstanding9.25% unsecured senior notes had been tendered and were purchased by SSCE at aprice equal to 105.8% of the principal amount thereof (together with accruedinterest thereon) and approximately $725 million of the outstanding 9.75%unsecured senior notes were tendered. Pursuant to the terms of the tenderoffer, the Company purchased approximately $102 million of the 9.75% unsecuredsenior notes on a pro-rata basis at a price equal to 105.1% of the principalamount thereof (together with accrued interest thereon).

 

On June 9, 2006, the Company and its subsidiary, Smurfit-StoneContainer Canada Inc., as borrowers and SSCC, as guarantor, entered into anamendment to the senior credit facility with its lending group permitting theCompany to use a portion of the net cash proceeds to be received from the saleof the Company’s Consumer Packaging division and additional borrowings, ifnecessary, to prepay certain unsecured debt. The amendment (i) required the useof $240 million of the proceeds to prepay Tranche B term loans; (ii) permittedthe use of up to $400 million of the proceeds to prepay the unsecured seniornotes; and (iii) permitted the reinvestment of up to $250 million of thebalance of the proceeds in the business of the Company and its subsidiaries. If,after giving effect to the payments described above, the remaining balance ofthe proceeds exceeds $10 million, the Company would be required to use theremaining balance of the proceeds to make a further repayment of the term loansin accordance with the provisions of the senior credit facility.

 

On June 30, 2006, the Company completed the saleof the Consumer Packaging division (See Note 3) and used the proceeds to repaythe following obligations under its senior secured credit facilities andunsecured senior notes:

 
| Tranche B term  loan, due in various installments through November 1, 2011 |   | $   | 240    |   |
|----------------------------------------------------------------------------|--------|-----|--------|--------|
| SSCE revolving  credit facility, due November 1, 2009                      |   | 218 |   |
| 9.25% unsecured  senior notes, due February 1, 2008                        |   | 298 |   |
| 9.75% unsecured  senior notes, due February 1, 2011                        |   | 102 |   |
| Other debt                                                                 |   | 20  |   |
| Total debt  repayment                                                      |   | $   | 878    |   |
| Tender premium  and fees                                                   |   | 24  |   |
| Total  application of net proceeds                                         |   | $   | 902    |   |

 

In the second quarter of 2006, the Company recorded a loss on earlyextinguishment of debt of $28 million related to the repayment of borrowingswith net proceeds from the sale of its Consumer Packaging division. The lossincluded $24 million for tender premiums and fees for the unsecured seniornotes called and a $4 million non-cash write-off of related unamortizeddeferred debt issuance costs.

 

8

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**10. Guarantees**

 

TheCompany has certain wood chip processing contracts extending from 2012 through2018 with minimum purchase commitments. As part of the agreements, the Companyguarantees the third party contractors’ debt outstanding and has a securityinterest in the chipping equipment. At June 30, 2006, the maximum potentialamount of future payments related to these guarantees was approximately $35million and decreases ratably over the life of the contracts. In the event theguarantees on these contracts were called, which the Company currently believesis not probable, proceeds from the liquidation of the chipping equipment wouldbe based on current market conditions and the Company may not recover in fullthe guarantee payments made.

 

**11. Employee Benefit Plans**

 

The Company sponsors noncontributory defined benefit pension plans coveringsubstantially all U.S. employees. The Company also sponsors noncontributory andcontributory defined benefit pension plans for its Canadian operations.

 

The Company’s postretirement plans provide health care and lifeinsurance benefits for all retired salaried and certain retired hourlyemployees, and for salaried and certain hourly employees who have reached theage of 60 with ten years of service as of January 1, 2007.

 

The components of net periodic benefit costs for the defined benefitplans and the components of the postretirement benefit costs, including thediscontinued Consumer Packaging division, are as follows:

 
| ** **                                   | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | **Defined  Benefit Plans**      | ** ** | **Postretirement  Plans**     | ** ** | **Defined Benefit  Plans** | ** ** | **Postretirement  Plans** | ** ** |
| ** **                                   | ** ** | **2006**                        | ** ** | **2005**                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost                                 |       | $                               | 19         |                          | $          | 21 |   | $ | 2 |   | $ | 2 |   | $ | 39 |   | $ | 41 |   | $ | 3 |   | $ | 4 |   |
| Interest cost                                |       | 48                              |       | 47                            |       | 3 |   | 3 |   | 96 |   | 95 |   | 7 |   | 7 |   |
| Expected return on plan assets               |       | (56                             | )          | (54                           | )          |   |   |   |   | (111 | ) | (105 | ) |   |   |   |   |
| Amortization of prior service cost (benefit) |       | 3                               |       | 3                             |       | (1 | ) |   |   | 5 |   | 5 |   | (2 | ) | (1 | ) |
| Amortization of net loss                     |       | 22                              |       | 15                            |       | 1 |   | 2 |   | 43 |   | 31 |   | 2 |   | 3 |   |
| Settlements                                  |       |                            |       |                          |       |   |   |   |   | 2 |   |   |   |   |   |   |   |
| Multi-employer plans                         |       | 1                               |       | 1                             |       |   |   |   |   | 3 |   | 3 |   |   |   |   |   |
| Net periodic benefit cost                    |       | $                               | 37         |                          | $          | 33 |   | $ | 5 |   | $ | 7 |   | $ | 77 |   | $ | 70 |   | $ | 10 |   | $ | 13 |   |

 

The Company’s 2006 expected contributions to its qualified definedbenefit plans and benefit payments to its non-qualified defined benefit plansand postretirement plans are not expected to be materially different from theamounts disclosed at December 31, 2005.

 

**12. Derivative Instruments and Hedging Activities**

 

The Company’s derivativeinstruments used for its hedging activities are designed as cash flow hedgesand relate to minimizing exposures to fluctuations in the price of commoditiesused in its operations, the movement in foreign currency exchange rates and thefluctuations in the interest rate on variable rate debt.

 

9

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**Commodity Derivative Instruments**

The Company uses derivative instruments, including fixed price swaps andoptions, to manage fluctuations in cash flows resulting from commodity pricerisk in the procurement of natural gas. The objective is to fix the price of aportion of the Company’s purchases of natural gas used in the manufacturingprocess. The changes in the market value of such derivative instruments havehistorically been, and are expected to continue to be, highly effective atoffsetting changes in price of the hedged item. As of June 30, 2006, themaximum length of time over which the Company was hedging its exposure to thevariability in future cash flows associated with natural gas forecastedtransactions was 30 months. For the three and six months ended June 30, 2006,the Company reclassified a $1 million loss (net of tax) and an immaterialamount, respectively, from other comprehensive income (“OCI”) to cost of goodssold when the hedged items were recognized. For the three and six months endedJune 30, 2005, the Company reclassified an immaterial amount and a $1 millionloss (net of tax), respectively, from OCI to cost of goods sold when the hedgeditems were recognized. The fair value of these commodity derivative instrumentsat June 30, 2006 was a $3 million liability, of which $2 million was includedin other current liabilities, and $1 million was included in other long-termliabilities.

 

For the three and six months ended June 30, 2006, the Company recorded a$3 million loss (net of tax) and an $8 million loss (net of tax), respectively,in cost of goods sold related to the change in fair value of certain commodityderivative instruments not qualifying for hedge accounting. For the three andsix months ended June 30, 2005, the Company recorded a $3 million loss (net oftax) and a $3 million gain (net of tax), respectively, in cost of goods soldrelated to the change in fair value of certain commodity derivative instrumentsnot qualifying for hedge accounting.

 

For the three and six months ended June 30, 2006, the Company recorded a$1 million loss (net of tax) and a $2 million loss (net of tax), respectively,in cost of goods sold on settled commodity derivative instruments related tocommodity derivative instruments not qualifying for hedge accounting. For the threeand six months ended June 30, 2005, the Company recorded an immaterial amountand a $1 million loss (net of tax), respectively, in cost of goods sold onsettled commodity derivative instruments related to commodity derivativeinstruments not qualifying for hedge accounting

 

**Foreign Currency Derivative Instruments**

The Company’s principal foreign exchange exposure is theCanadian dollar. The Company uses foreign currency derivative instruments,including forward contracts and options, primarily to protect against Canadiancurrency exchange risk associated with expected future cash flows. As of June30, 2006, the maximum length of time over which the Company was hedging itsexposure to the variability in future cash flows associated with foreigncurrency was 18 months. For the three and six months ended June 30, 2006, theCompany reclassified a $1 million gain (net of tax) and a $2 million gain (netof tax), respectively, from OCI to cost of goods sold related to therecognition of the foreign currency derivative instruments. For the three andsix months ended June 30, 2005, the Company reclassified an immaterial amountand a $2 million gain (net of tax), respectively, from OCI to cost of goodssold related to the recognition of the foreign currency derivative instruments.The change in fair value of these derivative instruments is recorded in OCIuntil the underlying transaction is recorded. The fair value of the Company’sforeign currency derivative instruments at June 30, 2006 was a $6 millionasset, included in prepaid expenses and other current assets.

 

For the three and six months ended June 30, 2006, theCompany recorded an immaterial amount in cost of goods sold related to thechange in fair value of certain foreign currency derivative instruments not qualifyingfor hedge accounting. For the three and six months ended June 30, 2005, theCompany recorded an immaterial amount and a $1 million loss (net of tax),respectively, in cost of goods sold related to the change in fair value ofcertain foreign currency derivative instruments not qualifying for hedgeaccounting.

 

For the three and six months ended June 30, 2006, theCompany recorded an immaterial amount in cost of goods sold on settled foreigncurrency derivative instruments not qualifying for hedge accounting. For thethree and six months ended June 30, 2005, the Company recorded an immaterialamount and a $1 million

 

10

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gain (net of tax), respectively, in cost of goods sold onsettled foreign currency derivative instruments not qualifying for hedgeaccounting

 

**Interest Rate Swap Contracts**

TheCompany uses interest rate swap contracts to manage interest rate exposure on$300 million of the current Tranche B and Tranche C floating rate bank termdebt, effectively fixing the interest rate at 4.3%. These contracts extenduntil 2011, consistent with the maturity of the Company’s Tranche B and TrancheC term loans. Changes in the fair value of the interest rate swap contracts areexpected to be highly effective in offsetting the fluctuations in the floatinginterest rate and are recorded in OCI until the underlying transaction isrecorded. The accounting for the cash flow impact of the swap contracts isrecorded as an adjustment to interest expense each period. For the three andsix months ended June 30, 2006, the Company reclassified an immaterial amountfrom OCI to interest expense when the hedged items were recognized. For thethree and six months ended June 30, 2005, the Company reclassified a $1 millionloss (net of tax) and a $2 million loss (net of tax), respectively, from OCI tointerest expense when the hedged items were recognized. The fair value of theCompany’s interest rate swap contracts at June 30, 2006 was an $18 millionasset included in other assets.

 

Thecumulative deferred hedge gain on all derivative instruments was $12 million(net of tax) at June 30, 2006, including a $1 million loss (net of tax) oncommodity derivative instruments, a $2 million gain (net of tax) on foreigncurrency derivative instruments and an $11 million gain (net of tax) oninterest rate swap contracts. The Company expects to reclassify a $1 milliongain (net of tax) into cost of goods sold within the next 12 months, related tothe commodity and foreign currency derivative instruments.

 

**13. Income Taxes**

 

The sale of the Consumer Packaging division (SeeNote 3) generated a taxable gain for U.S. income tax purposes that will beoffset by available net operating loss (“NOL”) carryforwards, a portion ofwhich are subject to valuation allowances previously established in a priorpurchase business combination. Due to the utilization of these NOLcarryforwards, the related valuation allowances were reduced by $157 million inthe second quarter of 2006 with a corresponding reduction in goodwill relatedto the prior business combination.

 

U.S. federal alternative minimum tax ofapproximately $14 million is expected to be paid during the second half of 2006related to the sale of the Consumer Packaging division.

 

**14. Comprehensive Income (Loss)**

 

Comprehensive income (loss) is asfollows: 
| ** **                                          | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net income  (loss)                                  |       | $                                | (41        | )                              | $          | 4 |   | $ | (102 | ) | $ | (12 | ) |
| Other  comprehensive income (loss), net of tax:     |       |                             |       |                           |       |   |   |   |   |
| Net changes in  fair value of hedging instruments   |       |                             |       | (11                            | )          | (9 | ) | 1 |   |
| Net hedging loss  (gain) reclassified into earnings |       |                             |       | 1                              |       | (2 | ) | 1 |   |
| Foreign currency  translation adjustment            |       |                             |       |                           |       | (1 | ) | 1 |   |
| Comprehensive  income (loss)                        |       | $                                | (41        | )                              | $          | (6 | ) | $ | (114 | ) | $ | (9 | ) |

 

 

11

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**15. Goodwill**

 

Thefollowing table summarizes the activity of goodwill by segment for the sixmonths ended June 30, 2006:

 
| ** **                                                                                            | ** ** | **Containerboard  & Corrugated  Containers** | ** ** | **Consumer  Packaging** | ** ** | **Total** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|-------------------------|------------|-----------|------------|
| Balance at January  1, 2006                                                                           |       | $3,030                                           |       | $279                    |       | $3,309    |       |
| Goodwill  included in loss on sale of discontinued operations                                         |       |                                             |       | (279                    | )          | (279      | )          |
| Goodwill reduced  as a result of a reduction of valuation allowances associated with NOL  utilization |       | (157                                             | )          |                    |       | (157      | )          |
| Balance at June  30, 2006                                                                             |       | $2,873                                           |       | $666                    |       | $2,873    |       |

 

TheConsumer Packaging segment goodwill was eliminated as part of the ConsumerPackaging division sale (see Note 3). Goodwill was reduced by $157 million as aresult of a reduction of the valuation allowances associated with NOLcarryforwards utilized as a result of the sale (see Note 13).

 

**16.  BusinessSegment Information**

 

The Company’s ConsumerPackaging segment, which was sold as of June 30, 2006 (See Note 3), has beenclassified as discontinued operations and is excluded from the segment resultsfor all periods presented. As a result, the Company has one reportable segment,Containerboard and Corrugated Containers. The Containerboard and CorrugatedContainers segment is highly integrated. It includes a system of mills andplants that produces a full line of containerboard that is converted intocorrugated containers. It also provides single source full merchandisingsolutions to retailers and consumer packaging companies. Corrugated containersare used to transport such diverse products as home appliances, electricmotors, small machinery, grocery products, produce, books, tobacco andfurniture.

 

The Company evaluatesperformance and allocates resources based on profit or loss from operationsbefore income taxes, interest expense and other non-operating gains and losses.The accounting policies of the reportable segment are the same as thosedescribed in the summary of significant accounting policies in the 2005 10-K. Intersegmentsales and transfers are recorded at market prices.

 

Other includes corporaterelated items and a non-reportable segment, Reclamation. Corporate relateditems include expenses not allocated to reportable segments, includingcorporate expenses, restructuring charges, unrealized gains or losses on derivativeinstruments not qualifying for hedge accounting, non-cash foreign currencygains or losses, gains or losses from the sale of businesses and real estateand interest expense.

 

12

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A summary by business segmentfollows:

 
| ** **                        | ** ** | **Containerboard &  Corrugated  Containers** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|-----------|------------|-----------|------------|
| Three months ended June 30,       |       |                                             |       |      |       |      |       |
| 2006                              |       |                                             |       |      |       |      |       |
| Revenues from  external customers |       | $                                                | 1,677      |      | $          | 88        |       | $ | 1,765 |   |
| Intersegment  revenues            |       |                                             |       | 56        |       | 56        |       |
| Segment profit  (loss)            |       | 118                                              |       | (192      | )          | (74       | )          |
|                              |       |                                             |       |      |       |      |       |
| 2005                              |       |                                             |       |      |       |      |       |
| Revenues from  external customers |       | $                                                | 1,661      |      | $          | 99        |       | $ | 1,760 |   |
| Intersegment  revenues            |       |                                             |       | 59        |       | 59        |       |
| Segment profit  (loss)            |       | 94                                               |       | (110      | )          | (16       | )          |
|                              |       |                                             |       |      |       |      |       |
| Six months ended June 30,         |       |                                             |       |      |       |      |       |
| 2006                              |       |                                             |       |      |       |      |       |
| Revenues from  external customers |       | $                                                | 3,323      |      | $          | 171       |       | $ | 3,494 |   |
| Intersegment  revenues            |       |                                             |       | 101       |       | 101       |       |
| Segment profit  (loss)            |       | 128                                              |       | (316      | )          | (188      | )          |
|                              |       |                                             |       |      |       |      |       |
| 2005                              |       |                                             |       |      |       |      |       |
| Revenues from  external customers |       | $                                                | 3,270      |      | $          | 199       |       | $ | 3,469 |   |
| Intersegment  revenues            |       |                                             |       | 116       |       | 116       |       |
| Segment profit  (loss)            |       | 160                                              |       | (222      | )          | (62       | )          |

 

 

**17. Contingencies**

 

The Company’s past and present operations include activities which aresubject to federal, state and local environmental requirements, particularlyrelating to air and water quality. The Company faces potential environmentalliability as a result of violations of permit terms and similar authorizationsthat have occurred from time to time at its facilities. In addition, theCompany faces potential liability for response costs at various sites for whichit has received notice as being a potentially responsible party (“PRP”)concerning hazardous substance contamination. In estimating its reserves forenvironmental remediation and future costs, the Company’s estimated liabilityof $4 million reflects the Company’s expected share of costs afterconsideration for the relative percentage of waste deposited at each site, thenumber of other PRPs, the identity and financial condition of such parties andexperience regarding similar matters. As of June 30, 2006, the Company hadapproximately $25 million reserved for environmental liabilities includedprimarily in other long-term liabilities in the consolidated balance sheet. TheCompany believes the liability for these matters was adequately reserved atJune 30, 2006.

 

If all or most of the other PRPs are unable to satisfy their portion ofthe clean-up costs at one or more of the significant sites in which the Companyis involved or the Company’s expected share increases, the resulting liabilitycould have a material adverse effect on the Company’s consolidated financialcondition or results of operations.

 

The Company is a defendant in a number of lawsuits and claims arisingout of the conduct of its business, including those related to environmentalmatters. While the ultimate results of such suits or other proceedings againstthe Company cannot be predicted with certainty, the management of the Companybelieves that the resolution of these matters will not have a material adverseeffect on its consolidated financial condition, results of operations, or cashflows.

 

13

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| **ITEM 2.** | ** ** | **MANAGEMENT’S DISCUSSION AND  ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|------------|-------------------------------------------------------------------------------------------------|

 

**FORWARD-LOOKING STATEMENTS**

Some information includedin this report may contain forward-looking statements within the meaning ofSection 21E of the Securities Exchange Act of 1934, as amended. Although webelieve that, in making any such statements, our expectations are based onreasonable assumptions, any such statement may be influenced by factors thatcould cause actual outcomes and results to be materially different from thoseprojected. When used in this document, the words “anticipates,” “believes,” “expects,”“intends” and similar expressions as they relate to Smurfit-Stone ContainerEnterprises, Inc. or its management, are intended to identify suchforward-looking statements. These forward-looking statements are subject tonumerous risks and uncertainties. There are important factors that could causeactual results to differ materially from those in forward-looking statements,certain of which are beyond our control. These factors, risks and uncertaintiesare discussed in our 2005 Annual Report on Form 10-K (2005 Form 10-K).

Our actual results, performance or achievements coulddiffer materially from those expressed in, or implied by, these forward-lookingstatements. Accordingly, we can give no assurances that any of the eventsanticipated by the forward-looking statements will transpire or occur, or ifany of them do so, what impact they will have on our results of operations orfinancial condition. We expressly decline any obligation to publicly revise anyforward-looking statements that have been made to reflect the occurrence ofevents after the date hereof.

 

**GENERAL**

 

We meet the conditions set forth in General Instruction (H) (1) (a) and(b) of Form 10-Q and are therefore filing this form with the reduced disclosureformat permitted thereby. The omitted information is substantially similar tothe disclosures contained in Smurfit-Stone Container Corporation’s QuarterlyReport on Form 10-Q for the quarter ended June 30, 2006 filed with theSecurities and Exchange Commission on the date hereof. In accordance withGeneral Instruction (H) (2) (a), the discussion of our results of operationsbelow includes only a narrative analysis of the most recent fiscal year-to-dateperiod presented and the corresponding year-to-date period in the precedingfiscal year.

 

We are a wholly-ownedsubsidiary of Smurfit-Stone Container Corporation (Smurfit-Stone), a holdingcompany with no business operations of its own. Smurfit-Stone conducts itsbusiness operations through us. We are the surviving company resulting from themerger (the Merger) of Smurfit-Stone’s primary operating subsidiaries onNovember 1, 2004. JSCE, Inc. merged with andinto Jefferson Smurfit Corporation (U.S.) (JSC(U.S.)), with JSC(U.S.) as thesurviving company, and then JSC(U.S.) merged with and into us, with us as thesurviving entity. The Merger was effected principally to consolidate debtfinancing activities of Smurfit-Stone and its subsidiaries. We weresimultaneously renamed Smurfit-Stone Container Enterprises, Inc.

 

We and JSC(U.S.) were wholly-owned subsidiaries of Smurfit-Stone and,therefore, the historical cost basis of the acquired entity, JSC(U.S.), carriedover into us. As a result of the Merger, our financial statements for allperiods presented have been restated to include the combined results of us andJSC(U.S.). The Merger did not impact the operating activities of the mergedcompanies, which continue to do business as Smurfit-Stone.

 

Our Consumer Packagingsegment, which was sold as of June 30, 2006 (see “Discontinued Operations”),has been classified as discontinued operations and is excluded from the segmentresults for all periods presented. As a result, we have one reportable segment,Containerboard and Corrugated Containers.

 

14

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**DISCONTINUED OPERATIONS**

 

During the secondquarter of 2006, we entered into an agreement to sell substantially all of theassets of the Consumer Packaging division to a company formed by Texas PacificGroup for approximately $1.04 billion. On June 30, 2006, we completed the saletransaction and received cash proceeds of $902 million, which excluded $126million of certain accounts receivables previously sold by us to StoneReceivables Corporation under the accounts receivable securitization programand was net of sales transaction costs and other closing adjustments. Werecorded a pretax gain of $174 million, offset by a $175 million income taxprovision, resulting in a net loss on sale of discontinued operations of $1million, subject to post-closing adjustments as provided in the sale agreement.The after-tax loss is the result of a provision for income taxes that is higherthan the statutory income tax rate due to non-deductible goodwill of $273million.

 

The Consumer Packagingdivision was a reportable segment comprised of four coated recycled boxboardmills, 39 consumer packaging operations in the United States, including foldingcarton, multiwall and specialty bag, flexible packaging, label, contractpackaging and lamination businesses, and one consumer packaging plant inBrampton, Ontario. Net sales for these operations were $787 million, for thesix months ended June 30, 2006, and $777 million for the six months ended June30, 2005. These facilities employed approximately 6,600 hourly and salariedemployees. The results of operations from the Consumer Packaging segment havebeen reclassified as discontinued operations for all periods presented.

 

**RESULTS OF OPERATIONS**

 

**Strategic Initiatives**

 

During the fourth quarter of 2005, we announced a strategicreassessment plan to improve performance and better position us for long-termgrowth. Our plan focuses on (i) cost reduction initiatives from which we expectto achieve $525 million in annual savings by the end of 2008, (ii) revenuegrowth initiatives and (iii) organizational changes to enable the costreduction and revenue growth initiatives.

 

As part of the initiative plan, we completed the sale of our ConsumerPackaging division on June 30, 2006 and used the proceeds to reduce debt. Ouroriginal cost reduction initiative target included cost savings benefits to bederived from the Consumer Packaging division and accordingly, we have adjustedthis target to exclude the impact of the Consumer Packaging division from boththe target and actual savings achieved.

 

For 2006, we are targeting $240 million of cost savings from ourstrategic initiatives. For the six months ended June 30, 2006, we realized costsavings of approximately $78 million from our strategic initiatives. Since weannounced our strategic reassessment plan, we have realized cumulative costsavings of approximately $123 million. The cumulative cost savings include areduction of fixed costs primarily related to the closures of twocontainerboard mills in August 2005, other workforce reductions in theContainerboard and Corrugated Containers segment and a one-time curtailmentgain related to the elimination of postretirement health care and lifeinsurance benefits for certain employees. To date, we have closed twocontainerboard mills, shut down or announced the closures of eleven convertingfacilities and idled two corrugators. As a result of these actions, we havereduced our headcount by more than 2,500 since June 30, 2005, including 1,000during the first half of 2006.

 

**Recently Adopted AccountingStandards**

 

In September 2005, the Emerging Issues Task Force reached a consensuson Issue No. 04-13, “Accounting for Purchases and Sales of Inventory With theSame Counterparty” (EITF No. 04-13) effective for us April 1, 2006, for newarrangements and modifications or renewals of existing arrangements. EITF No.04-13 requires certain inventory buy/sell transactions between counterpartieswithin the same line of business to be viewed as a single exchange transaction.We adopted EITF No. 04-13

 

15

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effective April 1, 2006 which required us to prospectively reportcertain inventory buy/sell transactions of similar containerboard types in ourContainerboard and Corrugated Containers segment on a net basis in ourconsolidated statements of operations, thereby reducing net sales and cost ofgoods sold by $70 million for the three months ended June 30, 2006. Had EITFNo. 04-13 previously been in effect, net sales and cost of goods sold wouldhave been reduced by an additional $58 million for the six months ended June30, 2006 and $153 million for the six months ended June 30, 2005.

 

**Overview**

 

We had a net loss of $102 million for the first half of 2006. Net salesincreased 0.7% compared to the first half of 2005 due primarily to higheraverage sales prices and higher sales volume for corrugated containers andcontainerboard. Net sales for the first half of 2006 were unfavorably impactedby the adoption of EITF No. 04-13. Compared to the first half of 2005, our netloss increased due primarily to a loss on early extinguishment of debt, highernon-cash foreign currency losses, restructuring charges and interest expenseand higher costs for energy, freight and chemicals.

 

We expect our results from operations to improve in the second half of2006 as a result of higher average sales prices for containerboard andcorrugated containers, lower interest expense, lower energy and employeebenefit costs and the continuing benefit from our strategic initiatives.

 

**Six Months 2006 Compared to SixMonths 2005**

 
| ** **                                                              | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                              | ** ** | **2006**                      | ** ** | **2005** | ** ** |
| **(In millions)**                                                       | ** ** | **Net  Sales**                | ** ** | **Profit/  (Loss)** | ** ** | **Net  Sales** | ** ** | **Profit/  (Loss)** | ** ** |
|                                                                    |       |                          |       |   |   |   |   |   |   |
| Containerboard  and corrugated containers                               |       | $                             | 3,323      |   | $ | 128 |   | $ | 3,270 |   | $ | 160 |   |
| Other operations  (1)                                                   |       | 171                           |       | 8 |   | 199 |   | 12 |   |
| Total segment  operations                                               |       | $                             | 3,494      |   | 136 |   | $ | 3,469 |   | 172 |   |
|                                                                    |       |                          |       |   |   |   |   |   |   |
| Restructuring  charges                                                  |       |                          |       | (22 | ) |   |   | (4 | ) |
| Gain on sale of  assets                                                 |       |                          |       | 24 |   |   |   |   |   |
| Interest  expense, net                                                  |       |                          |       | (188 | ) |   |   | (172 | ) |
| Loss on early  extinguishment of debt                                   |       |                          |       | (28 | ) |   |   |   |   |
| Non-cash foreign  currency gains (losses)                               |       |                          |       | (12 | ) |   |   | 4 |   |
| Mark-to-market  unrealized gains (losses) on derivative instruments (2) |       |                          |       | (15 | ) |   |   | 2 |   |
| Corporate  expenses and other (3)                                       |       |                          |       | (83 | ) |   |   | (64 | ) |
| Loss from  continuing operations before income taxes                    |       |                          |       | $ | (188 | ) |   |   | $ | (62 | ) |

 

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(1) Other operations consists of our reclamationdivision, which is a non-reportable segment.

 

(2) Amounts include mark-to-market unrealized gains orlosses on natural gas commodity and foreign currency derivative instruments notqualifying for hedge accounting.

 

(3) Amounts include corporate expenses, corporatecharges to segments for working capital interest and other expenses notallocated to segments.

 

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The increase in net sales was due primarily to the improvement inaverage sales prices and sales volume for the Containerboard and CorrugatedContainers segment. The change in net sales for each of our segments, includingthe impact of adopting EITF No. 04-13, as described in “Recently AdoptedAccounting Standards,” is summarized in the chart below:

 
| **(In millions)**           | ** ** | **Container-  board &  Corrugated  Containers** | ** ** | **Other  Operations** | ** ** | **Total** | ** ** |
|-----------------------------|------------|-----------------------------------------------------|------------|-----------------------|------------|-----------|------------|
|                        |       |                                                |       |                  |       |      |       |
| Sales price and product mix |       | $                                                   | 59         |                  | $          | (26       | )          | $ | 33 |   |
| Sales volume                |       | 64                                                  |       | (2                    | )          | 62        |       |
| EITF No. 04-13              |       | (70                                                 | )          |                  |       | (70       | )          |
| Total                       |       | $                                                   | 53         |                  | $          | (28       | )          | $ | 25 |   |

 

Cost of goods soldincreased from $3,023 million in 2005 to $3,102 million in 2006 due primarilyto the higher sales volume ($55 million) and higher costs for energy ($40million), freight ($29 million), chemicals ($10 million) and wood fiber ($6million). Cost of goods sold was favorably impacted by lower cost for reclaimedmaterial ($46 million) and the impact of adopting EITF No. 04-13 ($70 million).Cost of goods sold as a percent of net sales increased from 87.1% in 2005 to88.8% in 2006 due primarily to the higher costs.

 

Selling and administrative expense increased $13million compared to last year due primarily to higher stock-based compensationexpense ($6 million), including $3 million due to the impact of adopting SFASNo. 123(R) on January 1, 2006, and costs related to the implementation of thestrategic initiatives ($8 million). Selling and administrative expense as apercent of net sales increased from 9.5% in 2005 to 9.8% in 2006 due in part tothe adoption of EITF No. 04-13.

 

In connection with our strategic initiatives, for the six months endedJune 30, 2006, we recorded restructuring charges of $22 million, includingnon-cash charges of $10 million related to the write-down of assets, primarilyproperty, plant and equipment, to estimated net realizable value. We shut downor announced the closure of six converting facilities and idled twocorrugators, which resulted in the termination of approximately 480 employees. Theremaining charges were primarily for severance and benefits. Additional chargesof up to $10 million will be recorded in future periods for severance andbenefits related to the closure of three converting facilities and for pensionsettlement costs.

 

Interest expense, net was $188 million in 2006. The $16 millionincrease over 2005 was the result of higher interest rates ($12 million),higher average borrowings ($3 million) and the reclassification of $1 millionof interest expense to discontinued operations. Our overall average effectiveinterest rate in 2006 was higher than 2005 by approximately 0.50%.

 

In the second quarter of 2006, we recorded a loss on earlyextinguishment of debt of $28 million related to the repayment of borrowingswith net proceeds from the sale of our Consumer Packaging division. The lossincluded $24 million for tender premiums and fees for the redemption ofunsecured senior notes and a $4 million non-cash write-off of relatedunamortized deferred debt issuance costs.

 

We recorded a gain of $23 million in the first quarter of 2006 relatedto the divestiture of our Port St. Joe, Florida joint venture interest andrelated real estate.

 

Other, net for 2006 included non-cash foreign currency losses of $12million compared to gains of $4 million in 2005.

 

Benefit from income taxesdiffered from the amount computed by applying the statutory U.S. federal incometax rate to loss before income taxes due primarily to state income taxes andthe effect of other permanent differences. In connection with the sale of theConsumer Packaging division, during the

 

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second quarter of 2006,we recorded a pretax gain of $174 million, offset by a $175 million income taxprovision, resulting in a net loss on sale of discontinued operations of $1million. The after-tax loss is the result of a provision for income taxes thatis higher than the statutory income tax rate due to the non-deductibility ofgoodwill. U.S. federal alternative minimum tax of approximately $14 million isexpected to be paid during the second half of 2006 related to the sale of theConsumer Packaging division.

 

**Containerboardand Corrugated Containers Segment**

Net sales increased 1.6% in 2006 compared to last year primarily as aresult of higher sales volume and higher average sales prices for corrugatedcontainers and containerboard. Shipments of corrugated containers increased0.8% and containerboard shipments to third parties increased 16.8% compared tothe same period last year. Average domestic linerboard prices in the first halfof 2006 were 5.4% higher compared to the first half of 2005. Our average NorthAmerican selling price for corrugated containers was 0.5% higher compared tothe first half of 2005. Our average sales prices for market pulp, kraft paperand SBS increased approximately 3.9%, 2.1% and 1.9%, respectively, compared tothe first half of last year.

 

Our containerboard mills operated at 98.5% of capacity in the firsthalf of 2006 and production increased 0.8% compared to last year. Production ofmarket pulp and kraft paper were comparable, while production of SBS increasedby 8.8%, compared to last year.

 

Profits decreased $32 million compared to lastyear due primarily to higher costs of energy ($40 million), freight ($29million), chemicals ($10 million) and wood fiber ($6 million). Profits werefavorably impacted by the higher sales volume, higher average sales prices andlower costs for reclaimed fiber ($12 million).

 

**OtherOperations**

Net sales decreased 14.1% due primarily to lower average sales pricesfor reclaimed fiber. The average price for OCC decreased approximately $20 perton compared to last year. Total tons of fiber reclaimed and brokered for thesix months ended June 30, 2006 was comparable to the same period last year.Lower external sales volume was offset by higher internal consumption. Profitsin 2006 decreased $4 million compared to last year due primarily to the loweraverage selling prices and the loss of a profitable customer account.

 

#### **StatisticalData**

| **(In thousands of tons, except as noted)**                      | ** ** | **Six months ended  June 30,** | ** ** |
|------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                       | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Mill production                                                  |       |                           |       |   |   |
| Containerboard  (1)                                              |       | 3,631                          |       | 3,603 |   |
| Kraft paper                                                      |       | 101                            |       | 102 |   |
| Market pulp                                                      |       | 281                            |       | 280 |   |
| SBS                                                              |       | 149                            |       | 137 |   |
| North American corrugated containers sold (billion  sq. ft.) (2) |       | 40.3                           |       | 40.0 |   |
| Fiber reclaimed and brokered                                     |       | 3,296                          |       | 3,298 |   |

 

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(1)          For the six months ended June 30, 2006 and 2005, ourcorrugated container plants consumed 2,701,000 tons and 2,708,000 tons ofcontainerboard, respectively.

 

(2)          Excludes intercompany shipments. Includes our proportionateshare of affiliates reported on an equity ownership basis.

 

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**CRITICAL ACCOUNTING POLICIES AND USE OF ESTIMATES**

 

**Income Taxes**

The sale of the Consumer Packaging divisiongenerated a taxable gain for U.S. income tax purposes that will be offset byavailable net operating loss (NOL) carryforwards, a portion of which aresubject to valuation allowances previously established in a prior purchasebusiness combination. Due to the utilization of these NOL carryforwards, therelated valuation allowances were reduced by $157 million in the second quarterof 2006 with a corresponding reduction to goodwill that resulted from a priorpurchase business combination.

 

**ITEM 3.**          **QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

Intentionally omitted in accordance with GeneralInstruction (H) of Form 10-Q.

 

**ITEM 4.          CONTROLSAND PROCEDURES**

 

**Evaluation of Disclosure Controls and Procedures**

Our management, with the participation of our principal executive officerand our principal financial officer, evaluated the effectiveness of ourdisclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e)and 15d-15(e)) as of the end of the period covered by this report and haveconcluded that, as of such date, our disclosure controls and procedures wereadequate and effective.

 

**Changes in Internal Control**

There have not been any changes in our internal control over financialreporting during the most recent quarter that have materially affected, or arereasonably likely to materially affect, our internal control over financialreporting.

 

**PART II - OTHER INFORMATION**

 

**ITEM 1.          LEGAL PROCEEDINGS**

 

In May 2003, we received a Violation Notice from the IllinoisEnvironmental Protection Agency (IEPA) alleging that our flexible packagingfacility in Schaumburg, Illinois violated various provisions of the IllinoisEnvironmental Protection Act and various conditions of the applicable Clean AirAct permit issued to the facility. In June 2003, we received a Notice of Violation(NOV) and Finding of Violation (FOV) from the EPA containing similarallegations. The allegations primarily relate to the alleged failure of twoafterburner systems designed to capture and reduce certain emissions fromprinting presses below required levels and the potential impact of such failureon past and future regulatory standards, permitting requirements, emissioncredit requirements, recordkeeping and reporting. After making certain repairsto the two old systems, we subsequently replaced these systems with a singleregenerative thermal oxidizer to eliminate future failures and ensure long-termcompliance. The Schaumburg facility was among the assets of the ConsumerPackaging Division, which were sold on June 30, 2006 to Bluegrass Container Company,LLC, an entity formed by Texas Pacific Group. We responded to the IEPAViolation Notice and the EPA NOV and FOV and are negotiating an acceptableresolution with IEPA and EPA. The costs to resolve this matter will not bematerial and will be the responsibility of Bluegrass Container Company, LLC,which has assumed all obligations with respect thereto.

 

**ITEM 1A.       RISK FACTORS**

 

Thereare no material changes to the risk factors as disclosed in our 2005 AnnualReport on Form 10-K.

 

**ITEM 2.          UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

Intentionallyomitted in accordance with General Instruction (H) of Form 10-Q.

 

 

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**ITEM 3.          DEFAULTS UPON SENIOR SECURITIES**

 

Intentionallyomitted in accordance with General Instruction (H) of Form 10-Q.

 

**ITEM 4.          SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

Intentionallyomitted in accordance with General Instruction (H) of Form 10-Q.

 

**ITEM 5.          OTHER INFORMATION**

 

Intentionallyomitted in accordance with General Instruction (H) of Form 10-Q.

 

**ITEM 6.          EXHIBITS**

 

Thefollowing exhibits are included in this Form 10-Q:

 
| 10.1   |   | Second Amendment of Employment Agreement of Patrick  J. Moore effective as of July 25, 2006, between Smurfit-Stone Container  Corporation (“SSCC”) and Patrick J. Moore (incorporated by reference to  Exhibit 10.1 to SSCC’s Quarterly Report on Form 10-Q for the quarter ended  June 30, 2006).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.2   |   | First Amendment of Employment Agreement of Charles  A. Hinrichs effective as of July 25, 2006, between Smurfit-Stone Container  Corporation and Charles A. Hinrichs (incorporated by reference to Exhibit  10.2 to SSCC’s Quarterly Report on Form 10-Q for the quarter ended June 30,  2006).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.3   |   | Amendment No. 3 dated as of June 9, 2006, to the  Credit Agreement dated as of November 1, 2004, as amended by Amendment No. 1  dated as of September 30, 2005, and Incremental Term Loan Assumption  Agreement and Amendment No. 2 dated as of December 20, 2005, among  Smurfit-Stone Container Corporation, as Guarantor; Smurfit-Stone Container  Enterprises, Inc. and Smurfit-Stone Container Canada Inc., as Borrowers; the  Lenders from time to time party thereto; Deutsche Bank Trust Company  Americas, as Senior Agent, Administrative Agent, Collateral Agent, Swingline  Lender and Revolving Facility Facing Agent; Deutsche Bank AG, as Canadian  Administrative Agent and Revolving (Canadian) Facility Facing Agent; and  JPMorgan Chase Bank, N.A., as Senior Agent, Deposit Account Agent and Deposit  Funded Facility Facing Agent (incorporated by reference to Exhibit 10.1 to  SSCC’s Current Report on Form 8-K dated June 13, 2006). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.4   |   | Asset Purchase Agreement, dated May 11, 2006, by and  among Smurfit-Stone Container Enterprises, Inc., Smurfit-Stone Container  Canada Inc. and Bluegrass Container Company, LLC (incorporated by reference  to Exhibit 2.1 to SSCC’s Current Report on Form 8-K dated July 6, 2006).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 10.5   |   | Amendment No. 1 to Asset Purchase Agreement, dated  June 30, 2006, by and among Smurfit-Stone Container Enterprises, Inc., Smurfit-Stone  Container Canada Inc. and Bluegrass Container Company, LLC (incorporated by  reference to Exhibit 2.2 to SSCC’s Current Report on Form 8-K dated July 6,  2006).                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.1   |   | Certification Pursuant to Rules  13a-14 and 15d-14 under the Securities Exchange Act of 1934, as Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 31.2   |   | Certification Pursuant to Rules  13a-14 and 15d-14 under the Securities Exchange Act of 1934, as Adopted  Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 32.1   |   | Certification Pursuant to 18  U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 32.2   |   | Certification 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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Signature

 

Pursuant to the requirements of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|   |   | SMURFIT-STONE CONTAINER  ENTERPRISES, INC. |
|--------|--------|--------------------------------------------|
|   |   | (Registrant)                               |

 

 

 
| Date: August 7, 2006 | /s/ Paul K. Kaufmann                            |
|----------------------|-------------------------------------------------|
|                 | Paul K. Kaufmann                                |
|                 | Senior Vice President and Corporate  Controller |
|                 | (Principal Accounting Officer)                  |
|                 |                                            |

 

 

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