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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2010

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             

Commission File Number: 001-33494

KapStone Paper and Packaging Corporation

(Exact name of registrant as specified in its charter)

KapStone Paper and Packaging Corporation

1101 Skokie Blvd., Suite 300

Northbrook, IL 60062

(Address of Principal Executive Offices including zip code)

Registrant’s Telephone Number, including area code (847) 239-8800

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the preceding 12 months (or for such shorter 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 mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  o No o

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

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

There were 45,976,601 shares of the Registrant’s Common Stock, $0.0001 par value, outstanding as of July 30, 2010, excluding 40,000 shares held as treasury shares.

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KapStone Paper and Packaging Corporation Index to Form 10-Q

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PART 1. FINANCIAL INFORMATION

ITEM 1. - FINANCIAL STATEMENTS

KapStone Paper and Packaging Corporation

Consolidated Balance Sheet

(In thousands, except share and per share amounts)

See notes to consolidated financial statements

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KapStone Paper and Packaging Corporation

Consolidated Statement of Income

(In thousands, except share and per share amounts)

(unaudited)

See notes to consolidated financial statements

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KapStone Paper and Packaging Corporation

Consolidated Statement of Cash Flows

(In thousands)

(unaudited)

See notes to consolidated financial statements

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KAPSTONE PAPER AND PACKAGING CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(In thousands, except share and per share amounts)

(unaudited)

1.              Financial Statements

The accompanying unaudited consolidated financial statements of KapStone Paper and Packaging Corporation (the “Company,” “we,” “us,” “our” or “KapStone”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information, the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of a normal recurring nature) considered necessary for a fair presentation have been included. Operating results for the three and six months ended June 30, 2010 are not necessarily indicative of the results that may be expected for the year ended December 31, 2010. For further information, refer to the consolidated financial statements and related footnotes included in our Annual Report on Form 10-K for the year ended December 31, 2009.

2.              Recent Accounting Pronouncements

In January 2010, the Financial Accounting Standards Board (“FASB”) issued Accounting Standard Update (“ASU”) No. 2010-06, “Fair Value Measurements and Disclosures,” which amends the disclosure requirements related to recurring and nonrecurring fair value measurements.  The guidance requires disclosure of transfers of assets and liabilities between Level 1 and Level 2 of the fair value measurement hierarchy, including the reasons and the timing of the transfers and information on purchases, sales, issuance, and settlements on a gross basis in the reconciliation of the assets and liabilities measured under Level 3 of the fair value measurement hierarchy. The guidance is effective for annual and interim reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for annual and interim periods beginning after December 15, 2010. The implementation of this standard did not have a material impact on the consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (“SFAS No. 141(R)”). This guidance is included in FASB ASC 805, Business Combinations. This guidance requires the Company to continue to follow the guidance in SFAS No. 141 (also included in FASB ASC 805) for certain aspects of business combinations, and provides additional guidance defining the acquirer, recognizing and measuring the identifiable assets acquired, the liabilities assumed, any noncontrolling interest in the acquiree, assets and liabilities arising from contingencies, defining a bargain purchase and recognizing and measuring goodwill or a gain from a bargain purchase. This guidance also requires transaction costs to be charged to earnings and requires contingent consideration to be recorded at its fair value on the acquisition date. In addition, under this guidance, adjustments associated with changes in tax contingencies that occur after the measurement period, not to exceed one year, are recorded as adjustments to income. This guidance is effective for all business combinations for which the acquisition date is on or after the beginning of an entity’s first fiscal year that begins after December 15, 2008; however, the guidance regarding the treatment of income tax contingencies is retrospective to business combinations completed prior to 2009.  No business combinations occurred during the six months ended June 30, 2010.

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3.              Alternative Fuel Mixture Tax Credit

A summary of alternative fuel mixture tax credits (“AFTC”) recognized in the consolidated financial statements for the three and six months ended June 30, 2010 and 2009 is as follows:

(1) The alternate fuel mixture tax credit expired on December 31, 2009.

At December 31, 2009 the Company included $14.3 million of AFTC as a reduction to the cost of inventory based on its FIFO accounting policy. No amounts were deferred in inventory at June 30, 2010.

The Company earned an additional $7.9 million AFTC during 2009 based on a U.S. Internal Revenue Service (“IRS”) Advice Memorandum released on March 12, 2010 which indicated that the portion of inorganic content included in the fuel burned was eligible for a $0.50 per gallon refund. The Company had excluded this amount when submitting refunds during 2009. Inorganic content represented about 4% of the total gallons burned in 2009. The Company received $7.9 million from the IRS in the six months ended June 30, 2010.

4.              Planned Maintenance Outage

Cost of sales for the six months ended June 30, 2010 included approximately $6.8 million for the tri-annual planned maintenance outage for the Company’s South Carolina paper mill.

5.              Inventories

Inventories consist of the following at June 30, 2010, and December 31, 2009, respectively:

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6.              Derivative Instruments and Hedging Activities

The Company uses derivative instruments to manage its foreign currency exchange risks associated with euro-denominated sales of its U.S. operations. Foreign currency forward contracts are used to hedge the variability of exchange rates on the Company’s cash flows and foreign exchange forward contracts are used to offset the impact on earnings relating to the variability in exchange rates on euro-denominated sales.  The derivative instruments are valued using Level 2 inputs which are significant observable inputs for similar assets and liabilities in active markets. The Company does not acquire or issue derivative financial instruments for trading purposes.

The foreign currency forward contracts are designated as cash flow hedges.  The contracts are recorded in the consolidated balance, measured at fair value.  The effective portion of the gain or loss on the derivative is recorded as a component of accumulated other comprehensive income (“AOCI”) in the accompanying consolidated balance sheet and is reclassified into net sales in the consolidated statement of income upon recognition of the hedged sales. The foreign currency forward contracts outstanding have monthly maturity dates through December 31, 2010. The effectiveness of these forward contracts are assessed both at inception and on a quarterly basis to ensure that they are effective in offsetting changes in the cash flows attributable to the hedged risk.

The notional amount of these foreign currency forward contracts was $18.3 million and $0 at June 30, 2010 and December 31, 2009, respectively. The estimated pre-tax gain to be recognized in earnings during the next twelve months upon settlement of the forward contracts is $0.1 million.

The Company’s foreign exchange forward contracts, which are not designated as qualifying accounting hedges, are recorded at fair value with changes in the fair value of these contracts recognized in earnings.

For consolidated financial statement presentation, net cash flows from such hedges are classified in the categories of the consolidated statement of cash flows with the items being hedged.

The table below lists the fair value and location of the Company’s derivative instruments in the consolidated balance sheet:

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The table below presents the pre-tax effect of derivative instruments and their location within the consolidated statement of income for the six months ended June 30, 2010 and 2009:

7.      Long-Term Debt

For the three months ended June 30, 2010, long-term debt repayments totaled $3.8 million. For the six months ended June 30, 2010, long-term debt repayments totaled $18.0 million including a $10.0 million voluntary prepayment. In connection with the voluntary prepayment, $0.3 million of debt issuance costs were amortized.

At June 30, 2010 the carrying amount and fair value of the Company’s long-term debt was $103.6 million and $83.4 million, respectively.  At December 31, 2009 the carrying amount and fair value of the Company’s long term debt was $121.0 million and $94.8 million, respectively. The fair value of the Company’s long-term debt was estimated using an income approach based on current interest rates available to the Company for debt of similar terms and maturities.

8.     Income Taxes

The Company’s U.S. federal statutory income tax rate is 35% for 2010 and 2009. The Company’s effective tax rate for the six months ended June 30, 2010 and 2009 was 34.8% and 40.0%, respectively.  The differences between the effective tax rate and the federal statutory tax rate for the six months ended June 30, 2010 were due to the benefit related to the refundable tax credit from the inorganic content of the black liquor burned in 2009 and a higher expected benefit from the domestic manufacturing deduction.

Differences between the effective tax rate and the federal statutory tax rate for the six months ended June 30, 2009 were due to the impact of state tax net of federal benefit, the domestic manufacturing tax deduction and a discrete item relating to the sale of the dunnage bag business.

The gross unrecognized tax benefits, including interest as of June 30, 2010 increased by $5.8 million to $68.8 million from $63.0 million at December 31, 2009.  Unrecognized tax benefits of $68.8 million were included in other long term liabilities in the accompanying consolidated balance sheet.

In the normal course of business, we are subject to examination by taxing authorities. The Company’s open tax years are 2006 through 2009. The Company’s tax returns for 2007, 2008 and 2009 are currently under examination by the Internal Revenue Service.

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9.    Net Income Per Share

Basic and diluted net income per share is calculated as follows:

Common stock warrants were not included in the calculation of diluted earnings per share for the three and six months ended June 30, 2009 since the weighted average share price per share of common stock was $3.68 and $2.81, respectively, compared to the warrant’s conversion price of $5.00, and the effect would be anti-dilutive.  The common stock warrants expired on August 17, 2009.

Unexercised stock options totaling 2.2 million were outstanding during the three and six months ended June 30, 2009, but were not included in the computation of diluted earnings per share because the options were not-in-the-money.

In March 2010, the underwriter’s purchase option was exercised and converted into 348,393 shares of common stock. Underwriter’s purchase option of 1,000,000 units were outstanding at June 30, 2009, but were not included in the computation of diluted earnings per share because the option was not-in-the money for the three and six month periods ended June 30, 2009.

10.    Pension Plan and Post Retirement Benefits

Defined Benefit Pension Plan

The KapStone Paper and Packaging Corporation Defined Benefit Pension Plan (“Pension Plan”) provides benefits for approximately 1,000 union employees.

Net pension cost recognized for the three and six months ended June 30, 2010 and 2009 for the Pension Plan, is as follows:

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KapStone funds its Pension Plan according to Internal Revenue Service funding requirements. Based on those limitations, KapStone has funded $1.2 million for the six months ended June 30, 2010 and expects to fund an additional $2.9 million to the Pension Plan in 2010.

Other Post-retirement Benefits

Net post-retirement cost recognized for each of the three and six months ended June 30, 2010 and 2009 for the Company’s retiree medical and life insurance plan was less than $0.1 million.

Defined Contribution Plans

The KapStone Defined Contribution Plan (“Contribution Plan”) covers all eligible employees. Company monthly contributions to the Contribution Plan are based on the matching of employee contributions, vest immediately for salaried, non-bargained hourly and certain union employees, and vest after three years for other union employees. For the three months ended June 30, 2010 and 2009, the Company recognized expense of $0.9 million and $0.4 million, respectively, for matching contributions.  For the six months ended June 30, 2010 and 2009, the Company recognized expense of $1.9 million and $1.2 million, respectively, for matching contributions.

The Company’s Retirement Savings Plan (“Savings Plan”), which covers all eligible salaried and non-bargained hourly employees, provides for an annual contribution based on an employee’s salary and age.  The Company contributions vest 100% after three years. For the three and six months ended June 30, 2010, the Company recognized expense of $0.5 million and $1.0 million, respectively. Effective February 1, 2009, the Company temporarily suspended contributions to the Savings Plan due to economic conditions, and as a result, no expense was recognized during the three and six months ended June 30, 2009. The Company reinstated contributions to the Savings Plan in November 2009.

11.          Stock-Based Compensation

On May 27, 2010, stockholders approved the Amended and Restated 2006 Incentive Plan to increase the maximum shares of common stock available for issuance under the 2006 Plan to 5.7 million shares.

The Company accounts for stock awards in accordance with ASC 718, Compensation – Stock Compensation, which requires that the cost resulting from all share-based payment transactions be recognized as compensation cost over the vesting period based on the fair value of the instrument on the date of grant. The Company recognized $1.6 million and $2.2 million of non-cash compensation cost for the three and six months ended June 30, 2010, respectively, and $0.5 million and $1.0 million for the three and six months ended June 30, 2009, respectively.

Stock Options

In May 2010, the Company’s Compensation Committee granted 450,098 stock options to directors, executive officers and employees of the Company.  The stock options vest as follows: 50% after two years and the remaining 50% after three years or upon reaching age 65.  The stock options awarded in 2010 have a contractual term of ten years. The stock options are subject to forfeiture should the recipient terminate his or her employment with the Company for certain reasons prior to vesting in their awards, or the occurrence of certain other events such as termination with cause. The exercise price of these stock options is based on the closing market price of our common stock on the date of grant ($11.36 for the 2010 awards) and compensation expense is recorded on an accelerated basis over the awards’ vesting periods.

The weighted average fair value of the KapStone stock options granted in May 2010 was $4.90. The fair value was calculated using the Black-Scholes-Merton option-pricing model based on the market price at the grant date and the weighted average assumptions specific to the underlying options. The expected volatility assumption is based on volatility of related industry stocks. The Company uses the “simplified method”, defined in SEC Staff Accounting Bulletin (“SAB”) No. 107, to determine the expected life assumption for all of its options.  The Company uses the “simplified method”, as permitted by SAB No. 110, as it does not have historical exercise data to provide a reasonable basis upon which to estimate expected life due to the limited time its equity shares have been publicly traded. The risk-free interest rate was selected based upon yields of U.S. Treasury issues with a term similar to the expected life of the stock options.

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The assumptions utilized for calculating the fair value of stock options during the period are as follows:

The following table summarizes stock options amounts and activity:

Total stock-based compensation related to the stock option grants was $0.9 million and $1.2 million for the three and six months ended June 30, 2010, respectively, and $0.3 million and $0.6 million for the three and six months ended June 30, 2009, respectively.

As of June 30, 2010 and 2009, there was $2.5 million and $2.1 million, respectively, of total unrecognized compensation cost related to non-vested stock options. The cost is expected to be recognized over a weighted average period of 2.0 years.

Restricted Stock

In May 2010, the Company’s Compensation Committee granted 166,534 restricted stock units to executive officers, directors and employees as compensation for service. These restricted stock units are restricted as to transferability until they vest three years from the grant date or upon reaching age 65. These restricted stock units are subject to forfeiture should these employees terminate their employment with the Company for certain reasons prior to vesting in their awards, or the occurrence of certain other events. The value of these restricted stock units is based on the closing market price of our common stock on the date of grant and compensation expense is recorded on a straight-line basis over the awards’ vesting periods.

The following table summarizes restricted stock amounts and activity:

(1) Includes 40,714 of restricted stock units that immediately vested upon issuance in May 2010 for awardees age 65 or older.

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Total stock-based compensation related to the restricted stock awards was $0.7 million and $1.0 million for the three and six months ended June 30, 2010, respectively, and $0.2 million and $0.4 million for the three and six months ended June 30, 2009, respectively.

As of June 30, 2010 and 2009, there was $2.1 million and $1.8 million, respectively, of total unrecognized compensation cost related to the restricted stock. The cost will be recognized over the remaining vesting period of 1.8 years.

12.   Stockholder’s Equity

In connection with the Company’s initial public offering on August 19, 2005, the Company issued for $100 an option to the representative of the underwriters to purchase up to a total of 1,000,000 units at a price of $7.50 per unit. Each unit consisted of one share of the Company’s common stock, $0.0001 par value, and two warrants. The warrants expired on August 17, 2009, but were not exercised. In March 2010, the purchase option was exercised at a market price of $11.51 per share.  The purchase option was exercised on a cashless basis and therefore no cash proceeds were received by the Company.  Accordingly, 348,393 shares of common stock were issued in March 2010.

For the three and six months ended June 30, 2010, exercises of employee stock options totaled 31,786 shares and 80,236 shares, respectively, with cash proceeds to the Company of $0.3 million and $0.5 million, respectively.

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13.   Segment Information

The Company has one reportable segment, unbleached kraft. The unbleached kraft segment consists of the Company’s paper mills in Roanoke Rapids, North Carolina and North Charleston, South Carolina, which produce kraft paper, linerboard, saturating kraft and unbleached folding carton board. These products are sold to customers who convert our products into end market finished products.

In the table below, “Other” represents the Company’s dunnage bag business, which was sold on March 31, 2009.

The Company’s reportable and operating segment is based on financial information regularly evaluated by the chief operating decision maker in determining resource allocation and assessing performance, in accordance with ASC 805, “Segment Reporting.” In the third quarter 2009, the Company revised its reporting structure. Segment disclosures have been revised to conform to the current presentation for all reporting periods.

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Item 2. — MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This Quarterly Report on Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. We have based these forward-looking statements on our current expectations and projections about future events. These forward-looking statements are subject to known and unknown risks, uncertainties and assumptions about us that may cause our actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by such forward-looking statements. In some cases, you can identify forward-looking statements by terminology such as “may,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “continue,” or the negative of such terms or other similar expressions. Factors that might cause or contribute to such a discrepancy include, but are not limited to, those described in Part I Item 1A of our Form 10-K for the fiscal year ended December 31, 2009 and in our other Securities and Exchange Commission filings.  The information contained in this Form 10-Q represents our best judgment at the date of this report based on information currently available.  In providing forward-looking statements, KapStone does not intend, and does not undertake any duty or obligations, to update its statements as a result of new information, future events or otherwise.

The following discussion should be read in conjunction with our Consolidated Financial Statements and related Notes thereto included elsewhere in this report.

Comparison of Results of Operations for the Three Months Ended June 30, 2010 and the Three Months Ended June 30, 2009

Net sales for the quarter ended June 30, 2010 were $199.1 million compared to $156.5 million for the second quarter of 2009, an increase of $42.6 million or 27.2%. The increase in net sales was driven by $23.7 million of higher sales volume in the second quarter of 2010 compared to the second quarter of 2009, mainly due to increased demand reflecting improving economic conditions, $12.2 million due to higher average selling prices and $8.0 million due to a more favorable product mix reflecting a lower percentage of export linerboard sales. Exchange rates negatively impacted net sales by $1.3 million.

Cost of sales, excluding depreciation and amortization expense, for the quarter ended June 30, 2010 was $146.7 million compared to $88.4 million for the second quarter of 2009, an increase of $58.3 million, or 66.0%. The increase in cost of sales was mainly due to a $48.5 million decrease in alternative fuel mixture tax credits (the tax credit expired on December 31, 2009), $7.9 million from increased sales volume and a $2.4 million increase in compensation and benefit costs as the Company reinstated certain benefits in November 2009 and January 2010. Partially offsetting the increase in cost of sales was $0.8 million due to deflation on input costs.

Freight and distribution expenses for the quarter ended June 30, 2010 totaled $20.0 million compared to $13.2 million for the quarter ended June 30, 2009. The increase of $6.8 million was primarily due to $3.4 million reflecting a 14.5% increase in sales volume, $1.8 million due to product mix and $1.6 million due to inflation.

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Selling, general and administrative expenses for the quarter ended June 30, 2010 totaled $8.9 million compared to $7.6 million for the quarter ended June 30, 2009. The increase of $1.3 million reflects $1.6 million of higher compensation and benefit expenses as the Company reinstated certain benefits in November 2009 and January 2010 and $1.0 million of higher stock compensation expense. Partially offsetting the increase in selling, general and administrative expense was a $1.4 million reduction in expense for the termination of transitional services provided by MeadWestvaco in the fourth quarter of 2009.

Depreciation and amortization for the quarter ended June 30, 2010 totaled $11.1 million compared to $13.5 million for the quarter ended June 30, 2009. The decrease of $2.4 million was due to lower intangible asset amortization. The Company acquired a coal contract with below market prices in conjunction with the Charleston Kraft Division (“CKD”) acquisition. The contract and related amortization expired on December 31, 2009.

Gain (loss) on sale of business reflects a working capital adjustment of $0.7 million for the three months ended June 30, 2009 in connection with the sale of the dunnage bag business.  The dunnage bag business was sold in March 2009.

Foreign exchange losses for the three months ended June 30, 2010 were $0.5 million compared to a foreign exchange gain of $0.2 million for the three months ended June 30, 2009. The change reflects the impact of a strengthening U.S. dollar compared to the euro in 2010.

Interest expense for the quarters ended June 30, 2010 and 2009 was $1.3 million and $5.0 million, respectively. Interest expense reflects interest on the Company’s senior credit agreement and amortization of debt issuance costs. Interest expense was $3.7 million lower in the quarter ended June 30, 2010 primarily due to lower debt balances resulting from $280 million of debt repayments in 2009.

Provision for income taxes for the quarters ended June 30, 2010 and 2009 was $3.6 million and $10.4 million, respectively, reflecting an effective tax rate of 33.7% for the quarter ended June 30, 2010 compared to 36.5% for the same period in 2009. The lower provision for income taxes in 2010 reflects a $17.8 million reduction in pre-tax income. The lower effective tax rate in 2010 is due to the benefit related to the refundable tax credit from the inorganic content of black liquor burned in 2009 and a higher expected benefit from the domestic manufacturing deduction.

Segment Results

The following table presents a reconciliation of consolidated net sales and operating income to amounts reported by operating segment: