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Executives

Roger W. Stone – Chairman and Chief Executive Officer

Andrea K. Tarbox – Chief Financial Officer and Vice President

Analysts

James Armstrong – Vertical Research Partners

Steve Chercover – D.A. Davidson & Co.

KapStone Paper and Packaging Corp. (KS) Q4 2012 KapStone Earnings Call February 14, 2013 11:00 AM ET

Operator

Good day ladies and gentlemen, and welcome to the Fourth Quarter 2012 KapStone Paper and Packaging Corporation conference call. My name is Kim, and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of the conference. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

The information in this earnings call contains certain forward-looking statements within the meanings of federal securities laws. These statements reflect management’s expectations regarding future events and operating performance and speak only as of February 14, 2013. These forward-looking statements involve a number of risks and uncertainties. A list of factors that could cause actual results to differ materially from these expressed in or underlying any forward-looking statements can be found in the company’s filings with the Securities and Exchange Commission, such as its annual and quarterly report. The company’s disclaim any obligations to revise or update such statements to reflect the occurrence of events after the date of this earnings call.

I would like to turn the call over to Mr. Roger Stone, Chairman and CEO. Please proceed.

Roger W. Stone

Thank you very much. Good morning, and happy Valentine’s Day, and thank you for being with us this morning. As usual, Andrea Tarbox our CFO is with me.

2012 was a good year for KapStone and it turned out just about the way we planned it with an adjusted EBITDA of about $183 million. However, the fourth quarter could have been better. Because of the threat of the longshoremen strike, we rushed to build our overseas Durasorb inventories and we pushed back domestic linerboard to ship export orders.

These moves have a small negative impact on the fourth quarter revenue and results. And it would appear that some other companies did the same thing, as December was a particularly strong export month for container board. Although fourth quarter corrugated container shipments were ahead of last year’s comparable numbers, they fell off much more than we had expected in the last two weeks of December, almost off a cliff. But the good news is that January and February so far have been quite strong.

And finally, our fiber costs were also higher than our expectations. And as you know in the quarter, we made an event-driven decision to pay our first company dividend or special dividend to benefit our shareholders before the huge impact of the administration’s plan to raise the dividend tax to an extraordinary level. Similarly we paid out about 80% of the estimated bonuses except for [Mattamy] to save our employees increased taxes on the money they earned in 2011.

For much of the same reason, we accelerated the spring dusting of our RS use, again except for Mattamy. And because of the dividend tax issues as we saw an unusual level of options exercised as well.

And now I’ll turn it over to Andrea who will cover our numbers and then I’ll return with a few comments about the future before we open the phones. Andrea?

Andrea K. Tarbox

Good morning. Before I get going on this probably too long presentation I do want to point out something. We all know today is Valentine’s Day, but what you all might not know or possibly don’t care about is the fact that this call marks Roger’s and my 25th earnings call here at KapStone. So, happy 25th for us and happy Valentine’s Day to you all.

Roger W. Stone

[It’s aging] what you measure.

Andrea K. Tarbox

Well, you know, anyway. The presentation for today’s review of fourth quarter and the full year 2012 financial results is located on our website, www.kapstonepaper.com in the Investors section for those of you who haven’t already located it.

We’ll start on slide three, which is clearly one of our favorite, detecting KapStone’s remarkable growth in both net sales and adjusted EBITDA at compounded annual growth rates of 40% and 30% respectively over our six-year operating history. More remarkable is that these robust results were achieved by the fairly weak economy.

Given the very strong cash flows generated from these earnings, KapStone was able to return to its shareholders on December 20, a $2 per share dividend equaling 9% of the stock price on the dividend announcement date. The dividend payout totaled $95 million. Post dividend KapStone remained well capitalized with a net debt-to-EBITDA ratio of 1.9 and it’s well-positioned to continue to pursue additional growth opportunities.

Slide four is a financial snapshot of our 2012 full year results compared to 2011. Record results were achieved in numerous categories. Some key items to note are net sales of $1.2 billion, adjusted EBITDA of $183 million, adjusted net income of $71 million, and adjusted diluted EPS of $1.48, all of which were records for Kapstone.

Slide five shows an annual and quarterly mill production in tons. Operations ran well in 2012, achieving record production of 1.6 million tons and it is notable that our legacy mills collectively surpassed their previous production record.

In the fourth quarter, we produced 383,000 tons. Two of our mills Roanoke Rapids and [Charleston] completed their annual planned maintenance outages in the fourth quarter which reduced production by 12,500 tons. We ended 2012 with approximately the same year-over-year finished goods inventory level for our legacy operations.

On slide six, we have analyzed the changes in sales in the adjusted EBITDA from 2011 to 2012. Net sales are up $311 million, or 34% and adjusted EBITDA was up $18 million or 11%. Clearly the USC acquisition was a key driver in our improved results with 2012 benefiting from having a full year of USC operations versus 2011’s two months. USC added $331 million of revenue, year-over-year, and $35 million of adjusted EBITDA.

Lower average selling prices was $622 per ton, down $5 for the year resulted in a $5 million decrease to both net sales and adjusted EBITDA. Export container board prices began recovering during the first quarter of 2012, and prices by the end of the year were $54 per ton higher than the end of 2011. The $50 per ton domestic containerboard. Price increase was fully implemented by the end of the fourth quarter, offsetting some of the price declines from export sales prices. The weaker euro, which averaged $1.29 in 2012 versus 2011, $1.39, also negatively impacted net sales prices and adjusted EBITDA by $4 million, as a large percent of our Durasorb sales are denominated in euros.

Finally, after having remained fairly innocuous during the second and third quarters, inflation once again became a factor in the fourth quarter with higher wood and compensation costs, together with the higher chemical cost earlier in the year. The total inflation impact for the year was $13 million.

Turning to slide seven, we have the full 2012 year results for our USC acquisition. Total net sales were $389 million and 6.2 billion square feet of sales, and adjusted EBITDA was $41 million. The box and corrugated sheet price increases of 8% and 10% were substantially implemented by the end of the fourth quarter with a few remaining contractual increases to be realized in 2013.

We have now integrated USC’s corporate and administrative functions, realizing $8 million of corporate synergies. The remaining operational synergies consisting of product sourcing, paper machine utilization, freight rationalization and purchasing of $8 million are on target. USC has been accretive from day one and has contributed $0.27 to our bottom line in 2012.

To achieve this, we adjusted USC earnings by excluding any one-time acquisition costs, but we included all interest expense and amortization of related financing fees. USC also provided $37 million of acquired pre-tax NOLs, which reduced KapStone’s cash taxes.

Finally, from a strategic viewpoint USC provided KapStone with greater stability and flexibility over the economic cycles by allowing us to use our paper for internal consumption purposes when it makes sense.

Slide 8, is a summary of our fourth quarter results compared to both the prior year’s quarter and to the previous sequential quarter. Fourth quarter 2012 net sales were $301 million and adjusted EBITDA reached $38 million. Adjusted net income for the fourth quarter of 2012 was $13 million down $1 million or 7% year-over-year. And fourth quarter adjusted diluted EPS was $0.28 down $0.01 from Q4 2011.

To get more color on these changes, let’s move to slide 9, which analyzes the $32 million increase in net sales from Q4 2011 to Q4 2012. And the ups and downs of adjusted EBITDA and the fourth quarter of 2012, which kept it flat at $38 million versus the prior year. The USC acquisition added $40 million of net sales and $5 million of adjusted EBITDA and was the primary driver of change for the quarter. As 2012, included three months of operations compared to two months in 2011.

In addition, an increase in the average selling prices driven by the fourth quarter containerboard increase added $2 million to both net sales and adjusted EBITDA. Average no revenue per ton was $634,000 up $14 from 2011. And the partial realization of the domestic containerboard price increase and the continuing price recovery for export containerboard. The $5 million benefit from USC was offset by inflation, primarily on fiber. In Q4 2012, seasonally wet weather returned to the southeast, after over a year of drier than normal weather resulting in higher fiber cost, compensation and benefit cost were also higher.

Higher planned maintenance outages reduced adjusted EBITDA by $2 million in Q4 of 2012. Outage costs were lower than we announced in November due to more efficient completion of work required and two outages were differed to 2013. The planned major maintenance for 2013 is included in the assumptions page towards the back of this presentation. And we’ll cover that in a few minutes.

Turning to slide 10, we show the components of the changes in net sales from Q3 to Q4 2012, keep in mind that in Q4 we had our Roanoke Rapids and Cowpens’ annual planned maintenance outages that increased our cost and reduce the tons of paper available for sales by 12,500 tons. Net sales were down $9 million or 3% and adjusted EBITDA was down $11 million or 22%.

Despite an increase in average mill revenue per ton of none to 634 in Q4, lower volume from tons loss due to the outage and increased internal shipments more than offset the gain. The seasonal slowdown in our corrugating plants also impacted results. The planned maintenance outage cost incurred for Roanoke Rapids and Cowpens were $13 million higher in Q4 compared to none in Q3.

Slide 11 is a special slide, a special slide because it describes the KapStone’s special dividend, announced and paid in Q4. An interesting fact is that the $95 million special dividend is 43% of the combined total $222 million invested by shareholders in our IPO and for the warrant.

The anticipated personal tax rate changes in the dividend triggered significant stock option activity in Q4. Employees elected to exercise $1.3 million stock options, most of which were on a cash-less basis. The pay for their related payroll taxes, the employees surrendered 0.4 million shares and the company then used 8.3 million, yeah, and the company then used 8.3 million of cash to pay the taxes.

This activity resulted in increased employee share ownership and the CEO and COO increased their ownership by 439,000 shares collectively. The option exercises generated $6 million of cash benefits for the company, most of which will be realized in 2013. Finally, KapStone accelerated divesting of 71,877 restricted stock units that would invested in early 2013 for all eligible employees, excluding the CEO and the COO.

On slide 12, you can see that KapStone is producing a high level of sustainable free cash flow. Adjusted free cash flow calculated by starting the cash flow from operations and subtracting capital expenditures was $91 million for 2012, or $1.90 per diluted share. The decrease in free cash flow from 2011 was primarily due to the acceleration of $7 million of employee incentive payments from Q1 2013 to Q4 2012 in anticipation of the impending tax rate changes. 2013’s Q1 cash flow will benefit from this early payment.

CapEx for the year was $67 million including about $25 million for maintenance related projects. Strategic capital spending included $10 million for the USC acquisition, systems integration and $4 million for the initial work on the Charleston paper machine upgrade project. The adjusted effective income tax rate for the 2012 year was 34.2% compared to an adjusted rate of 38% for 2011. In 2012, the effective income tax was lower due to lower state taxes. The company’s tax rate in the fourth quarter of 2012 includes a $1.7 million costs for the impact of $1.3 million employee stock option to exercise in conjunction with the December 2012 special dividends. The intrinsic value of the stock options exercise is required by the IRS. To be treated as a compensation expense, which then included in our tax provision, reduce the benefit from the domestic manufacturing detection.

Accordingly, we have included a $1.7 million income tax adjustment in our adjusted net income and adjusted fully diluted EPS. The positive size of the stock option exercises from a tax perspective is that it reduced the amount of cash taxes that the company paid in 2012, resulting on a cash tax rate for the year at 7%, down from 10%, and will contribute to a cash tax rate of about 15% in 2013.

On slide 13, net debt at December 31 was $352 million. Our average interest rate is currently 1.7%, and our net debt to EBITDA leverage ratio was 1.9 times. We amended our credit agreement in Q4, primarily to accommodate the special dividend, but while we were added; we also subsided in reducing our interest rate grade by 25 basis points and extended the agreement by one additional year to November 2017.

As of December 31, we had $17 million of cash and $80 million of revolver borrowing capacity. Additionally, our credit facility has a $450 million accordion provision to provide for future borrowings. On slide 14, we summarize some key assumptions to keep in mind for Q1, 2013. In a few minutes, Roger will address pricing in our expectations there. Our mills will have two less production days in Q4, 2012 and one less day in Q1 2012 due to the leap year. From a production perspective, current plan adage and major maintenance should cost approximately $4 million and result in a loss of approximately 2,000 tons.

Q1 2013 maintenance cost therefore should be about $9 million left than Q4 2012. We’ve set some upward cost pressure on input cost driven mainly by fiber costs with seasonal conditions currently impacting Q1. Q1 payroll taxes should be approximately $1 million higher than Q4 2012 particularly in unemployment.

Turning now to slide 15, we have summarized our thoughts on the key assumptions for the 2013 year. Once again, Roger will talk about pricing and we’ll talk about the planned outages.

The current planned outages and major maintenance are solid. Q1, we already discussed, Q2 should be about $8 million of expense, a loss of about 6,000 production tons because in that quarter, we have our tri-annual Charleston co-mill outage. In Q3, we expect about $3 million outages expense and no loss in production tons and then Q4, $9 million of expense and expected loss of about 10,000 production tons.

Planned maintenance outrage costs for the year of 2013 therefore, is expected to approximate $24 million, up $6 million in 2012 which is due to the tri-annual outage Charleston. Our estimated income tax rate is expected to be 35% and the cash tax rate will be about 15%. 2012 average FX rate was $1.29, and currently, we are at $1.33. So, you can predict on that. Finally, thanks for bearing with me and I’m going to turn this back over to Roger now.

Roger W. Stone

Thank you, Andrea. Looking ahead, our major story continues to be product pricing, a container and containerboard increase was successful, and the roll-up in this increase will have a significant positive effect on this year’s results. Export linerboard prices are more than $50 a ton, ahead of last year’s average number. We’ve implemented a $50 a ton increase on kraft paper with many accounts up February 1 and the balance to follow according to our contract terms. Also it’s worth noting that boxboard and coated unbleached kraft producers have announced $25 to $50 a ton increases.

Our kraft pack prices tend to follow coated, unbleached kraft pricing. As of today, we have not made any announcement.

Industry inventories have remained low in containerboard side at 3.6 weeks of supply. Our year-end containerboard inventories were about right for us and down about 8% from the previous year. We expect industry inventory levels to remain low.

2013 is off to a very good start with a strong January and February so far. Backlogs are strong and Durasorb, even Durasorb appears to have to be having its best first quarter since 2008, which we believe reflects the improvement in the constructions area. We’re looking-forward to a very good year and now we’ll open the phones for questions.

Question-and-Answer Session

Operator

(Operator Instruction) And your first question comes from the line of James Armstrong with Vertical Research Partners, please proceed.

James Armstrong – Vertical Research Partners

The first is can you give you debt. It’s you put a lot of it in the short term dept. Is there any plan of your short term borrowings or just pay them off with cash generated this year? And, on that also looking at M&A, would you be surprised if you not make any acquisitions in 2013?

Unidentified Company Representative

I’m always surprised. [Jim your] how do you announce, I hope we got it all. But the question was short term debt versus…

Unidentified Company Representative

Right, right, we used our revolver, and with the revolver we can put that out at the same rate as our long term debt. So, we do intend to pay off the revolver. We don’t intend to do anything else of that, other than pay it off, but it’s at the rate as our terms loans, so, that’s it on the dept, I guess...

Unidentified Company Representative

Yeah, I would say, always careful what you say about that subject. I would say what we – we always hope to make a good acquisition timing and opportunity could vary, but some of this, it’s always on our mind.

James Armstrong – Vertical Research Partners

Fair enough. Switching gears just a bit with the announcement today in the European container-board market, in your opinion, do you think there is a need for further pricing in the U.S. market on container board as we look out into the year?

Unidentified Company Representative

Well, containerboard were still a great bargain as our containers in the United Sates relative to most of the world, if not all of the world. I think conditions, I don’t know if there is going to be a price increase, I wish I get. But I believe the conditions will be right this year with low inventories, slight or improved demand. And so, yeah, I think the conditions are still good for the pricing, will be good for the price increase this year.

James Armstrong – Vertical Research Partners

Extremely helpful. And lastly, is there any projects what you are doing with the maintenance that are helping off and mitigate the cost inflation that you’re seeing in 2013?

Unidentified Company Representative

Yeah, we’ve done a number of things in the project we had in the fourth quarter at Roanoke Rapids. We increased the capacity of our turbine for example, and therefore our purchased energy cost will be down. And yes, we did a number of investments and productivity and reliability and reduce cost. Our biggest project which doesn’t get completed until this time next year, as it scheduled on my birthday. Does a lot to increase our capacity in lightweight containerboard and reduces cost substantially and will enable us to move paper in our system around which will give us further economies.

James Armstrong – Vertical Research Partners

And have you announced that how much capacity that will add in lightweight next year?

Unidentified Company Representative

I don’t think we’ve announced that, we might have. We announced the money in more details about it, but I’m not sure we gave our balance sheet in

James Armstrong – Vertical Research Partners

Okay. Thank you very much.

Operator

Your next question comes from the line (inaudible). Please proceed.

Unidentified Analyst

Hey, guys. It's actually Rich.

Roger W. Stone

Hi, Rich.

Unidentified Analyst

Couple of questions, so US corrugated looks – now looks like a really solid acquisition that we did with really low cost financing. I guess, what does the pipeline look like now for companies out there for sale or just one-off mills, box plants? And then, if we had been six months further along on corrugated, would that have changed what you did with the mills IP was divesting?

Roger W. Stone

Well, I think IP got a great deal, and it turned out as a great deal for the people broader as well, so it’s one of those things that was win-win. I don’t – yeah, in perfect hindsight obviously we should have them today, I’m not sure like of two years from now. We’re not disappointed that we don’t hand the mills. And but we do believe that we are very happy with the acquisition. We do believe we’ve got – we have substantial opportunity for improvement in our whole company but we think the container division has particularly a lot of opportunity.

Unidentified Analyst

And also thank you for the dividends on behalf of my partners…

Roger W. Stone

Okay.

Unidentified Analyst

Paying that in December.

Roger W. Stone

You’re welcome Rich. I liked it too…

Operator

Your next question comes from the line of Steve Chercover with D.A. Davidson. Please proceed.

Steve Chercover – D.A. Davidson & Co.

Thanks, good morning, everyone. First of all, you indicated that you thought that your fiber prices would be up a little bit, because last year was extremely dry. But is there any chance that saw mill residuals will be more plentiful, and therefore, that will neutralize the impact?

Roger Stone

Yes, it’s certainly possible. Clearly, in the southeast you have generally wood yards to take care of long logs shipped due to long shipping and so on, as opposed to the Northwest which relies heavily on saw mill residuals, don’t have a comprehensive wood yard in general. So it’s less impact where we are but yeah I think an improvement in demand for dimensional number should result in increased shifts, and therefore should help moderate the pressure.

Steve Chercover – D.A. Davidson & Co.

And speaking of saw mills, if I'm not mistaken, you have one small one. Is that going to be a profit center this year?

Roger Stone

Its always part of our wood costs and our one unit, but its doing substantially better than it’s ever done for us. And I suspect for a very long time.

Steve Chercover – D.A. Davidson & Co.

Great. And one other, switching gears a bit. Can you talk about the outlook for your Chicago box plant? I mean how are your early bookings looking?

Roger Stone

Well, we haven’t started booking yet, but the plant is going along well. We would hope to start our initial production near the end of March, okay. At Chicago, it’s a market that we now involve and we think we’ll be just fine.

Steve Chercover – D.A. Davidson & Co.

Great. All right, that’s all I had. Thanks.

Operator

(Operator Instructions) I have no further questions at this time. I would now like to turn the call over to Roger Stone for closing remarks.

Roger Stone

No, I never have closing remarks. But thank you all for calling in, it’s been a interesting day and if you can’t tell I’ll say it again, we are very, very excited about this year. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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