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Executives

Roger W. Stone - Chairman of the Board, Chief Executive Officer

Andrea Tarbox - Chief Financial Officer, Vice President

Analysts

Jack Ripstein - Potrero Capital

Matt Erwood

Todd Cohen - MTC Advisors

David Cohen - Athea Capital Management

Kevin Beck - Artisan Partners

Ron Gutfleish - Elm Ridge Capital

Jerry Chan - William Harris Investors

KapStone Paper and Packaging Corp. (KPPC) Q4 2007 Earnings Call March 17, 2008 2:00 PM ET

Operator

Good day, ladies and gentlemen, and welcome to the KapStone Paper and Packaging Corporation full year and fourth quarter 2007 earnings release conference call. (Operator Instructions)

Statements in this news release that are not historical are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements can often be identified by words such as "may," "will," "should," "would,' "expect," "project," "anticipate," "intend," "plan," "believe," "estimate," "potential," "outlook," or "continue," the negative of these terms or other similar expressions and include, among others, statements under the caption "Operating Highlights".

These statements reflect management's current views and are subject to risks, uncertainties and assumptions, many of which are beyond the company's control that could cause actual results to differ materially from those expressed or implied in these statements.

Factors that could cause actual results to differ materially include, but are not limited to: industry conditions, including changes in cost, competition, changes in the company's product mix and demand and pricing for the company's products; market and economic factors, including changes in pension and healthcare costs and natural disasters, such as hurricanes; results of legal proceedings and compliance costs, including unanticipated expenditures related to the cost of compliance with environmental and other governmental regulations; and the ability to achieve and effectively manage growth; ability to pay the company's debt obligations; and ability to carry out the company's strategic initiatives and manage associated costs.

Further information on these and other risks and uncertainties is provided under Item 1A "Risk Factors" in the company's Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, which is incorporated herein by reference, and elsewhere in reports that the company files or furnishes with the SEC. These filings can be found on KapStone's website at www.kapstonepaper.com and the SEC's website at www.sec.gov.

Forward-looking statements included herein speak only as of the date hereof and the company disclaims any obligation to revise or update such statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or circumstances.

At this time, I would now like to turn the presentation over to your host for today’s call, Mr. Roger Stone, Chairman and CEO. Please proceed, sir.

Roger W. Stone

Thank you very much. Again, thank you all for joining us and good St. Patrick’s Day to you, I guess. As usual, Andrea Tarbox, our CFO, is with me. On Friday afternoon we filed our 10-K and our 2007 earnings release. Since it’s unlikely that many of you have had a chance to study our filings, as usual I’ve asked Andrea to review the fourth quarter and our annual highlights. Andrea.

Andrea Tarbox

Good afternoon. Our full year 2007 basic earnings per share was $1.08 and fully diluted EPS was $0.75 for the year. Adjusted basic EPS was $1.12 and adjusted diluted EPS was $0.78 for the year. Adjusted net income of $27.9 million was up 40% or $8 million from the previous year. Adjusted EBITDA for the year was $57.2 million versus $52.2 million for 2006, an increase of nearly 10% or $5 million.

The adjusted numbers exclude first quarter 2007 pretax adjustment of $1.5 million for a one-time, non-cash charge made in connection with the KPB acquisition to adjust inventory to fair value.

Our net sales for 2007 increased 4% to $256.8 million from $246.2 million. Sales for our unbleached segment were $227.9 million, compared to $214.2 million in 2006, and were driven by higher prices from a full year’s realization of unbleached kraft paper price increases implemented in 2006 and additional price increases during 2007.

Average revenue per ton, up $18, or 3%, accounted for approximately $7.6 million of the sales increase. Our volumes increased by 11.4 thousand tons, or 3%, so 11,358 tons, driven by a 38.5 thousand ton increase in linerboard, more than offsetting a 27.2 thousand ton reduction in kraft paper sales.

The net sales increase in the unbleached segment was partially offset by lower dunnage bag sales, down $3 million or 8% to $32.8 million compared to the previous year, mainly due to volume decline on lower demand from the less-than-truckload market and the loss of two key accounts at our distributors. Volume declined 7% to 8.7 thousand bags from 9.4 thousand bags. Average price per bag was $3.78, down $0.03 per bag.

Selling, general, and administrative expenses of $16.5 million were up $5.2 million, or 46% over the prior year on higher corporate charges. Included in the corporate charges are approximately $2.4 million per quarter for the cost of transitional services provided by international paper that will be terminated upon completion of the company’s own ERP system. We will begin to use our new ERP system in the second quarter of 2008.

Total operating income for the 2007 full year was up $10.3 million to $44.3 million, or 30% over 2006. Adjusting for the $1.5 million non-cash purchase accounting charge for inventory, operating income would have been up almost $12 million, or 35%.

Adjusted unbleached kraft operating income of $53.1 million was nearly $19 million, or 55% over prior year, resulting in a 23% operating margin. Our unbleached segment benefited from higher selling prices, volume increases, productivity gains, and lower depreciation charges.

During 2007, we had several unplanned outages at our mills. In June, an electrical fire reduced our production by approximately 2,200 tons, negatively impacting our operating income by $1 million. In the fourth quarter, several shorter unplanned outages negatively impacted our operating income by an additional $1.9 million.

On January 8th, we announced a $40 per ton price increase on our kraft paper product and we expect to see the benefits from this price increase in the second quarter of 2008. In addition, the major manufacturers of linerboard have announced their intentions to raise linerboard prices by $50 per ton. This linerboard price increase is supported by low inventories, strong export demand, and higher costs for fiber, energy, freight, and chemicals. At this point, it is unclear as to when and how much of this increase will be implemented.

Partially offsetting the gains in operating income from the unbleached kraft segment was the decline of $0.9 million, or 12% in the dunnage bags adjusted operating income from the prior year. Adjusted operating margin was 20.3%, down 0.7% from the previous year on the decreased volume and prices.

Depreciation and amortization expenses for the full year of 2007 were $11.3 million versus $18.2 million recorded in the full year of 2006. The change is due to the revaluation of plant, property, and equipment to fair values as required by U.S. GAAP purchase accounting.

Our full year 2007 adjusted EBITDA of $57.2 million contributed to the generation of cash for our balance sheet. Cash generated from operations of $52.2 million for the full year of 2007 was an increase of $16 million, or 44% over 2006. We invested approximately $12 million on capital expenditures. The majority, $6 million, was spent on our unbleached business segment and $4 million was for our ERP system.

Our working capital was $65.8 million at December 31, 2007 and we paid down debt by $7.5 million. We ended 2007 with cash and short-term investments of $56.6 million, exceeding our combined current and long-term debt balances of $52.5 million by $4.1 million.

Looking at our balance sheet, you will notice that our current portion of long-term debt is $19.6 million. This resulted from a high class problem that Roger likes to refer to. Based on the strength of our EBITDA, we are required to share some of those positive cash flows with the bank and to prepay $11.6 million of our debt early. In addition, we received $1.6 million from the exercise of common stock warrants in 2007 and that will also be used to pay down debt. These prepayment amounts will be prorated against our future debt payments, lowering them.

We’ve come a long way in our first year of operations and we are looking forward to 2008’s opportunities.

Okay, I’m going to turn it back to Roger.

Roger W. Stone

Thank you, Andrea. We believe KapStone had a great first year in 2007 and although we did not do as well as we had hoped, frankly we ran raggedly in much of the third and fourth quarter and it cost us $3 million in operating income, $1.9 million of that in the fourth quarter.

We’ve got a great team at Roanoke Rapids and are working through their problems and we expect to be back to high efficiency levels in the near future. We continue to have a very strong balance sheet and strong cash flows. As a matter of fact, our cash on the day that we announced our earnings was actually $66.6 million.

Our kraft paper price increase, as Andrea mentioned, is in place and will have a positive impact on the second quarter results and have a small impact on the first quarter. There has been very little push-back from kraft paper converters and most of them are out obviously out raising their prices.

Also, all major companies have announced a kraft linerboard price increase and that appears to be going well. Inventories remain low and export demand remains strong. Clearly the weak dollar is helping keep a good balance between supply and demand.

Our backlogs continue to be a bit higher than we would like for service levels and not surprisingly, cost pressures on energy and freight and chemicals continue. We believe that 2007 net income and EBITDA as a percentage of revenue rank among the very best in our industry, and although we no longer forecast results, we are very optimistic about this year’s outlook and I’m sure that doesn’t surprise anybody on the call.

And finally, we continue to pursue strategic acquisitions that we believe will build significant shareholder value and we are spending a lot of time on that effort. And now we’ll turn the floor over to questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from the line of Jack Ripstein with Potrero Capital. Please proceed.

Jack Ripstein - Potrero Capital

Good morning. A question about strategic acquisitions, given debt markets aren’t all that formidable and -- or aren’t that great, you’ve got a decent amount of cash and you’ve got a low priced stock and there appears to be some sellers in the market with size. It seems to me that would be a heck of a good value strategic acquisition. Any thoughts on that?

Roger W. Stone

It’s a fair question and it’s something we always do consider. And if we don’t think that we can make a strategic acquisition that was better, create better shareholder value than buying in our own stock or warrants, then we’ll probably consider that direction. But it’s something that we’re constantly evaluating. But we’re optimistic. The current situation probably has created a few more pessimists.

Jack Ripstein - Potrero Capital

Well, just that -- I mean, you guys don’t have -- I guess you have a lot of cash, a very depressed stock price. We’d hate to see an acquisition with stock. Any thoughts on how you view the weapons in your arsenal in terms of being able to go out and make an acquisition?

Roger W. Stone

Well, we think that along with our very strong balance sheet and our good EBITDA, we think financing is available to make good acquisitions. We never would intend to leverage up as, for example, as some of the financial buyers have done in the past, which would probably be more difficult to do today but we think the things that we think -- that we hope that will be good if we can make them happen for the company can be financed appropriately through the debt markets at a very good cost.

Jack Ripstein - Potrero Capital

Okay, but you would agree also that your stock is not the best currency to use at this price?

Roger W. Stone

Well, you’re right. It would have to be a most incredible deal for us to consider our stock as a currency, right. I think the stock is selling at a very, very low multiple compared to the industry and is performing superior against the industry. It would be tough to consider using our stock.

Jack Ripstein - Potrero Capital

Just wanted to make sure we were on the same page. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of Matt [Erwood]. Please proceed.

Matt Erwood

Great quarter. Just was wondering if you could -- I know you don’t provide guidance but if you could help walk through the changes year over year that you are seeing in the business. For example, how much EBITDA was the ERP system supposed to contribute? And then, if you look at the 400,000 ton of volume in the kraft paper segment and you apply the $40 price increase to that, is that -- that should mainly fall to the bottom line, is that right?

Roger W. Stone

Well, yes. Obviously we do have cost increases that I mentioned out there but yes, $40 a ton when in place fully would contributed close to $9 million to our bottom line and of course, linerboard would be the balance of the tons and on that at $50 in place, that would contributed annually about another $10 million, if and when those things happened.

The question was --

Andrea Tarbox

ERP.

Roger W. Stone

ERP, what we’ve said, we forecasted we were going to be [inaudible] for so long. This time, I think we believe we are giving you a very accurate forecast.

Andrea Tarbox

Yeah, we think we mean it this time.

Roger W. Stone

And we said that would increase our EBITDA about $0.5 million a quarter.

Matt Erwood

Okay, so $2 million. And then the $9 million is for the full year of a $40 or for nine months?

Roger W. Stone

No, both of those numbers were annualized numbers. We produce -- we sell 220,000, 230,000 tons of kraft paper related -- related to the kraft paper increase and the rest of our tons, a couple-hundred-thousand, are priced according to the kraft linerboard.

Matt Erwood

Okay. And then just looking at the recent data, industry data, it seems like the inventories remain low and the operating rates remain pretty high. Have you seen that following the price increase or is a lot of that just people pre-buying for the price increase?

Roger W. Stone

Well, industry -- on the kraft paper side, industry inventories have remained quite low and operating rates are very high. Some of that, as I said before, is because of more exports because of the weak dollar and also because of less imports, mostly from Canada but some from Europe for the industry. So inventories are quite low and operating rates are quite high on kraft paper.

On linerboard, the inventories are still quite low but there’s been a little build-up of inventories. Historically it happens in January and a little bit in February. The numbers came out today, but still in weeks of supply very balanced with good operating rates. I think the February operating rate for linerboard was something like 97%-plus.

Matt Erwood

Great. Thanks a lot.

Operator

Your next question comes from the line of Todd Cohen with MTC. Please proceed.

Todd Cohen - MTC Advisors

Any guidance on your costs per ton increases going forward, to kind of help understand the dynamics between that and your price increases?

Roger W. Stone

No, we don’t give guidance. In our case, fiber has been pretty steady. We really haven’t had much pressure on fiber but we don’t use any recycled fiber, so that’s very helpful in our profile. But clearly the energy related costs do eventually pass through, not only in the energy we buy on the outside and don’t generate but obviously in the freight and distribution system, and some chemicals have gone well through our forecast. But the question is, I don’t know what the -- we’re not giving guidance.

You know, some of those are short-term, some of those are longer term issues.

Todd Cohen - MTC Advisors

And then on the consolidation side or strategic option side for you guys, does the news today or yesterday on International Paper and Weyerhaeuser present some opportunities for you potentially?

Roger W. Stone

Potentially, yes. Yes, they certainly do. And obviously we think it’s good for the industry and glad to see it finally done but yes, we think there are some potential opportunities.

Todd Cohen - MTC Advisors

So there might be some pieces in that that might fit better for you than for IP, possibly?

Roger W. Stone

Well, it’s possible. We hope so but you never know.

Todd Cohen - MTC Advisors

All right. Thank you.

Operator

(Operator Instructions) Your next question comes from the line of David Cohen with [Athea] Capital Management. Please proceed.

David Cohen - Athea Capital Management

One question, one comment; the question is this -- could you talk a little about your CapEx budget for the year and whether there’s any delta to it or whether you expect, whether you are pretty sure as to what the number’s going to be, and could you share that number with us?

Roger W. Stone

Our capital expenditures will be probably a little less than last year, but pretty close to it. We have no major projects and the ERP is winding up and so -- and we have some good energy projects that we are pursuing but it will be about the same as last year, we think a little less, rather than more.

David Cohen - Athea Capital Management

The observation is this -- I’ve heard you sort of puzzle a little about the valuation the stock is getting in the marketplace and there are probably any number of possible explanations for that and it’s probably some combination of them but I can assure you with the kind of warrant overhang there is out there, you are never going to get a full valuation and I would urge you to use weakness in the broad stock markets to take advantage of the warrants and try and retire as many as you can, using whatever means you deem appropriate. I understand capital is somewhat valuable in this environment but I really -- I think you’d be much better served by backing back some warrants and having a higher stock price.

Roger W. Stone

Well, it’s certainly clearly something that we think about but even on a fully diluted basis, which is what, ours is $0.75 from last year or something like that, fully diluted? You know, the industry multiple is on average is about 11 times, of course, and ours is substantially less than that and we think we ought to be at the top end of the multiple, based on performance. But I probably always will think that.

And the industry in terms of EBITDA goes at about 21 times on the median average, something like that. That’s old news, not -- before this last stock market collapse situation, the multiples were much higher than that now. So we think that the values are very low but clearly the warrant overhang is an issue. It’s something that we do think of all the time and when we consider what we should strategically do to build shareholder value because at the end of the day, like you, I hope, but certainly like our interests are to create as much shareholder value that we can for the long-term investor.

David Cohen - Athea Capital Management

Thanks very much.

Operator

Your next question comes from the line of Kevin Beck with Artisan Partners. Please proceed.

Kevin Beck - Artisan Partners

Thanks for taking my call. I just had a question, if you have any planned outages this year like you had in the second quarter and could you provide any more clarity on I guess the outages that were unplanned in the fourth quarter and what you’ve done to make sure those don’t happen again?

Roger W. Stone

Well, the planned outage, we plan to take a planned maintenance outage. This year it will be in the third quarter, not the fourth quarter, and will be of roughly the same magnitude.

The unplanned outages, most of them related to in the fourth quarter to a problem with the press and the rollers in that press and getting them engineered on -- we had a lot of problems to work that through on the mix and we are still working some of them through but we think that we’re on top of it and we’ll get our, as I said, get our machine efficiencies up to where we think they ought to be and product the tons that we are capable of.

Kevin Beck - Artisan Partners

And secondly in the 10-K, you talked about the acquisition of Sun Rise, Arkansas and the dunnage business has obviously been disappointing I guess in ’07. Can you provide any more clarity on what maybe you are doing there to improve that business and how much risk is there that the Sun Rise business goes away ultimately?

Roger W. Stone

Well, actually the dunnage bag business is a very good business, number one, but suffered relative -- in comparison relative to the previous year. In the fourth quarter, it was, from an earning point of view, it was just about the same as the previous year because we have a non-cash increase in rent because of a purchase accounting adjustment. If you take that out, it would be just about equal to the previous year.

Clearly the Sun Rise acquisition is a concern but we believe that we’ve been working hard on our markets and our customers and we believe that we’ll be able to market our product with the help of Sun Rise or on our own without a problem.

Kevin Beck - Artisan Partners

Can you give us any sense of how big that piece of business is within the dunnage business, in terms of profits or revenues?

Roger W. Stone

Well, it’s bigger in volume than it is in profits, by a significant amount. And I cannot give you a sense. We don’t give out the numbers.

Kevin Beck - Artisan Partners

Okay, and then just maybe lastly on the acquisition side; I mean, I think as you went through ’07, you guys have spoken quite a bit about being relatively disappointed if you don’t have anything done by the end of last year. Obviously that’s come and gone and we’re towards the end of the first quarter of ’08. Can you talk a little bit about what the problem I guess in doing deals out there has been and what else we should be looking for?

Roger W. Stone

Well, the problem isn’t doing a deal -- it’s doing a good deal, one that strategically fits and one that has good value for our shareholders. We could do transactions but we’re not in the business of doing ones that we think are marginal of value to the shareholders. We would rather -- if all we could find was marginal acquisitions, I think we’d take a hard look, as one of the earlier questioners said, take a hard look at the warrants or other equity values.

We think that there’s substantial opportunity out there to do good things. Some of these things take longer than you would think they would take to get accomplished. But we are -- we believe that we’ll be able to live up to the promise we made that we did in our IPO, that we would be able to build a good North American paper company with a couple of billion dollars of revenue within five years. So we believe we can do that and obviously that means that we believe we are going to do something this year.

Kevin Beck - Artisan Partners

And is it fair to say that’s why you’re saving the balance sheet here instead of buying back your own business at less than four times --

Roger W. Stone

It’s fair to say that if I didn’t think we could do that, there probably are better uses for the balance sheet.

Kevin Beck - Artisan Partners

Right. Okay, great. Thanks.

Operator

Your next question comes from the line of Ron Gutfleish of Elm Ridge Capital. Please proceed.

Ron Gutfleish - Elm Ridge Capital

Just a quick one -- you mentioned before it seems like half your tons are priced off liner and half your tons are priced off kraft paper. Does that reflect your production or is it more index pricing?

Roger W. Stone

Well, I mean the big thing there is that we price our roll wrap index to linerboard prices, so it doesn’t move with kraft paper. And so that’s why the tons seem large on the linerboard side versus kraft paper side. It’s priced as it should be, as roll wrap and kraft paper but its movement is timed to linerboard. But the reflection is a reflection of a 220,000 plus production, 220,000, 230,000 -- a [inaudible] [220,000 to 230,000]. You know, we hope eventually to get the mill up to about 440.

Ron Gutfleish - Elm Ridge Capital

Okay, but what is your liner production these -- what was your liner production last year? You mentioned the change but you didn’t mention the total.

Roger W. Stone

I’m sorry, what?

Ron Gutfleish - Elm Ridge Capital

How much liner did you produce last year?

Roger W. Stone

My guess would be it was about 70,000 to 80,000 tons.

Ron Gutfleish - Elm Ridge Capital

Okay. Thank you.

Operator

Your next question comes from the line of [Jerry Chan] with William Harris Investors. Please proceed.

Jerry Chan - William Harris Investors

Congratulations on a good year and a very good fourth quarter. With regard to the production, how much higher will the average production be in ’08 versus ’07, roughly? And how much more are you going to add, or can you add this year?

Roger W. Stone

Jerry, it does depend on the mix that we sell and in theory, if we could sell all kraft paper, we’d have the lowest tons but we’d have the best profits. But that’s not going to happen.

I think that the mill, for the mix that we think we could sell the mill at can be about a 440,000 ton mill without spending any significant capital to get there, as you would spend. But we would hope that this year that we would get into that 430 area.

Jerry Chan - William Harris Investors

Okay. The multiple you were using before, Roger, which was I think 11 times for industry --

Roger W. Stone

Right, for last year’s multiples.

Jerry Chan - William Harris Investors

Yes, is that EBITDA? Is that EBITDA?

Roger W. Stone

No, that would be earnings, Jerry. Earnings, that would be the median of the -- look at any of the sell side analyst numbers, the median sort of pops out at about 11.

Jerry Chan - William Harris Investors

Okay, and then you used a number, I guess you did say EBITDA -- did you say -- were you using --

Roger W. Stone

That would be about 20, 21.

Jerry Chan - William Harris Investors

Twenty-one times? If you had to guess, how much do you think those multiples --

Roger W. Stone

Jerry, I think [I would say it] backwards.

Jerry Chan - William Harris Investors

Yeah, that makes -- yeah, okay. Okay. Thank you. I think I have it straight now.

Roger W. Stone

Well, I’m glad. I thought I had it straight but I gave it to you backwards.

Jerry Chan - William Harris Investors

That’s all right. That’s the way I process information anyway. Thank you. That’s it.

Operator

You have a follow-up question from the line of Matt Erwood. Please proceed.

Matt Erwood

I was just trying to understand, Roger; were you saying that the mix has been downgraded from kraft to linerboard, or were you just saying that the way you are classifying things, the tonnage was more evenly split?

Roger W. Stone

No, the mix has not been downgraded to linerboard. It’s -- roll wrap is still kraft paper. Price changes on roll wrap move with linerboard. The rest of the kraft paper moves with kraft paper.

Matt Erwood

Great. Thank you.

Operator

At this time, there are no further questions. I would now like to turn the call back over to Mr. Roger Stone for closing remarks.

Roger W. Stone

Well, again, have a very happy St. Patrick’s Day. We obviously feel last year was a great year for us, as I said, but not quite as great as we had hoped. And we remain very, very positive about this year and I know that’s tough to do in some areas but that’s how we feel and believe we will deliver. And that’s [all I can say]. Thank you for listening and thank you for calling in. Bye.

Operator

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

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