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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2012

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 Securities Exchange Act of 1934 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 x  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 46,714,963 shares of the Registrant’s Common Stock, $0.0001 par value, outstanding at July 24, 2012, 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 Sheets

(In thousands, except share and per share amounts)

See notes to consolidated financial statements.

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KAPSTONE PAPER AND PACKAGING CORPORATION

Consolidated Statements of Income and Comprehensive 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 Statements 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 (“GAAP”) 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 GAAP 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, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012. For further information, refer to the consolidated financial statements and related footnotes included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011.

2.                                      Recent Accounting Pronouncements

Intangibles — Goodwill and Other

In September 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-08, “Intangibles — Goodwill and Other.” This guidance provides an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. However, if an entity concludes otherwise, then it is required to perform the first step of the two-step impairment test by calculating the fair value of the reporting unit and comparing the fair value with the carrying amount of the reporting unit, as described in paragraph 350-20-35-4. This guidance is effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company will adopt the provisions of this guidance in conjunction with its annual impairment testing in the fourth quarter of 2012.

Comprehensive Income

In June 2011, the FASB issued ASU 2011-05, “Presentation of Comprehensive Income,” which revises the manner in which entities should present comprehensive income in their financial statements. The new guidance requires entities to report components of comprehensive income in either (1) a continuous statement of comprehensive income or (2) two separate but consecutive statements. This guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company adopted the provisions of this guidance in using the continuous statement approach in 2012 on a retrospective basis for all periods presented.

Fair Value Measurements

In May 2011, the FASB issued ASU 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” This ASU is the result of joint efforts by the FASB and International Accounting Standards Board (IASB) to develop converged guidance on how to measure fair value and what disclosures to provide about fair value measurements. The ASU is largely consistent with existing fair value measurement principles in U.S. GAAP; however, it expands existing disclosure requirements for fair value measurements and makes other amendments, many of which eliminate unnecessary wording differences between U.S. GAAP and IFRS. This ASU is effective for interim and annual periods beginning after December 15, 2011. The application of the requirements of this guidance did not have a material effect on the consolidated financial statements.

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3.                                      USC Acquisition

On October 31, 2011, the Company consummated the acquisition of U.S. Corrugated Inc. (“USC”) from its stockholders by merger for $330.0 million in cash plus $1.6 million of working capital adjustments. On March 9, 2012, KapStone reached an agreement with USC on the final calculation of Merger Consideration and paid an additional $0.3 million which was allocated to acquisition consideration.

The following table summarizes the acquisition consideration:

The USC acquisition was accounted for in accordance with the provisions of ASC 805, “Business Combinations,” and the accompanying consolidated financial statements include the results of USC since October 31, 2011. The Company estimated the fair value of the assets and liabilities of USC at the time of acquisition and used third-party appraisals to determine the fair market value for tangible and intangible assets. The excess of the purchase price over the aggregate estimated fair value of net assets acquired was allocated to goodwill. The allocation is not final as the review of the fair value of deferred income tax assets and liabilities and certain other acquired assets and liabilities is in process.

The following table summarizes the preliminary allocation of acquisition consideration to the fair value of the assets acquired and the liabilities assumed at the date of acquisition:

4.                                      Annual Planned Maintenance Outage

Annual planned maintenance outage costs for the three months ended June 30, 2012 and 2011 totaled $3.8 million and $3.0 million, respectively. In addition, planned maintenance outage costs for the six months ended June 30, 2012 and 2011 totaled $4.6 million and $3.4 million, respectively.

5.                                      Inventories

Inventories consist of the following at June 30, 2012 and December 31, 2011, respectively:

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6.                                      Debt

Amendment to Credit Agreement

On May 10, 2012, the Company entered into a First Amendment to Credit Agreement (the “First Amendment”), by and among Kapstone Kraft Paper Corporation, as Borrower (the “Borrower”), the Company and certain subsidiaries of the Company as Guarantors, the lenders party thereto, and Bank of America N.A., as Administrative Agent, which amends the Credit Agreement, dated as of October 31, 2011 (collectively, the “Credit Agreement”). The First Amendment, among other things, expands the “accordion” feature under the Credit Agreement, removes certain mandatory prepayment events, and modifies the calculation methodology of the financial covenants. The “accordion” feature in the Credit Agreement now permits KapStone, subject to certain terms and conditions, to request an increase in the revolving commitments and/or additional term loans in an aggregate principal amount of up to $450.0 million.

Voluntary Prepayment

On June 29, 2012, the Company made a $50.0 million voluntary prepayment on its term loan under the Credit Agreement using cash generated from operations.

Debt Covenants

The Company’s Credit Agreement contains, among other provisions, covenants with which we must comply while the agreement is in force. The covenants limit our ability to, among other things, incur indebtedness, create additional liens on our assets, make investments, engage in mergers and acquisitions, pay dividends and sell any assets outside the normal course of business. As of June 30, 2012, the Company was in compliance with all applicable covenants in the Credit Agreement.

Other Current Borrowings

In 2012 and 2011, the Company entered into financing agreements of $3.4 million and $2.3 million, respectively, at an annual interest rate of 2.00 and 1.75 percent, respectively, for its annual property insurance premiums. The agreements required the Company to pay consecutive monthly payments through the term of each financing agreement ending on December 1st. As of June 30, 2012, there was $1.6 million outstanding under the current agreement which is included in “Other current borrowings” on the Consolidated Balance Sheets.

Interest Paid

Interest paid was $2.4 million and $0.6 million for the three months ended June 30, 2012 and 2011, respectively. In addition, interest paid was $4.7 million and $1.3 million for the six months ended June 30, 2012 and 2011, respectively. The increase in interest paid reflects a higher term loan balance resulting from the USC acquisition.

Fair Value of Debt

At June 30, 2012 the fair value of the Company’s debt approximates the carrying value of $293.4 million as the variable interest rates re-price frequently at current market rates. The debt was valued using Level 2 inputs in the fair value hierarchy which are significant observable inputs including quoted prices for debt of similar terms and maturities.

7.                                      Income Taxes

The Company’s effective tax rate for the six months ended June 30, 2012 and 2011 was 36.0 percent and 38.6 percent, respectively. The effective tax rate decreased in 2012 due to a higher expected benefit from the domestic manufacturing deduction. The differences between the effective tax rate and the federal statutory tax rate for the periods ended June 30, 2012 and 2011 are due to the impact of state tax, net of the federal benefit and the domestic manufacturing deduction.

The gross unrecognized tax benefits, including interest, as of June 30, 2012 is $5.0 million and is unchanged from December 31, 2011. Unrecognized tax benefits of $5.0 million are included in “Other liabilities” on the Consolidated Balance Sheets.

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In the normal course of business, the Company is subject to examination by taxing authorities. The Company’s open tax year is 2010.

Income taxes paid net of refunds were $4.0 million and $0.1 million for the three months ended June 30, 2012 and 2011, respectively. In addition, income taxes paid net of refunds were $4.3 million and $0.3 million for the six months ended June 30, 2012 and 2011, respectively.

8.                                      Net Income Per Share

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

Unexercised stock options to purchase a total of 0.3 million shares were outstanding during both the three months ended June 30, 2012 and 2011, but were not included in the computation of diluted earnings per share because the options were anti-dilutive.

9.                                      Pension Plan and Post Retirement Benefits

Defined Benefit Pension Plan

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

Net pension cost recognized for the three and six months ended June 30, 2012 and 2011 for the Pension Plan is as follows:

KapStone funds the Pension Plan according to IRS funding requirements. Based on those requirements, KapStone funded $2.6 million for the six months ended June 30, 2012 and expects to fund an additional $3.0 million to the Pension Plan in 2012.

Defined Contribution Plan

The KapStone Defined Contribution Plan (the “Contribution Plan”) covers all eligible employees. The Company’s monthly contributions to the Contribution Plan are based on the matching of employee contributions. For the three months ended June 30, 2012 and 2011, the Company recognized expense of $2.6 million and $1.6 million, respectively. In addition, for the six months ended June 30, 2012 and 2011, the

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Company recognized expense of $5.4 million and $3.6 million, respectively. Effective October 31, 2011, employees who joined the Company as part of the USC acquisition are included in the Contribution Plan.

10.                               Stock-Based Compensation

On March 7, 2012, the Compensation Committee of the board of directors approved stock awards to executive officers, certain employees and directors. The 2012 awards included 310,847 stock option grants and 124,341 restricted stock units.

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.

Total stock-based compensation expense related to the stock option and restricted stock unit grants for the three and six months ended June 30, 2012 and 2011 is as follows:

Total unrecognized stock-based compensation cost related to the stock option grants and restricted stock units as of June 30, 2012 and December 31, 2011 is as follows:

As of June 30, 2012, total unrecognized compensation cost related to non-vested stock options and restricted stock units is expected to be recognized over a weighted average period of 1.9 years and 2.1 years, respectively.

Stock Options

Stock option awards vest as follows: 50% after two years and the remaining 50% after three years or upon the retirement of a grantee of such stock options who has reached the age 65. The stock options awarded in 2012 have a contractual term of ten years and are subject to forfeiture should the recipient terminate his or her employment with the Company for certain reasons prior to vesting in his or her 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 ($19.75 for the 2012 awards described above) 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 March 2012 was $10.38. The fair value was calculated using the Black-Scholes option-pricing model based on the market price at the grant date and the weighted average assumptions specific to the underlying options. 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 sufficient 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 expected volatility assumption is based on the volatility of KapStone stock from the same time period as the expected term of the stock options. 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 periods are as follows:

The following table summarizes stock options amounts and activity:

For the three and six months ended June 30, 2012, exercises of employee stock options totaled 9,274 shares and 100,378 shares, respectively, with cash proceeds to the Company of $0.1 million and $0.5 million, respectively.

Restricted Stock

Restricted stock units are restricted as to transferability until they vest three years from the grant date or upon the retirement of the grantee who has reached the age 65. These restricted stock units are subject to forfeiture should the employee terminate employment with the Company for certain reasons prior to vesting in their award, or upon 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 units amounts and activity:

11.                               Contingencies

We are subject to various legal proceedings arising from our operations. We are party to a legal proceeding arising from an accident which occurred during our 2009 annual planned maintenance outage at our mill in Roanoke Rapids, NC. We establish reserves for claims and proceedings when it is probable that liabilities exist and where reasonable estimates can be made. While it is not possible to predict the outcome of this matter, based on our assessment of the facts and circumstances now known, we do not believe there is a reasonable possibility that this matter will have a material adverse effect on our financial position. However, actual outcomes may be different from those expected and could have a material effect on our results of operations or cash flows in a particular period.

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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, 2011 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 Company has one reportable segment as of June 30, 2012. The Company manufactures and sells unbleached kraft paper and corrugated products.

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, 2012 and 2011

Net sales for the quarter ended June 30, 2012 were $306.3 million compared to $214.8 million for the second quarter of 2011, an increase of $91.5 million or 42.6 percent. The increase in net sales was driven by the U.S. Corrugated Inc. (“USC”) acquisition which accounted for $97.2 million. Excluding the acquisition, net sales decreased by $5.7 million due to $2.7 million of lower average selling prices, $1.6 million of unfavorable exchange rate effects due to a stronger US dollar, as certain sales to European customers are invoiced in euros, and 5,575 fewer tons of paper sold, partially offset by $2.9 million of higher lumber sales. Average selling prices decreased primarily due to lower export containerboard prices partially offset by the partial realization of kraft paper price increases announced in 2011. Average selling price per ton for the quarter ended June 30, 2012 was $623 compared to $633 for the prior year’s quarter.

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The following represents the Company’s tons of paper sold by product line:

Tons of paper sold for the quarter ended June 30, 2012 was 323,506 tons compared to 329,081 tons for the quarter ended June 30, 2011, a decrease of 5,575 tons or 1.7 percent. Domestic containerboard sales increased 10.4 percent reflecting the impact of the acquisition and higher sales of lightweight containerboard. Export containerboard sales decreased 22.1 percent due to a shift in product mix. Kraft paper sales decreased 6.6 percent reflecting an overall decrease in demand in the industry and a transfer of volumes to lightweight containerboard grades. Durasorb® sales increased 4.2 percent due to increased demand.

Corrugated product sales for the quarter ended June 30, 2012 totaled 1.6 billion square feet compared to none for the quarter ended June 30, 2011. The Company’s corrugated product sales began with the USC acquisition which closed in the fourth quarter of 2011.

The following represents a summary of tons of paper sold and produced by the Company:

The 61,766 increase in tons of production in the second quarter of 2012 includes 60,452 tons from the acquisition and 1,314 tons from higher production rates.

Cost of sales, excluding depreciation and amortization expense, for the quarter ended June 30, 2012 was $213.3 million compared to $143.1 million for the second quarter of 2011, an increase of $70.2 million, or 49.0 percent. The increase in cost of sales was mainly due to the $72.6 million impact of the acquisition. Excluding the acquisition, cost of sales decreased by $2.4 million due to lower sales volumes and $1.8 million of productivity gains partially offset by $2.3 million of inflation on labor, benefits and input costs. Annual planned maintenance outages in the quarters ended June 30, 2012 and 2011 totaled $3.8 million and $3.0 million, respectively.

Depreciation and amortization expense for the quarter ended June 30, 2012 totaled $15.3 million compared to $12.8 million for the quarter ended June 30, 2011. The increase of $2.5 million was primarily due to $3.1 million from the acquisition, $0.6 million of which is amortization of identified intangible assets. Excluding the acquisition, depreciation and amortization expense decreased $0.6 million in the quarter ended June 30, 2012.

Freight and distribution expenses for the quarter ended June 30, 2012 totaled $27.9 million compared to $19.7 million for the quarter ended June 30, 2011. The increase of $8.2 million was primarily due to $7.7 million from the acquisition. Excluding the acquisition, freight and distribution expenses increased $0.5 million due to inflation on fuel costs and product mix.

Selling, general and administrative expenses for the quarter ended June 30, 2012 totaled $17.4 million compared to $8.9 million for the quarter ended June 30, 2011. The increase of $8.5 million was primarily due to $8.0 million from the acquisition. Excluding the acquisition, selling, general and administrative expenses increased $0.5 million due to higher stock compensation expenses and acquisition related expenses. For the

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quarter ended June 30, 2012, selling, general and administrative expenses as a percentage of net sales increased to 5.7 percent from 4.1 percent in the quarter ended June 30, 2011.

Foreign exchange loss for the quarter ended June 30, 2012 of $0.5 million was higher than the negligible gain for the quarter ended June 30, 2011. The change reflects the strengthening of the U.S. dollar compared to the Euro in the quarter ended June 30, 2012.

Net interest expense for the quarters ended June 30, 2012 and 2011 was $3.2 million and $1.1 million, respectively. Interest expense reflects interest on the Company’s Credit Agreement and amortization of debt issuance costs. Interest expense was $2.1 million higher in the quarter ended June 30, 2012 primarily due to a higher term loan balance to fund the USC acquisition.

Provision for income taxes for the quarters ended June 30, 2012 and 2011 was $10.4 million and $11.4 million, respectively, reflecting an effective tax rate of 36.0 percent for the quarter ended June 30, 2012 compared to 38.6 percent for the similar period in 2011. The lower provision for income taxes in 2012 primarily reflects a lower effective tax rate due to a higher expected benefit from the domestic manufacturing deduction.

Comparison of Results of Operations for the Six Months Ended June 30, 2012 and 2011

Net sales for the six months ended June 30, 2012 were $606.1 million compared to $421.5 million for the first six months of 2011, an increase of $184.6 million or 43.8 percent. The increase in net sales was driven by the USC acquisition which accounted for $191.8 million. Excluding the acquisition, net sales decreased by $7.2 million due to $4.2 million in lower average selling prices, $2.0 million due to the unfavorable exchange rate effect of a stronger US dollar and a less favorable product mix, partially offset by an increase of 662 tons of paper sold and $4.1 million of higher lumber sales. Average selling prices decreased primarily due to lower export containerboard prices. Average selling price per ton for the six months ended June 30, 2012 was $615 compared to $626 for the prior year period.

The following represents the Company’s tons of paper sold by product line:

Tons of paper sold for the first six months of 2012 was 653,116 tons compared to 652,454 tons for the first six months of 2011, an increase of 662 tons or 0.1 percent. Domestic containerboard sales increased 11.5 percent reflecting the impact of the acquisition and higher sales of lightweight containerboard. Export containerboard sales decreased by 5.0 percent due to a shift in product mix. Kraft paper sales decreased 9.7 percent reflecting an overall decrease in demand in the industry and a transfer of volumes to lightweight containerboard grades. Kraftpak® sales declined 6.0 percent due to lower demand.

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Corrugated product sales for the first six months of 2012 totaled 3.1 billion square feet compared to none for the first six months of 2011. The Company’s corrugated product sales began with the acquisition which closed in the fourth quarter of 2011.

The following represents a summary of tons of paper sold and produced by the Company:

The 131,983 increase in tons of production in the first six months of 2012 includes 121,292 tons from the USC acquisition and 10,691 tons from higher production rates and one extra day of production.

Cost of sales, excluding depreciation and amortization expense, for the six months ended June 30, 2012 was $427.4 million compared to $285.8 million for the first six months of 2011, an increase of $141.6 million, or 49.5 percent. The increase in cost of sales was mainly due to the $144.2 million impact of the acquisition. Excluding the acquisition, cost of sales decreased by $2.6 million due to product mix and $6.5 million of productivity gains, partially offset by $6.6 million of inflation on labor, benefits and input costs. Annual planned maintenance outages during the six months ended June 30, 2012 and 2011 totaled $4.6 million and $3.4 million, respectively.

Depreciation and amortization expense for the six months ended June 30, 2012 totaled $30.5 million compared to $24.6 million for the six months ended June 30, 2011. The increase of $5.9 million was primarily due to $6.3 million from the acquisition, $1.3 million of which is amortization of identified intangible assets. Excluding the acquisition, depreciation and amortization expense decreased $0.4 million in the first six months of 2012.

Freight and distribution expenses for the six months ended June 30, 2012 totaled $53.7 million compared to $37.5 million for the six months ended June 30, 2011. The increase of $16.2 million was primarily due to $15.0 million from the acquisition. Excluding the acquisition, freight and distribution expenses increased $1.2 million primarily due to inflation on fuel costs and product mix.

Selling, general and administrative expenses for the six months ended June 30, 2012 totaled $35.0 million compared to $18.2 million for the six months ended June 30, 2011. The increase of $16.8 million was primarily due to $14.9 million from the acquisition. Excluding the acquisition, selling, general and administrative expenses increased $1.9 million due to the higher compensation related expenses and acquisition related expenses. For the six months ended June 30, 2012, selling, general and administrative expenses as a percentage of net sales increased to 5.8 percent from 4.3 percent in the first six months of 2011.

Foreign exchange loss for the six months ended June 30, 2012 was $0.4 million compared to a foreign exchange gain of $0.3 million for the six months ended June 30, 2011. The change reflects the strengthening of the U.S. dollar compared to the Euro in the first six months of 2012.

Net interest expense for the six months ended June 30, 2012 and 2011 was $6.5 million and $2.2 million, respectively. Interest expense reflects interest on the Company’s Credit Agreement and amortization of debt issuance costs. Interest expense was $4.3 million higher in the first six months of 2012 due to a higher term loan balance to fund the USC acquisition.

Provision for income taxes for the six months ended June 30, 2012 and 2011 was $19.1 million and $20.9 million, respectively, reflecting an effective tax rate of 36.0 percent for the first six months of 2012 compared to 38.6 percent for the similar period in 2011. The lower provision for income taxes in 2012 primarily reflects a lower effective tax rate due to a higher expected benefit from the domestic manufacturing deduction.

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Liquidity and Capital Resources

Amendment to Credit Agreement

On May 10, 2012, the Company entered into a First Amendment to Credit Agreement (the “First Amendment”), by and among Kapstone Kraft Paper Corporation, as Borrower (the “Borrower”), the Company and certain subsidiaries of the Company as Guarantors, the lenders party thereto, and Bank of America N.A., as Administrative Agent, which amends the Credit Agreement, dated as of October 31, 2011 (collectively, the “Credit Agreement”). The First Amendment, among other things, expands the “accordion” feature under the Credit Agreement, removes certain mandatory prepayment events, and modifies the calculation methodology of the financial covenants. The “accordion” feature in the Credit Agreement now permits KapStone, subject to certain terms and conditions, to request an increase in the revolving commitments and/or additional term loans in an aggregate principal amount of up to $450.0 million.

Voluntary Prepayment

For the first six months of 2012, the Company made a $50.0 million voluntary prepayment on its term loan under the Credit Agreement using cash flow from operations.

Debt Covenants

Under the financial covenants of the Credit Agreement, KapStone must comply on a quarterly basis with a maximum permitted leverage ratio. The leverage ratio is calculated by dividing KapStone’s debt by its rolling twelve month total earnings before interest expense, taxes, depreciation and amortization and allowable adjustments. The maximum permitted leverage ratio declines over the life of the Credit Agreement. On June 30, 2012, the maximum permitted leverage ratio was 3.50 to 1.00. On June 30, 2012, KapStone was in compliance with the Credit Agreement with a leverage ratio of 1.65 to 1.00.

The Credit Agreement also includes a financial covenant requiring a minimum fixed charge coverage ratio. This ratio is calculated by dividing KapStone’s twelve month total earnings before interest expense, taxes, depreciation and amortization and allowable adjustments less cash payments for income taxes and capital expenditures by the sum of our cash interest and required principal payments during the twelve month period. From the closing date of the Credit Agreement through the quarter ending June 30, 2012, the fixed charge coverage ratio was required to be at least 1.25 to 1.00. On June 30, 2012, KapStone was in compliance with the Credit Agreement with a fixed charge coverage ratio of 7.69 to 1.00.

As of June 30, 2012, KapStone was in compliance with all applicable covenants in the Credit Agreement.

Other Current Borrowings

In 2012, the Company entered into a financing agreement of $3.4 million at an annual interest rate of 2.00 percent, for the annual property insurance premium. The agreement required the Company to make consecutive monthly repayments through the term of the financing agreement ending on December 1. As of June 30, 2012, there was $1.6 million outstanding under the current agreement.

Income taxes

The Company’s effective tax rate for 2012 is projected at 36.0 percent. The cash tax rate for 2012 is projected at 10.0 percent reflecting utilization of federal net operating losses and the cellulosic biofuel producer’s credit.

Income taxes paid, net of refunds, were $4.3 million and $0.4 million for the six months ended June 30, 2012 and 2011, respectively.

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Sources and Uses of Cash

Cash and cash equivalents increased by $1.6 million from December 31, 2011, reflecting $77.0 million of net cash provided by operating activities, $27.8 million of net cash used in investing activities and $47.6 million of net cash used in financing activities.

Net cash provided by operating activities was $77.0 million primarily due to net income of $34.0 million for the first six months of 2012 and $49.7 million of non-cash charges. Changes in operating assets and liabilities used $6.7 million of cash. Net cash provided by operating activities increased by $23.9 million in the first six months of 2012 compared to the same period in 2011 mainly due to changes in operating assets and liabilities using $15.2 million of less cash, $8.0 million of higher non-cash charges and $0.7 million of higher net income in the first six months of 2012 than the first six months of 2011.

Net cash used in investing activities was $27.8 million reflecting $27.5 million of capital expenditures. For the six months ended June 30, 2012, capital expenditures for legacy operations were $20.4 million related to spending on equipment upgrades and replacements at the paper mills. In addition, there were $7.1 million of capital expenditures related to the acquisition, primarily related to investments in information technology. Net cash used in investing activities decreased by $34.8 million in the first six months of 2012 compared to the same period in 2011 mainly due to the $49.7 million contingent earn-out payment in 2011, partially offset by higher capital expenditures in the first six months of 2012.

Net cash used in financing activities was $47.6 million reflecting the $50.0 million voluntary prepayment of the term loan under the Credit Agreement, partially offset by $1.6 million of net proceeds from other current borrowings and $0.8 million of proceeds from share transactions. Net cash used in financing activities increased by $39.6 million for the first six months of 2012 compared to the same period in 2011 primarily due to a higher amount of debt repayments in 2012.

Future Cash Needs