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PAPERWEIGHT DEVELOPMENT CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 7, 2014

Unless stated to the contrary or the context requires otherwise, all references in this report to the Company refer to Paperweight Development Corp. ("PDC" or "Paperweight") and its 100%­owned subsidiaries. It includes Appvion, Inc., formerly known as Appleton Papers Inc., and its 100%-owned subsidiaries (collectively "Appvion," formerly "Appleton").

Overview



This discussion summarizes significant factors affecting the consolidated operating results, financial condition and liquidity of PDC for the quarter ended June 29, 2014. This discussion should be read in conjunction with the accompanying condensed consolidated financial statements and related notes. Reference should also be made to the Annual Report on Form 10-K for the year ended December 28, 2013, the consolidated financial statements and related notes included therein.

During June 2014, Appvion, Inc. entered into an accounts receivable securitization program with a commitment size of $30.0 million, whereby transactions under the program are accounted for as sales of trade receivables in accordance with ASC Topic 860, "Transfers and Servicing." Sales of trade receivables under the program were recorded as a reduction of accounts receivable in the Condensed Consolidated Balance Sheet as of June 29, 2014. Proceeds received, including collections on the deferred purchase price notes receivable, were included in cash flows from operating activities in the Condensed Consolidated Statement of Cash Flows for the six months ended June 29, 2014. Appvion deems the interest rate risk related to the deferred purchase price notes to be de minimis primarily due to the short average collection cycle (60 days) of the related receivables. Trade receivables sold to a third-party financial institution, and being serviced by Appvion, totaled $47.3 million as of June 29, 2014. Due to an average collection cycle of 60 days or less for such trade receivables, as well as Appvion's collection history, the fair value of the deferred purchase price notes approximates carrying value. The fair value of the deferred purchase price notes receivable recorded as of June 29, 2014 was $17.3 million and was included in accounts receivable in the Condensed Consolidated Balance Sheet as of June 29, 2014. Transaction costs totaling $0.7 million were deferred and recorded in other long-term assets of the current quarter-end balance sheet. They will be amortized over the three-year term of the securitization agreement.

Financial Highlights



Second quarter 2014 net sales of $207.9 million were $6.4 million, or 3.2%, higher than second quarter 2013 net sales. Encapsys® net sales of $13.6 million were $0.6 million, or 4.6%, higher than second quarter 2013 net sales of $13.0 million. Though current quarter Encapsys sales volumes to external customers decreased approximately 5% compared to the same quarter last year, net sales to external customers increased $1.0 million, or 11.9%. Net sales within the Company's paper business increased $5.4 million, or 2.8%. Shipment volumes were approximately 6% higher than second quarter 2013. Current quarter thermal papers net sales of $110.9 million were $6.1 million higher and shipment volumes were approximately 11% higher than the prior year period. This was the second consecutive quarter that thermal papers net sales and volumes increased. Second quarter carbonless papers sales of $87.6 million were $0.7 million, or 0.8%, less than second quarter 2013 net sales.

Second quarter 2014 cost of sales of $162.7 million was $14.0 million higher than second quarter 2013. This resulted in a decrease in gross margin of four and one-half percentage points. Though a portion of the increase in cost of sales was due to increased sales, the majority of the increase was a result of increased costs associated with unfavorable manufacturing performance. Current quarter selling, general and administrative ("SG&A") expenses were $2.1 million, or 6.5%, higher than the previous year quarter. This included an increase in compensation and benefit costs, largely in support of future growth. Legal expenses were also higher in second quarter 2014 compared to the same period last year.

The Company recorded a net loss for second quarter 2014 of $1.1 million compared to a net loss of $18.9 million in second quarter 2013. Current year results included a $3.0 million decrease in interest expense realized as a result of the 2013 voluntary debt refinancing transactions. The Company also recorded $0.1 million of expense incurred as a result of the accounts receivable securitization program. In addition, $24.7 million of debt extinguishment expense was recorded during second quarter 2013 as a result of the June 2013 voluntary refinancing.

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Table Of Contents Comparison of Unaudited Results of Operations for the Quarters Ended June 29, 2014 and June 30, 2013 For the Quarter Ended June 29, June 30, Increase 2014 2013 (Decrease) (dollars in thousands) Net sales $ 207,946$ 201,500 3.2 % Cost of sales 162,763 148,717 9.4 % Gross profit 45,183 52,783 -14.4 % Selling, general and 34,455 32,344 6.5 % administrative expenses Operating income 10,728 20,439 -47.5 % Interest expense 11,888 14,788 -19.6 % Debt extinguishment - 24,767 -100.0 % expense Other non-operating 92 (331) -127.8 % expense (income), net Loss before income taxes (1,252) (18,785) 93.3 % (Benefit) provision for (121) 110 -210.0 % income taxes Net loss $ (1,131)$ (18,895) 94.0 % Comparison as a percentage of net sales Cost of sales 78.3 % 73.8 % 4.5 % Gross margin 21.7 % 26.2 % -4.5 % Selling, general and 16.6 % 16.1 % 0.5 % administrative expenses Operating margin 5.1 % 10.1 % -5.0 % Loss before income taxes -0.6 % -9.3 % 8.7 % Net loss -0.5 % -9.4 % 8.9 %



Net sales for second quarter 2014 were $207.9 million, an increase of $6.4 million, or 3.2%, compared to the prior year period. Encapsys net sales of $13.6 million were $0.6 million, or 4.6%, higher than second quarter 2013 net sales of $13.0 million. Net sales to external customers increased $1.0 million, or 11.9%, on a volume decrease of approximately 5%. Net sales within the Company's paper business increased $5.4 million, or 2.8%. Shipment volumes were approximately 6% higher than second quarter 2013.

Second quarter 2014 operating income of $10.7 million was $9.7 million, or 47.5%, lower than second quarter 2013 operating income of $20.4 million. The positive impact of increased revenue, resulting from higher overall shipment volumes, was offset by unfavorable pricing and product mix of $5.5 million, largely due to increased foreign competition, as well as unfavorable manufacturing costs of $6.9 million. Second quarter 2014 SG&A expenses were $2.1 million higher than the previous year quarter. This included an increase in compensation and benefit costs, largely in support of future growth. Legal expenses were also higher in second quarter 2014 compared to the same period last year.

During the second quarter of 2014, the Company recorded a net loss of $1.1 million. This compares to a net loss of $18.9 million in second quarter 2013. In addition to the items noted above, current quarter interest expense decreased $3.0 million as a result of the 2013 voluntary debt refinancing transactions. Current quarter foreign exchange gain was $0.3 million lower than the same quarter last year and $0.1 million of expense was incurred as a result of the accounts receivable securitization program. In addition, $24.7 million of debt extinguishment expense was recorded during second quarter 2013 as a result of the June 2013 voluntary refinancing.

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Table Of Contents Comparison of Unaudited Results of Operations for the Six Months Ended June 29, 2014 and June 30, 2013 For the Six Months Ended June 29, June 30, Increase 2014 2013 (Decrease) (dollars in thousands) Net sales $ 411,700$ 412,334 -0.2 % Cost of sales 320,262 311,313 2.9 % Gross profit 91,438 101,021 -9.5 % Selling, general and 66,205 62,700 5.6 % administrative expenses Operating income 25,233 38,321 -34.2 % Interest expense 24,208 29,749 -18.6 % Debt extinguishment - 24,767 -100.0 % expense Other non-operating loss, 209 380 -45.0 % net Income (loss) before 816 (16,575) 104.9 % income taxes (Benefit) provision for (64) 177 -136.2 % income taxes Net income (loss) $ 880$ (16,752) 105.3 % Comparison as a percentage of net sales Cost of sales 77.8 % 75.5 % 2.3 % Gross margin 22.2 % 24.5 % -2.3 % Selling, general and 16.1 % 15.2 % 0.9 % administrative expenses Operating margin 6.1 % 9.3 % -3.2 % Income (loss) before 0.2 % -4.0 % 4.2 % income taxes Net income (loss) 0.2 % -4.1 % 4.3 %



Net sales for the first six months of 2014 were slightly lower than the same period last year. First half 2014 net sales of $411.7 million were $0.6 million, or 0.2% lower than first half 2013 net sales of $412.3 million. Encapsys net sales for the current year period of $28.1 million were $2.0 million, or 7.7%, higher than 2013 first half net sales of $26.1 million. Net sales to external customers were $2.8 million, or 16.6%, higher than the previous year on flat shipment volumes. During the first two quarters of 2014, net sales recorded in the Company's paper business of $392.0 million were $3.4 million, or 0.9%, lower than in 2013. Thermal papers net sales and carbonless papers net sales were down 0.5% and 1.3%, respectively.

The Company recorded operating income of $25.2 million for the first six months of 2014. This compared to operating income of $38.3 million for the same period last year. The positive impact from higher shipment volumes, was offset by unfavorable pricing and product mix of $9.6 million and unfavorable manufacturing costs of $3.9 million. Year-to-date 2014 SG&A expenses were $3.5 million higher than last year due to increases in compensation, benefit costs and legal fees.

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Table Of Contents

The Company reported net income of $0.9 million for the first six months of 2014 compared to a net loss of $16.8 million reported last year. In addition to the items noted above, year-to-date interest expense decreased $5.6 million as a result of the 2013 voluntary debt refinancing transactions. Also, first half 2014 foreign exchange losses were $0.3 million lower than last year and $0.1 million of expense was incurred as a result of the accounts receivable securitization program. The 2013 loss included $24.7 million of debt extinguishment expense recorded as a result of the June 2013 voluntary refinancing.

Business Segment Discussion Encapsys



•Second quarter 2014 net sales of $13.6 million were 4.6% higher than second quarter 2013 net sales of $13.0 million. Despite a 5% decrease in shipments to external markets, second quarter 2014 net sales to external customers of $9.4 million were $1.0 million, or 11.9%, higher than the previous year quarter, largely due to favorable product mix. Year-to-date 2014 net sales of $28.1 million were $2.0 million, or 7.7%, higher than net sales recorded during the same six-month period last year. Current year-to-date external net sales of $19.7 million were $2.8 million, or 16.6%, higher than the previous year on flat shipment volumes.

•Second quarter 2014 operating income was $3.1 million compared to $3.2 million during the same quarter of 2013. Current quarter operating income from external sales was $2.6 million, which was flat when compared to 2013. Operating income for the six months ended June 29, 2014 was $7.1 million, of which, $5.9 million was generated by external sales. Operating income during the same period last year was $6.7 million, of which, $5.3 was generated by external sales. The Encapsys business continued to benefit from improved product mix. However, manufacturing costs were higher due to increased processing costs to support the more complex product mix. SG&A was also higher due to spending in support of future growth.

Paper Business



Second quarter 2014 net sales within the Company's paper business were $198.5 million, $5.4 million higher than second quarter 2013 net sales. First half 2014 net sales within the paper business were $392.0 million, $3.4 million lower than the same period last year. Second quarter 2014 operating income of $11.4 million compared to second quarter 2013 operating income of $21.0 million. First half 2014 operating income of $24.4 million compared to first half 2013 operating income of $38.2 million. The year-on-year operating income variance was the result of the following (dollars in millions):

For the Three For the Six Months Ended Months Ended June 29, 2014 v. June 29, 2014 v. the Three Months the Six Months Ended June 30, 2013 Ended June 30, 2013 Favorable shipment volumes $ 3.7 $ 3.3 Impact of raw materials and utilities pricing 0.6 (0.2) Higher selling, general and administrative expenses and other (0.9) (2.1) Unfavorable manufacturing costs (6.0) (2.3) Unfavorable price and mix (7.0) (12.5) $ (9.6) $ (13.8) 25



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Table Of Contents Thermal Papers



•Second quarter 2014 thermal papers net sales totaled $110.9 million, an increase of $6.1 million, or 5.8%, compared to the same prior year period. Shipment volumes were up nearly 11%. This was the second consecutive quarter that thermal papers net sales and volumes increased. Second quarter 2014 shipments of tag, label and entertainment ("TLE") were over 14% higher than second quarter 2013 and shipments of receipt paper increased over 7% compared to the same period last year. During the first six months of 2014, thermal papers net sales totaled $216.4 million, a decrease of $1.0 million, or 0.5%, from prior year. On a year-to-date basis, 2014 thermal shipment volumes were approximately 3% higher than last year, with TLE volumes increasing over 12%. However, receipt paper volumes decreased nearly 7% against a very strong first six months last year.

•The thermal papers segment recorded operating income of $6.6 million for second quarter 2014. This compared to second quarter 2013 operating income of $12.1 million. Increased shipment volumes added $4.1 million of operating income which was more than offset by $5.9 million of unfavorable pricing and product mix as well as $3.4 million of unfavorable manufacturing costs. During the first six months of 2014, operating income of $10.4 million was reported compared to $18.5 million of operating income for the same period last year. Current year-to-date operating income was negatively impacted by unfavorable pricing and product mix of $7.7 million, largely due to increased foreign competition. The business also recorded increased legal fees associated with the defense of anti-dumping claims.

Carbonless Papers



•Second quarter 2014 carbonless net sales totaled $87.6 million, a decrease of $0.7 million, or 0.8%, from prior year. Current quarter shipment volumes were flat compared to second quarter 2013 though benefited from increased sales of specialty papers. During the first six months of 2014, carbonless net sales totaled $175.6 million, a decrease of $2.4 million, or 1.3% from prior year. On a year-to-date basis, 2014 carbonless shipment volumes were up over 1% compared to last year due to increased sales of carbonless rolls and specialty products.

•Second quarter 2014 carbonless papers operating income of $4.8 million compared to operating income of $8.9 million reported in second quarter 2013 largely due to increased costs associated with unfavorable manufacturing performance. During the first six months of 2014, operating income of $14.0 million was reported compared to $19.7 million of operating income for the same period in 2013 largely due to unfavorable sales mix as well as unfavorable pricing.

Unallocated Corporate Charges



•Unallocated corporate charges totaled $3.3 million in second quarter 2014 and $3.1 million in second quarter 2013. Year-to-date 2014 expense was $5.1 million compared to $5.2 million for the first six months of 2013. Increased legal fees impacted both current year reporting periods.

Liquidity and Capital Resources

Overview. The Company's primary sources of liquidity and capital resources are cash provided by operations and credit available under its revolving credit facility. The Company expects that cash on hand, internally-generated cash flow and available credit from its revolving credit facility will provide the necessary funds for the reasonably foreseeable operating and recurring cash needs (e.g., working capital, debt service, other contractual obligations and capital expenditures). At June 29, 2014, the Company had $4.8 million of cash and approximately $81.4 million of unused borrowing capacity under its revolving credit facility. The revolving credit facility had an outstanding balance of $5.3 million compared to $7.6 million at year-end 2013. Net debt (total debt less cash) was $588.2 million compared to $595.3 million at year-end 2013.

The Company was in compliance with all debt covenants at June 29, 2014, and is forecasted to remain compliant for the next 12 months. The Company's ability to comply with the financial covenants in the future depends on achieving forecasted operating results and operating cash flows. The Company's failure to comply with its covenants, or an assessment that it is likely to fail to comply with its covenants, could lead the Company to seek amendments to, or waivers of, the financial covenants. The Company cannot provide assurance that it would be able to obtain any amendments to or waivers of the covenants. In the event of non-compliance with debt covenants, if the lenders will not amend or waive the covenants, the debt would be due and the Company would need to seek alternative financing. The Company cannot provide assurance that it would be able to obtain alternative financing. If the Company were not able to secure alternative financing, this would have a material adverse impact on the Company.

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Table Of Contents

Cash Flows from Operating Activities. Net cash provided by operating activities during the first six months of 2014 was $28.7 million compared to $29.1 million of net cash used during the same six-month period last year. Net income of $0.9 million, adjusted for noncash charges, provided $18.9 million in operating cash for the period. Non-cash charges included $14.9 million of depreciation and amortization, $1.3 million of noncash employer matching contributions to the KSOP and $1.8 million of other noncash charges. During the first half of 2014, working capital decreased by $22.9 million. The primary component of this decrease was a $17.2 million decrease in accounts receivable. During June 2014, Appvion entered into an accounts receivable securitization program with a commitment size of $30.0 million, whereby transactions under the program are accounted for as sales of trade receivables in accordance with ASC Topic 860, "Transfers and Servicing." Sales of trade receivables under the program were recorded as a reduction of accounts receivable in the Condensed Consolidated Balance Sheet as of June 29, 2014. Proceeds received, including collections on the deferred purchase price notes receivable, were included in cash flows from operating activities. Trade receivables sold to a third-party financial institution, and being serviced by Appvion, totaled $47.3 million and deferred purchase price notes receivable totaled $17.3, resulting in a net reduction of accounts receivable of $30.0 million as of June 29, 2014. This reduction in accounts receivable was offset by a nearly $13 million increase in accounts receivable since year-end 2013.

In addition, accounts payable and other accrued liabilities increased $6.9 million. Positive cash flow included increased accounts payable resulting from improved vendor terms. This was reduced by interest payments made during the first half of the year. Other current assets decreased by $1.9 million. Higher finished goods inventories, partially offset by a decrease in raw material inventories, caused total inventories to increase by $3.1 million. A decrease in the pension liability, which included $12.3 million of pension plan contributions, resulted in an $11.3 million net use of cash. Other uses of cash totaled $1.8 million which included $0.7 million of transaction costs associated with the accounts receivable securitization.

Cash Flows from Investing Activities. During first half 2014, $8.5 million of cash was used for investing activities. This included $10.5 million used for the acquisition of property, plant and equipment and $2.0 million of proceeds from the second quarter auction of papermaking equipment located at the West Carrollton, Ohio facility. This compared to $10.5 million used during first half 2013, all of which was used for the acquisition of property, plant and equipment.

Cash Flows from Financing Activities. Net cash used by financing activities during the first six months of 2014 was $17.2 million compared to $44.3 million of cash provided during the same prior year period. First half 2014 proceeds from the issuance of PDC redeemable common stock totaled $1.3 million. The ESOP trustee purchased this stock using pre-tax deferrals, rollovers and loan payments made by employees during the first six months of 2014. Payments to redeem PDC stock were $7.8 million during this same period. The Company also made mandatory debt repayments of $2.4 million on its first lien term loan and State of Ohio loans. During the first half of 2014, the Company repaid a net $2.3 million of its revolving credit facility. In addition, cash overdrafts decreased $5.8 million during this current year period. Cash overdrafts represent short-term obligations, in excess of deposits on hand, which have not yet cleared through the banking system. Fluctuations in the balance are a function of quarter-end payment patterns and the speed with which the payees deposit the checks. Other uses of cash were $0.2 million.

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Table Of Contents New Accounting Pronouncements



In May 2014, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update ("ASU") No. 2014-09, "Revenue from Contracts with Customers." This guidance provides a single comprehensive revenue recognition model to apply in determining how and when to recognize revenue. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. When applying the new revenue model to contracts with customers, the guidance requires five steps to be applied which include: 1) identify the contract(s) with a customer, 2) identify the performance obligations in the contract, 3) determine the transaction price, 4) allocate the transaction price to the performance obligations in the contract and 5) recognize revenue when (or as) the entity satisfies a performance obligation. The guidance also requires both quantitative and qualitative disclosures, which are more comprehensive than existing revenue standards. The disclosures are intended to enable financial statement users to understand the nature, timing and uncertainty of revenue and the related cash flow. ASU 2014-09 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. The Company is currently assessing the impact the guidance will have on its consolidated financial statements.

In February 2013, the FASB issued ASU No. 2013-04, "Obligations Resulting from Joint and Several Liability Arrangements for Which the Total Amount of the Obligation Is Fixed at the Reporting Date." This guidance requires an entity to measure obligations resulting from joint and several liability arrangements for which the total amount of the obligation within the scope of this guidance is fixed at the reporting date, as the sum of the following: (a) The amount the reporting entity agreed to pay on the basis of its arrangement among its co-obligors and (b) Any additional amount the reporting entity expects to pay on behalf of its co-obligors. The guidance also requires an entity to disclose the nature and amount of the obligation. ASU 2013-04 was effective for the Company's annual and interim periods beginning after December 15, 2013 and retrospective application is required for all prior periods presented. As required, the Company adopted this guidance beginning in the first quarter ended March 30, 2014 and there was no impact to the Company's consolidated financial statements as a result of adoption.

In December 2011, the FASB issued ASU No. 2011-11, "Disclosures about Offsetting Assets and Liabilities." It expands required disclosures related to the nature of an entity's rights of setoff and related arrangements associated with its financial instruments and derivative instruments. It requires disclosure of net and gross positions in covered financial instruments and derivative instruments which are either (1) offset in accordance with ASC Sections 210-20-45 or 815-10-45, or (2) subject to an enforceable netting or other similar arrangement. To clarify the guidance provided in ASU 2011-11, the FASB issued ASU No. 2013-01, "Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities" in January 2013. It clarifies the scope of the guidance to include derivatives, repurchase and reverse repurchase agreements, and securities borrowing and lending transactions that are either offset in accordance with Section 210-20-45 or Section 815-10-45 or subject to master netting or similar arrangements. The amendments were effective for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. As required, the Company adopted this guidance for its fiscal year beginning December 29, 2013 and the first quarter interim period ended March 30, 2014. The impact to the Company's consolidated financial statements, as a result of adoption, was not material.


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