10-Q 1 c99497e10vq.txt QUARTERLY REPORT ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2005 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____________________ to _____________________ COMMISSION FILE NUMBER: 0-49741 PACKAGING DYNAMICS CORPORATION (Exact name of registrant as specified in its charter) DELAWARE 32-0009217 (State or other jurisdiction (I.R.S. Employer of incorporation) Identification No.)

~~3900 WEST 43RD STREET CHICAGO, ILLINOIS 60632 (Address of Principal Executive Office) (Zip Code)~~

(773) 843-8000 (Registrant's Telephone Number, Including Area Code) 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 [ ] Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes [ ] No [X] At October 28, 2005, there were 10,578,064 shares of common stock, par value $0.01 per share, outstanding. ================================================================================ PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS PACKAGING DYNAMICS CORPORATION CONDENSED CONSOLIDATED BALANCE SHEETS (DOLLARS IN THOUSANDS)

The accompanying notes are an integral part of this statement. 2 PACKAGING DYNAMICS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of this statement. 3 PACKAGING DYNAMICS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of this statement. 4 PACKAGING DYNAMICS CORPORATION CONDENSED CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND OTHER COMPREHENSIVE INCOME (DOLLARS IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of this statement. 5 PACKAGING DYNAMICS CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA) (UNAUDITED) NOTE 1 -- BASIS OF PRESENTATION GENERAL In the opinion of management, the information in the accompanying unaudited condensed consolidated financial statements reflects a fair statement of the results of operations, cash flows and stockholders' equity for the three and nine months ended September 30, 2005 and 2004 and the financial position at September 30, 2005. The interim results are not necessarily indicative of results for a full year and do not contain information included in the Company's annual consolidated financial statements and notes for the year ended December 31, 2004. The consolidated balance sheet as of December 31, 2004 was derived from audited financial statements, but does not include all disclosures required by accounting principles generally accepted in the United States of America. These interim financial statements should be read in conjunction with our audited annual consolidated financial statements and notes thereto included with the Company's filings with the Securities and Exchange Commission. NOTE 2 -- SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES EARNINGS PER SHARE Basic earnings per share excludes dilution and is computed by dividing net income by the weighted average number of common shares outstanding during each period. Diluted earnings per share reflects the potential dilution that could occur if common stock options are exercised and is computed by dividing net income by the weighted average number of common shares outstanding, including common stock equivalent shares issuable upon exercise of outstanding stock options, to the extent that they would have a dilutive effect on the per share amounts. Dilution of the Company's weighted average shares outstanding results from common stock issuable upon exercise of outstanding stock options (383,704 and 360,603 for the three months ended September 30, 2005 and 2004, respectively and 390,418 and 330,081 for the nine months ended September 30, 2005 and 2004, respectively). In accordance with SFAS 128, "Earnings per Share," the denominator used in the diluted earnings per share calculation is based on the control number concept, which requires that the same number of potentially dilutive securities applied in computing diluted earnings per share from continuing operations be applied to all other categories of income or loss, regardless of their anti-dilutive effect on such categories. The following table details the calculation of basic and diluted earnings per share for continuing operations:

6 Excluded from the computations of diluted earnings per share were options to purchase 405 and 361 shares of common stock for the third quarter and nine months ended September 30, 2005, respectively. These outstanding options were excluded because the option exercise prices were greater than the average market price of the common shares during these periods and therefore, their effect would be anti-dilutive. DERIVATIVES AND OTHER COMPREHENSIVE INCOME (LOSS) The Company maintains interest rate derivative instruments (typically swaps, collars and caps) that are designated as cash flow hedges to manage the market risk from changes in interest rates on a portion of its variable rate term loans. The Company recognizes all derivative instruments which are cash flow hedges as assets or liabilities at fair value, with the related gain or loss reflected within stockholders' equity through accumulated other comprehensive income. Such instruments are recorded at fair value, and at September 30, 2005 and December 31, 2004, the fair value approximates an asset of $922 and $471, respectively, which is included in other current assets within the accompanying condensed consolidated balance sheet. Changes in fair value, based upon the amount at which the instrument could be settled with a third party, are recorded in other comprehensive income only to the extent of effectiveness. Any ineffectiveness on the instrument would be recognized in the consolidated statement of operations. The differentials to be received or paid under the instrument are recognized in income over the life of the contract as adjustments to interest expense. RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In November 2004, the FASB released FASB Statement No. 151, "Inventory Costs -- an amendment of ARB No. 43, Chapter 4" (which we refer to as "SFAS 151"). SFAS 151 is the result of the FASB's efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS 151 requires abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are currently evaluating the effect that the adoption of SFAS 151 will have on our consolidated results of operations and financial condition but do not expect SFAS 151 to have a material impact. In December 2004, the FASB issued two FASB Staff Positions (FSP's) that provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 (the Act) that was signed into law on October 22, 2004. The Act could affect how companies report their deferred income tax balances. The first FSP is FSP FAS 109-1 (FAS 109-1); the second is FSP FAS 109-2 (FAS 109-2). In FAS 109-1, the FASB concludes that the tax relief (special tax deduction for domestic manufacturing) from the Act should be accounted for as a "special deduction" instead of a tax rate reduction. FAS 109-2 gives a company additional time to evaluate the effects of the Act on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109, "Accounting for Income Taxes." The Company has adopted the FSP 109-1 in the first quarter of 2005 which resulted in a decrease in the effective tax rate of approximately one percentage point. FSP 109-2 has no impact on the Company. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. In April 2005, the SEC issued a ruling that FAS 123R will be effective for public companies beginning with the first annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that beginning with the first quarter of adoption of SFAS 123R compensation expense will be recorded for stock options and restricted stock as such items vest, while the retroactive methods would record compensation expense for all stock options and restricted stock as they vest beginning with the first period restated. We have not 7 yet determined the method of adoption or the effect of adopting SFAS 123R, and have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In June 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections - replacement of APB Opinion No. 20 and FASB Statement No. 3" (SFAS 154). SFAS 154 changes the accounting for and reporting of a change in accounting principle by requiring retrospective applications to prior periods' financial statements of changes in accounting principle unless impracticable. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS 154 to have a material impact on its results of operations, financial position or cash flows. FAIR VALUE OF FINANCIAL INSTRUMENTS The carrying amounts of financial instruments including cash and cash equivalents, accounts receivable, accounts payable and variable rate debt approximates their estimated fair value based either on the short-term maturity of these instruments or on market prices for the same or similar type of financial instruments. The fair market value and carrying value of the Company's interest rate instruments were a net asset of $922 and $471 at September 30, 2005 and December 31, 2004, respectively. At September 30, 2005, the fair value of the remaining amounts payable under a non-compete agreement (eight quarterly payments totaling $2,667) was estimated to be $2,525. Also at September 30, 2005, the fair value of a $7,000 note payable on September 14, 2006 and bearing a 5% annual interest rate payable quarterly approximates recorded value. PAPERCON ACQUISITION On September 14, 2004, the Company completed the acquisition of 100% of the issued and outstanding shares of capital stock of 3141276 Canada Inc. from the sole shareholder (the "Seller") pursuant to an acquisition agreement dated August 6, 2004. 3141276 Canada Inc. was a Canadian corporation and the ultimate parent holding company of Papercon, Inc. (Papercon, Inc. and 3141276 Canada Inc. are collectively referred to as "Papercon"), a Georgia corporation, which conducts all of Papercon's business operations. During the third quarter of 2005, the Company resolved the net asset purchase price with the Seller and finalized the purchase price allocation, resulting in no change to goodwill. PRODUCT CLAIM COST During the second quarter of 2005, the Company recorded a charge of $1,100 related to a product quality claim by a large building products customer in the Company's Specialty Laminations segment. The charge is comprised of products to be returned by the customer, reimbursement for costs incurred by the customer in processing certain products supplied by the Company and one third party repair claim. The claim relates to de-lamination during the customer's manufacturing process which involves the use of laminated facer material supplied by the Company. The Company has worked closely with the customer to evaluate the issues involved and make manufacturing process changes which are believed to have remedied the situation. The Company is not aware of any additional related customer or third party claims. The Company intends to analyze and evaluate the returned goods to determine whether such products have alternative uses, although there can be no assurances that there will be any alternative uses. The charge was recorded as sales returns and allowances and is reflected in "Net sales" for the Company's Specialty Laminations segment in the Company's Condensed Consolidated Statement of Operations. ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. 8 NOTE 3--DISCONTINUED OPERATIONS During the fourth quarter of 2003, the Company shut down its paper mill, located in Detroit, Michigan, and exited the Specialty Paper operation. The Specialty Paper operation is classified as a discontinued operation. The following table details selected income statement information for the Specialty Paper operation.

The net loss for the three and nine months ended September 30, 2005 represents approximately $223 and $868, respectively, of pretax administrative costs associated with the ongoing program to maintain and dispose of the Detroit property. The Company is working towards a resolution of the Detroit property. The assets and liabilities associated with the Specialty Paper operation are included in the Consolidated Balance Sheet. The following table details selected balance sheet information for the Specialty Paper operation.

A summary of the changes in the reserves related to the Company's exit from the Specialty Paper operation is as follows:

9 NOTE 4--GOODWILL AND INTANGIBLE ASSETS Goodwill and intangible assets at September 30, 2005 consist of the following:

Amortization expense for intangible assets subject to amortization was $228 and $57 for the three months and $703 and $160 for the nine months ended September 30, 2005 and 2004, respectively. Amortization expense for the remainder of 2005 and years 2006, 2007, 2008, 2009 and 2010 is estimated to be $226, $906, $906, $906, $904 and $904, respectively. NOTE 5--STOCK BASED COMPENSATION At September 30, 2005, the Company has a stock-based compensation plan. The Company accounts for this plan under the recognition and measurement provisions of Accounting Principles Board Opinion ("APB") No. 25 "Accounting for Stock Issued to Employees," and related interpretations. Stock-based employee compensation cost is reflected in earnings to the extent that option grants under those plans had an exercise price below the market value of the underlying common stock on the date of grant. SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS No. 123") issued subsequent to APB No. 25 and amended by SFAS No. 148, "Accounting for Stock-Based Compensation -- Transition and Disclosure," ("SFAS No. 148") defines a fair value based method of accounting for employees' stock options but allows companies to continue to measure compensation cost for employee stock options using the intrinsic value based method described in APB No. 25. The Company's stock-based compensation plans are accounted for under the intrinsic value based method. No compensation expense is reflected in net income in the three and nine months ended September 30, 2005 and September 30, 2004, as all options granted under the plan had an exercise price that was equal to the market price on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 as amended by SFAS No. 148, to stock-based employee compensation.

10 The fair value of the options granted was estimated on the date earned using the Black-Scholes option-pricing model and utilized the following assumptions:

NOTE 6--INVENTORIES Inventories are stated at the lower of cost or market as determined by the first-in, first-out (FIFO) method. Such cost includes raw materials, direct labor and manufacturing overhead. Inventories at September 30, 2005 and December 31, 2004 consist of the following:

NOTE 7--LONG-TERM DEBT Long-term debt at September 30, 2005 and December 31, 2004 consists of the following:

SENIOR CREDIT FACILITY The Company maintains a credit facility with a group of banks (the "Senior Credit Facility") that provides for Term A and Term B Loans totaling $115,000 and a $50,000 revolving credit facility, up to $8,000 of which could be in the form of letters of credit. Borrowings are collateralized by substantially all of the stock and assets of the Company's operating subsidiaries. As of September 30, 2005, the Term A Loan had a balance of $21,000 and will mature in 2008. The required aggregate annual payments, payable in quarterly installments, total $5,250, $6,250, $7,250 and $6,000 in years 2005 through 2008, respectively, of which $3,750 was paid during the nine months ended September 30, 2005. As of September 30, 2005, the Term B Loan had a balance of $83,197 and will mature in 2009. The aggregate annual payments, payable in equal quarterly installments, total $843 in years 2005 through 2008 and $80,459 in 2009 of which $632 was paid during the nine months ended September 30, 2005. The revolver had a balance of $2,700 as of 11 September 30, 2005. The revolving credit facility is due in 2008. The revolving credit facility and Term A Loan will terminate on September 29, 2008 and the Term B Loan will terminate on September 29, 2009. Loans under the Senior Credit Facility are designated from time to time, at our election, either (1) as Eurodollar Rate Loans, which bear interest at a rate based on the London Interbank Offered Rate, or LIBOR, adjusted for regulatory reserve requirements, or (2) as Base Rate Loans, which bear interest at a rate based on the Federal Funds rate or the prime rate. The interest rate on Eurodollar Rate Loans is equal to LIBOR plus an applicable percentage that varies with the leverage ratio of the Company and its consolidated subsidiaries. The interest rate on Base Rate Loans is equal to a base rate equal to the greater of (1) the Federal Funds rate plus 1/2 of 1% or (2) the prime rate, plus an applicable percentage that varies with the leverage ratio of the Company and its consolidated subsidiaries. At September 30, 2005, the Term A Loan and revolving loans were bearing interest at rates of up to 1.25% plus the base rate, in the case of Base Rate Loans, and up to 2.25% plus LIBOR, in the case of Eurodollar Loans. The Term B Loan was bearing interest at rates of 1.25% plus the base rate, in the case of Base Rate Loans, and 2.25% plus LIBOR, in the case of Eurodollar Loans. At September 30, 2005, the interest rates on borrowings under the Term A Loan and the Term B Loan were 2.00% plus LIBOR (3.49%) and 2.25% plus LIBOR (3.49%), respectively, compared with 3.0% plus LIBOR (1.59%) and 3.0% plus LIBOR (1.59%), respectively, at September 30, 2004. As of September 30, 2005, we had interest rate instruments in effect with banks having notional amounts totaling $75,000 and varying maturity dates through December 31, 2007. We have an interest rate swap agreement with a notional value of $25,000 which became effective on December 31, 2003 and matures on December 29, 2006. This swap fixes our LIBOR rate for $25,000 of our Senior Credit Facility indebtedness at a rate of 2.91%. We have an interest rate collar agreement with a notional amount of $20,000 which became effective on December 31, 2004 and matures on December 31, 2007. This collar results in our paying market LIBOR rates for $20,000 of our Senior Credit Facility indebtedness from a floor of 3.08% to a cap of 5.00%. In addition, we have two interest rate caps of $15,000 each which became effective on December 31, 2004 and mature on December 31, 2007. We purchased these caps for a cap premium of $376 of which $83 was amortized during the nine months ended September 30, 2005. These caps limit our LIBOR rate for $30,000 of our Senior Credit Facility indebtedness at a maximum rate of 4.00%. Under the Senior Credit Facility, as amended, the Company is required to comply on a quarterly basis with the following four financial covenants: - under the leverage ratio covenant, as of the last day of each fiscal quarter, the ratio of total funded debt of the Company and its consolidated subsidiaries to consolidated EBITDA of the Company and its consolidated subsidiaries for the 12-month period then ended must not exceed specified levels, decreasing from 4.5 to 1 at September 30, 2005 to 4 to 1; - under the senior secured leverage ratio covenant, as of the last day of each fiscal quarter, the ratio of total secured funded debt of the Company and its consolidated subsidiaries to consolidated EBITDA of the Company and its consolidated subsidiaries for the 12-month period then ended must not exceed specified levels, decreasing from 3.75 to 1 at September 30, 2005 to 3 to 1; - under the fixed charge coverage ratio covenant, as of the last day of each fiscal quarter, for the 12-month period then ended, the ratio of consolidated EBITDA less capital expenditures and cash tax payments of the Company and its consolidated subsidiaries to cash interest expense and scheduled funded debt payments (excluding the $7,000 seller note issued in connection with the Papercon acquisition) of the Company and its consolidated subsidiaries must be equal to or greater than certain specified levels, increasing from 1.1 to 1 at September 30, 2005 to 1.2 to 1; and - under the net worth covenant, Packaging Dynamics' consolidated net worth as of the last day of each fiscal quarter must be equal to or greater than 80% of the net worth as of September 30, 2003 increased on a cumulative basis by (1) as of the last day of each fiscal quarter, 50% of the consolidated net income of Packaging Dynamics (to the extent positive) for the fiscal quarter then ended, (2) 75% of the net cash proceeds from any equity issuance by Packaging Dynamics or any subsidiary of Packaging Dynamics, and (3) 75% of the amount added to the equity of Packaging Dynamics in accordance with GAAP in connection with the Papercon acquisition. 12 For purposes of the Senior Credit Facility, as amended, consolidated EBITDA, calculated on a consolidated basis for Packaging Dynamics and its subsidiaries, consists of (1) net income from continuing operations, excluding the effect of any extraordinary or other non-recurring gains or losses or non-cash gains or losses (in each case, other than in connection with the sale and/or closure of the Detroit paper mill), plus (2) an amount which, in the determination of net income, has been deducted for interest expense, taxes, depreciation and amortization, non-cash expenses relating to the granting of options, cash and non-cash charges and/or losses with respect to the sale and/or closure of the Detroit paper mill, and charges related to the Papercon owner bonus program prior to the date of acquisition by the Company, minus (3) cash expenditures related to non-cash charges previously added back to net income in determining EBITDA (other than in connection with the closure of the Detroit paper mill), plus (4) the write-off of capitalized financing costs existing as of the closing of the Senior Credit Facility. The Senior Credit Facility also contains various negative covenants that, among other things, require Packaging Dynamics and its subsidiaries to limit future borrowings and payments to related parties and restricts Packaging Dynamics' ability and the ability of its subsidiaries to merge or consolidate. In addition, the Senior Credit Facility prohibits changes in the nature of business conducted by the Company and its subsidiaries. The failure to comply with the covenants would result in a default under the Senior Credit Facility and permit the lenders under the Senior Credit Facility to accelerate the maturity of the indebtedness governed by the Senior Credit Facility. The Senior Credit Facility includes terms that limit changes in our ownership structure. Modifications to the ownership structure outside the limits prescribed by such agreements could place us in default under these debt instruments. The Senior Credit Facility requires Packaging Dynamics Operating Company ("PDOC") to maintain specified financial ratios and levels of tangible net worth. PDOC was in compliance with those covenants as of September 30, 2005, the latest measurement date. The occurrence of any default of these covenants could result in acceleration of our obligations under the Senior Credit Facility ($106,897 as of September 30, 2005) and foreclosure on the collateral securing those obligations. The Senior Credit Facility limits and restricts the payment of dividends and distribution or transfer of assets by Packaging Dynamics and its subsidiaries. Dividends to shareholders may not exceed $4 million in any twelve month period. Additionally, any redemption or repurchase of capital stock of the Company other than as defined in the Senior Credit Facility is not permitted. As a result, substantially all of PDOC's net assets are restricted. SELLER NOTE PAYABLE On September 14, 2004, the Company issued a $7,000 note to the former owner of Papercon in connection with the acquisition of Papercon. The note matures on September 14, 2006 and bears an annual interest rate of 5% payable quarterly. This note is unsecured and subordinated to the Senior Credit Facility. NOTE 8 - OPERATING SEGMENT INFORMATION Our continuing operations operate within, and sell to customers throughout, the U.S., Canada and Europe in two operating segments - Food Packaging and Specialty Laminations. The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products. The Specialty Laminations segment produces multi-layer laminated structures from a variety of substrates (foil, paper, paperboard and film), adhesives and coatings for use in various food, consumer, medical and industrial packaging applications as well as in the production of insulation and other products for the building materials market. Corporate administrative expenses are allocated to the segments on a direct basis where appropriate with the remainder being allocated based on revenues. 13 The reconciliation of Segment Operating Income to the Company's consolidated financial statements is as follows:

NOTE 9--COMPREHENSIVE INCOME The components of comprehensive income, net of tax, were as follows:

Accumulated other comprehensive income presented on the accompanying condensed consolidated balance sheet consists entirely of unrecognized gains and losses on derivatives. NOTE 10--COMMITMENTS AND CONTINGENCIES LEGAL PROCEEDINGS We are currently a party to various legal proceedings in various federal and state jurisdictions arising out of the operations of our business. The amount of alleged liability, if any, from these proceedings cannot be determined with certainty; however, we believe that our ultimate liability, if any, arising from the pending legal proceedings, as well as from asserted legal claims and known potential legal claims which are probable of assertion, taking into account established accruals for estimated liabilities, should not be material to our financial condition or results of operations. LEASE COMMITMENTS The Company occupies certain facilities under lease arrangements and leases certain machinery, automobiles, 14 and equipment. Future minimum rental commitments, including capital lease obligations, with noncancelable terms in excess of one year are as follows:

Accumulated amortization on capital leases as of September 30, 2005 is $150. ENVIRONMENTAL MATTERS AND GOVERNMENT REGULATION Since many of our packaging products are used in the food industry, we are subject to the manufacturing standards of the U.S. Food and Drug Administration. Historically, compliance with the standards of the food industry has not had a material effect on our earnings, capital expenditures or competitive position. There can be no assurance, however, that compliance with those standards will not have a material adverse effect on our future operating results or financial condition. Our manufacturing operations are subject to federal, state and local regulations governing the environment and the discharge of materials into air, land and water, as well as the handling and disposal of solid and hazardous wastes. As is the case with manufacturers in general, if a release of hazardous substances occurs on or from our properties or any associated offsite disposal location, or if contamination from prior activities is discovered at any of our properties, we may be held liable. From time to time, we are involved in regulatory proceedings and inquiries relating to compliance with environmental laws, permits and other environmental matters. We believe that we are in material compliance with applicable environmental regulations and do not believe that costs of compliance, if any, will have a material adverse effect on our financial condition, results of operation, or liquidity. We will continue to have additional costs related to our ongoing program to maintain and dispose of the Detroit property, although the total amount of such costs are not currently estimable. There can be no assurance, however, that items will not require additional expenditures beyond those that are anticipated and that additional expenditures, if any, would not have a material adverse effect on our operating results or financial condition. Papercon has been identified as a potentially-responsible-party ("PRP") under Comprehensive Environmental Response Compensation and Liability Act ("CERCLA") with respect to the Constitution Road Drum Superfund Site located in Atlanta, Georgia by virtue of having allegedly sent drums, totes, or other containers to the site containing substances classified as hazardous under CERCLA. During the third quarter of 2005, the Company and other PRPs formed the Constitution Road PRP Group to develop a plan to resolve liabilities of the members at the site. The plan may include activities such as negotiation with United States Environmental Protection Agency ("EPA"), evaluation of cleanup alternatives, as well as hiring contractors to do cleanup work at the site. The Company has established a reserve of $300 related to its estimate of the Company's obligations with respect to this site. However, there can be no assurances that this reserve will be adequate. Factors which are likely to impact the Company's potential liability include, but may not be limited to, the amount and content of any hazardous substances that Papercon and other parties may have sent to the site, the ultimate cost to remediate the site and the contributions of other parties towards the cost of remediation. In addition, the Company is evaluating its rights under indemnification provisions in agreements executed in connection with the acquisition of Papercon. NOTE 11 -- RELATED PARTY TRANSACTIONS Pursuant to an acquisition agreement (the "Acquisition Agreement") dated August 6, 2004, Packaging Dynamics acquired 100% of the issued and outstanding shares of capital stock of 3141276 Canada Inc., the parent holding company of Papercon, from its sole shareholder (the "Seller"). The acquisition closed on September 14, 2004. Prior 15 to the Papercon acquisition, the Seller was not affiliated with the Company. Effective with the closing, the Seller became an officer of the Company. In connection with the Papercon acquisition, the Company entered into the Acquisition Agreement and several related agreements with the Seller. Certain of these agreements obligate the Company to make payments to, or take other action for the benefit, of the Seller as discussed below. Pursuant to the Acquisition Agreement, Packaging Dynamics acquired Papercon for aggregate consideration of approximately $66,421, net of $22,650 of cash acquired. The Company issued a $7,000 two year Seller Note to the Seller which is due and payable on September 14, 2006. The principal amount payable under the Seller Note will accrue interest at a rate of 5% per year, which will be due and payable in cash on a quarterly basis. The Company has the right to set-off against its payment obligations under the Seller Note for the full amount of any indemnification obligations required to be paid by the Seller under the Acquisition Agreement. Events of default under the Seller Note would include the Company's failure to make any payment that is not subject to a claim for set-off, a material breach of any of the Company's representations and warranties under the Seller Note that are not cured within 30 days of notice of such breach and the bankruptcy or general insolvency of the Company. In addition, a default by the Company under the Non-Competition Agreement would constitute a cross-default under the Seller Note. In the event of a default and upon written notice of the Seller (except in the case of default due to the bankruptcy or general insolvency of the Company, in which case written notice is not required), the balance of consideration due under the Seller Note would become immediately due and payable and would also accrue interest at a rate of 12% per year until such time as the event of default is cured by the Company (or waived by the Seller) or all amounts due are paid in full. In connection with the Seller Note, the Seller entered into an intercreditor agreement with Bank of America, the administrative agent for the Company's credit facility, pursuant to which payments under the Seller Note are subordinated to payments under the Company's senior credit facility, as amended. The Company entered into a Non-Competition Agreement with the Seller which provides, among other things, that for a period of ten years following the closing of the Acquisition, the Seller may not own, operate, manage, control, engage in, invest in or participate in any manner in, act as a consultant or advisor to, or render services for any other person or entity in any similar or competitive business as Packaging Dynamics and its subsidiaries (including Papercon) anywhere in the United States and Canada. Also, during this period, the Seller may not without the prior written consent of the Company, solicit or advise any customer or vendor of the Company to patronize a competitive business or curtail or withdraw their business with the Company or solicit for employment any person employed by the Company. The Company is required to make twelve (12) equal quarterly payments of $333 to the Seller under the Non-Competition Agreement commencing in December 2004. The Company has the right to set-off against its payment obligations under the Non-Competition Agreement the full amount of any indemnification obligations required to be paid by the Seller under the Acquisition Agreement. A failure by the Company to make any payment under the Non-Competition Agreement that is not subject to a claim for set-off, so long as the Seller has not breached the Non-Competition Agreement, would constitute an event of default. Additionally, the failure to pay any amount of principal or interest due under the Seller Note would constitute a cross-default under the Non-Competition Agreement. In the event of a default and upon written notice of the Seller, the balance of consideration due under the Non-Competition Agreement would become immediately due and payable and would also accrue interest at a rate of 12% per year until such time as the event of default is cured by the Company (or waived by the Seller) or all amounts due are paid in full. The Company and the Seller entered into a registration rights agreement, dated September 14, 2004 (the "Papercon Seller Registration Rights Agreement"), between the Company, the Seller and Packaging Investors, L.P. ("Packaging Investors"). The Company also amended its existing registration rights agreement (the "Initial Registration Rights Agreement") with, among others, Packaging Investors. Pursuant to the Papercon Seller Registration Rights Agreement, the Seller has the right, under certain circumstances, to require the Company to register his shares of Seller Common Stock for sale in the public markets. The Seller also has piggyback registration rights to include his shares in any registration statement which the Company files on its own behalf (other than for employee benefit plans and business acquisitions or corporate restructurings) or on behalf of other stockholders. The Company amended the Initial Registration Rights Agreement to provide for the piggyback registration rights granted to the Seller under the Papercon Seller Registration Rights Agreement. In addition, under the Papercon Seller Registration Rights Agreement, until the date on which the Seller ceases to own at least 5% of the outstanding shares of Seller Common Stock, at each annual meeting of stockholders, the Company has agreed to nominate or cause to be nominated the Seller for election to the board of directors of the Company. The Seller and Packaging 16 Investors have agreed that until the date (a) on which Packaging Investors ceases to own at least 20% of the outstanding shares of Seller Common Stock, the Seller will vote any shares of Seller Common Stock then owned by him to nominate and elect the individual designated by Packaging Investors for election to the board of directors of the Company and (b) on which the Seller ceases to own at least 5% of the outstanding shares of Seller Common Stock, Packaging Investors will vote any shares of Seller Common Stock then owned by it to nominate and elect the Seller for election to the board of directors of the Company. In connection with the Papercon acquisition, Papercon entered into a new lease (the "Lease") with respect to its Atlanta headquarters and facilities, effective as of September 14, 2004, with GHGA Properties, L.P. (the "Landlord"), a limited partnership wholly-owned and controlled by the Seller. The initial term of the Lease is five years and has options to renew for three additional five-year terms. The monthly rent for the initial and first renewal terms has been fixed at $49 and $52, respectively, with the subsequent renewal terms to be set at the market rate as agreed upon by the parties. The payment and performance of the obligations arising under the Lease are guaranteed pursuant to a separate guaranty by the Company in favor of Landlord. This arrangement was amended during the fourth quarter of 2004 and is reflected in the accompanying financial statements as an operating lease. 17 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF THE FINANCIAL CONDITIONS AND RESULTS OF OPERATIONS (DOLLARS IN THOUSANDS) The following discussion addresses the consolidated financial statements of Packaging Dynamics Corporation (the "Company," "Packaging Dynamics", "we" or "our") which is a Delaware corporation established as a holding company to own all interests in Packaging Dynamics Operating Company ("PDOC"), a Delaware corporation which is the parent company of all our current operating companies. The following discussion should be read in conjunction with our interim financial statements and accompanying notes thereto, and the other financial information included elsewhere in this report. This discussion contains forward-looking statements. Please see "Special Note Regarding Forward-Looking Statements" for a discussion of the uncertainties, risks and assumptions associated with these statements. In the discussion that follows, dollar amounts other than per share data are stated in thousands. SUMMARY AND OUTLOOK During the balance of 2005, the Company will be focused on, among other things, achieving price increases in response to rising raw material, energy and transportation costs as well as addressing the ongoing sales weakness in the Specialty Laminations segment. Other priorities in each of the Company's operating segments include expanding sales of new and existing products, improving manufacturing productivity and reducing manufacturing costs. The Company is evaluating a number of specific capital investment opportunities to expand product capabilities and reduce production costs. The combination of projects which have been approved and others under consideration are expected to result in total capital expenditures of approximately $7,500 to $8,500 in 2005 and $9,000 to $11,000 in 2006 compared to $6,081 in 2004 and an estimated normalized range of $7,000 to $8,000. The Company is also continuing its efforts to identify and pursue acquisition candidates which have the potential to expand the Company's product capabilities, market participation and geographical presence. FINANCIAL PERFORMANCE Our continuing operations are comprised of two operating segments - Food Packaging and Specialty Laminations. The Food Packaging segment converts paper, film and foil into a variety of specialty value-added food packaging products. The Specialty Laminations segment produces multi-layer laminated structures from a variety of substrates (foil, paper, paperboard and film), adhesives and coatings for use in various food, consumer, medical and industrial packaging applications as well as in the production of insulation and other products for the building materials market. Our discontinued operation is the Specialty Paper segment which we exited during 2003 in connection with our decision to shut down the Detroit Paper mill. The Company's management reporting system measures segment operating performance based on Segment Operating Income. Certain items, such as asset sales and disposals are excluded from Segment Operating Income. Corporate administrative expenses are allocated to the segments on a direct basis where appropriate with the remainder being allocated based on revenues. Food Packaging

18 Net sales increased $21,708, or 43.5%, during the third quarter of 2005 compared to the same period in 2004 primarily due to the September 14, 2004 acquisition of Papercon as well as increased sales in key market segments. Segment Operating Income increased $1,508, or 51.5%, during the third quarter of 2005 compared to the same period in 2004 and Segment Operating Income margin increased to 6.2% from 5.9% during the third quarter of 2005 compared to the same period in 2004. The increase in Segment Operating Income was primarily due to incremental earnings from Papercon and reduced incentive compensation expense, partially offset by increased raw material costs. In addition, the third quarter of 2005 was negatively impacted by $699 of management severance and hiring costs. The third quarter of 2004 was negatively impacted by $234 related to fair value adjustments to inventory in connection with purchase accounting for the Papercon acquisition. Net sales increased $69,209 or 49.3% during the nine months ended September 30, 2005 compared to the same period in 2004, primarily due to the Papercon acquisition as well as increased sales in key market segments. Segment Operating Income for the nine months ended September 30, 2005 increased $5,242, or 62.7%, compared to the same period in 2004 and Segment Operating Income margin increased to 6.5% from 6.0% during the nine months ended September 30, 2005 compared to the same period in 2004. The increase in Segment Operating Income was primarily due to incremental earnings from Papercon, cost and productivity improvement initiatives and reduced incentive compensation expense, partially offset by increased raw material costs. In addition, the 2005 result was negatively impacted by $1,019 of management severance and hiring costs related to forming a single management team for the Food Packaging segment. The 2004 result was negatively impacted by $234 related to fair value adjustments to inventory in connection with purchase accounting for the Papercon acquisition. Specialty Laminations

Net sales decreased $2,431, or 9.6%, during the third quarter of 2005 compared to the same period in 2004. The decrease was primarily due to continued volume weakness for products sold into the building products market. Segment Operating Income decreased $1,444, or 59.4%, during the third quarter of 2005 compared to the same period in 2004 and Segment Operating Income Margin decreased to 4.3% from 9.6% in the third quarter of 2005 compared to the same period in 2004. The decrease in Segment Operating Income was primarily due to continued volume weakness for products sold into the building products market, increased raw material costs and $192 of management severance costs during the third quarter of 2005. Net sales decreased $11,523 or 15.5%, during the nine months ended September 30, 2005 compared to the same period in 2004. The decrease was primarily due to continued volume weakness for products sold into the building products market and the $1,100 charge for a product quality claim discussed below. During the second quarter of 2005, the Company recorded a charge of $1,100 related to a product quality claim by a large building products customer in the Company's Specialty Laminations segment. The charge is comprised of products to be returned by the customer, reimbursement for costs incurred by the customer in processing certain products supplied by the Company and one third party repair claim. The claim relates to de-lamination during the customer's manufacturing process which involves the use of laminated facer material supplied by the Company. The Company has worked closely with the customer to evaluate the issues involved and make manufacturing 19 process changes which are believed to have remedied the situation. The Company is not aware of any additional related customer or third party claims. The Company intends to analyze and evaluate the returned goods to determine whether such products have alternative uses, although there can be no assurances that there will be any alternative uses. The charge was recorded as sales returns and allowances and is reflected in "Net sales" for the Company's Specialty Laminations segment in the Company's Condensed Consolidated Statement of Operations. Segment Operating Income for the nine months ended September 30, 2005 decreased $4,250 or 60.7% compared to the same period in 2004 and Segment Operating Income margin decreased to 4.4% from 9.4% during the nine months ended September 30, 2005 compared to the same period in 2004. The decline in Segment Operating Income was primarily due to the impact of decreased sales volume and the $1,100 customer product claim recorded in the second quarter of 2005 as well as increased raw material costs and $192 of management severance costs during the third quarter of 2005. INTEREST EXPENSE Interest expense increased $562 and $2,335 during the quarter and nine months ended September 30, 2005, respectively. The increase in interest expense was primarily due to increased average outstanding indebtedness of approximately $38,000 during the quarter ended September 30, 2005 and $45,000 during the nine months ended September 30, 2005 compared to the same periods in 2004 and a higher average borrowing rate. The average interest rate on borrowings in the third quarter of 2005 was approximately 5.84% compared to 4.94% in the same period in 2004. The average interest rate on borrowings during the nine months ended September 30, 2005 was approximately 5.69% compared to 4.66% in the same period in 2004. INCOME TAXES The Company's effective tax rate on income from continuing operations was 38.5% and 39.5%, for the quarter and nine months ended September 30, 2005 and 2004, respectively. The decrease in the Company's effective tax rate during 2005 is due to the American Jobs Creation Act of 2004 (the "Act"). The Act provides a deduction for income from qualified domestic production activities, which will be phased in from 2005 through 2010. INCOME FROM CONTINUING OPERATIONS Income from continuing operations was $2,047 and $2,315 for the quarters ended September 30, 2005 and 2004, respectively. The decrease in income from continuing operations of $268 or 11.6% during the quarter ended September 30, 2005 compared to 2004 was primarily due to the increased interest expense associated with the Papercon acquisition and reduced Segment Operating Income from Specialty Laminations, partially offset by increased Segment Operating Income from Food Packaging which includes incremental earnings from the Papercon acquisition. For the nine month periods ended September 30, 2005 and 2004, income from continuing operations was $6,235 and $6,946, respectively. The decrease in income from continuing operations of $711 or 10.2% during the nine months ended September 30, 2005 was primarily due to increased interest expense associated with the Papercon acquisition and decreased Segment Operating Income from Specialty Laminations, partially offset by increased Segment Operating Income from Food Packaging which includes incremental earnings from the Papercon acquisition. DISCONTINUED OPERATIONS Loss from discontinued operations during the third quarter of 2005 was $137 compared to a loss of $122 in the same period in 2004. For the nine months ended September 30, 2005, loss from discontinued operations was $534 compared to a loss of $821 in the same period in 2004. The net losses for 2005 represent the administrative expenses associated with the ongoing program to maintain and dispose of the Detroit property. We will continue to have additional costs related to our ongoing program to maintain and dispose of the Detroit property, although the total amount of such costs are not currently estimable. There can be no assurance, however, that items will not require additional expenditures beyond those that are anticipated and that additional expenditures, if any, would not have a material adverse effect on our operating results or financial condition. 20 LIQUIDITY AND CAPITAL RESOURCES At September 30, 2005, we had cash and cash equivalents of $7, and $44,121 was available under the revolving portion of the Senior Credit Facility, after taking into account $3,179 in letter of credits outstanding. Our working capital at September 30, 2005 was $24,818 compared to $29,965 at December 31, 2004. Our primary short-term and long-term operating cash requirements are for debt service, working capital and capital expenditures. We expect to rely on cash generated from operations supplemented by revolving borrowings under the Senior Credit Facility to fund short-term and long-term cash requirements. The Company generated $6,022 of cash from operating activities in the nine months ended September 30, 2005 compared to $10,236 for the same period in 2004. The decrease in cash from operating activities is primarily due to a decrease in non-cash tax expense and an increase in cash used for operating assets and liabilities, partially offset by an increase in non-cash depreciation and amortization expenses and a decrease in cash used by discontinued operations. Cash used by discontinued operations decreased significantly during the nine months ended September 30, 2005 compared to the same period in 2004 as a result of a reduction in the costs to maintain and dispose of the Detroit property during 2005. Cash used by investing activities was $3,797 for the nine months ended September 30, 2005 compared to $48,699 for the same period in 2004. This change was primarily due to $23,711 paid in connection with the Papercon acquisition offset by the receipt of $704 related to Iuka purchase price adjustment in 2004, and $21,554 transfer of cash to restricted cash in connection with the Papercon acquisition in 2004, partially offset by decreased capital expenditures in 2005. The Company is evaluating a number of specific capital investment opportunities to expand product capabilities and reduce production costs. The combination of projects which have been approved and others under consideration are expect to result in total capital expenditures of approximately $7,500 to $8,500 in 2005 and $9,000 to $11,000 in 2006, compared to $6,081 in 2004 and an estimated normalized range of $7,000 to $8,000. Cash used by financing activities was $3,393 for the nine months ended September 30, 2005 compared to cash from financing activities of $59,755 for the same period in 2004. The change was primarily due to borrowings in connection with the acquisition of Papercon during 2004. In September 2005, the Company announced a cash dividend of $0.065 per common share, $686 in the aggregate, which was paid on October 3, 2005 to shareholders of record as of September 15, 2005. Disclosures about contractual obligations and commercial commitments are included in various parts of this Report, including Note 7 - Long-Term Debt and Note 10 - Commitments and Contingencies to the financial statements. A summary of significant contractual obligations as of September 30, 2005 is included as follows:

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS In November 2004, the FASB released FASB Statement No. 151, "Inventory Costs -- an amendment of ARB No. 43, Chapter 4" (which we refer to as "SFAS 151"). SFAS 151 is the result of the FASB's efforts to converge U.S. accounting standards for inventories with International Accounting Standards. SFAS 151 requires abnormal amounts of idle facility expense, freight, handling costs, and wasted material (spoilage) to be recognized as current-period charges. It also requires that allocation of fixed production overheads to the costs of conversion be based on 21 the normal capacity of the production facilities. SFAS 151 is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We are currently evaluating the effect that the adoption of SFAS 151 will have on our consolidated results of operations and financial condition but do not expect SFAS 151 to have a material impact. In December 2004, the FASB issued two FASB Staff Positions (FSP's) that provide accounting guidance on how companies should account for the effects of the American Jobs Creation Act of 2004 (the Act) that was signed into law on October 22, 2004. The Act could affect how companies report their deferred income tax balances. The first FSP is FSP FAS 109-1 (FAS 109-1); the second is FSP FAS 109-2 (FAS 109-2). In FAS 109-1, the FASB concludes that the tax relief (special tax deduction for domestic manufacturing) from the Act should be accounted for as a "special deduction" instead of a tax rate reduction. FAS 109-2 gives a company additional time to evaluate the effects of the Act on any plan for reinvestment or repatriation of foreign earnings for purposes of applying FASB Statement No. 109, "Accounting for Income Taxes." The Company has adopted the FSP 109-1 in the first quarter of 2005 which resulted in a decrease in the effective tax rate of approximately one percentage point. FSP 109-2 has no impact on the Company. In December 2004, the FASB issued SFAS No. 123 (revised 2004), "Share-Based Payment" ("SFAS 123R"), which replaces SFAS No. 123, "Accounting for Stock-Based Compensation," ("SFAS 123") and supercedes APB Opinion No. 25, "Accounting for Stock Issued to Employees." SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. In April 2005, the SEC issued a ruling that FAS 123R will be effective for public companies beginning with the first annual period after June 15, 2005, with early adoption encouraged. The pro forma disclosures previously permitted under SFAS 123 no longer will be an alternative to financial statement recognition. Under SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. Under the retroactive option, prior periods may be restated either as of the beginning of the year of adoption or for all periods presented. The prospective method requires that beginning with the first quarter of adoption of SFAS 123R compensation expense will be recorded for stock options and restricted stock as such items vest, while the retroactive methods would record compensation expense for all stock options and restricted stock as they vest beginning with the first period restated. We have not yet determined the method of adoption or the effect of adopting SFAS 123R, and have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS 123. In June 2005, the FASB issued SFAS No. 154, "Accounting Changes and Error Corrections - replacement of APB Opinion No. 20 and FASB Statement No. 3" (SFAS 154). SFAS 154 changes the accounting for and reporting of a change in accounting principle by requiring retrospective applications to prior periods' financial statements of changes in accounting principle unless impracticable. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 15, 2005. The Company does not expect the adoption of SFAS 154 to have a material impact on its results of operations, financial position or cash flows. 22 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We use interest rate swaps, collars and caps to modify our exposure to interest rate movements and to reduce borrowing costs. We have designated these instruments as cash flow hedges and consider these instruments effective at offsetting our risk to variable interest rates on debt. Our exposure to interest rate risk consists of floating rate debt instruments that are benchmarked to LIBOR. As of September 30, 2005, we had interest rate instruments in effect with banks having notional amounts totaling $75,000 and varying maturity dates through December 31, 2007. We have an interest rate swap agreement with a notional value of $25,000 which became effective on December 31, 2003 and matures on December 29, 2006. This swap fixes our LIBOR rate for $25,000 of our Senior Credit Facility indebtedness at a rate of 2.91%. We have an interest rate collar agreement with a notional amount of $20,000 which became effective on December 31, 2004 and matures on December 31, 2007. This collar results in our paying market LIBOR rates for $20,000 of our Senior Credit Facility indebtedness from a floor of 3.08% to a cap of 5.00%. In addition, we have two interest rate caps of $15,000 each which became effective on December 31, 2004 and mature on December 31, 2007. We purchased these caps for a cap premium of $376 of which $83 was amortized during the nine months ended September 30, 2005. These caps limit our LIBOR rate for $30,000 of our Senior Credit Facility indebtedness at a maximum rate of 4.00%. A 10% unfavorable movement in LIBOR would not expose us to material losses of earnings or cash flows. Income or expense related to settlements under these agreements is recorded as adjustments to interest expense in our financial statements. The fair market value of our derivative instruments outlined above approximates a $922 asset as of September 30, 2005 and is based upon the amount at which it could be settled with a third party, although we have no current intention to trade any of these instruments and plan to hold them as hedges for the Senior Credit Facility. The change in the fair market value of our derivative instruments, net of income tax, was recorded in other comprehensive income (loss). Substantially all of our sales, including export sales, are denominated in United States Dollars in order to reduce our exposure to changes in foreign currency exchange rates. ITEM 4. CONTROLS AND PROCEDURES EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES The Company's management, with the participation of the Company's Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of the end of the period covered by this report. Based on such evaluation, the Company's Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company's disclosure controls and procedures are effective. In addition to our responsibilities with respect to an evaluation of our disclosure controls and procedures, we, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, are in the process of performing the assessments required by Section 404 of the Sarbanes-Oxley Act of 2002 and the related rules adopted by the SEC (collectively, the "Section 404 requirements"). We are not deemed to be an Accelerated Filer for 2005 and thus the earliest we will be required to include a report on management's assessment of the effectiveness of our internal control over financial reporting in our Annual Report on Form 10-K will be the year ending December 31, 2006. When applicable, our independent registered public accounting firm will also be required to attest to and report on management's assessment of the effectiveness of our internal control over financial reporting. We have been and are continuing to devote significant resources to prepare for the Section 404 requirements. There can be no assurances that once completed, management's assessment and the independent registered public accounting firm's attestation will not report any material weaknesses in our internal control over financial reporting. In connection with our response to the rules pertaining to the evaluation of our disclosure controls and procedures, as well as our response to the Section 404 requirements pertaining to the assessment of our internal control over financial reporting, we are reviewing, documenting and testing our disclosure controls and procedures and our internal control over financial reporting, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business. For example, we are evaluating, documenting 23 and testing our key controls over financial reporting in preparation for management's assessment under the Section 404 requirements. These efforts are likely to lead to changes in our internal control over financial reporting, including enhanced documentation of certain of these internal controls. CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING. Except as further described in the following paragraphs, there have not been any changes in the Company's internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. On September 14, 2004, the Company acquired Papercon. The results of Papercon's operations from the date of acquisition have been included in the Company's 2004 financial results. Prior to its acquisition by the Company, Papercon operated as an independent private company, was not subject to public company reporting requirements and had a limited amount of resources available for financial reporting and internal control matters. The Company is conducting an ongoing review of Papercon's internal control over financial reporting and intends to make changes, where necessary, to conform Papercon's controls and procedures to the Company's controls and procedures and to ensure that such controls and procedures are effective and integrated appropriately. In 2004, the Company implemented a new enterprise wide financial accounting software system at each of its facilities except the Papercon facilities acquired in September 2004. In the second quarter of 2005, the Company implemented the financial and accounting software systems at Papercon. SPECIAL NOTE REGARDING FORWARD - LOOKING STATEMENTS Certain statements included in this quarterly report, including without limitation, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Results of Operations -- Summary and Outlook, -- Financial Performance, -- Liquidity and Capital Resources, -- Recently Issued Accounting Pronouncements, and -- Quantitative and Qualitative Disclosure About Market Risk" constitute "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995 (the "Reform Act"). Such forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of the Company to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Among the factors that could cause results to differ materially from current expectations are: (i) changes in consumer demand and prices resulting in a negative impact on revenues and margins; (ii) raw material substitutions and increases in the costs of raw materials, utilities, labor and other supplies; (iii) increased competition in the Company's product lines; (iv) changes in capital availability or costs; (v) workforce factors such as strikes or labor interruptions; (vi) the ability of the Company and its subsidiaries to develop new products, identify and execute capital programs and efficiently integrate acquired businesses; (vii) the cost of compliance with applicable governmental regulations and changes in such regulations, including environmental regulations; (viii) the general political, economic and competitive conditions in markets and countries where the Company and its subsidiaries operate, including currency fluctuations and other risks associated with operating in foreign countries; and (ix) the timing and occurrence (or non-occurrence) of transactions and events which may be subject to circumstances beyond the control of Packaging Dynamics and its subsidiaries. 24 PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS From time to time Packaging Dynamics and its subsidiaries are involved in various litigation matters arising in the ordinary course of business. Packaging Dynamics believes that none of the matters which arose during the quarter, either individually or in the aggregate is material to Packaging Dynamics. Papercon has been identified as a potentially-responsible-party ("PRP") under Comprehensive Environmental Response Compensation and Liability Act ("CERCLA") with respect to the Constitution Road Drum Superfund Site located in Atlanta, Georgia by virtue of having allegedly sent drums, totes, or other containers to the site containing substances classified as hazardous under CERCLA. During the third quarter of 2005, the Company and other PRPs formed the Constitution Road PRP Group to develop a plan to resolve liabilities of the members at the site. The plan may include activities such as negotiation with United States Environmental Protection Agency ("EPA"), evaluation of cleanup alternatives, as well as hiring contractors to do cleanup work at the site. The Company has established a reserve of $300 related to its estimate of the Company's obligations with respect to this site. However, there can be no assurances that this reserve will be adequate. Factors which are likely to impact the Company's potential liability include, but may not be limited to, the amount and content of any hazardous substances that Papercon and other parties may have sent to the site, the ultimate cost to remediate the site and the contributions of other parties towards the cost of remediation. In addition, the Company is evaluating its rights under indemnification provisions in agreements executed in connection with the acquisition of Papercon. ITEM 6. EXHIBITS (a) Exhibits

SIGNATURE PAGE FOLLOWS 25 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PACKAGING DYNAMICS CORPORATION By: /s/ PATRICK T. CHAMBLISS ------------------------------------ PATRICK T. CHAMBLISS Vice President and Chief Financial Officer (Principal Financial Officer) October 28, 2005 26

PACKAGING DYNAMICS CORP 10-Q