Reynolds American's CEO Hosts Investor Day (Transcript)

| About: Reynolds American, (RAI)

Reynolds American, Inc. (NYSE:RAI)

Investor Day

November 12, 2012 9:00 am ET


Morris Moore

Daniel M. Delen - Chief Executive Officer, President and Director

Andrew D. Gilchrist - President of R.J. Reynolds Tobacco Co and Chief Commercial Officer of R.J. Reynolds Tobacco Co

John Brice O'Brien - Executive Vice President - Consumer Marketing of R. J. Reynolds Tobacco Company

Jeffery S. Gentry - Chief Scientific Officer for R. J. Reynolds Tobacco Company and Executive Vice President for R. J. Reynolds Tobacco Company

Martin L. Holton - Executive Vice President, General Counsel and Assistant Secretary

Thomas R. Adams - Chief Financial Officer and Executive Vice President


Thilo Wrede - Jefferies & Company, Inc., Research Division

David J. Adelman - Morgan Stanley, Research Division

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Vivien Azer - Citigroup Inc, Research Division

Michael Lavery - CLSA Asia-Pacific Markets, Research Division

Morris Moore

Okay. We'll go ahead and get started. Good morning, and thank you for joining us for our Investor Day presentation. Our focus this year is on leading transformation. I'm Morris Moore, Head of Investor Relations.

And we'll start this morning with our CEO, Dan Delen, and he'll provide an overview of current business environment and an update on some of our strategies for continued success. After Dan, we'll have Andrew Gilchrist, who's the President and Chief Commercial Officer of R.J. Reynolds, and he'll provide an update on the businesses at each of our operating companies. Then, after a short break, Brice O'Brien, who's the Head of Consumer Marketing, will provide an update on the current brand building activities on Camels, Pall Mall, Natural American Spirit and Grizzly.

After that, before I go there, I'll just mention that both Brice and Andrew will be talking about both American Snuff and Santa Fe, as they provide services to those companies through the services agreement.

After that, Jeff Gentry is the Chief Scientific Officer at R.J. Reynolds, who will provide an update on the FDA environment. And then Jeff will be followed by Mark Holton, who's our General Counsel, and will obviously provide a litigation overview And then Tom Adams, our Chief Financial Officer, will provide some highlights on our financial situation.

We'll take another short break at the end, and then Dan will come back with some closing comments, and then we'll open up and we'll save the Q&A session for the end. Also joining us this morning from RAI's Board is Lionel Nowell. We also have Tommy Payne, who's the President of Niconovum USA, and Danny Herco, who is the Head of R&D at R.J. Reynolds.

And before I turn the presentation over to Dan, I'll give you just a minute to read the precautionary statement on the forward-looking information. And we will be discussing some forward-looking information today and the actual results could obviously vary from our forecast. We do have the risk factors listed in our third quarter earnings release and in our SEC filings.

And then we'll also focus on adjusted results today, as we normally do. And we do have a reconciliation of GAAP to adjusted results at the end of the presentation that you picked up as you came in. And the presentation will also be available on our website later on today.

And now I'll turn the presentation over to Dan.

Daniel M. Delen

All right. Thank you, Morris, and good morning, everyone. It's great to be with you on a sunny Monday morning here in New York. But of course, today is Veterans Day. And I think a lot of you know that I'm not American. I'm actually from Holland. But I think it's quite poignant for me to be up here because even Holland has been impacted by the service and dedication of the U.S. veterans here. And I think it's worth a shout out to them. Of course, the dedicated servicemen that liberated Holland, at least the southern part of Holland at the beginning part or the end of 1944 and the other part of Holland at the beginning of 1945.

So on that note, what I'll do is I'm going to just jump in. And here's my agenda for today and some of the things I'd like to discuss. I'd like to spend a little bit of time just talking about consumer trends in our category, what's actually going on from a consumer point of view, demographically, psychographically, what are some of the trends that we're really sort of digging in on from a marketing point of view. I'll talk about the U.S. profit pool and competition. What sort of our outlook, where we find ourselves and where we think it's headed. Of course, through that's, I'll discuss current performance from our company. But we'll also want to spend some time talking about our vision, strategies and performance expectations going forward.

And then what I'd also like to focus on is our innovations pipeline. There's been a lot of discussion, a lot of noise in the category on the innovation side. I'd really like to take a couple of our products and some of our new efforts and just kind of go a little bit deeper and talk to you sort of in relation to our performance expectations, but also what's going on from a consumer point of view in that category.

I'll spend a quick couple of slides to talk about the FDA and litigation and where we see that kind of going, and then talk a little bit about how this holistically comes together to create outstanding shareholder value. So without further ado, I'll jump straight in.

The U.S. tobacco consumer. The cigarette consumers, as we all know, they tend to be older and less affluent than the general U.S. population. The younger adult consumers are increasingly diverse. And that's true in our category, but it's true in all categories in the U.S. as well. Kind of following population trends.

There is quite a marked difference in terms of the demographic kind of profile of the cigarette consumer with that of moist-snuff, because moist-snuff consumers tend to be primarily white and primarily male. And then the newer smoke-free products, they tend younger adult and more diverse. Which is quite interesting. You see sort of the adoption cycle coming to new products. So it's an important kind of thing to focus on that they are younger adults and they tend to be more diverse than the population are than the tobacco user in general.

And of course, as we stand here today, all consumers are affected by the economy. And I think value seeking in all the categories is sort of the new norm. And that's, of course, is the trend that we see across the consumer space in the U.S. and of course, tobacco is no exception.

Having said that, what we also see at the same time, is we see that kind of down trading trend, if you want. We also see premium usage is actually up. And what I'm talking about here is true premium usage. But it becomes more selective, more situational. So consumers opting for different price points at different times.

What I've done on this chart -- and this is just a bit of a background data to some of the comments that I have made before. But this is U.S. government data. And what we see here is sort of the bottom axis, you see the age groups of different consumers. And what you see here is incidents by cohort. And this is decade-long data. So the green line here is 1988, the blue line being 1998 and the orange line being 2008. And what you see, as each cohort comes into the category, you see a declining incidence. And that, of course, has an impact on total category. And this is cigarette data as on total category of volume.

The important thing I just wanted to ask everybody to focus on is look what happened at about age 50. About age 50, you see incidence declining quite rapidly over time and sort of trending slowly towards 0 as consumers age. But that's important because that inflection point at about age 50 is what creates the drag on some of the brands with older consumer profiles. And of course, if that's the incidence, this is average daily consumption, which has a similar impact at around age 50. You see average daily consumption keeps growing up until that point and declines thereafter. And these kind of massive generational and cohort analysis, but also sort of this age inflection point, has a significant impact if you're ever trying to model out specific brands and sort of their growth potential in the marketplace.

And then we, at RAI, we spend a lot of time talking about consumers, studying consumers and really trying to get at some of the key trends in society, trying to predict the future, where is it all going. And of course, I could stand here and really spend all of my time just talking about these consumer trends. But what I've done here is just kind of boiled it down to 3 key trends that we're -- that we've sort of distilled everything down to and that we're really tracking. Those being multi-cultural, the growing green trend and navigating well-being. And I think what you'll see in my presentation, also subsequent presentations today, is how we've actually incorporated these key trends, which I'm sure you've all heard about, but how we've incorporated those in a lot of our portfolio efforts, a lot of our marketing efforts and particularly, our innovations efforts.

Okay. And so from a societal point of view, why are some of these trends important? Because, of course, and there are societal pressures. There's also regulations out there that continue to reposition cigarettes. So cigarette smoking is increasingly seen as creating emotional baggage. There's continued pressure from societal norms and values as we go. And increasingly, what we're picking up from consumers is using cigarettes is a social liability, they're having a harder and harder time kind of navigating their day in terms of product usage. And that's, of course, an important backdrop surrounding the cigarette category. And also gives us clues as to some of the new innovations coming out.

So for those who choose to smoke, we really see 3 future growth spaces as being very important. One being low price. And this is really just consumers reevaluating what a true premium choice is within the category, given some of the economic pressures out there. But also, given some of the true product differentiation out there in the category.

At the same time as that's happening, the superior enjoyment experience is still one that's valued and is actually growing by consumers. So you see a bifurcation going on in the category. And these are consumers really looking for fewer, but better products out there. And so they reevaluate their brand choices. And when they do smoke, although it's less frequently, they're looking for more intense, more pleasurable experience. And then in addition to that, there's the progressive experience. And these are consumers who seek greater societal acceptance, but they want that within some familiar product choices. And we'll come back and you'll see how this is actually integrated, particularly into that innovation effort we have.

So to conclude, and we talk a lot sort of at Reynolds about migration and where it's all going and where consumers are moving. But we've also distilled this down into what we believe the preconditions that are required for migration success. And one is obviously affordable price. It does help consumers sort of nudge in between categories. The second one is the enjoyable experience. And lastly, there's the harm reduction awareness as well. And those 3 things help a lot in terms of getting consumers to migrate between categories.

So that's the section on the consumers. Now what I'd like to do is just to change gears a little bit and talk about the total market. It is still a very, very attractive category. The profit pool is about $14 billion as we stand here today. 85% of that is accounted for by cigarettes. And that profit pool, if you take a look at recent experience, Has been growing about 4% per annum. And certainly, I stand here in front of you with a strong belief that there's additional long-term upside to that.

Now, of course, within that, if we start going to the different categories, we should thinking about cigarettes, and that's declining from a volumetric point of view, about 3% per annum. But moist-snuff within it is growing about 4% to 5% per year. And snus is growing at about 8% to 10%. So what you see is the largest category in cigarettes, about 85% of the profit pool declining, the other elements of it in terms of moist-snuff snus and so forth, actually growing and bringing at least some counterweight to that volumetric decline in cigarettes.

And there is a significant and growing smoke-free category, okay? There's early signs of regulation and taxation changes that support migration to smoke free.

Now, of course, I told you about how positive I'm feeling about the long-term potential of the profit pool. But if we take a look some of the pricing headwinds and I know a lot of your questions to me certainly over the last months have been about the short-term potential impact to the profit pool. But I do believe that there are pricing headwinds for the category and for us in the short term. I would describe the current sort of environment as being this way: it is a difficult environment, it's intensely competitive, but there is a rational pricing environment still in place today.

PM USA is increasingly dependent upon value to drive its growth. It's using Marlboro in both premium and in the value category. It's replicating the Marlboro strategy in moist-snuff. We see Newport Red also having been positioned full-time at a value positioning. And of course, Lorillard and Philip Morris USA have activated L&M and Maverick, respectively.

Having said that, there's a few sort of significant differences to what we see in the marketplace today from what we've seen at times in the past when there's been increased risk. And the first one, I'll note here, is that the market really appears to be consolidating behind some of the large brands. Those being Marlboro, Newport, Camel and Pall Mall. The big brands are getting bigger. The smaller brands, on average, are getting smaller.

And the other thing that's quite unique in this kind of a down trading environment, in the past, and when we look back over the decades in our category, what you see is the non-big 3 competitors. So let's call it everybody else outside of those 3. They generally are low-priced players. And they have grown in the past in this kind of a down trading environment. That, in aggregate, has not happened this time around.

And if we talk about the major -- the 3 major competitors in the category. I think what we'd say is that there is balanced and price tiered portfolio. So really what we see is a portfolio of each of the 3, they are evolving. And I have some more data on that. Because I think that certainly plays out to that hypothesis that I have that the long-term potential of U.S. profit pool is actually in good shape.

But before I get onto that, let me just take you back in history. And this is certainly a few decades worth of data. But what you actually see here is the shape of the entire profit pool back to 1991. First, you see the first inflection point that came in 1993, which was Marlboro Friday. And you see the De Facto price war in 2002, 2003, 2 major resets. And I know that one of the things that you certainly have on your mind and a lot of the questions I have is, are we due for a third reset? Sort of in recent memory.

And I think that's a very valid question, which I would just ask you to just bear in mind as I take you through the next couple of slides. The first thing is you'd say some of the precursors that lead to Marlboro Friday and that led to the situation in 2002, 2003 are still in place. What happened in Marlboro Friday 2002, 2003, there were significant down trading at that time. And this chart actually says, where we find ourselves today, you see the exact same level of down trading going on.

If we take the entire U.S. category and we actually segment it by what consumers actually pay, right? This is not the historical -- this brand is in premium, this brand is in value. This is what consumers actually pay in the marketplace. What you'd see is that today, the premium categories, just over 58% of the market, and the value category is defined by what consumers pay slightly over 41% of the category. But what's a very significant and what's very different is that, that volume has not gone away from the big 3 competitors. There's a lot of down trading going on within people's portfolios and within the 3 major competitors.

If we take a look at PM USA, first of all. They have a total market share, slightly North of 49 percentage points. But the percentage of their portfolio today that is in price value is slightly over 32%. And that's very significant because, of course, if you go back in history, they had most of their volume actually in premium. So they are a beneficiary or they're participating in that down trading, and their portfolio is becoming more in balance with the overall market.

Take a look at our similar numbers for ourselves. We have a market share that's slightly below 28%. And you take a look at what percent of our volume is actually in value. You see that's right around 41%. So we have about our fair share in value relative to the entire tobacco category.

Lorillard, on the other hand, they have about slightly south of 25% of their volume in the price value category. So when you look at it that way, what you see is the portfolios are coming more into balance. And fundamentally, what that does that in our categories, it changes the arithmetic long-term in terms of pricing. It -- because as prices go up, obviously, down trading is generated, irrespective of the economic environment. Of course, you'd expect there to be more down trading in the kind of environment we're in today. But even in good times when you increase prices, there is pricing pressure and down trading is generated.

But as each of the competitors have a more fair share within this value category, the math changes and there should be good long-term potential for the profit pool through manufacturing price increases.

And in addition to that on this slide, I've just put a few of the menthol shares in here. I think this is a great story for RAI and its operating companies, particularly R.J. Reynolds Tobacco. You see here that we have 9 share points or over 9 share points now in menthol. This historically was a significant weakness for us. And I'll come back to this one. I have some comments to make about Camel and particularly the capsule products, which is actually leading this growth.

But what you also see here is that each of the 3 competitors participating, not fair share within menthol, but each actually haven't quite a run within the menthol category as well. And then from an ASU30 side point of view, you start looking and saying, where is that going? That being probably the best predictor of long-term market share decades into the future. And you see that at RAI, we have fair share now of ASU30. This number has been coming up year after year. You see Lorillard overtrading within that category. Adult smokers under 30. And you see P.M. USA actually under trading their fair share within that category.

What's fundamentally led to some of the changes in performance, certainly, during 2012 and 2011, is how some of the relative price gaps between products have actually moved. What we've mapped out here is the predominant price categories in the market. You see the green line here really is the Premium segment and the dotted line, which I actually just asked you just to pay attention to, is what we would call premium value. And you actually see how that segment has actually come much closer to the true Value segment and really sitting right on top. And that's what's actually created these different dynamics, this down trading and some of the impact on different brand market shares.

And this has been the impact on us. If you take a look at the blue line here, these are our growth brands. And you actually see that come -- have been growing very, very rapidly ever since the economic recessions started in 2008. It was growing very rapidly. And then with the change in emphasis that we saw from Philip Morris USA, we actually see the growth of those brands actually slowed. Of course, the majority of this growth has accounted for by Pall Mall, which really started this period about 2 share points, came all the way up to 8. And there's been quite a bit of pressure brought on by the lower price line extensions of Marlboro. And that's actually arrested Pall Mall's growth somewhat in more recent period.

And of course, from a total company market share point of view, which is the other line here in orange. You see the impact. Because throughout this period, without an inflection sort of within the line, but you see the support brands that we have, those being Winston, Salem, Kool, and particularly, Doral, they have continued their declining trends throughout this period. And of course, all those brands, they are impacted by some of those early charts I showed you in terms of demographics and the average daily consumption because they have, on average, a significantly older consumer profile.

And here, you see the major brand share performance in the marketplace. What you saw is, historically, the early part sort of this chart is you see Marlboro actually declining. It was on a slight declining trend. And then more recently, with the aggressive pricing actions, you see them regaining some of the market share that they had lost, soft a few tenths in the back end of that period. And the impact there has been principally on Pall Mall, which is in orange in this chart. And you actually see that it was growing quite nicely and has dampened its growth. Camel, doing quite well. Slight growth about this period. And more recently, as well what we see from Newport was historically growing and more recently, tending down just a little bit in the last few quarters.

And I think the other thing that's worth talking about in the category is how the non-cigarette portfolios have been major competitors have changed. This is the way we like to kind of mapped out where the different companies find themselves. And I think we're quite proud at RAI of actually having started this trend. This trend of turning ourselves into a total tobacco company. But you see our competitors following suit.

So, of course, everybody is present in the cigarette category. And that still is 80 plus percent of everybody's profitability. But then if you take a look and you compare ourselves to Altria, you see that with the exceptions of cigars of the NRT category and the nontobacco profit streams, there are still differences. But both companies, quite clearly, have a total tobacco strategy in place.

And then more recently, we see Lorillard as well with the acquisition of Blu e-cigarettes beginning to put their toe in the water on this front as well.

So what is the marketplace and strategic context that we find ourselves in today? I think the industry players need cigarette pricing. But I also think it's fair to say that PM USA needs less because they have more reliance and actually are utilizing a lot of their resources that they generate from SAB Miller, from the Sese and so forth to actually take some pricing pressure off of themselves in the marketplace. They are, and we believe they will continue to mix down the portfolio to hold or grow market share.

And for ourselves, Camel, Pall Mall, NAS and Grizzly, we believe they're well-positioned for modest share growth. R.J. Reynolds, non growth brands, we believe they will continue to experience moderate losses and that's due to those demographics that we've talked about. And on the innovation side, I believe they are very promising. But everybody in the category, obviously, faces regulatory hurdles to bring the best ideas to market. And smoke-free growth, although it helps a lot and takes a lot of the pressure off of the cigarette category, it's insufficient to offset volume losses completely that happened on the cigarette side of things. And then the vapor category, we believe is poised for a very substantial growth as we stand here.

So in line with that, and I hope most of you are familiar with this, but I'd like to through it again. This is our transformation journey. This is what we set out on some years back. And it's really sort of helped us with all the employees, all the different stakeholders to get a clear vision in place and to get that kind of multiple kind of impact through a lot of our efforts. And what we're all about is we're about achieving market leadership by transforming the tobacco industry.

Now that transformation word is obviously a big word, there's a lot of implications. But it's not just about transforming ourselves, really the way we look at it is we're going to be out there, out in front, leading the pack and transforming the entire industry while we're at it.

And the way we're going to do that is we're going to do that through driving innovation throughout our businesses. In each of the product categories that we compete in, we're going to continue to drive innovation. We're going to redefine enjoyment for adult tobacco consumers, what does pleasurable products, what does enjoyment really mean for consumers? And we're going to reduce the harm caused by smoking while we're at it. So really tackling some of the big, big fundamental issues in the category through our transformation agenda.

And in line with that, here is one of our flagship brands, Camel, doing very well in the marketplace. 8.5% market share currently. It's got the best demographics in the industry.

We look at the age profile of consumers, it's got the best demographics. It's a brand that's known for innovation. It's got a growing position in premium menthol. Where historically it had been quite weak. It's grown very rapidly within the premium menthol category.

And the capsule have also opened up a new demographic segment for a Camel where historically it had been weak, which is in the Hispanic consumer. It's not too long ago that we had virtually no share amongst Hispanic consumers, but as we stand here today, Camel has more than fair share amongst the Hispanic consumers. And that obviously is a growing segment within the cigarette category. But we already, today, have more than fair share, and it continues to come in leaps and bounds.

Pall Mall, 8.7% market share. It's the largest value brand in the history of the U.S. category. And of course, this lasts longer is a significant point of difference. The fact is something you can take our entire portfolio, all the brands we focus on, our innovation efforts and so forth, we are adverse. We do not have "me too" products out there. It's all about being different and having a relevant point of difference in each brand proposition, each element of the portfolio. And for Pall Mall, that lasts longer. And fundamentally, this works in a very simple way. So consumers, when they buy a value product, they expect to get less quality, to get less puff than for premium brands. And the way Pall Mall is physically been put together, how the cigarette is actually been made, it delivers more puff. So you get a point of difference that way. You are exceeding consumers' expectations very significantly when they try a Pall Mall for the first time. And of course, Pall Mall is also driving growth in menthol. We have 2 new styles out there, which is Pall Mall Black, the menthol black, and Pall Mall menthol White. 2 new styles in the marketplace today.

Moving onto Natural American Spirit. For this brand -- it's a fantastic brand. Any way we look at it, whether we look at it from a volume point of view, from a market share point of view or from an operating income point of view, frankly, we see double-digit growth any way you want to look at it. It's currently tracking 1.2 market share points. It's a super premium price position. And it comes back to what I was talking about earlier from the consumers trend we see a bifurcation of markets. But this brand is actually growing very rapidly in the marketplace at a significant price premium to the existing premium brands. It's growing in every geography in the United States. It's got a loyal and a very committed consumer base.

In fact, the people at Santa Fe Natural Tobacco Company who work on the NAS brand, they don't even talk about consumers or purchasing behavior and so forth. They talk about brand evangelists. It's literally, that's how it works. That's how this brand has been constructed. The majority of consumers smoking it today have not been introduced to the spend by ourselves. It's not been our marketing effort. It's actually consumers educating each other and advising each other that this might be a relevant choice for them.

Now all of these brands, Brice O'Brien, will come back in a little bit and give you more details and kind of talk a bit more about the brand architecture.

And then Grizzly. Grizzly is a category leader at 28.8 market share points. And we spent a lot of time over the last years actually building equity for this brand. And it's growing extremely, extremely well. It's up 1.8 share points year-to-date. But this equity, I think, it's fair to say that maybe even ourselves, but a lot of people in the category that we're familiar with it, is probably underestimated. We've seen the price gaps actually compress significantly with some of the historic premium brands and they've actually sat right on top of Grizzly now, those price gaps closed a lot, yet Grizzly has kept right on growing. I think that's a testament to its equity, to how well it's doing in the marketplace. But also the efforts in the investments we keep making to continue to enhance the equity. And you see some of the ads we actually use for Grizzly on the slide here.

Now in addition to the 4 sort of brands that we focus on, we also have a strategy for migration. This is all about encouraging adult smokers to switch to smoke-free tobacco products. It's about aligning with consumer preferences and society's expectations. Of course, there's a desire for new alternatives, there's fewer places for consumers to smoke and also harm reduction as an element within that. And so we're capitalizing on the opportunity for profit and share growth through migration.

What's interesting to note is actually the category that we generate the lowest operating margins in today in our business is actually cigarettes. Everything beyond cigarettes for us is margin-enhancing, and that's very important.

So today, I'd really like to focus on 3 innovations. The first one being the heat-not-burn cigarettes. There's obviously, been a lot of talk in the category about this. Some of our international competitors talking about some of their efforts in heat-not-burn. We do have a heat-not-burn cigarette in the marketplace today, existing in the marketplace already. It's called Eclipse. And I would think it's fair to say that our folks at R&D have continued to develop this product. And there is a new generation of product that is ready to go, that has been submitted to the FDA for approval. And so, I believe, that's certainly, from a peer group point of view, we're headed the pack in terms of the development of our heat-not-burn technology. And I think that's exciting times. But of course, here in the U.S., we were require FDA approval before we can bring that market.

So in addition to Eclipse, there's 2 other products I just like to draw your attention to. The first one is the electronic cigarette side of things. It was a product called Vuse. And the other one is the NRT category, a product called Zonnic, which is a nicotine replacement therapy product. And I'll talk about these last 2 in a bit more detail.

So let me first talk about the e-cigarette and the space that's out there. The consumer space. What's this kind of looking like as we sit here today? First of all, in the e-cigarette space, I think what's the best way to put it is that there are extremely, and I'd like to emphasize that, extremely high levels of trial in -- for e-cigarettes out there. Irrespective of the brand, very significant levels of trial.

At the same time that I'm emphasizing extremely high levels of trial, I'd also like to emphasize that there are extremely, and I mean, extremely low levels of conversions. And even what we see, when we talk to consumers, is we even see significant iterate trial. And what that means is something like this, which might be a consumer who hears about an e-cigarette or finds it at retail says, "That's interesting. Let me try it." Purchase it, might use it for a little bit, decide it's not for them. drop it. Go back to the existing tobacco category most likely in their predominantly cigarette smokers. And then they might hear about a different one, see a different one at retial and say, yes, let me try that one. And have a different kind of expectation. They'll buy it, try it, smoke for a little bit but decide it's still not for them. But when you get iterative trial like that, I think it's a key indication that the consumer space and the consumer understanding of the proposition of that consumer space is very viable.

Of course, when we see an iterative trial, from a manufacturer point of view, we understand why that's happening and why there are low levels of conversion. All the products in the marketplace today, they use a commoditized technology. There's nothing different between one or another out there today. We also believe there's -- they're very inconsistent with the smoking experience. So fundamentally, the product, how it works, it's too different from the smoking experience today. We also believe there are significant product quality issues with all the manufactured products out there today. And at least for our own standards, we believe there are potential product stewardship issues.

And so the good news is that a couple of years ago, we started looking at the space, and we asked our team at R&D to actually go back and address a lot of these issues, fundamentally saying the consumer space, it's there, it's real. It works, and the consumer wants these products to work. Now design around and give consumers something that actually addresses their expectations and works the way they want it to. And at the same time, you need to address the quality issues, and you need to meet our own internal product stewardship standards. And the good news is that we've achieved that.

And just to give you one more little fact -- point of fact in here. If you take a look at government data today, it'll indicate that about 5 million consumers, 5 million consumers, let's compare and contrast that to about 43 million smokers in the U.S. today, but 5 million consumers have tried an e-cigarette in the last 6 months. So when I put the emphasis on this very high level of trial, that's what it is, okay? But of course, we also see those low levels of conversion. But here, you think about these kind of awareness numbers, and here we've compared and contrasted them to moist snuff and to snus. You see the awareness actually for e-cigarette is extremely high in the market place as well, even bigger than moist snuff which is a historic category, very large category, but just the levels of awareness have already come up -- come in higher than moist snuff. At the same time, the claimed every use is also higher than moist snuff, and that just gives you a lot of evidence because you all know roughly what the size of the e-cigarette is today, quite small. But a lot of trial out there, just no conversion.

So this is what our product looks like. First of all, we started a new subsidiary. It's called the R.J. Reynolds Vapor Company. They have completely reengineered the product. It uses a proprietary and patented technology. We're not even calling this an e-cigarette, although that's the category space. We're really calling it a digital cigarette. And why? Because if you think about all the products that are out there today, sure, they have a battery in them, right, that generates electrons. But the only reason that there's a battery in there is to -- is the heat source. It helps generate heat in the current products out there today. Ours literally is digital in the sense that it actually has computer chips inside that's fundamentally controlling the operation of how that product works to make sure you get a cigarette experience -- a product experience that's close to a cigarette, but also that you get consistency and quality from the product. We believe we have a significantly superior vapor and taste, and that we're able to deliver that product experience that's very similar to traditional cigarettes.

Now of course, the products that we're competing with are all coming out of a few facilities in China, and they're hand-assembled there today. We're coming to market with a product that's made in the U.S.A. Now it's actually made with automated, high-speed machinery. And that allows us to kind of counterbalance the relatively low labor rates in China, but also gets the quality up and the product consistency up over time.

And our product is made with only food grade materials. What I'm trying to describe for you here is a product that's not a little bit better than what's out there, but that is fundamentally a step change in the category, significantly different in the category. Or put it another way, we're not looking to make a little splash in the category. We're looking to make a big splash in the category.

Okay. So that's some remarks there on the e-cigarette side. Now I'd like to move on to the nicotin replacement therapy category. Today, in the U.S., this is about a $1 billion category. There's 2 significant sort of players in the marketplace. You've got Nicorette, it's about half the market and the other half is predominately private label. And that's kind of the shape of that category today.

Having said that, similar to what we see in e-cigarettes, in the NRT side, we believe the competitors' products don't address some fundamental consumer needs. And it's largely because it's -- they have a kind of a pharma company mindset that they've brought to these products, which is not surprising because they are pharma companies, right? But of course, they are targeting tobacco consumers, and that's something we know a lot about.

So today, that category is sold primarily in the drugstore channel. They tend to be sold in large quantity packaging, generally 100 or 200 count packaging, sort of the big boxes that you see at retail. They have a relatively high price point, anywhere between $25 to $50 plus for a pack. And I think what we would also say is they have quite a judgmental approach to tobacco users in terms of their communication, the way they talk to them and so forth. And of course, we know and understand these consumers and trade channels, at least as well as a lot of the pharma competitors.

So in line with that thinking, a few years ago, we actually bought a subsidiary called Niconovum AB. It's a subsidiary of ours now in Sweden. Of course, that's based in Sweden. That's not haphazard. In fact, it's not only based in Sweden. It's based in Helsingborg, Sweden, which is a small town in Sweden. In fact, the locals have a little nickname for Helsingborg. They call it Nicotine Valley, okay. And of course, the analogy there is to Silicon Valley. But that is important because that's where all the development for all the NRTs of all the major pharma companies happen there. They had the fundamental expertise there. The R&D effort came all out of Helsingborg. And the company that we bought called Niconovum AB was a startup, and it was obviously started by some folks that used to work for some of those major pharma companies.

At the time we bought them, they had about 4 market share points of the NRT category in Sweden. Of course, Sweden is not that large of a country. It doesn't have a significant population. We didn't actually buy it for the market share that they had at the time in Sweden. But we bought it for the know-how of the folks and the company and also for the product pipeline, the pipeline of products that they had.

Since that acquisition, we're at about 10 market share points in Sweden now. I'd recommend you don't stick that in your modeling because Sweden is really, really small. It still is a rounding area, but it is growing nicely. And that certainly gives us a clue that the products in those -- in the pipeline actually has potential in the marketplace. And of course, this accusation really sort of allowed us and put ourselves on the map and really showed the word that we're quite serious about harm -- our harm reduction strategy.

And so since that acquisition, we've been exploring new products and new markets to bring some of these to market. And in line with that, Niconovum USA, they introduced their first product into the marketplace here. This went into -- it went to market in Des Moines, Iowa, in September of this year, early September. It's a gum product under the Zonnic brand name. There's 2 styles out there. One's a 2-milligram, the other is a 4-milligram product, and we have a very positive inspirational positioning behind.

And I'll come back and make some more comments about Niconovum and what we're doing in the marketplace. But what I thought I would do, and this is quite a new experience for us as a tobacco company, but I thought I'd show you some of the TV ads that are actually out there in support of this category.


Daniel M. Delen

So of course, for us and some of the marketeers and certainly myself back in my career when I first started, we still had access to TV. But of course, a lot of those skills had atrophied over time. So we're busy dusting those off at the company as we speak. But I think that's quite exciting.

These products that we put into the marketplace, I think they're differentiated not only from a product point of view, but really what we're most focused on here is how some of the other elements of the market that makes it quite different than what's done in the space today. So they offer great growth potential, we believe. But they're sold primarily in convenience and gas stores, and those are the important channels. If you think about gas convenience, it is an important channel, certainly, for tobacco consumers today. 75% of tobacco products are actually sold through gas convenience today, which is why we focused and brought these to market in that channel.

We're selling them in a 10-count package, much more convenient. And of course, it's got an accessible price point. We're selling these packs for $2.85 in the marketplace. That is exactly half the price of a pack of premium cigarette. So 20 equivalent, so at the per unit, the exact same price. And that's really, really important because of course, a lot of consumers who are looking for these kind of products and where they interact with it is in gas convenience. They may not want to have that very large outlay from a price point of view and a much more convenient and discrete packaging in terms of the 10-count pack.

Okay. All right. So let's -- those are just a few sort of quick comments about what's going on from the e-cigarette space and from the NRT. But I really do believe at RAI, that innovation is our strong suit. These new product formats, they offer significant growth potential for RAI and its operating companies. It addresses shifting consumer preferences that are essential for long-term sustainability of the total tobacco space. And the other thing is that both these products I've talked about, but indeed everything we're working on from an innovation point of view is higher margin than cigarettes. And we target to have at least a 50% operating margin in all these categories long term.

Now of course, there's an investment phase within all of that. That's important. There's a couple of ways into new categories. You can either acquire something, right, which is a one-off kind of cost to the company, if you want, or the other way is you can grow it organically. And we can -- you sort of have -- and reasonable minds can disagree about which is more efficient, which is more cost-effective and so forth. But when you grow organically, it actually layers into the P&L sort of over time, and the total cost of that may not be so different than actually doing an acquisition in the category. So what's important is to keep an eye sort of on that margin game long-term that as consumers migrate, we're actually trading them up in terms of margin and that consumer is value to our company.

And RAI's operating companies have a competitive edge. I think the R&D side of things, we have significant expertise, and we certainly have proprietary technology. And we're fundamentally always, always, focused on differentiation. So no me-too kind of mindset in our product development. Everything needs to be not just a little bit better, but significantly better over time.

And also, when we think about some of these new products and new to the world products, that also allows us to think more broadly than just the U.S. So there's also international opportunities that present themselves, and that can be through partnerships or direct exploitation and so forth. But that's all about monetizing our technology. And because of that core concept of tobacco harm reduction is relevant here in the U.S., but it's very relevant internationally as well. And so I think that creates new opportunities, new whitespace for us as a company.

So moving on quickly to the FDA. The regulatory environment, we believe, it's evolving rapidly. The good news is everything that we hear and that's been written and certainly our belief is, is that it will be science-based protocols that will govern the actions of the FDA. It's a critical issue, and the key critical issue for us there really is the impact it has on innovation and largely, speed-to-market of innovation. And I believe, and certainly our posture and everything we've done so far and that is our strategy behind it, is that we will continue to be the industry's change agent on this front. And coming back a little bit later in some of the presentations this morning, we'll hear from Dr. Jeff Gentry, and he'll actually take us through more in-depth in terms of what's actually going on at the FDA and some of our beliefs and strategies behind. Having said that, we believe there are very significant opportunities available for the company that best navigates this process.

And so I think it's fair to say that despite some of the short term kind of challenges bringing our entire companies into regulatory compliance, I think we're actually quite optimistic on the long-term outlook. And I certainly believe that as a company, if we were to fast forward a few years in time, maybe even sort of 4, 5 years, we'll look back and say, "Actually, this regulatory environment hasn't hampered our efforts, and I think we could all point to a number of different areas where it might actually have enhanced our effectiveness in the marketplace."

The litigation environment, we believe it continues to improve. It's certainly been over a decade now of progress. We see a favorable docket trend in terms of all cases out there in general, but specifically on the Engle cases as well. I think the Engle cases, they certainly are the biggest challenge we have out there from a litigation point of view. But even there, we see improvement, small steady steps, and we're quite confident in our ultimate appellate strategy there.

And of course, when we talk about transforming tobacco, harm reduction and so forth, responsibility is key as well because transforming tobacco strategy, it drives conflict resolution and commercial success at the same time. And I'm glad to announce that for the fifth consecutive year in a row, we're a member of the Dow Jones Sustainability North America Index. This has been a long-term effort for us that are headed up by somebody that you know very well, Mr. Morris Moore, who's in charge of that effort inside of the company, but 5 consecutive years on the Dow Jones Sustainability North America Index.

So kind of looking at it in general, I think we're very well positioned in an evolving market. Our strategic business model, we invest in high-equity, high-potential brands being Camel, Pall Mall, Natural American Spirit and Grizzly. We manage the rest of the traditional portfolio for optimal volume and profit mix. We're all about commercializing innovation and innovation in the cigarette side of things and smoke-free in vapor and in NRT.

We have a little mantra inside of the company that we use, which we call the 80-90-90. And the way that this kind of works is from a brand support expenditure, we spend about 80% of our resources in the combustible space. The combustible space is still 80%, 80-plus percent of our operating income. We spend the majority of our resources still in the combustible space. 90% of the organizational focus, the human resources inside the company, are actually focused on the combustible space. And despite a lot of these new innovations that you see coming out, 90% of our R&D budgets are actually directed at the combustible category.

So what I'm trying to highlight is, yes, we do a lot of innovations to some big excitement that's out there. But the majority of our resources inside the company are still squarely focused on combustible. That is the category that's still going to deliver a lot of growth into the future, but it's very important as well to keep focusing on that as we make this transition to these new categories of products.

And of course, a big enabler of the success of this strategy is the proactive regulatory management and cost controls. And in terms of the cost control side of things, our resource efficiency is key to success. Since the merger in 2004, our total headcount as a total company has actually been reduced by 35%. At the same time, our product conversion cost is down 26%. It's down 26% in absolute terms. Nevermind what inflation would have done if we hadn't been proactive on the cost side. And our adjusted operating margin reflects the impact of these efforts. We're currently tracking at about 34% operating margin, and that's actually doubled since the merger in 2004.

And at the same time as we're driving efficiency through, we're delivering value to shareholders. We have a dividend yield of over 5.5% today. And that's increased almost 150% since merger. We have the share buyback program in place. That's a $2.5 billion program, and that runs through the middle of 2014. And then look at this nice sort of steady growth that we've been able to generate since merger on the EPS, and that's actually doubled since the merger. And of course, we've delivered outstanding shareholder return at the same time. Whether we look at it over the 5-year period, the 3-year period, we've significantly outperformed, we're roughly in line sort of over the last 12 months.

So in summary, RAI and its operating companies are leading transformation, not just transforming ourselves, but the entire industry while we're at it. We're successfully managing through a quite challenging environment. We're building the equity of our powerful key brands, and we're driving innovation for future growth and delivering excellent shareholder returns while we're at it.

So one question I get, just in summary and just as some concluding remarks. But one question I get from a lot of you out there is what is the investment thesis? You ask me a lot, how should you be looking at our company? And so I've developed one here, and let me try it out for you, okay?

My investment thesis for our company, and just as I'm doing that, let me compare and contrast to some of the other tobacco companies in the space. And I'll talk about our investment thesis maybe by first sort of highlighting, and a lot of you know I used to work for a large international tobacco company, but let me talk about what the international kind of players look like and what their investment thesis is and then talk about ours.

But if you work in international tobacco, the investment thesis kind of sounds like this, is you have a high market share in some of the very profitable markets in the world, which tend to be the developed countries, sort of the Western Europe. You look at Japan, look at Korea, some of the real developed economies. They have a big market share. They're very profitable markets. But of course, volume is declining in all those markets like it is here in the U.S. And so the investment thesis kind of runs like this, that's where a lot of the profit is generated today. But don't worry, there's also significant exposure to the emerging markets because that's where you see population growth. You see volume increases, with a little caveat on the end that they're not very profitable markets today. But over time, right, there's confidence that you can get the margins up in those markets to kind of keep the total category sustainable.

No, I'm not going to stand here and tell you that I don't think that's a relevant thesis. I think it's a great thesis and I buy it. Having said that, if I take a look at our investment thesis, I actually believe that we have the best emerging market exposure of any tobacco company globally.

A lot of you sort of -- I can see some of the looks on your face and you say that's not possible because we have exactly 0 exposure to emerging markets, and you'd be right. What I mean by emerging market exposure is I'm going to define that quite differently. The emerging market exposure that we have is in terms of these new categories. These new white spaces that are out there. They are very relevant emerging categories, emerging products. That is an emerging market. It's huge. By the way, we don't even have to put the caveat out there to say, "And one day, we hope those consumers will be able to pay for it and pay more and up-trade the margin." They already are more profitable today.

So my investment thesis to you is that actually long term, the ship is going to come into balance. We've got significant emerging market exposure. We're leading that train of thought globally to actually get that emerging -- that exposure to those emerging markets and bring it online to help balance out the ship and help begin that compensation for that fundamental kind of volume decline that we see in the cigarette space. And it's happening already. Just look at moist snuff, look at snus. Look at some of these other new products that are out there. It's helping to bring the balance to the ship. So I fundamentally believe we have the best emerging market exposure out there today.

So on that note, I'll pass it over to Andrew Gilchrist, our Chief Commercial Officer at R.J. Reynolds Tobacco. Andrew?

Andrew D. Gilchrist

Thanks, Dan. Good morning, everyone. I'm glad to have the opportunity to be here with you again this year, especially given everything that's taken place here in the northeast over the last few weeks. Certainly, our hearts go out to all of the folks in the area affected by Hurricane Sandy.

I'm going to talk with you this morning about our cigarette and moist-snuff business and what we see going on in the tobacco category overall. You'll see we have a great story to tell despite the challenging environment. Our strategies of investing in key brands that provide adult smokers a combination of strong equity and highly differentiated products has been very successful and provides us with the opportunity for near and long-term growth.

I'll start by taking a look at our largest contributor to our business, cigarettes. As you're aware, cigarette volume continues to decline, and the weak economy is driving smokers to seek value. As a result, we are seeing consumers shop around for the best price, which has resulted in substantial down trading to low-priced offerings. And not surprising, these factors are driving a very competitive, though manageable, environment and also driving a shift in premium and value segment performance.

Now looking at the cigarette industry in the traditional sense, where we have premium and value segment defined by traditional brand positioning, the overall premium to value mix hasn't really changed too much. However, as you can see, if you look at it from the consumers' point of view, which is the price they actually pay at retail, the story is quite different. More and more smokers continue to trade down to value brands for at least some of their cigarette purchases. And of course, that volume comes straight from the premium segment.

But unlike our competitors, we have a positive story to tell in the premium segment. Camel is holding steady with the brand's innovative product offerings driving performance and providing a strong foundation for future growth. And Natural American Spirit continues to grow share in premium, actually at a super premium price point, providing consumers with high-quality, additive-free and organic blends and a brand proposition that resonates with a very loyal franchise. As you can see, that's not the case with the other brands in the segment.

In the value segment, it's a different story as major players continue to see growth, including our brand, Pall Mall. With its rich heritage and longer-lasting product proposition, Pall Mall is well positioned as smokers continue to seek value in a weak economy. It's important to note the most significant growth is seen by what we call premium value brands that have hit the market in recent years, causing that shift in segment dynamics that I spoke of earlier.

It's also important to note that looking at the other companies within the cigarette category, those that really focus on the lower end of the price scale, you'll see that there's been very little change in their share over time. This isn't surprising given the pricing dynamics in the premium value and value segments from the major players. What has changed is what we call the pipe your own segment, which has grown over the past few years. This is tobacco that is characterized as pipe tobacco for tax purposes and actually used for roll-your-own or make-your-own cigarettes. As I mentioned earlier, our expectation is for about a 3% decline in cigarette volumes this year. But if the tax loopholes on these products are closed, it may improve the volume decline on cigarettes. We will also see if the recently enacted roll-your-own laws will affect this trend moving forward.

Another tax-driven factor in the industry can be seen with large filtered cigars, which some adult smokers are using as low-priced alternatives to cigarettes. As with pipe your own, their price advantage is a result of a favorable tax treatment. So both the large filter cigar and the pipe your own segments have grown in volume significantly in recent years, as smokers have moved to them in search for cheaper alternatives to cigarettes. And of course, this is an important dynamic and one in which we are working hard to educate all of our stakeholders.

Now let's take a closer look at R.J. Reynolds. Our brand strategy continues to focus efforts behind our 2 growth brands, Camel and Pall Mall. And that strategy is working, as Camel continues to perform well in the premium segment, and Pall Mall is now the #3 brand on the market. The focus on our growth brands has resulted in significant transformation in the company's cigarette portfolio, with growth brands now accounting for more than 60% of our total cigarette volume. And this shift has allowed us to rationalize 80% of our cigarette styles since 2004. As you would expect, this has resulted in significant productivity gains, providing us the resources needed to invest in other important areas like innovation.

In this highly competitive marketplace, our overall company market share has shown a modest decline as we focus resources behind our growth brand and on achieving a reasonable balance between marketplace and financial performance. And probably one of the most significant gains seen as a result of our cigarette brand strategy and productivity improvement is our margin improvement, which is nearly doubled since 2004.

So let's take a closer look at our premium growth brand, Camel. Despite the continued weak economy and intense price competition, Camel's overall share has been relatively stable, a real testimony to the brand's resilience, its innovative product offerings and its attractive demographics. And as you can see here, Camel's growth in the premium segment is quite significant. It's the only brand outside of Natural American Spirit that is experiencing growth in this segment. This is quite an accomplishment in this environment.

The primary driver of Camel's overall share growth continues to be the brand's menthol styles. The innovative capsule technology utilized in all of the brand's core menthol styles has strong appeal among adult smokers, particularly adult smokers under 30. And that's helping Camel lead the growth of the premium menthol segment. And that growth is clearly evident as menthol now represents a much larger portion of Camel's overall mix. As a matter of fact, Camel is now the #1 or the #2 menthol brand in 15 states. So the brand has clearly established itself as a strong player in the menthol category. And that's significant as menthol continues to be a growing segment among adult smokers.

Looking at Camel's development geographically, the brand has strong performance across much of the country, but there are also significant opportunities for growth, primarily in strong menthol markets on the East Coast and in the southeast. Certainly, we believe that Camel's innovative capsule technology can play a major role in building on the brand's momentum in these areas.

Now looking at Camel SNUS, the story continues to be a good one, showing how a combination of strong brand, a superior product and a focused marketing plan can create a winning formula. Though still an emerging category, snus is growing between 8% and 10% annually. Camel SNUS has recently -- Camel SNUS currently has about an 80 share of that growing market. Our most recent addition to the portfolio, Camel SNUS Mint, rolled out nationally earlier this year and is doing very well. In fact, it's already the #4 brand in the entire snus category.

With this kind of growth and an 80 share of market, it's easy to see why we're optimistic about the future of this category. We believe this trend will continue as adult smokers continue -- consider a wide range of options for tobacco enjoyment.

As this chart shows clearly, Camel SNUS is a product adult tobacco consumers are choosing. The brand has grown share, while competitive brands really haven't gained much of a foothold. This is a trend we're confident will continue as adult tobacco consumers become more aware of the product attributes Camel SNUS offers: fresh, premium, discreet tobacco pleasure.

Now looking at Pall Mall. Despite only modest share growth this year, it remains the #1 value brand. That's quite an accomplishment given the pressure from the influx of what you've heard us call premium value styles. Despite that pressure, Pall Mall continues to grow. This is a testament to the true value beyond price that the brand offers adult smokers, an excellent brand with a high-quality, longer-lasting, great-tasting cigarette.

Yet another benefit of our strategy of focusing on our growth brands is that they complement each other very nicely geographically. While Pall Mall share is growing nationally, the brand shows particular strength in areas like the Southeast, where Camel is relatively underdeveloped. And Pall Mall is well positioned to experience continued growth, providing adult smokers a premium-tasting, longer-lasting cigarette at an affordable everyday price.

And as I mentioned earlier, the menthol segment continues to see growth. But Pall Mall is rather underdeveloped in that category. So to help change that, the brand introduced 4 additional menthol styles in October. And Brice will touch on this more in his presentation.

So it all comes together for R.J. Reynolds by focusing on our key brands, driving growth through innovation and offering true value to adult tobacco consumers. And the foundation that enables us to do this is our focus on productivity, giving us the resources to drive our strategies forward.

Now let's take a look at Santa Fe Natural Tobacco Company where the story continues to get better and better. Remember now, we're talking about a brand at a super premium price point. And Natural American Spirit continues to see significant volume, share and margin growth. Really, a great success story, particularly given the economy and the intense competitive environment.

The elements driving Santa Fe's growth remain the same, a very loyal franchise and a unique product point of difference with additive-free and organic styles. The brand's core proposition, including its natural tobacco products and its commitment to sustainability, really resonates with its core consumers. And the results, well, they speak for themselves. We're growing in every state.

Now let's switch gears and take a look at the moist-snuff category. Like cigarettes, the market is highly competitive with premium price brands offering value price line extensions and aggressive discounting, now the norm in this category. The critical difference, however, is that the category is experiencing robust volume growth.

Certainly, this is a graph we love to see. Moist-snuff volume continues to grow at about 4% to 5% a year, and we expect that trend to continue.

Like cigarettes, there's been a change in the traditional definition of what premium and value pricing means. And if you use the traditional definition, you would think that premium brands are actually experiencing volume growth, while value brands are declining. But if you base it on the actual selling price at retail, the story is very different.

As you see, value price brands are continuing their long-standing growth trend and have actually passed premium price products in volume. That has actually accelerated in recent years with the introduction of the value price line extensions on the competitive premium brands. This has effectively transformed the traditional value price segment into the popular mainstream price point.

As the pricing environment has evolved, there has been significant variations in the company's relative performance. As you can see, the American Snuff Company has clearly outperformed USST and all other companies during this time period.

Now let's take a closer look at the American Snuff Company. This is a great story, with American Snuff Company steadily growing share in a growing category. Since becoming part of RAI in 2006, American Snuff Company has captured the majority of the total category growth and now accounts for over 32% of the market.

And driving the company's growth and the category's growth is Grizzly, the top-selling moist-snuff brand on the market today. Despite a highly competitive marketplace, Grizzly continues to grow volume, share and margin, and it's now approaching 29 share of the market. And remember, this is a brand that was launched just 11 years ago.

Here, you can see how the industry breaks out by flavor. Wintergreen is the largest flavor segment and Grizzly's long cut wintergreen is the top-selling style overall and, of course, the top-selling Wintergreen style. The brand also performs well in the mint and straight segments.

Where Grizzly is underdeveloped compared to the competition is in the natural flavor segment. Given the size and popularity of that segment, there's a great opportunity for Grizzly to build on its overall momentum by growing its share in naturals.

And earlier this year, American Snuff made moves to address that opportunity, by transforming Grizzly's premium natural offerings. We believe these changes make Grizzly even more competitive within this important segment.

So what it all boils down to is, American Snuff is well-positioned in a growing category. No doubt, a great place to be. The company continues to enjoy volume, share and margin growth, and we expect that to continue moving forward.

To sum it up, RAI's operating companies are well-positioned for long-term growth, with key brands performing very well in a highly competitive marketplace in a down economy.

Looking ahead, our key focus on innovation and productivity provide great opportunities for continued success as we transform the tobacco category.

Now we'll take a short break. And when we return, Brice will tell you more about our brand building efforts. Thank you very much.


John Brice O'Brien

Okay, why don't we get started. Thanks, and I'm glad to be back. I'm Brice O'Brien, the Executive Vice President of Consumer Marketing. Today, I've got on tap to talk about our growth strategy around our brands and how our brands are building consumer equity, how our investments are paying off and how those investments are paying off in consumer growth, market share growth and how we're leading innovation in the category.

On deck today, I want to talk about Camel, Reynolds' iconic premium brand; Pall Mall, the nation's #1 value brand; the fast-growing Natural American Spirit brand in super premium segment; and then lastly, talk about the #1 brand in the moist-snuff category, which is Grizzly.

But let's start off with Camel and Camel's total tobacco approach. And Camel was really the first total tobacco brand in the U.S. and leading growth as a total tobacco brand. And I'm going to talk about cigarettes and snus today and what Camel's doing to build a brand equity.

But I want to first start with really what makes Camel special, and I get asked that a lot. It's really a pop icon brand. It's bigger than just a cigarette brand, bigger than just a consumer staker -- staple. It's really a legendary brand, which goes beyond just its trademark icons of the Camel Beast, the bent logo. What Camel has is a century of tradition, a century of heritage, long-standing tradition in innovation. But most importantly, what Camel has is a strong connection with its consumer base.

Camel has some amazing fans, and its consumers, it's well-connected. It's a brand that over -- throughout over 100 years has listened to its consumers, responded to the consumers and developed innovative, market-leading innovations, as well as marketing programs.

It is the consumer that makes Camel so strong. And when you look at Camel's consumer, Camel's consumers tend to be more ASU30, more adult smoker under 30, more urban, more progressive. They tend to be the creative class, which you may have heard in the popular press. They are more unique, more open-minded, more aspirational. They are leaders, and particularly, leaders of their generation. And it's the strong connection between Camel and its consumer that's made Camel an iconic brand.

What we see with Camel really is the industry's best and leading consumer profile. What we see with Camel is that about 42% of Camel's consumers, 40% of its volume is made up of adults age 18 to 29. That compares very favorably to the industry of 22%.

What's driving the growth here are the Camel capsule styles. 58% of Camel capsule buyers are age 18 to 29. What Camel capsule is also doing for Camel is broaden its buyer base. It's made it more balanced from a gender basis. It's made it more diverse.

And I think with the election last week, who can ignore demographics? Demographics are and will always be important. What we see is, Camel becoming slightly less Caucasian, slightly more African-American. But growing significantly, having a large percentage of the capsule base, but even Camel, now in the Hispanic segment. 15% of the Camel buyer base is Hispanic. About 10 years ago, Camel would have been well underrepresented in the Hispanic segment, and capsule is what's leading the growth here.

Now let's turn to Camel's ASU30 share. Camel's ASU30 share is about 17%, about a 17 share of adult smokers under 30, which is double its market share. And as you know, ASU30 share is a leading indicator of brand strength and future growth potential. Camel continues to grow its ASU30 share. And the large -- what's driving Camel's growth amongst ASU30 are its capsule styles. Capsule and ASU30 are what's growing Camel.

So when we look back 1 decade ago, and Camel has grown just over 3 share points. So what's most interesting when we look at Camel's growth is the mix of the brand volume. Over time, its volume has become more menthol and more ASU30.

Today, Camel has 3 share points in its menthol styles, which is about 36% of the brand's volume in menthol. So it's over-indexing and overtrending in menthol, where you see back in the year 2000, Camel was well underdeveloped in menthol at that point of time. We've grown over 0.5 share point this year and about 0.5 share point over the last 4 years in menthol. The segment continues to grow, and Camel continues to lead the segment.

And we're leading with Camel Crush, its capsule products. We have 4 styles of capsule products: 2 in Camel Crush, Crush and Crush Bold, which are non-menthol cigarettes, which when the capsule is crushed, they change to menthol; and Menthol and Menthol Silver when the capsule is crushed, it gives the adult smoker just a little extra menthol. What we see and have seen in this segment is substantial growth because of the innovativeness, but particularly, it gives consumers control and it gives consumers empowerment.

Overall, what we've seen is about 2 share points of growth since 2009, 1.5 share points to be exact. The share is split about equally between the non-menthol Crush style and the menthol style, with both being about 1.5 share points and both growing about equally.

On the consumer side, the ASU30 share, just like the market share, has grown precipitously and sequentially since '09. The ASU30 share is up almost 5 share points, from 2.2 to 7.6, significant growth. And that's what's driving Camel's overall ASU30 share.

Even in this competitive environment, Camel continues to show strong solid growth on the market side in menthol, as well as ASU30. But it's not just product innovation that's propelling Camel growth. It's also marketing innovation. Camel has a long-standing history of developing interesting, innovative, cutting-edge marketing programs. And that's a big part of what makes Camel a pop culture icon and strong ASU30 brand.

Next year in 2013, Camel will turn 100 years old. But we celebrated Camel's birthday this year, its 99th birthday. Let me take a drink of water here.

So as I said earlier, Camel is a bit of a quirky, irreverent, all-feed ASU30 brand. We're not celebrating its centennial, we're celebrating its Humptennial, its 99th birthday. We began in January, and every month have rolled out new modules to our consumer base through our database, through our website, through direct mail, as well as consumer engagement to engage, excite and create interest among competitive smokers. And it all culminates at the end of the year when millions of Camel smokers will vote on the President of Hump Day, the President that will represent Camel for the next year on its website with its large group of Camel consumers to keep them connected. The promotion has run, as I said, all year through all the marketing touch points.

I've talked in years past about Camel's large database. And as far as database, I think it was kind of Camel's ground game, its ability to connect, to engage and convert competitive adult smokers, as well as excite its loyal franchise.

To support the promotion, we also have a long history of promotional packaging. This year, we ran the Humptennial packaging across the entire line of Camel products. The Camel smokers continue to look for these promotional packs all across America. The promotional packs went out during the first quarter, ran through the second quarter and will culminate in the third quarter. Just another interesting way in which Camel builds excitement and interest at retail.

Now what I'd like to do is turn to Camel SNUS. I'm still very bullish on SNUS. We still continue to see strong volume growth at just at 10%, just about double the category growth. The consumer fundamentals still remain very positive in terms of migration, move to smokeless, spit-free convenience, and Camel leads the way in this.

When you look at the competitive set, we sit at just about 80%, 81% market share with Camel SNUS. We've been growing market share even with competitive entrants from market-leading brands over the last few years. Camel SNUS also sits at a premium price point to both draw [ph] with Marlboro Snus in the marketplace. We've been gaining volume, as well as market share since its inception in 2009.

So to break it down a little further, Camel SNUS has 4 of the top 10 leading styles, with Camel Frost at 45% overall market share in just 1 style.

What's particularly impressive to me is Camel Mint. We launched Camel Mint in the second quarter of this year, expanded it nationally and achieved 8 share points since then. So in 2 quarters, 8% of the market, which will make that 1 style of Camel SNUS about as big as the 2 leading competitors.

Camel is seen as the leader, its product is superior and its innovation is superior. And again, I remain very positive.

When you look at the buyer profile in this snus thing. SNUS has a very attractive buyer, and when I looked up, I sum it up in a nutshell, it is younger adult males who tend to be higher educated and have higher incomes.

So clearly, more male like moist-snuff than cigarettes at 81%. They are more AUS30 or adult tobacco user under 30 at 53%. They also tend to be higher educated and higher income. So a very attractive buyer profile, which is a leading indicator of future growth.

Also what's important, when we look at the buyer and buyer usage dynamics. What we see is, just under half of the buyers have been using snus less than 1 year, just under half of them have been using between 1 and 5 years and a very small portion of them using it over 5 years. This is important because what we see is, the longer adult tobacco users use snus, the more they enjoy the product, the more they enjoy the taste, the flavor and the more they enjoy it than they do smoking. So what we see is, overall, higher levels of conversion for longer of the adult tobacco users and then using snus. Still a very early category. We still are very pleased with the overall volume growth. The dynamics are right from a competitive standpoint.

We talked about Mint earlier. Again, nationally expanded in the second quarter, very strong results so far. What Mint is doing for us -- what Mint is doing really for Camel SNUS is giving adult tobacco users more options to find flavors and choices that better suit their taste.

Our marketing efforts and our marketing investment have been geared to adult smokers and challenging adult smokers to rethink smokeless tobacco. We ran an ad campaign at the beginning of the year, the 2012 smoke-free resolution, where we challenged smokers who weren't interested in quitting to consider Camel SNUS as an option to continue to smoke.

We also built on our successful Pleasure Switch Challenge program, which ran to our database of adult tobacco users, where we challenged smokers to quit smoking for 1 week and use SNUS exclusively.

Our challenge has been to get smokers to discover the benefits, discover the taste and discover the experience of SNUS. Both programs have been successful. We continue to see strong volume growth and see good things ahead.

On the brand side, what we've seen with Camel SNUS is, actually, SNUS has been accretive -- significantly accretive to Camel's overall equity, and there are 3 bars here -- take another sip.

We have the green bar, which are perceptions among adult tobacco users who are not aware of SNUS; the blue bar are those that are aware, but don't use it; and the red bar, amongst SNUS users. What we see across all 7 of Camel's key equity perception is significantly higher perceptions amongst those that are aware of SNUS and significantly higher amongst those that are using it. SNUS is lifting Camel's ownership and equity of innovation, premiumness, fun brand, lifting it across all of Camel's key equity attributes, which bodes well for Camel's overall trademark equity and growth potential in the future.

So in summary, we see continued growth in this challenging environment. Camel, again, is leading innovation as a total tobacco brand. We continue to see strong equity build amongst the consumer, the perceptions are rising and continue to gain momentum and gain strength and growth among adult smokers under 30.

So let me turn to Pall Mall, Reynolds' largest cigarette brand, the nation's #1 value brand, and talk about it for just a moment here. So coming into the 2012 period, we had seen just absolutely outstanding growth and momentum. And I think this year has been the most challenging year for Pall Mall, but in my opinion, one of the most outstanding years, with all the pricing pressure from the premium brands down on top of Pall Mall. What we've seen is an exceptionally resilient brand, an exceptionally loyal consumer and the market share growing slightly, but incredible loyalty amongst the brand here.

And I'm going to dive a little bit more into menthol, the story there, and a little bit into consumer dynamics because that's where we see, really, the incredible equity behind this brand, and it's those equities that make Pall Mall so strong.

It starts with a product with superior quality, more tobacco, which again, creates a longer-lasting smoking experience to the consumer. And consumers can tell it right away, the difference between Pall Mall and other value brands. All it takes is to hold a pack in your hand versus a pack of another brand of cigarette, then you can feel the difference right away. When you smoke it, Pall Mall lasts longer. It's a little harder to draw. It's different, it's different. And that's the difference that consumers like, the difference they appreciate, and it's ultimately the difference that creates the brand loyalty.

Pall Mall also is a modern, contemporary, vibrant, colorful brand with well over 100 years of heritage. All those wrap up to what we call, genuinely more, and that's what gives this brand its strength.

Now I'm going to dive into the next several slides and talk about what's going on at the consumer front. First slide here, we're looking at consumer switching. Our consumer switching still is very positive this year, about 9.2% of all switchers switched into Pall Mall, while only 4.6% of all switched out. So we have net positive switching, more consumer switching in than are switching out at twice the rate, twice the positive switching than we have seen switching out. That's exceptionally good and exceptionally positive, in my mind, given the current environment.

Now let me dive a little bit into more of what we see -- that's going on in the trial front and the awareness front. We talked about this many years past that the fact that 50% of those who tried Pall Mall ultimately end up staying with it and smoking the brand. That was true in 2008, 2009, '11 and even today. Today, Pall Mall has garnered about 22% trial amongst all tobacco smokers. 11% of them have Pall Mall in their repertoire. Some smoke it exclusively, some just occasionally. And I'll talk about loyalty in a minute and where our opportunities are to continue to accelerate growth.

On the loyalty front, we still see very, very strong dynamics. However, our share requirements have softened up a bit. Now the way to think about share requirements are among all buyers is to think about all 11% of those buyers there. Among all buyers, how much of their purchases -- what percentage of their purchases do they give to Pall Mall? So in total, we see 77%. So out of 10 packs, think of 7.7% of all their packs go to Pall Mall.

Now, what's interesting here as what we've seen, this loyalty from '11 to '12 has actually increased. Those Pall Mall smokers who claim Pall Mall as their usual brand, it's increased. They give almost 9 out of 10 purchases to Pall Mall, which is exceptional. Most value brands are down in the low-70s. Most premium brands are in the high-80s. Pall Mall's loyalty is on par with the leading premium brands.

Now where we've seen some softness is in what we call occasional usage. They are smokers of other brands, so I may claim Marlboro as my usual brand, but I also smoke Pall Mall. So it's that occasional usage where we've seen some slippage, given the pricing dynamics, where they are giving sort of less of their purchases to Pall Mall.

But overall, very pleased with the loyalty side. And it's the occasional usage and trial side where we've got our opportunities to continue to accelerate growth.

A big part of accelerating growth is driving awareness in trial. The longer-lasting proposition remains a very compelling proposition amongst adult smokers, with over 1/2 giving the extremely important rating. Our opportunity is to continue to grow Pall Mall's ownership of it. Only 1/4 of all adult smokers grant Pall Mall ownership of the longer-lasting proposition, and that's our challenge, in growing it.

At retail, we have a very simple, very focused message in driving brand impact, but particularly awareness of longer-lasting. Through print advertising, our focus is in driving brand awareness, but particularly focused on building a stronger connection with the consumer around the longer-lasting proposition, the benefits of longer-lasting, but also delivering in a compelling, colorful, confident and engaging way.

Now let me turn to menthol Pall Mall. Many of you don't know, but Pall Mall is actually the leading value brand in the menthol segment, #1 at over 1.6 share points. We've had over 1 share point of growth over the last 3 years and continued solid growth even in this environment from 2011 to 2012.

While we're the leading brand, while we continue to grow, Pall Mall is still underrepresented in menthol. When we look at value menthol, the value category, about 73% of the value category volume is in non-menthol, 27% in menthol. Pall Mall has 81% of its volume in non-menthol, yet only 19% in menthol. So for us, menthol remains, clearly, a key segment for us to continue to grow, continue to win in. Today, we're #1 in the segment, but plenty of upside, plenty of runway to continue growing Pall Mall in the menthol segment.

And that's what we've done. We've expanded 4 new styles into the Pall Mall menthol family: menthol Black, which is a full -- 2 full-flavor style in king-size and 100s to compete more effectively for competitive Newport smoker; menthol White, the smooth style in king-size and 100s to compete more effectively for Marlboro Menthol smokers. Both have seen a resounding and exceptional reception from our craig customers, as well as consumers. We're already seeing some nice positive results.

We've also developed print advertising to communicate awareness of the menthol style, to communicate Pall Mall's longer-lasting proposition, as well to do it in a colorful, contemporary, interesting and engaging way, just another part of being genuinely more.

So in summary, we've got, with Pall Mall, a tough operating environment right now. We're seeing growth most recently in the brand. Menthol, again, remains very positive. More importantly though, the consumer fundamentals behind Pall Mall remain outstanding. We have a very differentiated product from our competitors, which is the secret to Pall Mall's equity. And we remain focused on building awareness and building trial to continue to grow in this segment.

All right. Now let me turn to the Natural American Spirit brand. We'll talk about Santa Fe Natural Tobacco Company's super premium brand and the phenomenal growth story that underlies this brand. And what is particularly of interest is, in this economic environment, how -- over the last 4 years, how much growth this brand has achieved at a super premium price point.

But any discussions about Natural American Spirit really has to begin with the people of the Santa Fe Natural Tobacco Company, a real values-driven set company, real values-driven set of people who are completely committed to the utmost product quality around their natural products, to the Earth, sustainability to the community they live in.

And the products are really what underlies the company. And the pride that the people take in developing these products. We've got the core range of products, which deliver the vast majority of the share growth and volume. We've also got the industry's only 2 organic styles, which continue to grow and continue to deliver volume and share growth, as well as overall equity growth, as well as the roll-your-own products and Santa Fe's own unique natural and perique products, which are made really from exclusive tobaccos that are aged in whiskey barrels. It's very interesting and very unique, all part of the Santa Fe equity.

Now we look at NAS' share performance. We'd go back really 1 decade ago, and it's kind of hard to say that Natural American Spirit was on the radar map. It's just about 2/10, 3/10 of 1 share point. When you look today, it's over now 1.25 share points in the latest all-take read. It's got incredible momentum, an incredible growth story. But what's most impressive to me is, really, when we came through the economic crisis, '08, '09, '10, '11, even today, at a super premium price point, the brand has continued to gain strength, gain momentum and gain speed. And this really is being driven by its consumers, by its promise and by its development.

This brand started in America's trendiest cities, particularly those on the West Coast, and it really started from pockets of strength and emanated out from there. Today, it's growing in every state across the country. We look at cities like Seattle at 4.3 share points; Portland, 6 share points; San Francisco at almost 6 share points; Santa Cruz, California, 12 share points; LA, 4.2. Then you come across and you look at cities like Boulder at 11 share points; Madison, 3.3; New York City, 2 share points. So almost a 200 index in New York City, but when you look in New York, really what's more important is when you take areas like Chelsea, Tribeca, Brooklyn, SoHo, the brand's 5, 6, 7 share points. The brand has an incredibly loyal consumer following, and that's what's driving the brand's growth.

And when we talk about a NAS consumer, it's hard to really talk about demographics. NAS has a very broad consumer base. But what differentiates NAS are really the values around its consumers. They're socially aware, more socially conscious, more well-informed. They tend to buy brands that they know about. They tend to buy brands that they know and value, brands that stand up with the values that they stand for.

When we talk about our consumers being evangelists, they are true evangelists. As Dan said, most of our trial comes from adult smoker to adult smoker, as opposed from the brand to consumer because consumers love the brand and respect the brand and everything it does so much.

And I think, when I look at this chart, I think about NAS market share and its consumer and neither one are what they used to be. We go back a decade ago, NAS was 2/10 a share point, today it's over 1.25 share point. We go back a decade ago, in all natural, green, organic -- they were granola. We talked about them as tree huggers, granola, spotted out, but what's changed really is granola. What was once granola is now mainstream. It went from really fringe and niche, to green, to today it's just a cost of doing business. It is absolutely mainstream. The brand has gone mainstream, and that's what we see propelling the growth behind it.

It's a simple story. And I think that's what makes it so compelling for consumers, 100% tobacco, made with only tobacco and water. No additives. The brand has more tobacco the way like Pall Mall. When you put it in your hand, you can feel it. It tastes a bit different, smokes a bit different and has a fabulous story behind the company and the brand, and again, the only all-natural, all-organic certified products in the marketplace.

What really makes the brand thick though is its relationships with consumers. A lot of the brands in the marketplace send their consumers birthday cards. A great thing to do, a very nice thing to do. Well Santa Fe does it. The brand has seeds embedded in the cards, marigold seeds, sunflower seeds. We dispose of the seeds, it's consumers who put them in the garden. Drop them in, up come the flowers. It's those deeds and actions that lead to the growth and the connection, and ultimately, the evangelism of this brand is created. It's those seeds in action that I'll talk about in just a second around a new innovative program that Santa Fe has put together. Sante Fe has partnered up with a company called TerraCycle to create a cigarette waste or cigarette butt recycling program. TerraCycle is one of the world's leading recycling companies which specializes in hard-to-recycle materials. They partnered up, put together a national program whereby adult smokers send in their butts, the butts are recycled to create renewable products, renewable materials. A first of its kind anywhere in the world. It's those deeds and actions that Sante Fe does so well with its Natural American Spirit brands to make that connection deeper, make that connection stronger because it's consumers that keeps the growth going, even at a super premium price and even in today's environment.

So in summary, the Natural American Spirit brand, as you've seen, has very strong growth, an incredible decade-long growth story. We have the right consumer trends, the right dynamics and the right brand to continue growing at a superpremium proposition. Again, high interest, the brand is uniquely positioned. It's really a 1 out of 1 in the category to continue leading growth here.

Now let me turn to the American Snuff Company's Grizzly brand, the #1 brand in the moist-snuff segment. Talk to you a bit about it, what makes it special and what's going on there. I think the slide speaks for itself, and these are the things I'm going to talk about. But they continue to be -- lead market share in the moist-snuff segment, continue to lead consumer perception, as well as have the industry-leading demographic profile. If you take a look at the Grizzly brand's market share, really, we go back to 2009, over 3 share points of solid steady growth with the exception really of one year in there in 2010. Now that's actually a pretty critical period. So when I look at the trend of Grizzly here, it's just that one year we saw them, but what happened in there? What we had is the 2 premium brands launched entirely new families down at the Grizzly price point. Those brand families now, the 2 premium brands, have over 15 share points at that value price point. So we think about time period between 2010 and today, 15 share points at low price, yet Grizzly has kept its trajectory, its growth and momentum during all that pricing and during that environment. That's what makes them a leading brand.

What makes it work is its brand equity. We look at a personality that is honest, straightforward, what I call a trusted friend. There's the visceral imagery of the Grizzly bear, the Grizzly typography, very masculine, very iconic. The Grizzly brands also built off the American Snuff Company. It's over 100 years old, it's over a -- with over a century of smokeless tobacco expertise. And then probably lastly, but most importantly, is the Grizzly portfolio and its exceptional high-quality products that it offers to adult dippers. It has a very straightforward product range, extremely premium. They compete extraordinarily well in all the big competitive segments in the marketplace with its flagship style, Grizzly Long Cut Wintergreen, now over 15 share points in 1 SKU. We've also seen exceptional pouch growth, as well as exceptional natural growth, which I'll talk about later on.

Now turning to the Grizzly consumer. The Grizzly consumer is a lot like moist-snuff consumer. They're all American, heartland values, predominately male, predominantly Caucasian. These are guys that have a work-to-live mindset, absolute salt to the earth, genuine folks. And the Grizzly brand, Grizzly attitude, the Grizzly equities, all reflect this. And they -- and this is what's giving Grizzly, really, an industry-leading profile. If we look at Grizzly's share of legal age to 24 adult dippers, it sits at about 31.5 share points today, compared exceptionally well and well over indexes versus its 2 premium competitors. What we've seen over time is that legal age to 24 share translating into 25 to 29, 31 to 34 and so on and so forth. So we're seeing really strong, strong demographics and strong growth driven off Grizzly's equity. It's the equity that makes Grizzly special.

Now what we're looking at on this chart are consumer perceptions of their usual brand. So this is how a consumer feels about their moist-snuff brand, their individual brand. So how a Grizzly consumer feels about Grizzly, how Copenhagen consumers feel about Cope and so on. And what we see is the Grizzly consumer feeling as strongly and passionately about Grizzly as the Copenhagen dipper with the Skoal dipper. Now what's important here is typically, what we see among either value smokers or even value dippers is they typically don't feel as strongly. They don't typically feel their brand has a taste they really like. They feel a little more ashamed about the quality, the premiumness, the satisfying taste. Grizzly dippers don't feel that way. Grizzly dippers don't see they're making a trade-off in price. They feel they're getting the utmost premiumness, the utmost quality, the utmost equity on par with the premium brands. And that's what propelled this brand to its decade-long growth.

The advertising campaign, I introduced you to it a couple of years ago, is continuing to build equity. We've been investing in it now for a bit over 2 years. We've extended it beyond just print media into direct mail, websites, as well as retail, and it's delivering for us. The campaign has a strong emotional appeal, very masculine with great sense of wit to it. So you see how the Grizzly consumers, they differ quite significantly from, let's say, the National American Spirit consumer. We have all our consumers in, through the website, actually create ad copy for us through a special promotion. We've got a guy here, Daniel Lee [ph] from North Carolina, "My version of going green, put some camo on it." Just highlights this, that the all-American heartland values, the irreverent wit of Grizzly, as well as its consumer base.

This year, we launched a promotion called the Ultimate Man Cave. I don't know how many ultimate man caves are in flats in New York, but they are very aspirational really across the U.S. And we've leveraged this with print media, also from a website, had hundreds of thousands of consumers enter. And what we did, it's really fun and interesting where they had 6 different lifestyles that they could pick there for their Ultimate Man Cave, whether it was like a garage, a hunting theme, a sports theme. Consumers had to write in, tell us why they wanted it, what was it about it. And ultimately, at the end of the year, we'll have one winner. There are hundreds of thousands of other prizes awarded, but it was just another way for Grizzly to get its consumers interested and excited about the brand.

Now turning to Premium Natural. Because Andrew showed you the Premium Natural or the natural segment, is about 1/3 of the overall moist-snuff segment. This has historically been a segment that Grizzly was well under-indexed in from a product as well as a geographic standpoint. We relaunched and expanded our natural products this year in the first quarter. We've seen nice sequential quarter after quarter growth there, both in the segment, as well as geographically. We'll continue to focus in the natural segment for the remainder of this year and into next year. We're seeing great buyer dynamics, as well as great brand dynamics on both the product format, as well as geography.

So in summary, Grizzly, we continue to see strong, strong momentum in share growth on both the volumetric side, as well as the consumer side. But what's most interesting and what's most exciting are the consumer perceptions and how they continue to grow and how they continue to be a leading indicator of future share growth on Grizzly. Pouches, natural and Wintergreen, all growing for Grizzly. We've seen, again, nice growth in some areas of the country that Grizzly hasn't historically been so strong. We'll continue those efforts around the natural segment, continue to invest in building brand equity.

So in summary, when we look at Reynolds American growth portfolio. It's a strong portfolio of brands, iconic brands, #1 brands, brands leading innovation. Our equity, our investment, programs, be they marketing or product, are paying off and are well positioned for future growth.

Thank you. And now, I'll turn it over to Jeff Gentry to give you an update on the FDA.

Jeffery S. Gentry

Thank you, Brice. Good morning, everyone. It's great to be back again this year and I'd like to provide an update on the FDA. This year, I'm going to do something a little bit different. Rather than just paint sort of just where we are, I'd like to provide a little bit of perspective around the regulatory environment and then paint the landscape as it exists today, and it's going to continue to evolve, so that there's a good appreciation and understanding of that. And then touch on some milestones that have been achieved, have been ticked off or are yet to come in the future. And I'd be remiss if I didn't talk a little bit about menthol and provide you a status on that, and then I'll conclude with an outlook on the regulatory environment.

Starting, first of all, with the perspective. And I think this is a very critical place to start. The protection of public health standard really gives the FDA extremely broad authority to regulate from. And when I say that, you have to consider that you're taking into account not only individual risk of a product to a user, but also what is the impact to the general population when people use those products. So that's what I'm talking about when I talk about the public health standard or the population level standard. That gives them extremely broad authority to regulate from. And that regulatory authority will be seen in things such as premarket clearance or premarket approval of products. Post-market authority, where they can have the authority to recall a product from the marketplace. Or product standards, standards that will be promulgated over time that may restrict the use of materials or may limit the level of constituents in smoke or in products.

So extreme broad level of authority with that public health standard. I had to say that the agency remains fairly conservative with respect to their regulatory approach right now. And you can really see that when you look at their guidance. The scope in that guidance is very broad. And what that does is it provides them quite a bit of latitude in their enforcement authority. So we see it there, we also see it in so much as they're so slow to make precedent-setting decisions. And one of the reasons for that is they're gaining a lot of understanding of the industry, its products and its processes. And they want to understand that in order to make some precedent-setting decisions.

I will say that the relationship between the agency and the industry remains arm's length, but very professional. We see the frequency of interaction increasing quite substantially. We see that in terms of administrative requests. We see that in terms of scientific assessments, scientific dialogues on issues. So I'd say that the frequency of it is increasing. It's not to say that we agree on every topic though. In fact, there's a number of topics that we have differences in opinion. I will say though, on the other hand, by and large, the industry is fairly aligned on most issues. So that's important.

I'll talk a little bit about product pipeline and this will be a theme throughout the whole thing. Product pipeline is incredibly important. It's putting submissions in front of the FDA. It's putting your scientific arguments in front of the FDA to allow products to come to the marketplace. And that pipeline management, I believe, will be critical for commercial success. And that will be a component of what differentiates the various competitors in the marketplace. And I think you'll see the importance of product pipeline on this next slide as I paint sort of the regulatory landscape.

One of the things that I think is important to recognize is that the vast majority of products in the marketplace today can be challenged by the FDA. Now when you think about that, think of there's almost 3,500 or so Substantial Equivalence Reports sitting at the FDA. Some of those filed pre-March 2011, some of them, post-March 2011. Those posted after March of 2011 are waiting premarket clearance. But those that were posted before March of 2011, those products can be challenged through those submissions. So the vast majority of the products in the marketplace can be challenged today. That's critical to defend that pipeline.

As you go forward, new tobacco products are subject to regulatory scrutiny, whether that's through product change or whether that's through a significant level of innovation. And it certainly wouldn't surprise me that the timeline for approvals or clearances of products will depend, one, on the level of change, how significant is the magnitude of the change and the maturity of the regulatory environment. As the maturity of the environment evolves, we will see response times get faster. Right now, we view that flow, it will continue to increase its speed.

Now let me step back just a minute and talk about the evolving world. A lot of you have heard about deeming regulations that are going to cover other tobacco products. Well, following the Sottera decision, the FDA announced in April of 2011 that they intended to promulgate regulations to cover all tobacco products that did not make therapeutic claims. In other words, NRTs would not be covered, but any other tobacco product not making a therapeutic claim, they intended to promulgate regulations to cover those products. We anticipate those regulations to be quite parallel to those that already exist for cigarettes, smokeless tobacco, cigarette tobacco and roll-your-own. In other words, they will be subject to manufacturing registration, product listing, ingredients listings, GMPs in the future. So a lot of the similar things that are in place for cigarettes and smokeless, we expect to be there for these other products, those products ranging from cigars to e-cigarettes to products that are made or derived from extracts of tobacco. So that's an evolving area that we will see coming forward.

So the landscape, a lot is out there to be challenged, pipeline management absolutely critical, and the regulatory landscape will continue to evolve through deeming regulations and other regulations promulgated through the act.

In the milestone area, obviously, we had smokeless tobacco warnings that were promulgated in 2010, where 30% of the 2 principal panels of the pack have to have a warning, and then 20% of advertising space is covered by the warning. Substantial Equivalence Reports, and as I've referred to, you have to think of those in 2 buckets, one pre-March 2011, then post-March 2011. The ones post-March 2011 are the ones that would be awaiting premarket clearance, and there's a number of those. The TPSAC concluded their report on menthol in March of 2011, and I'll provide you just a little bit of an update on that in just a minute.

Facility inspections. In October of '11, the FDA announced that they would begin inspections of facilities. But those inspections did, in fact, begin October 3 of 2011. One of American Snuff Company's facilities was the first one inspected by the FDA. And we've now had a number of our facilities inspected by the FDA, and that will continue.

The TPSAC reported on dissolvable tobacco products in March of this year. And if you'll remember back to that, I think it was a very objective report. The Scientific Advisory Committee concluded that those products pose less risk than cigarettes to users of those products, but that a whole lot more science needed to be generated before they can understand the full impact to the general public.

Harmful and potentially harmful constituent submissions. Those have begun. For the large manufacturers, those submissions were due in September of this year, and we have completed our submissions for the operating companies at RAI. And then small manufacturers, those submissions are due in December of this year. Now those, obviously, in that space, there's been a lot of different testing methodologies used. So the absolute utility of that data is still to be determined because of that.

Good Manufacturing Practices, a regulation that we anticipate the FDA to promulgate covering tobacco products, the timing for that is still to be determined. And then the graphic warnings on cigarette packs, that the timing of that is still to be determined, and I'll let Mark cover that in his litigation update.

So that's kind of a recap of some milestones in the past and coming up. Now on menthol. As I mentioned, the TPSAC concluded their report in March of 2011. Shortly after the TPSAC issued their report and recommendation, the FDA announced that they would undertake their own independent review of the science and then produce a preliminary scientific assessment, send that out for external peer review and then subsequently publish that in the public register. Now I think last year, I was standing here in front of you and I told you we expected that by the end of last year, but it's still to be published. So it's still to come.

But let's talk about what that report and then what any potential regulatory action may be. We certainly believe that it will be promulgated through the rulemaking process that's associated with product standards if it has to do with regulation of menthol in the product. And what that means is the agency will take into account, population level standard, an evaluation of individual and the public health standard. And it will go through a process of basically, the first glimpse of that, we should see with the -- when the Office of Information and Regulatory Affairs under OMB publishes the fact that they're going through a Regulatory Impact Assessment. So there, we should be able to see that. And then that's generally a 90-day process. After that, then they would publish in the Federal Register, a Notice of Rulemaking, a draft regulation that would be followed up by a comment period, finally, assessment of those comments by the agency and then into a final regulation. And then through the Public Health -- or through the product standard rulemaking process, there's an effective date of one year past the final regulation publication, unless the FDA determines it in the immediate need of Public Health to do something earlier than that. So while regulatory action is not mandated nor is it time bound, we anticipate it would go through the product standard rulemaking process.

Now turning to the outlook on the regulation. As Dan said earlier, we firmly believe that ultimately, science-based decisions will prevail. There's been good indication in our interactions with the FDA that they are paying attention to science when it comes to making decisions. But I'll also say that it's going to take time for the industry to become educated with the FDA and the FDA process, and it's going to take time for the FDA to become educated on the industry, its products and its practices as well. In the U.S., we have a process that allows for appropriate resolution when you have disagreements. And what I mean by that is when you have disagreements, you generally have places where you can issue comments. You have the ability to engage with the FDA on a scientific level. And then in the unfortunate event that you have to take it up all the way to litigation, you have that avenue available to you in the U.S. in various ways. We firmly believe that equal enforcement is absolutely critical in order to make regulatory -- the regulatory environment not only fair, but effective. Without equal enforcement, the regulatory environment will not be as effective as it could be. So we think that is a critical component. We're committed to complying with the FDA.

In fact, we believe that in order to go forward, some of your strategy has to be making sure that your mindset is one of interacting with the agency, has to be a mindset of managing a pipeline and frankly, to embed a lot of the compliance processes within your business processes. That way, they are more effective and more efficient.

Ultimately, I think all of those things will -- the adaptations of that environment is what's going to differentiate competitors from one another. Whoever is better able to navigate the regulatory landscape will be the winners in this process. We think we are well positioned for that. We are working with the FDA. We're interacting with them and we believe that ultimately, we will be able to navigate those waters reasonably well with the innovation focus that is so critical to our company. With that, I'm going to turn it over to Mark Holton for an update on litigation.

Martin L. Holton

Second opportunity for me to come up here to this Investor Day. And I got to tell you, I really enjoy it. It gives me a great opportunity to meet so many of you, hear what's on your mind. And I sure hope that for the next few minutes, you'll sit back and get a little bit out of hearing what's on my mind about litigation.

When I talk about litigation, generally, the first thing I like to do for everyone is to remind you that if you're interested, the first stop is our quarterly litigation footnote we include in our SEC filings. For those of you who have read it, I think you'll agree it's quite comprehensive and very detailed. But today, what I want to do is sort of share more about the context of our litigation in addition to providing some of the factual developments. And I think Dan set the stage nicely earlier when he described the litigation environment as improving. And in fact, we've successfully navigated every litigation challenge that has faced the company over the past decade or more. And we believe that trend will continue.

Let me illustrate why we believe that, the sort of the metrics we use on a macro basis to indicate how that environment looks and how it shaped over time. For those of you who were here last year, you may remember most of this chart, it has changed a little bit. But what this does is describe by category the distinct improvement, the distinctly positive trend over time when you look at the types of cases that have been brought against us in the industry. And what I've done here is do the 2001 through 2011, which was presented last year. Now going into third quarter '12 to show you a couple of things. Number one, obviously, significant progress over that decade. But even in that short, relatively short time period between last year's Investor Day and this year, more progress being made in important areas.

I've also added the Engle progeny docket. Now it doesn't go back all the way to 2001, but if you look at it from its peak, and this is based on individual plaintiffs, once again, you'll see a very, very favorable docket trend going from about 12,500 individuals at its peak to less than 7,000 today. Those are all important metrics for us to look at as we shape our litigation environment for the company going forward.

How does that translate generally? Here, you see the overall trend, just a run rate of cases, our overall docket excluding Engle and excluding the Broin flight attendant litigation. It's very consistent with that qualitative chart we just saw, showing a very, very positive trend. And if you look at it as well on an annual basis, looking at the basic measure of filings versus dismissals, you'll see in every year since 2004, dismissals in the blue have exceeded filings, some years, by a wide margin. That's critical. That's critical for ensuring that the docket is managed properly. That's what we look at.

Now I want to turn to the Engle litigation. Before I get into sort of current developments, let me sort of remind everyone how we get to the Engle progeny individual cases. In those cases, well, it began with a class action. In 2000, a jury returned a verdict in favor of the plaintiffs, in favor of the class, and awarded a significant punitive damages number. Obviously, all of that was appealed. In 2006, ultimately, the Florida Supreme Court reversed the punitive damages judgment or affirmed the reversal, decertified the class but allowed individuals to file lawsuits, individual lawsuits through January of 2008. The Florida Supreme Court also allowed the plaintiffs in these individual lawsuits to rely on, to use a number of general findings that the jury found in the original class action relating to disease causation, product defect and certain aspects of company conduct. In other words, the plaintiffs will be able to use these findings as determined in the individual trials. And that's what led to the filing of these 12,000 cases initially, 7,000 today, and they're roughly equally distributed between federal court and state court. It's not necessarily equal, but roughly equal.

So how do we look at the Engle progeny today? Where is it today? And again, from the docket perspective, you can see dismissals increasing 44%. We've talked about that. Of course, we're having trials. Every year since 2009, we've had Engle progeny trials. We're now averaging around 25 to 30 per year. We're very prepared to defend these cases. And importantly, our success rate is greater than 50%. And that's important when you consider how we have to try these cases. The key thing from the Supreme Court ruling was how would these cases be tried and how these findings would be used in the trials of the cases. And what we have are roughly 4 different ways that these cases are tried in the state and federal courts in Florida. In all the cases, the findings are used, but it differs sometimes from trial court to trial court exactly how they're used and when they're used. And in many ways, this puts one hand behind our backs as we defend these cases.

As I've said, we're still winning greater than 50%, which is a very good record in light of these trial plans.

The other element of the trial, of course, is do you have the ability to appeal adverse judgments? That's something that faces every litigant in our system. And we have a bond cap in Florida that limits the amount of bond required to enable you to appeal to a lesser of $5 million or the amount of the verdict, which in Engle, for those of you who follow, we certainly have some large verdicts. It facilitates our ability to appeal these cases in a very significant way. That bond cap has been challenged by plaintiffs. We've won the challenges in every trial court. And just recently, the Florida Supreme Court dismissed a challenge that they originally agreed to hear. So at the trial level, we feel very good about the progress we've made, our ability to defend these cases, and we intend to continue to defend these cases to the best of our ability each and every time we get up.

The other aspect of Engle that is important is the appellate landscape. Now I mentioned when I was describing what happened at the Florida Supreme Court, the idea of how the findings are used at the trial. How those findings are used is very important because it implicates state court, state law in terms of fairness to a defendant, in terms of how findings can be used against a defendant without proof, and it also implicates due process. That's been one of our important aspects in appeals throughout the Engle progeny litigation, and it's been a good process. We've appealed everything. And we're pretty much maturing and progressing as we expected. And let me explain on the dimension of the due process.

Finally, in September, the Florida Supreme Court heard oral argument in a case that squarely presents how these findings are used at the trial court level, both from a state law perspective and from a due process perspective. That argument, as I said, occurred in Douglas. A decision could be -- come out by year end. The Florida Supreme Court isn't necessarily the fastest court on these types of issues. So any -- it's not clear when it will come out. But the important point is it will issue an opinion.

Second, as I mentioned earlier, we have a docket on the federal court system. And we've had trials in the federal court, had 7 this year. Two of those cases are now pending in the 11th Circuit Court of Appeals. The issue presented in those 2 federal cases is squarely how the findings are used and whether the use of those findings is consistent with the defendant's -- our due process rights. Now why is this important? Well, it gives us an opportunity, in both the state and the federal systems, to have high courts, the Florida Supreme Court on the one hand, the 11th Circuit Court of Appeals on the other, to rule on whether or not our due process rights are being protected or not. And getting opinions from those 2 courts, whatever the opinions are, is significant. A, I think under any scenario, they will shape the future of the Engle progeny trials as we go forward. But more significant is the prospect that they could reach different conclusions about what our due process requires in the Engle progeny litigation. That could be, and could mean, that we have a better chance, a more significant chance, of reaching the U.S. Supreme Court on the Engle question because you have a split between a federal appeals court and the highest court in the state. That's a vehicle that is often used. Notwithstanding that, having the opinions from the higher court is a critical component of our ability to get the U.S. Supreme Court to review the Engle progeny litigation. Obviously, we can't make any guarantees about whether they will review and then certainly, what their ruling would be, but we feel very good that the progress of the cases, the nature of the appeals that are pending, give us a great, great opportunity to get the issue heard by the right court.

One other element in the appellate landscape that is very important, and we all should focus on it when we're interested in litigation, is case-specific progress. As I said, we appeal these cases. And that means an intermediate appellate court in Florida reviews the case itself. And there, we've had great progress in the past year. As you can see from the chart, we've had certain cases reversed. We've had both of the highest damage awards against Reynolds reversed and reduced. We've had very favorable evidentiary rulings at the appellate level now, which were very significant. One I will share with you is a court found reversible error if a trial judge did not permit alternate cause evidence to be introduced. And alternate cause evidence simply means that the plaintiff was exposed to a different agent than cigarette smoke, and that exposure lead to his or her disease. That's critically important in smoking and health litigation. And in a number of the cases, judges were precluding us from putting in that kind of evidence, notwithstanding how significant the evidence was. That will have very important positive benefits to the cases as we continue to try them.

A couple of other things here, statutes of limitations, statutes of repose, the fact that appeals courts have affirmed that the courts must observe those statutes will help us in many of these cases, in many of these cases. So as you look at the Engle landscape overall, what you see is a very significantly reduced docket. You see a trial docket, a trial schedule year-over-year that is very manageable. You see success at the trials continuing trial after trial. And finally, you see an appellate landscape that is progressing just as we want it to, both at the very significant constitutional level and due process as well as that case-specific level, which helps define how these cases are tried every day. All of those dimensions, all of those dimensions make it a much more favorable environment in the State of Florida in the Engle progeny litigation.

But of course, you know we have other litigations. And that's important too us, we keep our eye on the other docket everyday as well. And I want to go through a few of these cases that are current, some of which are newsworthy. The West Virginia IPIC, individual personal injury cases. If you noticed on the first chart, you saw that there's significant number of individual plaintiffs tried in the State of West Virginia. We are about to begin, probably in the spring, our fourth effort at trying that case. The first 2 efforts ended with mistrials because the court was unable to seat a jury. The third effort ended with -- in the early stages of the plaintiffs' case, so when the plaintiffs wanted to introduce a new theory, and the judge basically said they'd have to take a mistrial or not have their theory, because it was unfair to the defendants. So they took the mistrial there. We're going to start again into April, probably March, April of next year.

The DOJ case, the Department of Justice case, continues to be important and making news. You may recall that that was the RICO case brought at near the end of the Clinton administration against the tobacco industry. After a long, drawn-out trial, the judge -- it was a judge case -- concluded that the tobacco industry had violated RICO and issued a number of injunctions, in other words, orders, that the defendants either do something or refrain from doing something. Earlier, the big news in that trial was that the government's efforts to get us to discourage profits which was $0.25 trillion effort on their part, the appeals court ruled that was unavailable to them. So the big financial penalties were taken off the table and we're left only with these injunctive points.

Most recently, we've been arguing about corrective communications, corrective communications to be seen at retail and corrective communications to go on our pack. There was a hearing before the court on October 15 where both sides, the government and the industry, presented their respective positions on what corrective communication should look like. The judge, Judge Kessler, took that under advisement and will come out with an opinion at some point. Obviously, we will look at that opinion and determine whether we should appeal or not. But more to come on the DOJ case.

Another important category to the industry and to Reynolds, is a category of cases, light class actions, which fundamentally are consumer fraud class actions, most of which are residing in the states. The good news, from our perspective, is that Phillip Morris has far more activity in this area than we do. They've tried a couple, had good success.

The Reynolds cases, good news as well, limited activity. Five cases were dismissed since November of last year and we've seen no new filing since 2009. Again, another example of how the litigation environment is improving dramatically over time.

And finally, quickly, I mentioned earlier the Broin flight attendant litigation, which is pending in Florida. That series of cases, and there are around 3,000 left, is dormant.

Let me turn now, as Jeff mentioned, to the FDA. And I want to talk about the 3 cases which we're suing either on the statute or the agency itself. First, the statutory challenge. That involves a facial challenge to certain aspects of the statute that was enacted in 2009. When I say facial challenge, I mean, the words in the statute, the actual command of the statute. Several areas we're challenging. First, the statute requires cigarette advertising to be black and white, not color. Second, the statute gives the FDA the authority to use 50% of packaging for its graphic warnings. And we challenged their ability to use that much real estate under the due process clause of the Constitution.

The statute also has a provision that prohibits manufacturers from communicating directly or indirectly with consumers, that a product has less risk than another product, unless the FDA has issued an order about modified risk. And as Jeff mentioned, it's a very challenging topic for the FDA to take anything but a very conservative approach in that area. Our position is that provision essentially chills our ability to communicate generally about harm reduction, among other things. Well, we brought the case in Kentucky, the trial court agreed with us on the color versus black and white issue, a very significant win, but disagreed with us on the other issues. We took that to the 6th Circuit Court of Appeals where they basically left everything the way it was. Yes, on the -- yes, they'd agreed with us on the black and white versus color, again a critical win, but sided with the government on the other issues. We asked the U.S. Supreme Court to review that case. We filed our petition on October 26. The government did not seek review. So we feel good. It looks like the black and white versus color issue will be resolved in our favor. We think we can continue to make progress, and that's our goal there.

The next case is our graphics warning challenge. As all of you probably know, the FDA issued their pictures to go along with the government's non-government-mandated warnings on 50% of the packs. We challenged those pictures, primarily on First Amendment grounds. But we also said they didn't have enough evidence to even sustain them under their own rules of how you could prove that they were effective. We won at the trial court level. We also won by a 2:1 vote at the D.C. Circuit Court of Appeals. The government has asked that court to review the issue with the entire panel of judges. My own opinion is whether they review it or not, this case will go to the U.S. Supreme Court. Or at least, both sides will openly ask the court to review it, the losing side will, and we'll see more. We feel very good, very good about the quality of our First Amendment challenge because these -- the graphics they came up was clearly, in our opinion, could not pass muster under any constitutional analysis.

Finally, we do have a third lawsuit that was filed shortly after the TPSAC was constituted and before the menthol report came out. So we, and certain other members of the industry, are challenging the original composition of the TPSAC, on the twin theories that the members have conflicts that make them inappropriate to serve on such a committee. And the committee as a whole, lacks what's called in the laws, fair balance. In other words, the committee has already come to the issues, and they can be demonstrably shown to have firm opinions on the very issues that are going to be before them. That lawsuit got a lot of press, obviously, it came out just before -- the lawsuit was filed just before the menthol report came out. But at the end of the day, the government filed a motion to dismiss. The trial court denied that motion to dismiss, so we are engaged in discovery with the agency. We're going to pursue that discovery and probably at some point, litigate the issue. We think it's important to litigate for the process standpoint. We think it's important that the agency observe these rules properly. And we feel good about our prospects in the case.

Now I know many of you are interested in our NPM Adjustment Arbitration. Let me speak a moment about that and then I'll conclude. Very briefly, because whenever you get inside the Master Settlement Agreement, it becomes complicated to use a phrase. So essentially every year, we and the other manufacturers pay in to the state government a large sum of money based on our volume, it's the MSA payment. Now as we pay that, there is an analysis done of our market share. There's a provision in the MSA that provides for a potential downward revision of your annual MSA payment that is determined by independent groups. And essentially, it's did you experience market share loss? And was the MSA a significant factor in causing that market share loss? Well, probably to no one's surprise, we have 100% track record over the years of them finding that yes, we experienced market share loss due to the non-participating manufacturers, and the MSA contributed to that loss. So once you have those 2 determinations, the contract provides the manufacturers the option of paying that percentage in, as you normally would, withholding it, or putting it into a disputed payment account. So for the most part, over the last 10 years, a lot of money has gone into this disputed payment account, most of it contributed by R.J. Reynolds.

The contract also provides a mechanism for determining who is entitled to that money, the participating manufacturer who experienced the market share loss, or the state, or states, who are entitled to the payment. The single issue that resolves the issue -- the question -- is whether the states had diligently enforced their relevant statutes that are designed to maintain a level playing field. That's the issue. So where are we?

As you can see here, if you look at us from 2003 to 2011, the total Reynolds share at issue is $4.5 billion. That's a big number. Now nothing associated with the Master Settlement Agreement moves quickly. 46 states involved don't move quickly on a good day. Where are we? Well, we are currently arbitrating the issue relating only to the 2003 adjustment. And for Reynolds, that issue is around $500 million. It took us over a year litigating with the states to get the right to have the arbitration, even though it's expressly spelled out in the contract.

Beginning in May of this year, we began a process that runs through June of next year having state-specific hearings. And as you can see, we're roughly 1/3 of the way through those state-specific hearings. The panel, 3 judge, 3 retired federal judges, will issue -- will not issue any opinions until after all of the hearings are finished in 2013. We hope, have every reason to believe that they could issue those opinions before the end of the year, next year. Obviously, we feel very good that we should be entitled to that money, and we look forward to those opinions coming out.

So let me finish. Where are we? As we end 2012, I think it's fair to say yes, the litigation environment is improving in about every measure you can think of. We think we are about where we were last year at this Investor Day conference, and we think we've even improved our lie in a very tangible way. What happens next year? Or it's not a lot of different from what happened this year? The docket is going to be Engle-centric. We will continue to argue, to fight with the states over the NPM Adjustment at some level. But we do think there'll be another 1, 2, maybe 3, smoking and health individual trials that aren't Engle. And this is -- still in this year, we actually will start one here in New York in a week or 2. It could be our first non-Engle individual trial in over 1 year. But we think we'll see a few more of those.

But I think again, the bottom line is what we'll see is another year where we successfully manage through the issues as they're presented to us, with a great team of lawyers managing the litigation and a great team of trial lawyers working through these issues every day. Thanks very much for your time and interest. Let me exchange with Tom Adams, our Chief Financial Officer.

Thomas R. Adams

Thank you, Mark. Okay. Good morning, everyone. It's good to be with you again. This morning, I'm going to touch on our financial philosophy, talk a little bit about our year-to-date performance and our growth outlook.

And turning to our financial philosophy, not really much has changed here. I mean we focus on the strong balance sheet and cash flows and look at -- watch the cost side of the equation to make sure our costs are aligned with our business needs. And that obviously supports our investment-grade credit ratings, which I'm pleased to say, were upgraded by Moody's to Baa2 a couple weeks ago right in advance of our most recent debt offering. And naturally, the investment-grade credit ratings and the strong balance sheet provides a lot of financial flexibility for the corporation and its operating companies.

And we're also committed to our 80% dividend payout ratio. That's 80% of adjusted net income over time. And we continue to look for additional opportunities and to return additional value to our shareholders.

Now let me turn to our debt structure. And most of the work -- most of the comments that I'll make will basically run through the third quarter of this year. But because the debt was immediately after our third quarter results, let me talk to you a little bit about where we stand today. We get total debt outstanding of about $5.1 billion. That's about 1.7x debt to EBITDA, and that's well within our range of 1.5 to 2.5x. Earlier in the year, we paid off $450 million of debt that came due in June. And with the proceeds of the $2.5 billion of debt that we issued several weeks ago, we repaid off our term loan, that's $650 million. And we also tendered for $625 million of debt that's due in -- 7.25% that's due in June of next year. So within the next week or 2, we sure have all that debt in and we'll eliminate making the payments on that.

Now what this offering has done is it's actually lowered our interest rates from about 5.5% to 4.7%. And it's increased our average duration from a little over 5 years to about 12 years. So we think, on the debt side, we're actually in pretty good shape.

And as you look up here on the screen, you can see the gold bars are the debts that we either have paid off or will have paid off. And then the most recent debt offering that we did, we have $450 million at 1.05% in 3-year, $1.1 billion at 3.25% in the 10-year and then, $1 billion in a 30-year at 4.75%. So all in, we think that we hit the markets at about the right time.

I will also note that all of our debt is fixed rate. As you go out and look into our filings, and noticed that some of it is actually higher coupon. But remember back in 2009, we swift -- we swapped from floating rate to fixed rate and locked in some really low rates. So we're all at fixed rates across the portfolio right now.

Now turning to our dividend. I think you'll agree with me, looking at this chart, that we have quite an attractive dividend. We pay $0.59 a quarter. That's $2.36 on an annualized basis, and we're up 36% in -- over a 3-year period. And we target a payout ratio, as I said earlier, of 80%. And I would reiterate that we are very committed to paying a dividend at 80%.

Okay, with respect to our pension plans, we've actually had a good run in the pension area this year. Our returns through September were about 11% versus our expected return of about 7%. In the past 4 years, we contributed $1.4 billion to the pension plan. We've actually put $50 million in September of this year and last week, we put another $50 million in. And so we're very well funded. We're at about 90%, about $5.3 billion, $5.4 billion in assets. So on the pension front, we're in good shape. And as you can imagine with these relatively low discount rates that we're seeing, the funded status has grown a little bit. As I've talked to you before in the past, a 1% movement upward in the discount rate will trim off, just on the liability side, about $500 million to $600 million in liabilities. And we're also -- I mean there'll be some reduction on the asset side since we're about 50% in hedged activity or in bonds, but not nearly so much as on the liability side. So we're in good shape on the pension plans.

In terms of delivering value to shareholders, we use our dividend as our primary vehicle to return value to shareholders. And in that regard, we increased our dividend 5.4% in May of this year. And that's currently yielding to the investors at a little over 5.5%.

Last year at this time, I stood in front of you and announced our $2.5 billion share repurchase program that's going to continue through mid-2014. We are on a pace that we're basically buying back about $250 million a quarter. And thus far, we're -- by the end of the fourth quarter, we'll be a little bit less than halfway through. So we're staying on pace with what we've talked to you about.

And then lastly in terms of workforce restructuring, this is the program that we announced in the first quarter of this year in connection with our business review. And we're on track to save $25 million this year, and then that's going to build to $70 million by 2013.

Now, over the year -- actually over the years, we've gotten a fair amount of questions about cost management and how do we do it. And as we've talked to you, that the way to basically grow earnings over time is to take pricing and then work the cost side of the equation pretty well. And I do think that we work it quite well. Several years ago, we created RAI Services Company, which is a group of individuals in Winston-Salem, largely, that look at the back-office processes such as invoicing, receiving cash, paying the bills and doing a whole host of things to support the operations of -- historically with the R.J. Reynolds Tobacco Company. And we've broadened that out and through service agreements, we're now serving the American Snuff Company as well as Santa Fe Natural Tobacco Company. And we've also moved to upgrade all of our SAP implementations across all of our operating companies. So we're now all in one instance of SAP. And what that allows is for a more seamless transition of people between and among the companies, everybody's using the same system, the same choice of accounts, all those things. And so what that is -- and what that manifests itself in is reduced training costs, simplicity of operations and fewer people over time. We've outsourced non-core functions at the company, most notably IT infrastructure and some IT applications and development. And by using SAP, that we implemented back in 2006, that replaced a number of legacy home built systems. We've actually reduced the costs of supporting that software over time, and that is kind of the path that we're moving down.

We've integrated our operating processes across all of the operating companies. And we comprehensively look at that at least once a month. And so we also kind of stay on the same page and know -- and each of the operating companies knows what the other one is doing, so that we go -- as we move forward, we do it in an efficient and effective manner. We've reduced our cigarette manufacturing footprint at R.J. Reynolds Tobacco, we've closed the Whitaker plant facility earlier this year, and we're now centered up in the Tobaccoville facility so there's more throughput there and there's -- that's bringing those costs down on an absolute basis, Dan had mentioned that earlier.

Andrew mentioned our cigarette styles were reduced by 80% since 2004. Just to put some context around that, we're moving -- we moved from about 830 SKUs down to about 150 today, so significant progress, significant efficiencies within our factories. And as Dan had mentioned, our headcount's been reduced by 35% since 2004.

Now looking at our performance. Over the 3 quarters that we've just been through, I mean we've had pretty solid performance at all levels in terms of operating income, net income, with earnings per share growing 5.7% during that period of time. And if you look at our operating margin at Reynolds American, we've gone from about 17% to 34.4%, so roughly doubling our operating margin over time, again with the efficiencies that we have and the pricing that we're taking. And we're actually mixing up in margin enhancing products such as moist snuff and Natural American Spirit, all of which is contributing to the increased margins that we see at Reynolds American.

Now turning to some of the operating companies. At Reynolds Tobacco, it's been a tough year competitively this year for Reynolds, and we talked about that in here earlier today. Operating margin -- operating income is down 1.4%, that's about $25 million. But Reynolds has maintained the focus on pricing and actually on the cost side of the equation. And you can see that they've increased their margins 1.4 percentage points to 33%. So a good achievement in that regard. At the American Snuff Company, operating income is up 8.4%, and that's driven by higher volume of Grizzly and also higher pricing. And operating margins stand at 55%. That's up about 2 percentage points from the prior year period, so really strong growth there.

And then lastly, from an operating company standpoint, I'll talk about Sante Fe. And you can see the operating income at Sante Fe for the 9-month period is up 23%, again, driven by higher pricing, higher volume on the Natural American Spirit brand. And operating margins increased a little bit less than 4 percentage points to just shy of 50% margins. So quite an outstanding performance in Natural American Spirit and the Sante Fe folks.

And what you can see is since 2004, which is the date of our merger with -- between Reynolds American -- between Reynolds Tobacco and Brown & Williamson, earnings per share has grown about 80%. And it's the contribution of all those operating companies over that period of time that has led to that growth over time. And that again has manifested itself in the higher dividends that the shareholders have enjoyed during this period of time.

Turning to our outlook. Our outlook stays as it was at the end of the third quarter at $2.91 to $3.01 for 2012. And that would show our earnings growth somewhere between 3.6% and 7.1%. And it excludes charges for Engle progeny and our restructuring. And there's other things that -- those other items that are on the screen.

So in summary, we believe Reynolds American remains a compelling investment for our shareholders. We have a strong balance sheet and cash flow, we have grown earnings and margins over time, and all that's underpinned by strong brand propositions as well as innovation. And we believe that sets us up to continue returning excellent value to shareholders in the future --

Thank you very much for your attention. We'll now take a short break and then I'll turn the stage back over to Dan for some closing remarks and Q&A. Thank you.


Daniel M. Delen

All right. I'm glad to see that everybody made it back. The food outside is smelling just much too good at the moment. So what I thought I'd do is just provide you some closing remarks, and then I'll open it up for question-and-answers.

When I think of RAI and its operating companies, we are successfully navigating an extremely difficult short-term environment, but we're successfully navigating through it. We're building key brand equity, certainly on Camel, on Pall Mall, on Grizzly and on Natural American Spirit. And we're leading innovation for long-term growth in the category.

We're successfully managing the FDA and the litigation environment. And we've seen some presentations there that actually show how that environment is getting better and how we're successfully navigating through it. And all along the way, we're delivering excellent shareholder value and excellent shareholder returns.

So I hope you find that the presentations that we've put out in front of you today have been helpful.

Question-and-Answer Session

Daniel M. Delen

And at this stage, I'd really like to open it up for Q&A. And I'll ask the team members here just to assist me in that. Anybody would like to ask some questions? Thilo? Just for the people that are on the webcast, we'll have a mic for everybody.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Dan, your growth brands have stopped growing lately. And obviously, you've talked about the intense competitive environment. At what point would you have to reconsider your go-to-market strategies with those brands, the support you give you give those brands if they don't pick up growth at some point in the future again?

Daniel M. Delen

Yes. I think, Thilo, it's very difficult for us to obviously talk about future intent in the marketplace, just for competitive reasons. But I think it's fair to say that we are comfortable with our performance, where it's at today. And certainly, over the last couple of months, what we've seen is sort of growth coming back to our growth brands. So I believe we're in good shape as we stand here in front of you today but very difficult for me to speculate or to make, be too transparent about what our future intent is from a pricing point of view in the category. David, you had one?

David J. Adelman - Morgan Stanley, Research Division

Yes. Dan, sort of 2 linked questions following up on that. What would cause you to sort of recalibrate the balance of share versus profit? Because arguably this year you've ceded some share. And then secondly, if the current pricing environment in cigarettes persists, do you feel comfortable that you can maybe at least maintain and maybe grow the total operating income of the company modestly?

Daniel M. Delen

Yes, I think it is fair to say that, certainly, compared to last year, really what's changed is the dynamic. I think this is important. If we take a look at the support brands, their decline rate has been relatively consistent actually throughout the last 5 years and beyond. So the slope of that decline hasn't changed significantly. What has changed is how much growth we have achieved on our growth brands. And by that not growing like it once did, that has the impact on the total company. And so I'm actually quite heartened. We look at this obviously on a week-to-week, month-to-month, quarter-to-quarter basis. We're confident that we can get our growth brands to actually grow, even in today's environment. And I think in terms of future financial projections, again, very hard for me to go into that direction more specifically. But I'm quite confident that we will and can and do find the right balance in the business in terms of being sure that we focus on both profitability and market share and can continue to do that going forward. Please, Michael?

Unknown Attendee

Just when you look at your targets and your internal planning, how do you think about the balance between operating income growth and net income growth? Obviously, you could bridge some gaps with things like share repurchases, but you seem to have a pretty steady run rate that you're comfortable with there. Is that a way you might close gaps or do you focus on the operating side? And what are some of the key levers there if the operating environment stays really challenging?

Daniel M. Delen

Yes, I think a couple of thoughts kind of come to mind there, Michael. The way I kind of look at it is, and I get this question a lot even internally, as you can well imagine. "What do you want, Daniel, do you want market share or do you want operating income?" And my general response to that is, yes. All right. I honestly don't believe in the sort of the tyranny of the "or." We're asking the wrong questions of ourselves. And when you say it's one or the other, it's actually both. And I think we're in business to obviously increase the long-term prospects from a marketing point of view, generally denominated in volume and market share, as we go. But at the same time, we're in business for our shareholders in providing those superior returns, which is all about the financial sort of bottom line at the end of the day. So we really look at both of those things. Now I think it is fair to say that on a month-to-month basis, sometimes the emphasis changes a little bit over time because, of course, some of spend rates and what happens in the marketplace gets slided in. You have a cycle plan within that. But I think I will just, leave you with a thought that I believe we are the most disciplined-price player in the category. We look at this very judiciously, day in, day out, week-to-week, month-to-month. I believe we're making the right decisions based on the competitive environment as we see it today. And I'm actually quite confident that we can balance out this equation into the future.

Unknown Attendee

Dan, just on the FDA. Do you expect more, I guess, activism in 2013? And I guess how you're thinking about how the agency might accommodate or not some of the innovation strategies that you have in thinking specifically about potential for modified risk products at this stage?

Daniel M. Delen

Okay. Do you want to take that one, Jeff?

Jeffery S. Gentry

I would anticipate that activity in '13 will pick up from where it is. We're already seeing a lot more frequency of interaction based on submissions that we got in front of them. And really, submissions are one of the best tools that we got to interact with the agency. So I believe that will pick up. We do have modified risk applications that we filed and are continuing to work back and fort with the FDA on. So all of those things will take time. Modified risk is not going to be something that they take likely, and that will take time. It's going to take a lot of back and forth for the agency. But I do think 2013 will have a lot more rate of interaction with the agency.

Daniel M. Delen

There was another question over here.

Unknown Attendee

A question for Tom, really. After this recent offering, you're still at the lower end of your debt-to-EBITDA target. How should we think sort of mid and longer term about the pace with which you'll get to the mid point or even higher end of that range?

Thomas R. Adams

We will -- I mean, I think I mentioned on -- I was interviewed by Bloomberg or -- I forget who it was, and I talked about -- or it's actually The Wall Street Journal. And I talked about that we will probably not be back in the debt markets for 6 to 9 months. But we do have -- we will need to go back into the market some time within the next year or so. So we will be moving that up slightly. I don't actually see us getting more than 2x on a strip-to-debt basis, I'm including the pension obligations. I see it approaching 2, but not going over it.

Unknown Attendee

So we shouldn't expect any sort of maybe ASR at the tail end or once you complete your share buyback?

Thomas R. Adams

I don't think so at this juncture. I mean, one thing that we may do, and I think this was to Michael's question to me. While I talked about most all of our debt is at fixed rates. And those that are actually at higher rates, most of it is swapped out. There are several tranches that are higher rate than we might -- can go after. But I want to talk that through with my team and my audit finance committee of the board before we would do something like that.

Daniel M. Delen

It appears all the questions are coming from the right side of the room. What's wrong with the left?

Unknown Attendee

Now Dan, a couple of questions. First, the housing market seems to be coming back. And obviously, the core consumer, tobacco consumers, are heavily employed in that industry. So just curious from your standpoint, if you've seen anything in the marketplace that would suggest things are better with that consumer. And that's the first question. The second question is the -- as you thought about the Vuse product, have you looked at if that product and the way it's put together, is violating any of existing patents are there? Because I know that's a big issue in the marketplace. And I just have one more question after that.

Daniel M. Delen

Okay. I think, first of all, your question about the consumer, consumer dynamics out there. I know we read a lot about sort of some of the macro indicators from the economy slowly getting better. I would say that, certainly, in our category, we have not seen any evidence of that. It appears to be sort of very much a continuation of what we've seen in recent history. So I think that's the first answer to the first part of the question. Secondly, on the Vuse product. I described for you a product that is fundamentally different than anything that exists in the category today. Of course, there are sort of patent litigation going on with regards to the existing products out in the marketplace. We are quite confident that our product is substantially differentiated. In fact, we've got all of our own patent protections in place for our own technology because it is just so different. So we're very confident about our patent and the proprietary technologies that we've developed for our e-cigarette.

Unknown Attendee

And then just the last question is more of a long-term question. How do you think about the balance between Pall Mall and Camel, right? So on the Pall Mall side, I mean, it seems like it has some good equity. But in the end, the consumer that's looking for Pall Mall is maybe more price-sensitive to switch to other brands. And so I just -- I'm just curious on how you think about philosophically, the mix between Camel and Pall Mall as you kind of go forward? I mean, would it make more sense to also keep the premium brand your biggest brand? Curious on your thoughts there.

Daniel M. Delen

Yes. I think always the more share you can generate at the top end of the market, premium brand, always better, you make more money, right? I mean, fundamentally, it's that kind of an equation. But we have a price stratified portfolio. So we have significant presence with Camel and premium. And frankly, with NAS and super-premium and, obviously, Pall Mall in value. Now though we're talking about down trading, I believe it's here to a certain degree it's a sort of a much overused word, but kind of the new normal in the marketplace. But I do think that better times will return economically now. Obviously, trading up consumers, that's quite a leap of faith in today's environment. But good times will return to the market as well. So when I kind of look at it, I say, this -- the portfolio needs to play out. It needs to play under any economic environment, the one we're in today and any of the ones in the future. So because Pall Mall has overtaken Camel by a couple of tenths in the marketplace today, third quarter was 8.7%, against 8.5% for Camel, that doesn't fundamentally worry me. The majority of our resources and focus as an organization remain on Camel. That is the flagship brand of the company. And that is sort of the future of the company really at stake on Camel, and the brand is doing very well. And I think Brice has done a great job sort of explaining a lot of those fundamental consumer dynamics, its performance in the marketplace. That is the priority from the organization, but that doesn't mean I'm worried because in the short term, Pall Mall has overtaken Camel. And it may be larger than Camel for many, many years out there. But organizational focus will remain disproportionately on Camel going forward. A question from the left of the room.

Unknown Attendee

I know you're saying, obviously, there are ongoing discussions with FDA. But I guess, initially, it looks like there are pretty onerous requirements laid out to get about a modified risk claim through. Can you talk about, I guess, generally frame the path to commercialization of some of the technology you're talking about? And I guess, specifically, do you think you need some kind of a statutory change in the requirements to get a modified risk claim in order to move forward? How does that work? And I guess, the path would be helpful.

Daniel M. Delen

I can give you a very general response. But given that we have the expert here, I'll let Dr. Jeff Gentry answer that one.

Jeffery S. Gentry

I can give you a very general response. Yes, it will be onerous. But no, in reality, there are a number of aspects that the FDA considered -- will expect the manufacturer to consider when making their applications. And a lot of their focus is not going to be just on individual risk of those products. It's going to be on the population or the public health standard associated with it. So that as people consider the use of that product, migrating away from something or coming into the categories. There are people who left the category who come back in. So they're paying attention to initiation, cessation, recidivism, et cetera. So that will be some of the biggest things that you have to address. At R.J. Reynolds, we are developing population harm models that we think are very critical to taking all of those factors into account and will be very important for the FDA's evaluation going forward. Framing it a lot beyond that, I mean, you've probably seen some of the guidance. You kind of know some of the things that are in there. But we believe that our population harm modeling will be a significant part of what is very convincing to the FDA we have there.

Unknown Attendee

And just as a follow-up, I guess, obviously, you've seen what PMI said, right, having a product in the market in 2016. I think you guys have talked about it. I mean, what is the -- from a regulatory standpoint, obviously, they're not selling here right. But how does what they're doing affect you and that timeframe? What do you guys think about that timeframe for a U.S. product being out?

Daniel M. Delen

Yes, I think in a couple of different sort of thoughts in regards to that. We actually thought the announcement that happened at the Investor Day of PMI not too long ago was actually quite interesting because a lot of the conceptual products described there are spaces that we've, frankly, been developing products in for quite a while. And of course, they're looking at it and looked at it more from an international point of view. But I think it clearly highlighted to us that from a portfolio of development point of view, it appeared at least from a timing point of view that we were ahead somewhat and have the ability to bring some of these products to market earlier. We've been doing a lot of the clinical work, a lot of the R&D work already and for many years. And -- but I think, really, the key reaction, I would have to that, is it's interesting that a company from a more international perspective really came to very similar conclusions to us from those conclusions we drew some years ago. And I think it really shows how the total tobacco space globally is kind of centering up on the future of these emerging kind of new product categories out there. And I think it just encourages us to redouble our efforts to bring some of these products to market as quick as we can, given the regulatory environment here in the U.S. or to explore some of the international opportunities for the products we have in our portfolio today.

Jeffery S. Gentry

And bear in mind that Eclipse is currently in the marketplace today. We simply aren't making claims on that product. But those products we're discussing with the FDA about.

Daniel M. Delen


Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I guess I have a question regarding your investment thesis, as you described it, and the opportunities that you see in the emerging spaces or the whitespace opportunities. Do you think you've been aggressive enough to take advantage of some of these opportunities? Do you foresee yourselves picking up the pace there next year and beyond? And then trying to understand how you're going to balance doing that organically, as well as possibly through acquisitions? I'm also kind of thinking about Santa Fe in that context.

Daniel M. Delen

Okay. Well, I think this investment thesis is obviously is something that's quite dear to my heart. The way I would kind of describe it is if you take a look our Tobacco Company, but really, any Tobacco Company, there's been decades that everything has been thrown at us, everything from litigation, from regulation, taxation. I mean, everything has kind of been a headwind to the industry. Ans fundamentally by through this transformation program. So what we're doing is slowly changing the environment. A lot of these were historical kind of headwinds. You're slowly kind of turning them so that they become more and more tailwind to our strategy going forward. As we sort of embarked down of this journey, I think it's fair to say that even our competitors were not that aligned in that strategy. Yet we kept going. We did some acquisitions in the category, developed new products and so forth. Most significant acquisition that way was the American Snuff Company, that time known as Conwood. And in line with that, we've seen the environment that we operate in changing already. We see our competitors, for all intents and purposes, now in the same strategy that we embarked upon. They've also been developed total tobacco portfolios through subsequent acquisitions and launches. And frankly, a lot of the public kind of statements out of the different tobacco companies are also very similar now. They were not similar historically. And so when we look at that and we start looking at the regulatory environment. And I'm not just talking FDA, federal side, but different states where we interact with different legislatures. I think it's fair to say that environment is not -- not that it's substantially different where we find ourselves, but it's slowly changing and sort of coming, I wouldn't say, but sort of pushing our strategy along, if you want. And so I'm actually quite confident that our investment thesis will play out. You do feel that environment changing. The second part to your question, you're going to need to remind me of again.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

[indiscernible] are you thinking about stepping things up there between even more aggressive, possibly doing more with that business, given the faster growth.

Daniel M. Delen

Sure. The second part of the question sort of on Santa Fe. But let me come back because I just remembered, you also had the point about organic versus acquisition. I think if you look at our sort of our track record, the organics versus acquisition side, we've done some of both. If you take a look at the moist-snuff category, we actually did that through acquisitions. Snus, we did organically because it was also a new to the, let's call it, at least new to the U.S. category. And I think we keep all our options open that way, as we look at some of these opportunities in this whitespace that's out there today. To do it some of both ways. But I would give you maybe just a bit of a thought on that sort of organic versus acquisitions side. Of course, when you do an acquisition, it's a one-off kind of hit, right? Do you pay something upfront and you've got that business and then you develop it. If you do it organically, the costs actually of doing it tends to sort of play out a bit over time. And then of course, the determination that's made internally as to which is more efficient, which is more effective based on each category that you're trying to get into. So I would say that our approach is to be the most efficient, but also the most effective, and we're balancing some of those elements. In terms of Santa Fe and the second part to your question. I think that is a very interesting sort of case study. And we have, implicit in some of the numbers we showed you today, actually been increasing our investments in the marketplace on Santa Fe, Natural American Spirit already and paying great dividends. I think it is a brand that's actually accelerating, right? If you sort of look at its percentage growth rates, they've remained relatively constant, but increasingly off a larger and larger base. And so I think -- and we commensurately stepping up investments behind the brand and the marketplace. But of course, and something very important to bear in mind, it's a super premium brand with super premium price credentials. And what that means is you never find Natural American Spirit on sale. As far as I know and, I might be technically wrong, but directionally right, it's the only brand in the marketplace that's never on sale. And what I mean by that is in the history of the brand in this market, it's never had a buydown, yes? Never had free goods when those that are widely available in the marketplace, right? it's never had a pre price promotion on the pack. I mean, it's true to its super premium positioning in all ways. So when we talk about increasing investment, we're really talking about equity investment, new marketing tools to help generate that word-of-mouth between consumers, and a lot of the materials that Brice showed you in his presentation. So there is increased equity investment. There's just no pricing investment. Vivien?

Vivien Azer - Citigroup Inc, Research Division

My question has to do with the 80/90/90 role in terms of your resource allocation. Without tipping your hand competitively, can you give us a sense of how that's evolved historically within combustibles, either premium versus discount, menthol versus non-menthol?

Daniel M. Delen

Yes, I think it's fair to say that if you take a look, first of all, just in the combustible space. The vast majority, and I don't have the exact split for you here today, but the vast majority of our spend, particularly, our equity spend, has actually been deployed on our premium proposition. So principally thinking of Camel here, but also, to a lesser extent, Natural American Spirit. Why? Because those brands are more equity sensitive, if you want. They are a slightly more complicated equity story to play out to consumers. And they are very rich and robust kind of imagery that you're trying to get across. The Pall Mall proposition, frankly, is an easier proposition to communicate. It's a product point of difference. It doesn't rely so much on imagery. It's this last longer proposition doesn't require the same level of resources. The product kind of speaks for itself. And so I think that's kind of then the historic balance that continues to date. I do think it's fair to say that the spend, as we found a very relevant proposition in premium menthol with the capsule products, that some of our equity spend had actually shifted towards our side of things. don't have the exact numbers, but directionally correct to say that our spend has actually shifted more towards the menthol side of things over recent years. And that's not for a lack of trying in the past. We've tried a number of different things in premium menthol. But frankly, it was a strategic weakness in the portfolio. And very proud of what the folks in R&D have developed on the capsule side to be able to address that strategic weakness in the portfolio to the point where we sit here today and can be really proud of just within a few short years, how we've addressed that and actually grown and captured a very significant share in premium menthol side of things.

Vivien Azer - Citigroup Inc, Research Division

If I could just ask a follow-up to that, then on the capsules. I know it's very early days. But can you give us a sense of any kind of competitive dynamics that you're seeing in the markets where all 3 have launched the Marlboro NXT? And then, as you think about that competitive landscape going forward, have you done any global benchmarking work around how the capsule sub segment has evolved globally, where you get a second entrance into the category?

Daniel M. Delen

Yes, I think on both sides, I think it's very early days to kind of give a definitive answer in terms of what's happening competitively on the capsule side. But I would say that we're very confident and we haven't seen any significant impact, or any impact whatsoever to date, on Camel's capsule portfolio through the launch of Marlboro NXT in the marketplace. So I think that side is kind of playing. There is a lot of learnings that can be gleaned internationally from the capsule side of things. I think one thing that we're keeping a keen eye on is the launch of a competitive capital line extension now, is that additive to the capital category or does the one that actually take away from the other? And certainly, international experience on that side would tend to indicate that it's additive, that it actually just makes the category bigger rather than one taking away from the other. That's certainly the case with, if I just remind everybody on the snus side of things, when we had a competitive entry into that category, it's what we saw as well. That it just made the category bigger. But that's what the international experience would indicate. It will make the capsule category even larger. The other thing you'll be able to glean from the international data, when you actually look at it, is that there is a definitive first mover advantage by going first. That is a benefit that tends to stick to the brand that's gone first. Michael?

Michael Lavery - CLSA Asia-Pacific Markets, Research Division

Just 2 quick ones. I know with the legal docket dwindling, is it too optimistic to think that there's a chance of legal expenses starting to decline? Or is that too soon and too optimistic? But that and then, with the SKU rationalizations that you've talked about over the last several years, how much room do you have to keep doing that with some of these other brands? And would it even involve perhaps, brand rationalization for some smaller ones? Is there savings still to be had there as well?

Daniel M. Delen

Okay. Well, let me take the second part of that question, and then answer the -- pass the first part over to Mark. But in terms of the SKU rationalization, we have had a very significant program in place. I think, for all intents and purposes, we're done. And what I mean by that is the majority of it has been done, we continue to optimize and tweak as we go. But you're not going to see the order of magnitude of changes that you've seen in the past. We have a highly efficient portfolio as we stand here today, and a highly efficient SKU lineup across the different categories. Spent a significant effort over many, many years designing that, making it future proof as well, depending on the different economic environments, different sort of consumer trends we see out there. So I don't think you're going to see substantial or very significant changes to that in the future. The first part of litigation, I'll just pass that over to Mart.

Martin L. Holton

Well, you heard Tom and you've heard us before talk about how cost is important in our organization. So we certainly look at it constantly. I think it's fair to say we tend to follow the proposal we win at the right cost. We're going to spend what is necessary to keep those trends moving in the right direction to ensure that the company and the risks that the company faces is managed appropriately. My belief is that we are competitively very, very strong in that area. I think as the docket continues to dwindle in the right place, we necessarily will see costs that we don't have to expend. I feel very good about where we are and where we're going.

Daniel M. Delen

Maybe I'll give a little bit of added perspective on that because I think Mark is selling himself and the team a little bit short on that front. Because if you look at it, you remember some of those demographics charts I was kind of talking about? We have a higher proportion of shares of some of the older consumer profiles out there. But that's been historically true as well. So we have a disproportionate share, let's call it of the smoking history, that comes through a lot of these litigation cases. Having said that, if you look at the relative litigation spend between the different companies out there, we benchmark extremely, and I would emphasize, extremely well, despite some of that disproportionate smoking history. So I think Mark and the entire litigation team, including the external counsel that we use, I think they are deploying a very cost-effective but very efficient strategy as we speak today.

Unknown Attendee

Just a general one. I guess, your thought process on the cash allocation. If there is some kind of change on the dividend tax front? What you're hearing from investors? How much flexibility there might be between, you've got a great dividend track record and how you're thinking about flexibility there?

Daniel M. Delen

Yes. Let me take that one head on, and then I'll pass it over to Tom to see if he has sort of any additional comments on that front. But more recently, and certainly, over the last year or so, I've been reading a fair number of studies on that front about what the impact may be or may not be. And I think it's fair to say that there isn't a consensus kind of opinion as to the value of one way of returning value to shareholders over the other. I think it's fair to say that we are very committed to our dividend. It is our preferred mechanism of rewarding shareholders. I think you can agree with me that an 80% payout ratio shows a lot of confidence, a, in the stability of the business, but also in that mechanism of rewarding shareholders. In terms of how that might change in the future, I frankly, at this stage, unless we have more definitive and know exactly what's going to be happen, it would be hard for me to speculate. But we are very committed to paying our dividend. And then, of course, if something was to change in that environment, we'd obviously love all of your feedback, as well as to whether that should warrant any change in strategy. But I'm more inclined at the moment to say, sort of to leave you with the flavor that, that is, by a wide margin, our preferred way of returning value to shareholders. Do you want to add anything to that?

Thomas R. Adams

The only thing that I would add is that when this proposed increase on dividends, that proposed tax increase on dividends, was bubbled up some months ago, we actually did as we were going out and talking to investors kind of solicit that and say, okay, so if it goes up, what -- how do you guys feel? And by and large, most of the people said, we're kind of indifferent. We're pass-through. And just keep in mind that a lot work -- a lot of the discussion that's going on now is actually raising taxes on the wealthy. And while they actually probably have a significant portion of their income coming through -- or more significant coming through dividends, than probably the working people, a lot of our shares are institutionally held, and they are held for pension funds and that is pass-through. And so those folks would not necessarily be affected. So I think we were just really have to kind of take a look and see how it all sorts out. I agree with Dan, let's kind of find out what the legislation is first then we'll have the discussion.

Daniel M. Delen

Okay. Well, that, I think, appears to be sort of all our questions for today. I just thank you all for attending today. There is an opportunity to sort of gather outside. And for those of you on the webcast today, thank you so much for dialing in as well. Thank you.

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