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Lorillard (NYSE:LO)

Q4 2012 Earnings Call

February 13, 2013 9:00 am ET

Executives

Robert Bannon - Director of Investor Relations

Murray S. Kessler - Chairman, Chief Executive Officer and President

David H. Taylor - Chief Financial Officer and Executive Vice President of Finance & Planning

Analysts

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

David J. Adelman - Morgan Stanley, Research Division

Nik Modi - UBS Investment Bank, Research Division

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Michael Lavery - Sidoti & Company, LLC

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Vivien Azer - Citigroup Inc, Research Division

Priya Ohri-Gupta - Barclays Capital, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Lorillard, Inc. Fourth Quarter 2012 Earnings Conference Call. My name is Brent, and I will be your operator for today's call. [Operator Instructions] A question-and-answer period will take place at the end of the call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

At this time, I would like to turn the conference over to your host for today's call, Mr. Bob Bannon. You may begin, sir.

Robert Bannon

Thank you, Brent, and good morning, everyone. I'm Bob Bannon, Lorillard's Director of Investor Relations, and joining me on today's call are Murray Kessler, Lorillard's Chairman, President and Chief Executive Officer; and David Taylor, its Chief Financial Officer.

By now, you should have received a copy of our fourth quarter 2012 earnings release. It can be found on the company's website, lorillard.com, under News Releases.

But before we begin, I'd like to remind you that some of the comments on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company's earnings release and in other filings with the SEC. Also, certain financial information, such as adjusted net income and adjusted earnings per share, that will be discussed on today's conference call is presented on a non-GAAP basis. The description, most directly comparable GAAP measure and reconciliation between the non-GAAP and GAAP measures are provided in the company's earnings release, which is available on our website.

I'd now like to turn the call over to Murray Kessler.

Murray S. Kessler

Thank you, Bob, and good morning, everyone.

I am pleased that Lorillard was back on track and delivered strong results in what we would still characterize as a highly competitive fourth quarter in cigarettes.

Specifically, during the quarter, our competitors shipped the most specially discounted promotional packs of the year and they launched several menthol new products. In the face of this intense competition, Lorillard's core business insulated itself from these activities through measured increases in promotional support, and the business responded.

As a result, I'm pleased to report improved volume trends and net price increases in cigarettes, and the incremental net sales contribution from eCigs allowed Lorillard to increase net sales by 5.3% over last year to $1.7 billion and delivered record sales of $6.6 billion for the year.

Strong net sales, solid cost control in the Cigarettes segment and continued share repurchases by the company resulted in adjusted diluted earnings per share growth of 8.2% for the quarter and 7.2% for the year to $0.79 and $2.82, respectively. Those EPS numbers are reported on a split-adjusted basis as we split the stock three-for-one on January 15. Also remember, those solid results came on top of some pretty tough comps as last year's fourth quarter volume was up 5.5% and adjusted fourth quarter EPS was up 26%.

Let me provide some more detail by segment.

In our traditional Cigarettes segment, Lorillard domestic fourth quarter volume increased 0.4% versus a year ago. Adjusting for inventory and 1 additional day in the industry in this year's fourth quarter, domestic volume was down 1%.

Newport domestic fourth quarter volume increased 0.9% for the quarter and was down 0.6% versus a year ago on an adjusted base. Both Lorillard's and Newport's volume performance marked a sequential improvement over the prior 2 quarters in response to our measured increase in promotional spending, bringing volume back in line with our historical trends, which is a great testament to the Newport brand's equity.

Despite the increase in spending, Lorillard still delivered cigarette net price realization of plus 3.7% for the quarter, which was higher than both of our major competitors. Both total Lorillard and Newport increased domestic market share in the fourth quarter by 0.2 points. Total Lorillard share finished 2012 at 14.4%, up 0.3 share point for the year, marking the 10th consecutive year of share growth for the company.

Lorillard also gained share during 2012 in the menthol segment, again, in the face of heightened competition. We estimate the industry declined 2.5% for the year.

Turning to our Electronic Cigarettes segment. As you remember, we acquired blu eCigs in April and have been hard at work integrating every since. blu eCigs had a fantastic quarter. We expanded distribution to over 50,000 retail outlets as of yearend, well ahead of our goal. And as of today, we have received authorization for an additional 25,000 retail outlets. According to our proprietary EXCEL database, which now includes eCigs, we estimate our fourth quarter share of the eCigs category, excluding Internet sales, to be just over 30%. We attribute strong retail sales and strong repeat to the superior quality of the blu product, its highly differentiated positioning and the national television advertising campaign that began during the quarter.

Net sales for blu were $39 million for the quarter and $61 million for the 8 months that we owned the brand. Fourth quarter net sales were almost triple the $14 million in sales we reported in the third quarter. On a pro forma basis, for the 12 months of 2012, blu net sales were $76 million. This translates to about $125 million in retail sales when you add margins, which is very consistent with a 30% market share, pretty good for something we still consider in the developmental phase. blu also contributed $7 million in operating income for the quarter.

On the regulatory front there, once again, is not much to report. We still await the peer review of the FDA menthol report. As we've said in the past, we do not believe the FDA's menthol report will contain any policy recommendation. When the report comes out, we will respond appropriately during the comment period. Again, we believe this is just one more step in what we believe will be a very long review process. And you know we believe that the best available scientific evidence does not support an assertion that menthol and cigarettes negatively or disproportionately impacts public health. And that any draconian regulation would have significant unintended consequence.

Speaking of very long processes, we also have nothing to report on the SC approval process of our pending new products. We continue to cooperate with the agency on additional data requests and we look forward to them approving these products soon.

In the meantime, Lorillard does have product news that could be brought forth without SC approval as, like our competitors, we had certain products in market prior to the March 22, 2011, deadline. You will see one of these in the very near future.

And finally, we await the deeming regulations on eCigs. We are hopeful these regulations will recognize the significant role eCigs products can play in a broad scale tobacco farm reduction strategy and encourage the responsible development of this category, but we will see.

So in summary, we had a solid finish to a challenging 2012. We delivered on our commitment for a double-digit total shareholder return as measured by EPS growth and the dividend yield. And we did so despite increased price competition and in the face of regulatory red tape.

We also completed our first acquisition in 50 years, positioning us as a leader in an emerging category that we believe can contribute significantly to our results over the long-term. We are bullish on 2013 as we have taken a more conservative planning stance than we did last year that assumes the FDA does not approve any SCs and that the competitive environment does not improve in the first half of the year. This should leave us in a position of more upside opportunity than downside risk. I also think we are more aligned with the Street, given the guidance scenarios David gave you last conference call.

Given our confidence, our Board of Directors has approved an increase in our quarterly dividend of 6.5% to $0.55 per share.

With that, I'll hand the call off to David to review the financials in more detail. David?

David H. Taylor

Thanks, Murray, and good morning, everyone. After a few comments, we'll open the line for questions.

Consolidated net sales for the fourth quarter increased 5.3% to $1.7 billion from last year's fourth quarter. Increases in cigarette average net selling prices, unit volume and the inclusion of blu this year, drove this increase. Reported operating income for the quarter declined 1.5% from last year. Remember that one element of our tobacco settlement expense is variable based on industry profit. The significant mark-to-market charge that Reynolds American recorded in the fourth quarters of both 2011 and 2012 reduced industry profits, and therefore, reduced our settlement expense.

Similar to last year, adjusted operating income, adjusted net income and adjusted EPS all exclude that positive impact on our settlement expense. Going forward, future mark-to-market adjustments reported by industry participants could have a significant impact on our settlement expense. They're not in our control and they could be either up or down. Again, we have excluded this benefit from the adjusted results, and I will be addressing our performance on an adjusted basis.

Adjusted operating income for the quarter increased 1.8% from last year and fourth quarter adjusted diluted earnings per share, on a split-adjusted basis, increased 8.2% from last year's fourth quarter to $0.79 per share; and annual adjusted EPS increased 7.2% to a record $2.82.

Beginning in the fourth quarter, we are reporting our results as 2 operating segments: Cigarettes and Electronic Cigarettes, so you can see the appropriate trends and make comparisons.

Looking at the results for traditional Cigarettes. We see net sales increase 2.9% from last year's fourth quarter, driven by increases in unit volume, combined with an increase in average net selling prices. Domestic wholesale cigarette volume increased 0.4% compared to last year's fourth quarter. And Newport domestic volume increased 0.9%, benefiting from increased promotional support and 1 additional shipping day.

Net sales per cigarette, calculated before excise taxes on a simple consolidated basis, rose 3.7% from last year's fourth quarter, reflecting the impact of list price increases taken over the last 12 months, offset, in part, by the increased promotional spending that I just mentioned.

Adjusted gross profit for Cigarettes increased 1.1% in the fourth quarter compared to 2011, and gross margins declined from 37.2% of sales to 37.9% last year (sic) [declined at 37.2% of sales compared to 37.9% last year]. Increased tobacco settlement costs, along with higher tobacco costs and other direct costs, were not fully offset by the net price realization. Adjusted gross margins for the full year were flat to last year at approximately 36%.

Selling, general and administrative costs in the Cigarettes segment increased from last year's fourth quarter but at a slower pace than we've seen for several quarters and was flat with the third quarter. The $5 million increase is driven by a variety of factors, including increases in compensation and benefits, but increased legal defense costs were not one of the major reasons. In fact, those costs were only up about $1 million this quarter.

Fourth quarter adjusted operating income for Cigarettes increased 0.4% to $507 million.

Now looking to Electronic Cigarettes. Net sales of blu eCigs totaled $39 million for the quarter as a result of the rapid expansion of retail distribution, a product with strong consumer appeal and the powerful marketing and advertising messages delivered in the quarter. We are ahead of our distribution goals for retail storefronts at this point and we have confidence in the future of the brand. We reached the goal of making the acquisition accretive in the first year and although the contribution is minimal for the quarter, we are happy with the results so far. This is a rapidly growing category and one we think is here to stay, with great potential over the long term.

Clearly, there will be many challenges ahead for blu and there's much to be done but we expect product innovation and improvement, further distribution gains and creative marketing to drive profitable growth for this segment in the future.

A couple of other items. Our effective tax rate for the 2012 fourth quarter was lower than last year, primarily due to discrete items affecting taxes in 2011. The effective rate for the year was 36.4% as we indicated in last quarter's conference call. After adjusting for the three-to-one stock split completed in January, we repurchased approximately 7.8 million shares of our common stock during the fourth quarter at a cost of $304 million under the $500 million share repurchase authorization.

Share repurchases for the year totaled $578 million. Also, the calendar for 2013 has 1 fewer shipping day in the 2013 first quarter than the 2012 first quarter, so remember that when you are developing your models.

Murray mentioned our increase in the dividend announced today, which continues to reflect our commitment to deliver a double-digit shareholder return, measured by EPS growth and the dividend yield.

In that regard, last quarter, I gave you some scenarios that could result in differing levels of EPS growth rates, depending largely on the competitive environment and the impact of potential incremental growth opportunities. I indicated at that time that we were closer to the mid-single digit EPS growth scenario which would assume a continuation of a very intense competitive environment, characterized by crowded competitive product launches and special pack promotions in the menthol category, and a lower level of price realization as we seek to balance share growth against profitability.

I also mentioned in our last call that there were upside earnings opportunities to the scenarios outlined. Those being incremental new product introductions in cigarettes, more meaningful profit contributions from blu and the positive EPS impact of our share repurchase program. Those upside opportunities continue to exist and we will continue to press those going forward.

Some have recently commented on a sea change in the promotional environment for cigarettes, and that 2013 will see a return to more normal price realization. However, I can say that we have not yet witnessed such a change. So our trends in terms of cigarette volume and price realization will remain under pressure for the short-term, and our earnings expectations remain the same. Even so, as you can see from our fourth quarter results, we believe we can successfully manage through those pressures.

So in summary, we finished 2012 in good fashion given the environment, and we are confident that our plans for 2013 and forward will continue to reward our shareholders.

Operator, we can now take questions from the call participants.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Bonnie Herzog with Wells Fargo.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I guess, my first question is on promotions based on what David just said. You were a little bit more promotional on Newport in the fourth quarter than you've been historically, yet, it didn't necessarily drive as much retail share growth as, I guess, I would have expected. So should we assume, going forward this year that these promos will continue and then possibly increase especially with David characterizing the competitive environment as still pretty heightened?

Murray S. Kessler

Well, the promos, first off -- I mean, on a relative scale, Bonnie, people sort of made a big deal last call about us having some promos. The amount of volume that we sent out at factory, or the specially marked factory pack promos is a fraction, it's a very tiny percentage of our volume. I think it's like 4% of our volume when some of our competitor brands in the menthol segment are up at 40% to 50% of their volume with that type of promotion. So it wasn't that big of a deal. The bigger issue that we did during the quarter was we didn't come off promotion during certain periods of time to keep more of a steady state. We gained share on a total basis at about the same level that we had been gaining share throughout the year. The only place that -- with a variance was on the sequential share of menthol and there's reasons for that. But in general, we were pleased with the way the business -- I mean, first and foremost, you saw a volume trend that we'd like to be in that sort of flattish area, minus 1% to plus 1%, and Newport Menthol responded beautifully right back into that historic trend. And that compares to 1.5 points or 2 points better than the trend had been in the previous couple of quarters. So I thought the business performed very well.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

So okay, and having said that, so we shouldn't expect to see much of a change, then, in your strategy with the brand this year or at least early on?

Murray S. Kessler

No. I think you'll -- we said we envision it to be competitive at a very low level. We would continue where we thought it tactically and efficiently made sense to use some specially marked promotions. We'll continue to do that, we already have. And we'll adjust rates in markets like we have for the last 12 years as we need to and we do that all the time.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Okay. And then, I have a question on eCigs. Just consumer trends, could you talk through that with us and just help us understand what you're seeing in terms of repeat versus trial? And then, what other consumer behavior are you noticing that seems promising for the long-term growth of this category? And then, how would you break down blu -- eCigs consumers by a percentage of, say, dual users with cigs and then, percentage of converts and then, percentage of trial and/or occasional users? Just trying to get a sense of that would be helpful.

Murray S. Kessler

That was a lot of questions. All right. Look, the e-cigarette category is growing very strong and we are very pleased. Let me give you a grounding of where I start to see it, and this is the roughest of all estimates, Bonnie. But in my opinion, taking the volume that we have from our EXCEL database for the fourth quarter and expanding it and just sort of nationalizing it and extrapolating it out for 4 quarters, we estimate that on an equivalent cigarette basis, and again, this is a rough estimate with the best data I have, just over 2 billion sticks of e -- in equivalent cigarette sales that were -- that are being sold, or about a 1% share, and that's at a very early stage. So people have asked, what kind of impact do you think it's having on cigarettes? That gets to your next question. The impact on cigarettes -- we know all these consumers are coming from cigarette, so the question then is, how much of it is complete substitution, how much of it is partial use or complementary use, and how much of it is trial and rejection? And we did a study as part of our acquisition analysis and we did it twice, and I don't have the numbers in front of me exactly, but it was roughly that 40% of e-cigarette consumers said that they had completely switched from cigarette smoking to e-cigarettes and then another large part -- maybe it was 25% or 30%, excuse me, it was more like 40% that used it on a complementary basis and smoked less and then there was about 20%, 25% that tried it and rejected it. Okay? So if you take that mathematical model, then you come up to this estimate that at about 1%, maybe it's having an impact on the cigarette category trend already of about 0.5%. All right? So those are the roughest estimates. People ask me it all the time. I'm doing the best I can with very limited data right now. But I think it's having an impact on the overall cigarette category right now by about 0.5%. The repeat purchases are very strong. We look at the accounts, frankly, we are having a hard time keeping up. And if you talk to retailers, you can see that the product is moving very well. During the fourth quarter, we had a lot of -- a fair amount of pipeline load but we're past that now. Granted, we're still adding distribution, but we see stores -- and there were big accounts and certainly, online that have been out there for a few years now. And what you see there is a large percent of the business in cartomizers. And cartomizers are 100% repeat business. So we feel like the repeat is strong, the idea's strong, and by the way, we think the technology is only a fraction of where it can be. And we have a crack team with very exciting developments and we think you'll see this category continue to evolve, and the product get better and better. And because of that, we have chosen to invest in this category and you only get one chance to be first and be a leader, and we're taking advantage of that, as you see, by the results of the business. But it's starting to become real.

Operator

Your next question comes from the line of David Adelman with Morgan Stanley.

David J. Adelman - Morgan Stanley, Research Division

Murray, I want to ask you about how you think about Newport's performance. Because that will obviously dictate how you respond in the marketplace. And in particular, I wanted you to reconcile the brand's overall performance where the market share sort of had its traditional year-on-year and sequential behavior versus its performance within the menthol category where, sequentially, it lost much more share than it normally would in the fourth quarter. Presumably, that has to do with competitors' cadence of activity, new products, promotional spending, but -- and if that is the case, is that something that you feel that you need to respond to?

Murray S. Kessler

No. I think -- I'm not worried about it at all, David. Let me give you some background on it. The strength of our database is that we get great coverage against 99% of our volume because you know the scanner data only covers around half of our volume because we sell so much in urban centers. So I love the EXCEL database because it gives us a true read. The weakness of it, time and time again, is it measures shipments from wholesale to retail. In the month of October, we had multiple competitive new product loads, and all of that pipeline inventory went into October. And 100% of the share loss in menthol happened in the month of October, both sequentially and versus year ago. In November we were up, in December, we were up versus year ago. And I will give you a peek under the tent that in January, against very strong seasonally rebounded numbers, we were up robustly again. So out of the last 3 out of the 4 months, we've gained share of menthol, and 100% of that loss was during that pipeline load period in October. So it doesn't dictate a response at all.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then separately, Murray, with respect to the FDA and substantial equivalents, I know it's not your base case assumption, but how would you assess the probability that the FDA will simply take the position that within the mantra of protecting the public health, it's not in the interest of the public health to allow any new products to enter the market, even if they are not more harmful than existing products because companies wouldn't introduce a product without the hope of generating sales and they'll just lock down the U.S. industry going forward?

Murray S. Kessler

It doesn't feel like that right now. What I said during your conference is that prior to that period of time, it had been dark. It was almost a black box, we had no correspondence. In the last 3 months, it's been completely different. It's almost been every few weeks, we get questions, there is -- they get near the end of their scientific review and we get questions relative to that, we answer them, we respond to them, they have follow-up questions, then they -- we get questions relative to their environmental review and we answer those questions -- as recently as last week. So it feels like it's moving towards closure. I don't know where the end zone is. I know that we are making progress against it. I know that we're communicating frequently now and going back and forth between them, and that all feels positive. And I know that Director Deyton spoke about SCs in terms of a ceiling of harm that he didn't -- so -- and a lot of the questions ask about where do you think the source of volume is and all that. And you and I both know that these are share plays, these aren't going to change the overall secular decline in the cigarette industry. So I'm optimistic they're going to get approved. But having said that, if you heard the subtlety in my earnings comments, while I think we have big strategic opportunities that I've shown you with white space opportunities and they're clearly the bigger ideas we, too, have opportunities with products that were on the market before March 2011. And you will see product news from Lorillard in the very near future.

Operator

Your next question comes from the line of Nik Modi with UBS.

Nik Modi - UBS Investment Bank, Research Division

So a couple of questions. On this cryptic message on new product news. Just curious if there is any clarity you can give us in terms of timing. I know probably from a competitive standpoint, you don't want to get too detailed, but just any frame you can give us on that would be helpful. And then lastly, on the promotional activity that you talked about, can you just talk about where the pressure points are, like, what exactly you're seeing that gives you the feeling that things remain elevated? Just want to understand exactly the source of the pressure.

Murray S. Kessler

Well, sure. Let's do the second half first. Relative to the promotional activity, I've seen the comment. So one competitor who was discounting a pack of cigarettes -- their cigarettes by $1 less, moderated their rates in the middle of the year from $1 to $0.95, so maybe a nickel better. But it is still $1 -- so now it's $0.95 less than the full revenue cigarettes that are -- or normal buydown levels in the marketplace. That doesn't feel like a big change. As we've seen announcements going forward and they're all published going forward, but for -- let's take the Altria program, for example. For the most part, their published rates are all the same with the exception of a flex dollar option on a few -- a small portion of the business. So it's sort of like 20% of their business is on flex dollars and 20% of that is on the part that they changed the rate on. You're talking about 4% of the volume maybe having a rate change, that doesn't feel like a big change. All buydown rates are out there. Then I look at specially marked factory pack promotion, and the fourth quarter had the most -- take us out of it, we weren't a huge one but we add to that -- but take us out of it, it was the highest number of factory pack promotions of the year and there were a couple additional new product launches. So it's hard for me to say the competitive environment is substantively any better. The good news is it took pretty minor adjustments for us to get our volume back on track, and it wasn't -- you saw it in our price realization, and you certainly saw it in our price realization relative to the price realization of our competitors. So I feel good about that. As of the peek under the tent, I'm surprised you're not telling me what it is...

Nik Modi - UBS Investment Bank, Research Division

I kind of know what it is, Murray, I just don't want to say on the conference call. Whatever you're willing to share, that would be helpful.

Murray S. Kessler

Yes. There's not much to share it. It's out on -- it's already begun selling to the trade. So you guys will pick it up very quickly. I don't characterize it as one of our big strategic opportunities. I'd characterize it as an ability, during a competitive time, to bring some product news to the shelf.

Nik Modi - UBS Investment Bank, Research Division

And will you -- will this come with an introductory price point, $1 off or whatever?

Murray S. Kessler

Not that deep. It will be more of our traditional. So we're trying not to go into the fray with this.

Operator

Your next question comes from the line of Judy Hong with Goldman Sachs.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Murray or Dave, I'm trying to reconcile your comment about the guidance and the different scenarios. Because Murray, I think on one hand, you talked about the consensus expectations being now more reasonable, and I think right now it's expecting about 9% growth year-over-year. On the other hand, you kind of talked about this being another year where a competitive environment stays pretty intense, and that sort of characterizes the mid-single digit kind of earnings growth scenario. So what's the difference in terms of those 2 scenarios?

David H. Taylor

Judy, I don't know that they're vastly different. The way I characterized those earnings growth scenarios was, a mid-single digit EPS growth, given the competitive environment, plus the incremental earnings opportunities associated with share buybacks, greater contribution for blu or incremental product news. So the mid-single digit earnings scenario would be absent any further major EPS, excuse me, share repurchase programs, product introductions or significant growth out of blu. So I don't think our expectation moving into 2013 is any different from that. So competitive environment will remain tough, at least, in the short term, and volume trends and price realization will remain under pressure, but we do have these upside opportunities in the form of share repurchases, blu and any kind of product news we might bring there.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay. So it sounds like maybe absent the competitive situation getting better, you have some levers in terms of a buyback, and then, it sounds like blu is doing a little bit better than you thought?

David H. Taylor

That's correct.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay. Murray, just on the blu and just kind of the dynamics in the eCigs category. I know you touched on this a little bit early in the call, but just curious to hear what you're seeing in terms of the brand loyalty. So obviously, there are a lot of competitive products out there, so how is the consumer kind of developing brand equity or brand loyalty on a particular brand? Also, if you could talk about retail allocation and kind of the relationship with the Cigarettes category where there's a lot of programs in place and the retailers get compensated that way. And then, just the industry standard, obviously, there are a lot of different products out there and not all of them maybe adhering to kind of the standard that you like to see, so how is that also affecting the category and the consumer behavior?

Murray S. Kessler

Yes. A lot those questions are hard to answer. We do not tie e-cigarettes into our cigarette merchandising contract, but we have separate contracts for e-cigarettes. And that's basically, to support what is a build out, one of the benefits of the e-cigarette category of Lorillard being there is we're trying to establish a permanent home in retail stores, and that means putting in merchandising units and creating the category and the visibility. And we understand that and we compensate retailers to do that. The brand loyalty numbers, the best measure of brand loyalty right now is the repeat purchases and how the business gravitates from disposables to -- in our model, from disposables to starter kits, to cartomizers, and that is progressing beautifully. We have -- I could give you sort of case-by-case examples of major retail chains in the United States that started with -- we'll do a 50-store test and it sold so well that they come crying back that we need to overnight ship it so they can go to -- expand the 500 to 1,000 stores. So everywhere we go, the product is selling extremely well. I don't really want to get into a discussion of competitors relative to is our share bigger than their share, it's not really important right now. This is a category that is growing exponentially, and in the end, there is going to be multiple players, and frankly, it -- the bigger opportunity -- if we're having a shared discussion at this point, then something's wrong. We believe that this category is going to continue to grow, frankly, at very rapid levels over the next few years. And the more relevant question is, what regulation is necessary to make sure it evolves in a way that is responsible? So no, we have already taken the position that this can't be sold, anyone who's not of legal age to consume tobacco products, we believe there should be quality controls. We spend a heck a lot of our money in resources to make sure that we have the controls in place, that the liquid inside is what it's supposed to be, that the nicotine levels are what they're supposed to be, reliably and credibly, that there's no contamination, that batteries are tested and safe, and everything else that goes within that. We have taken the position that, from our perspective, that there's some controversy around propylene glycol, which is what you sort of hear talked about from some of the public health folks. Well, we don't use propylene glycol, we use vegetable glycol, and we've done that purposely. So we think a responsible discussion with the FDA to get regulations that recognize how powerful a tool this might be in a total spec of harm reduction strategy is encouraged and not some knee-jerk reactions that slow the growth of the category. And to that end, the FDA granted us an opportunity to come in, months ago now, as they were writing these and looking at these deeming regulations. And we walked through a full presentation of, sort of, where we thought there needed to be regulation, where not, the -- giving them a grounding in how the technology will change and how the SC model on cigarettes in a rapidly changing category like this makes no sense. And we went through that whole exercise. So net-net, I'm hopeful that the FDA will do the right thing in these deeming regulations, but you never know, so we'll see.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay. And then just my last question, Murray, just your assessment about the competitive environment, would that change if you do see step-up in sort of the equity-building, the brand-building investment? Your competitors have talked about funding some of that with the NPM settlement benefit. So would your characterization of the competitive environment kind of change if you do see the step-up in spending on those initiatives, and would you think about them funding some of that initiative through your NPM settlement related benefit as well?

Murray S. Kessler

Well, we'll make the decisions that are right for our business on the NPM based on our own assessment of our own brands. As it relates to yesterday's conference call, which you're referring to on incremental brand spending, at first glance, you got to remember that -- I'm going to be specific. At first glance, Reynolds' brands don't directly compete with Lorillard's brand. They are in different geographies, different demographics and different product mix portfolios. So -- and I think you've seen some analysts who have done analysis on that, that, sort of the R-squared and the regression analysis showed the interaction tends to be between that company and Altria, which have very similar product portfolios and geographies. So a step-up there is not necessarily a concern. But I -- you got to watch sort of the ramifications down the line, does it change the dynamics of the industry, and of course, we'll keep an eye on that.

Operator

You're next question comes from the line of Michael Lavery with CLSA (sic) [Sidoti & Company]

Michael Lavery - Sidoti & Company, LLC

Back on e-cigarettes, what's the flavor profile look like in your shares? Does it also have a menthol SKU? I would assume it's a much smaller piece relative to your cigarette portfolio, is that fair?

Murray S. Kessler

Yes, that is correct.

David H. Taylor

I think the largest selling flavor is still the natural tobacco in e-cigarettes. In our product portfolio, menthol is second, but followed closely by cherry and vanilla. So that element of the product portfolio is not dominated by menthol.

Michael Lavery - Sidoti & Company, LLC

So do you have any sense of where you're sourcing from? If you can extrapolate even a rough impact of what might be coming out of the cigarette category, it would seem like that's heavily disproportionately skewed to your competitors, is that how you'd probably think about it?

Murray S. Kessler

Yes, that is how I think about it.

Michael Lavery - Sidoti & Company, LLC

I mean, it sounds like it's very incremental, correct?

Murray S. Kessler

Yes.

Michael Lavery - Sidoti & Company, LLC

But then so, just looking ahead competitively, if -- Reynolds has talked about their launch and if Altria were to enter the category, would you generally see that as a positive for category development or a risk to share, or I guess, possibly both? I mean, how do you view some of the threats or opportunities that could come from that?

Murray S. Kessler

You could read it both ways, but my gut feel is it would be positive. My gut feel is, it would ignite the category even further. It's hard for me to believe at this stage that this is really a share battle. Having said that, blu is a fantastic brand. And you can try -- and I'm not nervous about competitors' technologies. I've seen the technologies that are on the market and there's no one who has any offering on us. In fact, I would say, we have a bunch of rocket scientists that are working on this and an entire team that sits in Silicon Valley that is generations ahead already, so I'm pretty excited about the future. But I think a big piece of this is, like any category, it's getting a real brand identity and that's why we bought blu because it stands out in terms of sort of all of the attributes beyond the -- the physical, technical aspects about the product works. It's a hip and modern brand, and I think that's going to really benefit us for the long-term. I think it's pretty clear we're going to be up in the emerging segments.

Michael Lavery - Sidoti & Company, LLC

That's helpful. And your earnings, your EBIT margin was already positive in the fourth quarter, obviously, is there anything that could keep that from reaching the levels of the total Cigarettes business? I assume as you get scale, I think, you've said your gross margins are in line with cigarettes, is that something that, ultimately, would get at roughly parity?

Murray S. Kessler

Yes. I think, look -- I think, over time, there's a lot of costs associated with this product being made overseas, and shipping and there's real margin enhancement opportunities. On the other hand, the model that I think works, or we think works, is sort of this model of printers and ink. So I think the price of starter kits, over time, as technology gets better, while we'll get cost savings, you want to drive the price of starter kits down, and then, get the real long-term repeat business where you make great margins on the cartomizer. So there will be some factors that improve the margins and there will be some that challenge it. And also, I think the growth margins on it will be very good. But don't just assume that I'm going to milk this thing and take every dollar of profit I can right now. This is in early stages, and I intend to invest behind this. As I said before, you only get one chance to be first. So we're going to invest to make this a very big brand.

David H. Taylor

Said another way, don't expect us to -- in other words, expect us to spend behind that brand pretty significantly in 2013. In the short term, you shouldn't expect major profit contributions out of blu in terms of the components of our earnings.

Michael Lavery - Sidoti & Company, LLC

But you had some pretty heavy spending on merchandising and -- or merchandisers and the rollout in 4Q. So is it fair to think that -- are you talking about a level of investment that could mean downside to the -- I think, roughly, 18% margin you had in 4Q, or are you just saying to temper expectations for how -- where it goes up?

Murray S. Kessler

I think I'm trying to temper your expectations about where it goes up.

Operator

Your next question comes from the line of Ann Gurkin with Davenport.

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Two questions. One, continuing on the eCigs discussion, I get asked this and so I'm curious, Murray. Why do you have the confidence that this will be successful this time around? I mean, eCigs have been tried for years, I've listened to your comments on repeat purchases, and innovation and technology. I'm just curious why do you think it's going to stick this time?

Murray S. Kessler

I mean, honestly, Anne, I think the numbers speak for themselves. I mean, look at the results. I mean it's -- if you -- I'm having a hard time keeping up with orders. And it's not over a 2-month period of time. We have accounts that had been out there for a few years now. And every month, it increases and increases and increases. This is -- some people you're talking to are talking about what might be, I'm talking to you about what we're selling today.

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Fair enough. And then, second, CTP is supposed to submit a report to Congress regarding tobacco in April, how should we view that update? Is there anything we should think about as we get closer to that April time frame?

Murray S. Kessler

Was the question deeming regulations?

Ann H. Gurkin - Davenport & Company, LLC, Research Division

An update on progress in terms of regulating -- FDA regulating tobacco, I think something of an update to Congress or something?

Murray S. Kessler

That's not heavily on my radar screen. The only thing that is on the unified agenda or the FDA for the first quarter published for April is deeming regulations on eCigs and other tobacco products like cigars.

Operator

Your next question comes from the line of Vivien Azer with Citi.

Vivien Azer - Citigroup Inc, Research Division

My first question also has to do with blu eCigs. It sounds like the retail distribution has come in better than expected, but Murray, your comments about keeping up with demand that make me wonder a little bit how we should think about the sequential revenue trends as we move into the first quarter. I mean, was there so much build in 4Q that we should see a little bit of a deceleration, or you just -- there's so much demand that that's not going to be the case?

Murray S. Kessler

I think that both of your questions are correct. The fourth quarter included some build, a meaningful amount of build, but I think, sequentially, you'll see it continue to improve because demand is so solid.

Vivien Azer - Citigroup Inc, Research Division

Fair enough. My second question has to do...

Murray S. Kessler

But don't expect it necessarily to triple again next quarter.

Vivien Azer - Citigroup Inc, Research Division

Understood. My second question has to do with cigarette price realization. I hate to split hairs here, but given your commentary around the competitive landscape and the end price realization, if I look at cigarette price mix after I strip out MSA, FDA and tobacco buyout expense, which really did flatter, you actually got only 10 basis points of price mix, and that's the biggest kind of benefit from fees and things like that, that I can see in my model. So when you guys think about price mix realization internally, are you thinking about the 3.7% or are you thinking about the 10 basis points?

Murray S. Kessler

We're looking at each other on the 10 basis points to see how you got that. I mean, we do our price mix analysis and we believe we got 3.7% pricing realization in the quarter.

David H. Taylor

And the mix was not a big drag because you saw the trends on Maverick flatten.

Vivien Azer - Citigroup Inc, Research Division

Yes, I guess, I can talk to Bob about it off-line and walk through that soon enough.

David H. Taylor

We should take that off-line and look at your arithmetic.

Operator

Your final question comes from the line of Priya Ohri-Gupta with Barclays.

Priya Ohri-Gupta - Barclays Capital, Research Division

How should we think about your debt to EBITDA trending this year just given your guidance around earnings and, if I picture, it's the lower end of your target at this point?

David H. Taylor

I'm sorry, I don't really understand your question, Priya.

Priya Ohri-Gupta - Barclays Capital, Research Division

So you're at the lower end of your leverage target and you've said we should expect you to sort of move towards the middle of that range over time. Given your earnings guidance, it obviously gives you some capacity to add that this year. So should we expect you to stay at the lower half of your leverage target or should we expect you to be sort of in the mid to upper end, just with looking at...

David H. Taylor

You should not expect us to remain at the lower end of that range. I've given no indication that we're going to stay away from the debt market. I've given no indication that we want to stay at the lower end of that range. So yes, we have capacity to enter the debt market again and we evaluate those things regularly from time to time.

Operator

Thank you. I'd like to turn the call back over to Mr. Kessler for any closing remarks.

Murray S. Kessler

Well, thank you for your continued interest in Lorillard. I was pleased to see us finish the year well, the company back on track after a couple of challenging quarters. I think we have a good strong handle on what's going on, on the competitive situation. And we expect the company to continue to perform well and be successful in 2013. Thank you.

Operator

This concludes the Lorillard, Inc. Fourth Quarter 2012 Earnings Conference Call. For a replay of this call, please dial, domestically, (855) 859-2056 or internationally, (404) 537-3406. You can enter the conference ID number of 87738735. You may now disconnect.

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