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Lorillard Inc. (NYSE:LO)

Q1 2009 Earnings Call

April 27, 2009 10:00 am ET

Executives

Martin Orlowsky – Chairman, President and Chief Executive Officer

David Taylor – Chief Financial Officer

Nathan Owell – Investor Relations, Financial Dynamics

Analysts

David Adelman – Morgan Stanley

Nik Modi – UBS

Judy Hong – Goldman Sachs

Adam Spielman – Citigroup

Christine Farkas – Merrill Lynch

Ann Gurkin – Davenport & Company

Thilo Wrede – Credit Suisse

Operator

Welcome to the Lorillard Inc. first quarter 2009 earnings conference call. (Operator Instructions) I would now like to turn the call over to Nathan Owell from FD.

Nathan Owell

By now you should have received a copy of the company's first quarter 2009 earnings release. If you have not, please call our offices on 212-850-5600 and we'll be happy to send you a copy. The speakers we have on today's call are Martin Orlowsky, Chairman, President and Chief Executive Officer, and David Taylor, Chief Financial Officer of Lorillard Inc.

Before we begin, I would like to remind you that some of the comments made 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 the fillings with the SEC.

I'd now like to turn the call over to martin Orlowsky.

Martin Orlowsky

Lorillard's overall marketplace and financial performance for the first quarter of 2009 was positive despite the effects of the increase of federal excise tax effective April 1, 2009. Although wholesale has reduced their orders of cigarettes to minimize the increased tax owed on inventory held at the end of the quarter, Lorillard continued to reflect relatively strong results. I will provide a brief overview of how we performed despite this extraordinary event and then turn it over to David Taylor who will offer an update on our financial performance.

Comparing the first quarter of '09 with the first quarter of '08, Lorillard's total wholesale units shipped were down 7.6% and Lorillard's domestic units shipped was down 8.2%, and the domestic industries wholesale units shipped declined 10.4% for the same period. Adjusting these numbers for one less shipping day in the first quarter of '09 versus the first quarter of '08, Lorillard's domestic units shipped were down 6.7% and the industry was off by 9%.

Newport's wholesale units shipped were down 9.2% adjusted for the shipping date difference comparing the first quarter of '09 to the first quarter of '08. First quarter 2009 wholesale shipment shares for Lorillard and Newport were up .26 points and about flat respectively as compared with the same quarter year ago. At the retail level, this picture is slightly different. Lorillard's share improved 6/10 of a share and Newport was up .27 of a point for the first quarter of '09 versus the first quarter of 2008.

Total menthol share of retail for the first quarter of 2009 was 29.4% up .53 points over the first quarter of 2008. Newport's retail share of the menthol segment was 34.5% up 4/10 of a point for the first quarter of '09 versus the first quarter of 2008.

We believe that our first quarter 2009 performance continues to demonstrate the implementation of our longstanding strategy of balancing Newport's performance and profitability. We will continue to evaluate the market relative to Newport's performance trend as well as competitive action and make whatever adjustments we deem appropriate to achieve this balance between Newport's market position and profitability.

Now, I'm going to turn it over to David Taylor to review our financial performance.

David Taylor

Net sales for the first quarter of 2009 were $917 million compared to $921 million in the first quarter of 2008. This decrease of $4 million or less than 1% is the result of a decrease in units sold combined with the impact of higher net average selling prices. The company has taken several price increases since March 31, 2008, most recently on March 6, 2009 at which time we increased our wholesale selling prices by $0.71 a pack, which covers the increase in federal excise tax that became effective April 1 and improves margins.

As Marty mentioned, total units shipped in the quarter decreased by 7.6%, which is largely due to the reduction inventory by our wholesale customers. In addition, sales promotion costs accounted for as a reduction in net sales were higher in the first quarter of 2009 than in the first quarter of last year.

Gross profit increased by $19 million to $385 million or 42% of sales from approximately $366 million or 40% of sales in the first quarter of 2008, as the impact of the higher selling prices more than offset the impact of the decrease in units shipped. Amount due under the State Settlement Agreement declined as a result of the decline in used volumes.

Selling, general and administrative expenses decreased by approximately $9 million to $91 million in the first quarter of 2009 compared to last year. The 2008 quarter included a charge of $13 million related to the separation from Lowe's so all other SG&A expenses increased by about $4 million. This increase is primarily the result of higher legal fees, which were approximately $9 million higher in the first quarter of 2009 than in the prior year period.

As in prior quarters, this increase in legal cost is primarily the result of higher defense cost for the Engle prodigy cases underway in Florida among other things. A decline in other marketing expenses, such as direct marketing and point of sale materials, of $5 million partially offset this increase in legal costs.

So operating income increased by about 11% to $294 million or 33% of sales in the first quarter of 2009 from $266 million in the first quarter of last year. That investment income was $1 million for the first quarter of 2009 as compared to $9 million in the first quarter of 2008. This $8 million decline is the result of lower average yields in 2009 as compared to 2008.

Our effective income tax rate for the first quarter of 2009 was 37.7% as compared to 36.8% in the first quarter of 2008. This increase is primarily due to an increase in our effective state tax rates. We expect that this rate approximates our effective tax rate for the 2009 fiscal year.

Net income for the first quarter of 2009 was $184 million or $1.09 per share compared to $174 million or $1 per share for the first quarter of 2008. As in prior quarters, the board will take up the matter of a quarterly dividend in the next few weeks and you should expect an announcement shortly thereafter.

With that, we'd like to open the line for questions. Operator, can you help us with that?

Question-and-Answer Session

(Operator Instructions) Your first question comes from David Adelman – Morgan Stanley.

David Adelman – Morgan Stanley

You mentioned in the release, macroeconomic pressures and I'm just curious do you think at this point you're seeing any visible impact on the business from the economy?

Martin Orlowsky

No, we're not. Obviously, the economy is not good so that statement was only meant to reflect the general nature of the economy. We're not experiencing, to our knowledge anyway, any specific implication from that.

David Adelman – Morgan Stanley

With regard to the federal excise tax increase, Marty, can you give us a sense of your read of the initial impact of it on consumer behavior and Newport's performance?

Martin Orlowsky

I think it's a bit premature to reach any kind of conclusion or have frankly any real insight in terms of what's occurring as a result of the federal excise tax increase. Obviously, at the wholesale level there was some initial readjustment of the inventory levels but that certainly doesn't reflect consumer takeaway and it would be premature to, frankly, virtual impossible to reach any real conclusion.

David Adelman – Morgan Stanley

Can you quantify for us how much you think trade inventories came down for Lorillard in the quarter?

Martin Orlowsky

We think about at least four days worth of inventory was affected as we moved through the end of the quarter.

David Adelman – Morgan Stanley

Did that rebuild early in Q2?

Martin Orlowsky

It started to rebuild, yes.

David Adelman – Morgan Stanley

Okay, and then a couple of other quick things perhaps for David. David, your cost of goods sold excluding the settlement cost and excluding the federal excise tax were flat in the quarter despite volumes being down. Why was that the case? Why wasn't cost of goods sold down?

David Taylor

Well, there's a couple of factors at work, David. I think we talked in our last conference call, as well as in the 10-K, about an increase in pension cost that we expect to see in 2009 compared to 2008 because of the performance of the assets in the pension fund. That increase is significant.

I think we talked about it in the 10-K approximating $23 million a year so you've got one quarter of that impact impacting cost of sales, as well as higher input costs, the primary input being raw tobacco and we'll see the impact on cost of sales of that higher raw material cost in the first quarter. Those two things are the primary impacts on cost per unit.

David Adelman – Morgan Stanley

Okay, and then lastly can you comment on why there has not been the authorization of a new share repurchase program?

David Taylor

I don't think we can comment as to why, but there has not been now and when we have news to that end, we'll make the announcement.

David Adelman – Morgan Stanley

Is there anything that's precluding you from buying back your stock?

David Taylor

There's nothing precluding us from buying back our shares that I'm aware of.

Operator

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

Nik Modi – UBS

Just a quick question if you can provide any perspective on the mix match between what you shipped to wholesale and what wholesale shipped to retail during the first quarter.

Martin Orlowsky

When you say mix match, what do you mean?

Nik Modi – UBS

Well, clearly there was an inventory issue in the first quarter so I'm just curious what the delta was or if you can provide any perspective on the delta between what you shipped to the wholesalers and what the wholesalers shipped to retail, just to get a sense of –

Martin Orlowsky

Well, our retail share was higher than our wholesale share, so clearly there were more goods shipped from the wholesaler to the retailer. I shouldn’t say more goods necessarily. The share was higher, the actual level of retail shipments to retail for us was off actually was up 2.8% a lot of that driven by Maverick.

Nik Modi – UBS

Okay, and Newport, Marty, I'm kind of estimating roughly wholesale to retail is in the kind of flattish range, would that be a fair assumption.

Martin Orlowsky

That's fair.

Nik Modi – UBS

Okay, so just to get that straight, so you're overall shipments in the quarter were down 8 to 9 but the wholesale to retail number was basically up 2 to 3.

Martin Orlowsky

That is correct.

Nik Modi – UBS

Okay, so there is a huge delta there, and so would you expect that to reverse or has it reversed already in April or you're just starting to see evidence of that.

Martin Orlowsky

We really don't know. It's too soon to tell.

Operator

Your next question comes from Judy Hong – Goldman Sachs.

Judy Hong – Goldman Sachs

Marty, I know it's a little bit premature but is there any reason to think that the price elasticity is any different this time post the March price increases and just terms of the consumer behavior. And then secondly, is there any color in terms of your share performance after the March 6 price increases. We've heard that the price gaps in the industry had widened a little bit into the latter part of the year, sorry latter part of the quarter and I'm just wondering if you've seen some share impact as you got into the latter part of the quarter.

Martin Orlowsky

Well, to the first part of your question I have no answer. I have no idea what the elasticity relationship is post the tax increase. I think we'll see it'll take some time. It's going to take almost I anticipate it'll take two to there months for us to see any real trend formation if there's any change or whatever. So I think the next time we'll speak to that will be three months from now, roughly. As far as the share change, I'm not sure I understood your question.

Judy Hong – Goldman Sachs

I mean it seems like maybe post the March 6 price increases from you and from PM USA that maybe the deep discounters really hadn't followed as quickly so the gap's kind of widened towards latter part of the quarter and if you've seen any dislocation to your share performance towards the latter part of the quarter as the gap widened.

Martin Orlowsky

I can't give you a specific answer but my answer to that would be it's unlikely that there was any significant impact one way or the other. The period was three weeks or so it's too short a period for anything to really establish itself and have any kind of real impact, so I doubt that there was any substantial, if any, impact on the share differential.

Judy Hong – Goldman Sachs

Okay, and then on Maverick in the quarter, again, another strong buying growth there. Was any promotional timing or anything different about Maverick in the quarter or is this just basically the ongoing growth that we've seen from this brand over the last several quarters.

Martin Orlowsky

It's actually the ongoing trend. We don't promote the brand above and beyond it sells for the price that we sell it to the wholesalers and what they charge retailers. So we're not doing buy downs on Maverick. We have no special promotions on Maverick. Maverick's growth is essentially organic and related to its price point as it existed for retail sector.

Judy Hong – Goldman Sachs

Okay, and then, David, on the share buyback question if I can follow up here, historically you've talked about an opportunity to still lever up the balance sheet you didn't know really when that would be. Is it still your intention to take leverage on the balance sheet or at this point are you leaning now towards more using the cash at hands and the free cash flow generation for share buybacks?

David Taylor

Please don't read too much in the absence of announcements today about enhanced or change in strategy about use of the balance sheet or use of cash. So I can't really tell you how we're leaning one way or the other, but don't read too much into the absence of an announcement today about that.

Operator

Your next question comes from Adam Spielman – Citigroup.

Adam Spielman – Citigroup

Have you seen any change in intensity in competition in the menthol segment in the quarter you have just reported on?

Martin Orlowsky

Not really. The only change of sorts is the active support that Reynolds American has applied behind your Camel Crush product. There is a fair amount of pipeline activity behind that line extension and a fair amount of promotion support. Other than that, we have not seen any substantial difference.

Operator

Your next question comes from Christine Farkas – Merrill Lynch.

Christine Farkas – Merrill Lynch

David, back to the COGS comments you talked about leaf inflation in the first quarter. We are to, of course, assume that this inflation would carry throughout 2009 and not just a first quarter phenomenon, correct?

David Taylor

Yes.

Christine Farkas – Merrill Lynch

And then on the marketing spend you were clear about some costs being lower year-over-year or what were the impacts from a year ago, but we did see $5 million in reduced marketing spend. Was there something you've actually spent less on or was this more about, again, comps year-over-year and what was spent a year ago?

David Taylor

Its comps year-over-year in timing to a big part of that was the amount that we may have spent on catalog drops [inaudible] and other things so some of that's timing. So I don't know that we will see that kind of comp moving forward through the remaining quarters.

Christine Farkas – Merrill Lynch

And then, Marty, just looking for some comments on your smokeless program, what the learning's are, how that's going, and what your views are for that program going forward.

Martin Orlowsky

Well, I think we're experiencing a similar pattern as some of our competition as marketing or test marketing [SNUS] products. It's a relatively low level of interest that's being expressed by the consumers and we're just monitoring the situation as we move forward. I really don't have anything very specific to report. There have been no major changes to the consumer perceptions of that product.

Operator

Your next question comes from Ann Gurkin – Davenport & Company.

Ann Gurkin – Davenport & Company

David, in your comments I think you said that sales promotions were up this quarter versus last quarter. Did I hear that correctly?

David Taylor

Yes. We account for various consumer promotion activity in two places in the income statement that says buy downs gets recorded as a reduction of revenue and those amounts were increased in the first quarter '09 compared to the first quarter of '08, that's correct.

Ann Gurkin – Davenport & Company

Okay, and can you give us any more detail like market or brands?

David Taylor

No, I really can't. We try to steer clear of both quantifying and describing too specific our exact marketing programs, but we can tell you that it was an increase in the amount spent for retail buy downs in the first quarter of '09.

Ann Gurkin – Davenport & Company

Then my second question is it's been my understanding one of your key measures is market share gains and is that still part of your strategy to continue to gain share and are you changing the balance between share gain versus profitability. Can you just give an update on that strategy?

David Taylor

We haven't changed anything. In fact, the point that we've modestly increased the buy down level in promotion is simply an extension of what we've been doing frequently in the past. So there really isn't anything new to be assumed by virtue of that information. So, no, we haven't changed anything.

Operator

Your next question comes from Thilo Wrede – Credit Suisse.

Thilo Wrede – Credit Suisse

Could you give us an idea of how the inventory stocking by wholesalers how that proceeded throughout the quarter. Did that happen all throughout the quarter or just towards the end and did wholesalers maybe stock up at some point in the quarter.

David Taylor

Thilo, it happened really toward the end of the quarter where the price increase for Lorillard went into effect. Really, you saw the major inventory adjustment happen in March.

Thilo Wrede – Credit Suisse

Your market share in the western half of the country I think you're under indexing there and have you seen any improvement in market share in the west over last nine months or so since you responded from those.

Martin Orlowsky

Well, our market share's been consistent across geography and we're not going to comment specifically on the west.

Operator

(Operator Instructions) Your next question is a follow-up from David Adelman – Morgan Stanley.

David Adelman – Morgan Stanley

Can you talk about the trajectory of your Engle progeny defense cost. Has that reached a level now where you think on a sequential basis it will be fairly stable or is it likely given sort of what you know and have visibility on in terms of the potential trial count or to continue to escalate from here.

Martin Orlowsky

Well, David, you know very well that the costs directly correlate to the number of trials there were and/or the activities surrounding those trials. So we have no crystal ball to, we know up to a certain point in time what the trial schedule is going to be. That changes often and so it's very difficult to sort of guesstimate what the trajectory would be with respect to that.

The only thing I can say is we've experienced over the last year or so it's, obviously, increased. I will say at some point, and I don't think we're there yet I don't know, at some point there will be some leveling off because it will be impossible to see the increases in trial activity in geometric terms. But right now it's hard to estimate where it's going to come down.

David Adelman – Morgan Stanley

Can you talk about your MSA accrual rate? It looks like even from the average level for all of '08 in this quarter you're up about 5%.

David Taylor

I don't think that's right, David.

David Adelman – Morgan Stanley

On a per pack rate.

David Taylor

I'll have to get back to you on that.

Martin Orlowsky

Well, on a per pack rate that may be because we sold fewer packs.

David Taylor

It's due to the formulas in the agreement but up 5% doesn't make a whole lot of difference compared to prior quarters, so I'll have to get back to you on that.

David Adelman – Morgan Stanley

Lastly, Marty, I think of the premium menthol segment Newport today might have a 43 or 44 share. Over the long-term, what do you think that that can approach?

Martin Orlowsky

Well, I hate to give you a number, David then you'll hold me to it.

David Adelman – Morgan Stanley

Is there any reason that over time it can't be ten share points higher over the long-term?

Martin Orlowsky

What the exact number is I don't know, obviously. But clearly I said in the past that we still feel that there's opportunity for growth in that segment and we continue to demonstrate that. So how high is up, I can't really answer that?

Operator

Your next question is a follow-up from Adam Spielman – Citigroup.

Adam Spielman – Citigroup

Very quick question about New York State and the excise tax because obviously this quarter consumers were paying an extra $1.25 compared with the year ago quarter. I was wondering if there were any ways in which this affected your business and whether your share was helped by it or hurt by it in New York State.

Martin Orlowsky

Our share pretty well held up so volumes certainly were affected to some extent, but what happens smokers can go to adjacent states and buy at different pricing. So, it's kind of hard to really zero in and determine exactly what the effect is, but our shares held up very well in New York State our volumes are down somewhat.

Adam Spielman – Citigroup

When you said held up well, does that mean to say that it's actually done slightly better in New York State than other states or do you think it's done slightly worse but nonetheless decently.

Martin Orlowsky

No, not compared to any other state necessarily, it's compared to itself on a trend line basis. So, we're not seeing a diminishing share of picture relative to New York on its own trend line.

Operator

At this time, there are no additional questions. I would now like to turn the call back over to Mr. Nathan Owell for closing remarks.

Nathan Owell

Thank you everyone for joining us today. This concludes Lorillard's first quarter earnings call. We look forward to talking to you next quarter.

Operator

Ladies and gentlemen, this concludes the presentation. You may now disconnect. Thank you and have a good day.

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