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Reynolds American Inc. (NYSE:RAI)

Q1 2009 Earnings Call

April 29, 2009 9:30 am ET

Executives

Morris Moore - VP of IR

Susan Ivey - Chairman, President and CEO

Tom Adams - CFO

Analysts

Nik Modi - UBS

Thilo Wrede - Credit Suisse

Judy Hong - Goldman Sachs

David Adelman - Morgan Stanley

Adam Spielman - Citigroup

Christine Farkas - Merrill Lynch

Erik Bloomquist - JPMorgan

Ann Gurkin - Davenport & Company LLC

Operator

Welcome to the Reynolds American first quarter 2009 Earnings Call. (Operator Instructions).

At this time, for opening remarks and introductions, I would like to turn the conference over to Mr. Morris Moore, Vice President of Investor Relations. Please go ahead, sir.

Morris Moore

Good morning. Thank you for joining us. Today, we'll discuss Reynolds American's results for the first quarter and our full year outlook. We'll discuss our results on both a reported and adjusted basis. A reconciliation of reported to adjusted earnings is in our press release, which can be found on our website at ReynoldsAmerican.com.

Joining me this morning are RAI's Chairman and CEO, Susan Ivey, and our CFO, Tom Adams. Before I turn the call over to Susan, I need to cover the Safe Harbor provisions.

During the call, we'll discuss forward-looking information. When we talk about future results or events, a number of factors could make results materially different from our projections. These factors are in our press release and our SEC filings. Except as provided by Federal Securities laws, we are not required to publicly update or revise any forward-looking statement whether as a result of new information, future events or otherwise.

Now, I'll turn the call over to Susan.

Susan Ivey

Good morning. It is clear from our first quarter results that Reynolds American's total tobacco business model and strategy continue to provide a strong foundation for building shareholder value, even in difficult times.

The first quarter of 2009 was marked by significant shifts in tobacco industry pricing and wholesale and retail inventory levels as well as continued economic challenges. But, Reynolds American showed resilience, performing well in a rapidly changing environment, despite unusually high industry-wide volume declines in the first quarter.

We made solid gains at both our reportable business segments with higher adjusted margins and operating income, and share growth on key cigarette and moist-snuff brands. Our companies also continued to introduce product innovations to meet changing consumer preferences.

Reynolds American's first quarter results reflect the fundamental strength of the company and its total tobacco business model. R.J. Reynolds continued to strengthen its core cigarette business, and maintained its focus on strict cost control while developing new product innovations for long-term growth. Conwood maintained its momentum with strong share growth in the moist-snuff category.

Despite intensified competitive discounting and promotion, Grizzly, which is now the nation's best selling moist-snuff brand delivered exceptional share growth, gaining 2.6 share points over the prior year quarter. As we expected, it was a challenging quarter on the external front.

Unprecedented increases in Federal tobacco excise taxes took affect April 1. These tax increases drove major changes in industry pricing, as well as significant first quarter wholesale and retail trade inventory reductions. The tax increases and pricing changes also triggered trademark valuations, which resulted in non-cash impairment charges on some non-growth brands.

We continued to see excise tax activity this year at the state level as they seek ways to close their budget gaps. Since the 1st of the year, three states have raised cigarette taxes, and we will likely see additional increases this year. Tobacco tax increases are regressive. They're disproportionately paid by lower income Americans, and they're especially hard-hitting in a time of recession. We will continue to support adults who enjoy tobacco by vigorously fighting tobacco tax increases.

We have also seen an increased focus on efforts to establish Federal regulation of the tobacco industry. The House of Representatives passed the Waxman bill earlier this month. That bill was originally put on the calendar in the Senate. It now will be considered in the Senate Health Committee, and the timing is uncertain.

We remain hopeful that an alternative bill that was introduced in the Senate earlier this year, and which includes meaningful harm reduction measures will be considered during this process. As we've said before, we would support reasonable, comprehensive legislation, provided that it addresses the significant differences in risks between various tobacco products, and that it provides for a competitive environment that doesn't disadvantage our company's ability to meet the desires of adults who enjoy tobacco.

Next, I'll provide an update on the NPM adjustment. At this point, $2 billion covering 2003 through 2006 are in dispute. R.J. Reynolds continues to seek resolution of these disputes through arbitration or settlement with the state's Attorney General. If a settlement isn't reached, we expect national arbitration of the NPM adjustment to begin this fall.

So, that's an external update. Now, let's take a closer look at our business performance during the first quarter. R.J. Reynolds delivered higher adjusted operating profits and margin, as higher prices and productivity helped to more than offset the decline in cigarette volume and higher pension expense.

The company also continued to grow share and expand the appeal of its two growth brands, Camel and Pall Mall. The company's latest cigarette innovation, Camel Crush, is adding strength to the brand.

Camel crush is gaining appeal among both regular and menthol adult smokers. They enjoy its fresh menthol taste, which is available on demand. Camel Snus, R.J. Reynolds first modern, smoke-free tobacco product expanded nationally in the first quarter. And R.J. Reynolds first dissolvable product, Camel Orbs was introduced in three lead markets.

Turning to Pall Mall, R.J. Reynolds continued to leverage the brand high-value appeal as a longer lasting, quality cigarette at a reasonable price. Refinements to the brand's promotional strategy are generating high levels of trial and conversion. Pall Mall's latest promotion cycle began in mid-March, which coincided with significant price increases on other cigarettes. This timing gives Pall Mall the opportunity to provide consumers with even more of the value they seek. Pall Mall posted strong volume in share increases during the quarter, and we expect the brand to gain additional ground.

In the first quarter, R.J. Reynolds continued to focus on streamlining its structure and its product portfolio, improving productivity and reducing complexity. Last year's restructuring is already generating savings, while freeing up resources to enhance the company's focus on innovations to drive growth. All these efforts give R.J. Reynolds a strong platform for future success.

Turning to Conwood, the company again reported a strong quarter. With volume and share gains contributed to a higher adjusted margin and profits. Factoring out inventory adjustments, moist snuff category volume continued to grow at about 7%, in line with historical trends. And Conwood continued to post significant gains on Grizzly. Grizzly continued to capture more than half of the category's total volume growth and grew 2.6 share points over the prior year quarter. Grizzly's strength was especially evident in the southeast, where competitive discounting significantly reduced the price gap to premium brands while competitive value brands intensified their promotion.

Despite those dynamics, Grizzly continued to post strong share gains without lowering its price or increasing promotion. In addition, Grizzly expanded its offerings and appeal with the national introduction of two new [pall] styles. Mint and straight. Conwood's premium Kodiak brand lost share in the first quarter but the company has reduced Kodiak's price to bring it in line with other premium brands and this should benefit Kodiak going forward.

As we've stated, Conwood is focused on building its position in the premium segment. To that end, the company plans to leverage the strength and heritage of the Camel brand by introducing two styles of Camel Dip this summer. Camel Dip features a new to the market wide cut tobacco and innovative high quality packaging.

Turning to taxes, we don't expect the federal excise tax increases on smokeless and other tobacco products to have a negative impact on Conwood's growing moist snuff business. In fact, the disproportionately higher federal tax increase on cigarettes along with price reductions on premium moist snuff brands has given an even greater price advantage to the moist snuff category.

While these factors benefit moist snuff, the federal tax increases on roll your own tobacco and little cigars remove the significant price advantage that those products had. Conwood expects a negative impact on those products. In addition, higher prices are likely to accelerate declines on Conwood's loose leaf, plug, twist and dry snuff brand.

This impact on non-focused segments as well as the reduction in Kodiak's list price will negatively affect Conwood's year-over-year earnings. But we're confident that the company will continue to perform well with strong gains on Grizzly, improvements on Kodiak volume and further growth from product enhancements and innovations. So, the first quarter did have its challenges. But both our operating companies performed well.

For the full year, we anticipate adjusted EPS in the range of $4.15 to $4.45. I would point out that this excludes any trademark impairment charges, but it does include the year-over-year negative impact of higher pension expense. In summary, Reynolds American had a good first quarter and I'm pleased with our results. I believe our companies have the strategies and resources to face the challenges and seize the opportunities as we work through the year.

And now, Tom will provide more details about our performance.

Tom Adams

Thanks, Susan, and good morning. As you heard from Susan, our companies maintained their stability in a turbulent quarter with gains in adjusted operating earnings and margins and growth on key brands. As I talked about our performance, I'll focus primarily on adjusted results to provide perspective on our business fundamentals. I'll remind you that the reconciliation of adjusted to reported results is in our press release, which is on the Reynolds American website.

As we announced this morning, RAI reported earnings per share of $0.03 in the quarter. That compares with the reported earnings per share of $1.71 in the prior year period. Two big factors accounted for that difference.

First, you'll recall that last year, RAI recorded a first quarter gain of $0.71 per share from the termination of the Gallaher joint venture. This year, first quarter tobacco taxes and pricing adjustments drove non-cash trademark impairment charges of $0.97 per share. Excluding those factors, REI's adjusted first quarter earnings were $1 a share for both quarters.

Driving this year's first quarter earnings were higher pricing and productivity at both R.J. Reynolds and Conwood, which more than offset a larger than normal decline in cigarette volume, and higher year-over-year pension expense of $0.10 per share.

First quarter earnings also included $0.09 per share from non-operational factors, such as lower interest income and higher expenses on some financial items. So, despite the difficult economy and rapidly changing industry dynamics, Reynolds American's focus on productivity and innovation generated underlying growth.

Now, turning to R.J. Reynolds'. Excluding pre-tax non-cash trademark impairment charges of $377 million, the company's adjusted first quarter operating income was $459 million. That was up 7.7% from the year ago quarter.

R.J. Reynolds continued to improve its margin with a gain of 3.9 percentage points. That brought its adjusted operating margin to 27.5%. Driving those results were higher pricing and productivity, which more than offset a cigarette volume decline of 10.5%. Excluding the impact of wholesale inventory reductions, the company's volume would have been down 8.1%.

Notwithstanding its volume performance, R.J. Reynolds increased its adjusted earnings and margin, and gained market share on its two growth brands. R.J. Reynolds total cigarette market share was 27.7%, down 0.7 from the year-ago quarter.

Camel and Pall Mall, the company's growth brands had a combined share of 10.5%, up 0.8 of a point. The Camel family posted modest growth, up 1/10 of a share point to 7.6%, with Camel's menthol styles up 4/10 of a share point in the first quarter.

Camel Crush, which was introduced in the third quarter of 2008, had a first quarter share of 6/10 of a percent. Camel Crush has achieved this with only one style, and relatively low levels of promotion. Pall Mall was up 6/10 of a point at 2.9%, as refinements in its promotional strategy sustained high levels of trial and conversion.

Turning to Conwood. First quarter adjusted operating income was $84 million, up 3%. That excludes trademark impairment charges of $76 million. The company's adjusted operating margin was up 1.7 percentage points at 50.5%.

Conwood's moist-snuff shipments to wholesale grew 7/10 of a percent over the prior year quarter, which reflected significant inventory reductions associated with tax increases. Conwood's total market share was 28.8%, up two full percentage points from the prior year period.

Driving Conwood's results was the strong performance of Grizzly, which continued to post significant share growth. Grizzly's first quarter market share was 24.7%, up 2.6 share points. Contributing to Grizzly's growth were two new pouch styles that were introduced in the first quarter. These new styles contributed 4/10 of a share point with Grizzly's remaining 2.2 percentage point gain coming from the brand's core styles.

As we've noted, there was a significant first quarter reduction in trade inventory levels across the tobacco industry due to the timing of the Federal excise tax increases. But, as we expected, in April, we've seen above average shipment volume, as wholesale and resale cigarette and moist-snuff inventories return to more normal levels.

Now, I'll provide additional details on RAI beginning with an update on our share repurchase program. Total repurchases under the $350 million share repurchase program which ends tomorrow, came to $207 million. We have no plans for another repurchase program at this time.

Turning to our pension, as we indicated in our last call, we plan to contribute $50 million to RAI's pension fund, and we made that contribution this month. With respect to cash, we ended the quarter with $3.1 billion, and after making MSA payments of $1.8 billion this month, RAI still has well over $1 billion in cash.

R.J. Reynolds' total MSA obligation for 2009 was $2.1 billion. As allowed under the MSA agreement, the company withheld $406 million for the 2006 NPM adjustment.

At this point, the total amount of NPM adjustments in dispute is $2 billion for 2003 through 2006. We also have a debt maturity of $200 million coming due on May 15. We will pay that out of our existing cash. Also, in the first quarter, RAI entered into interest rate swap arrangements that effectively locked in a 4% interest rate on $1.6 billion of debt that have maturities ranging from three to eight years.

So, that's an update on several key items. As we have announced, Reynolds American expects full year adjusted EPS of $4.15 to $4.45. This excludes any trademark impairment charges but includes our year-over-year increase in pension expense of $0.40 per share.

With respect to our dividend, I want to reiterate RAI's commitment to returning value to shareholders through our dividend, which is $3.40 a share on an annualized basis.

So, in closing, we're pleased with RAI's performance in the first quarter. The strength of our balance sheet and our focus on innovation and productivity serve us well as we remain committed to building value for our shareholders.

We'll now turn to the Q&A portion of the call. Darryl, would you remind our callers how to get into the queue.

Question-and-Answer Session

Operator

(Operator Instructions). We'll take our first question with Nik Modi with UBS.

Nik Modi - UBS

Just a couple of questions. First, on the Camel Dip. Over the past few years, you've talked about Camel being really appropriate for Snus, now that you're going into the traditional market MST, just curious as to what the initial consumer research that you've done around the transferability of the Camel brand has come up with so far? And I understand, obviously, test market is on its way but just curious on your initial thoughts there.

Then, I just want to drill in on the buyback. It seems you guys are obviously generating a ton of cash flow. I would say the stock is not at crazy expensive levels these days. I just wanted to understand that a little bit more.

Susan Ivey

Sure. I'll talk a couple of minutes about Camel Dip. Our consumer research is actually very encouraging. The consumers validate that Camel has a strong heritage in tobacco pleasure, and that we believe the Camel trademark can bring innovation into the premium category of moist.

So, we will go into a couple of test markets, Colorado and Florida this summer and get a read on that. As you heard me describe, we have a wide cut, and we have some innovative packaging which we hope will bring some new life to the premium segment, and at the redefined premium segment price point.

Nik Modi - UBS

Susan, quickly on that, what is, in your view, the difference between the Camel brand and the Marlboro brand? Clearly, Marlboro was a flop. So, I just wanted to see if you had an opinion on that.

Susan Ivey

Nik, I believe that Camel has proved through its national expansion of Snus and the learning's that we had in those lead markets can encompass total tobacco. Most important aspect is to ensure that you have a great product in the segment, and using Conwood's expertise in product development for moist, and the Camel trademark, we believe it is a winning combination.

Tom Adams

Nik, on the share repurchases, we actually have an eye towards maintaining liquidity at this point. I mean, to go out and refinance debt. I've mentioned in my remarks that we've got $200 million due in May and another $300 next year. If we were to continue to execute a share repurchase program and then have to refinance that, the refinancing costs could be 9.5%, 10% in today's environment. So, we just thought it was better return for shareholders to actually buy down that debt and not incur the additional interest expense.

Nik Modi - UBS

I guess that makes sense on the refinancing part, Tom, but just in terms of completing the existing program, it just seems that with the cash you had on hand, you could have completed the program for this April 30 deadline. Any thoughts on that?

Susan Ivey

We obviously have a different view on that, and we were looking towards preserving some liquidity. This doesn't preclude us from doing something in the future, but at this point, we're going to hold our hand tight and just see how things unfold.

Operator

We'll take our next question with Thilo Wrede with Credit Suisse.

Thilo Wrede - Credit Suisse

A quick question on the EPS guidance you gave. What has really changed since the beginning of the year that you feel more comfortable now to give that guidance?

Susan Ivey

I think the biggest thing that's happened actually is of course, the tax increase has occurred, and the pricing changes have been made. As we said in our remarks, it is a pretty wide range of guidance, because we've seen, in the first quarter, the trade de-loaded. In April, they are re-establishing inventories. It will be the next couple of months when we actually see the consumer's reaction to this tax increase, and how does their behavior change.

So, we will certainly have even more clarity as we complete the second quarter, but we wanted to provide that guidance because that is our view, and obviously that's a wide view, but we feel very confident and we feel very confident with the dividend and we wanted that to be clear to our investors.

Thilo Wrede - Credit Suisse

With that in mind, can you give us a little bit more of an idea what the underlying assumptions are for the guidance. Where do you see your volume going for the year? Where do you see the industry going for the year?

Susan Ivey

I really rather not, Thilo, because again, that would have very wide ranges about it. Fortunately, this is a product that consumers buy just about everyday, and therefore we will be able to see how consumer behavior evolves in the very near term. Then, we'll be able to provide you clarity and we'll certainly keep you posted on that.

Thilo Wrede - Credit Suisse

Then a question on Camel Crush. It seems to be holding its share very nicely. I don't think it is growing share very much anymore, at least on a sequential basis. How is your menthol market share changed, and how do the plans for menthol look going forward?

Susan Ivey

We've seen Camel's menthol share grow. We see camel crush at about 6/10 of a share. Last year, obviously, it was launched nationally. We did not do a lot of promotion. It is now having a small level of promotion because there is still quite a bit of trial to be generated on Crush. So, we believe that Crush has more legs. We have great results from our buyer study. Consumers are enthusiastic about the fresh menthol and menthol on demand aspect of the variant. So, our expectation is that we'll continue to see growth this year.

Thilo Wrede - Credit Suisse

One last question on Camel Snus. Is the national rollout complete now? Is Suns in every point-of-sale where you want it to be?

Susan Ivey

I would say almost. The national rollout is almost complete. Obviously, as we were rolling it out in the first quarter, the price changes happened, and of course, the trade marketing teams had to help the retailers get through those price changes. But we are national. We're not in every store in every city where we want to end up, but we continue to be encouraged.

We think the timing is also very good for adults who are looking for an alternative either when they can't smoke but also when you look at the price point of Suns because it is taxed at the moist-snuff level. It has a very compelling price point. We're out there with trial programs with Camel Snus and we'll watch that. It is early days, but obviously, we had the confidence to go national because of the result of our rollouts over the last couple of years, and we'll keep you posted.

Operator

We'll take our next question with Judy Hong with Goldman Sachs.

Judy Hong - Goldman Sachs

Susan, if you adjust for the inventory destocking, what would the industry volume decline have been in the quarter?

Susan Ivey

If you exclude the inventory?

Judy Hong - Goldman Sachs

Yes. You gave us your number for what your volume would have been ex-inventory destocking, so I'm wondering what the industry number would have been ex-inventory?

Susan Ivey

We don't have a number that does a consumer takeaway. We don't really have that comparison. I think the numbers aren't really that meaningful to be honest. You saw the trade loading up through the second week of March. You saw them de-load as fast as they could, and now we look for the consumer response to that. So, I don't really have a consumer compare number.

Judy Hong - Goldman Sachs

Is it fair to say though that the inventory destocking on your brands were below the industry-wide inventory destocking, because if you look at your shipment share, it was relatively flattish, but if you look at the retail share you're down on a year-over-year basis.

Susan Ivey

Yes. At the wholesale level, it is fair to say that we were not unloaded at quite the same levels. We didn't come into the quarter loaded either. So, I think that had an impact.

Judy Hong - Goldman Sachs

Susan, if we look at the industry mix in the quarter, it looks like premium is down and lost shares as a percentage of the industry-wide mix. How concerning is this? Is this more also a reflection of the inventory movement or are you seeing more accelerated down-trading at the consumer level?

Susan Ivey

I think there are two things. One, on the shipment basis, a lot of the low price players did not take their price increases until the time of the tax. So, in the last couple of weeks of March, the only thing that was shipping to wholesale was some of the non-big three brands. So, I think that skewed the shipment date a little bit.

We do see on an off-take basis, I think 3/10 to 4/10 on a year-over-year, or even 3/10 from the fourth quarter increase in the non-big three arena, and how much of that is just due to the economy because most of that is being read prior to the price increase. Again, it is early days.

It is certainly not a runaway number. So, I think that's good news. Consumers have to navigate their way through these price changes in the next couple of months, and if you think about that behavior, I talked about, you know, a lot of people buy a pack every day. So, do they try some very low price cigarettes, and then not find that satisfying and come back to their usual brand? Do they smoke a few less cigarettes of their usual brand? Do they modify their behavior at all? That's what we'll find out here in the next couple of months.

Judy Hong - Goldman Sachs

Okay. Then a follow-up on the menthol segment. If you include Kool, and you look at your menthol on a collective basis, what would your share change have been within the menthol segment, for your menthol brands?

Susan Ivey

Judy, I don't have that number off the top of my head. Morris, can certainly follow-up with you. Obviously Kool is down year-over-year because the promotional mix for Kool has changed. But, we are satisfied actually, with the way that Kool is holding up, ex the promotional free goods.

As you know, the other change in the industry promotion mix with the implementation of this tax is there are no more free goods out there. So, things are being done with pricing, obviously dollars off to multipack, but no more free goods. So, that will manifest itself we expect going forward.

Judy Hong - Goldman Sachs

Tom a question for you. In terms of the other expenses, the $19 million of expenses and you've talked about some of these expenses below the operating line, can you explain what that was, and is it sort of a one-time expense or do we expect to see this going forward?

Tom Adams

At the end of my remarks, I talked about that we would fix the rate on $1.6 billion of our debt at 4%, and when we de-designated those hedges to fix that in, we had a mark-to-market adjustment, which was non-cash in the range of about $15 million on those swaps, and those the lions share of that. It is non-cash, Judy, and we expect to recover the cash over the period that the rate is fixed.

Operator

We'll take our next question with David Adelman with Morgan Stanley.

David Adelman - Morgan Stanley

Susan, first on Conwood. Do you think it is unlikely that Conwood will grow its underlying operating income this year?

Susan Ivey

Yes. As I said in the remarks, we're very confident in the moist-snuff business, but we are concerned about what happens to the roll-your-own and the other ATP products. It is early days again. We don't know exactly where those roll-your-own customers and little cigar customers will land. Will they land back in the conventional cigarette world? But, we are planning that for those declines, and the net impact of that will be a decline in Conwood's year-over-year earnings.

David Adelman - Morgan Stanley

It is about 3/4 more or less of Conwood's operating income from moist-snuff?

Susan Ivey

Roughly.

David Adelman - Morgan Stanley

Okay. And then, how are you thinking about the pricing strategy, Susan, on Grizzly, because, you know, obviously from the top down, premium prices have been cut, but at least for the time being, you're absorbing the FET increase on Grizzly.

Susan Ivey

That's right, David. Obviously, we followed the southeast market very closely. That was the first market where the premium price reduction was being tested. We really wanted to have a full assessment of how Grizzly performed in that environment. And then, of course, to get a little bit of a view of what happens now with the national price reduction of $0.62 at least and how does that flow through to retail prices vis-à-vis margins, et cetera.

Grizzly has performed very, very well. We did absorb the tax to ensure that we didn't find ourselves in a disadvantaged position, but it is something that we'll continue to monitor as we're very pleased with Grizzly's demonstrated strength in this environment, and we'll be watching that closely.

David Adelman - Morgan Stanley

Did Grizzly gain share in the southeast subsequent to the increased regional promotion?

Susan Ivey

Yes, it did.

David Adelman - Morgan Stanley

Okay. Then just out of curiosity, Susan, and I realize it is early days with regard to the changes going on in the industry and there's trade inventory movements and there's tactical pricing going on, and a whole variety of things, but what is your preliminary view? You must have a preliminary view about what's happening with underlying cigarette consumption, the outlook for the category mix and the impact, if at all, that it is having on other tobacco categories.

Susan Ivey

It really is early days, David. All we sort of get on a near-term basis is off take shares, and obviously some shipments to wholesale. What's happened so far is, as you know, the trade unloaded. The trade has reloaded, and this was not just a wholesale phenomenon. Retailers unloaded. There was a lot of out-of-stocks coming into the first of April.

So, what we've seen so far is reloading back to more normalized levels in terms of wholesale inventory and obviously retail restocking. What is still unknown is where will the retail inventories net out? Now, you've got the consumer phenomenon which, as we talked, will unfold over the next couple of months. But clearly, the cost of goods for cigarettes and for retailers, how will they define their inventory portfolio? Will they just reload and pay more? Will they only load enough at the same dollar value they used to carry? That is what is still unfolding here.

So, what will be the net inventory adjustment in the category and then what do the consumers do? As I said, fortunately, as this is a frequently purchased item, it will come soon, but it is too early to tell.

David Adelman - Morgan Stanley

Okay. Then a last question. On the disputed MSA payment dynamic, you know, for the last four years, you made a conscious decision to declare a disputed payment but to put those funds into escrow. This year, you've behaved differently. Can you just explain why did you take a different approach this year?

Susan Ivey

Yes. I would be happy to. Obviously, we sat down and looked at it, and we had two choices. We could have put it in the disputed payment account and followed our traditional path. We also have the absolute right not to pay it. And if, of course, we're found to then owe it, the interest rate to be paid back would be something like 6%.

So, we thought that was pretty cheap money and actually, I think even if you were looking at this from the point of view of the state, that's more interest than they would get if it was sitting in the disputed payment account. So, we just thought that it was a smart financial decision. We didn't need the cash, and we decided this was a smarter financial way to navigate our way through this dispute.

David Adelman - Morgan Stanley

Do you think that it may create a little more urgency on the part of the states to resolve the issue?

Susan Ivey

I would like to think so. I don't really know that in its own right it does, but I do believe when you start to look at numbers of $2 billion in this recessionary environment, with states in deficit positions, that we are hopeful there will be some momentum around settling, and of course, if that doesn't occur, we have a time where this arbitration will begin this October.

David Adelman - Morgan Stanley

Okay. Susan, last question. I realize the adverse impact from the tax harmonization of roll-your-own and little cigars as it relates on Conwood, but is it fair to say from a holistic corporate-wide perspective, you advocate the change on the taxes of those alternative products because of the presumably favorable implication it will have on the conventional cigarette category pricing dynamic?

Susan Ivey

Yes. I would say so, David. I think that would be a fair assessment on a holistic basis, industry wide, and we'll see where these consumers land. But certainly, they could easily land in other parts of our RAI's portfolio as well.

David Adelman - Morgan Stanley

Actually, one last thing. Your cigarette portfolio, obviously in ordinary times, you suffer volume declines at some multiple of what's happening in the overall industry. Now, in a more stressed environment, both from an economic perspective and with respect to what's just happening in absolute pricing levels, how do you think that your underlying share trends or volume, shipment or consumption relative to the overall category is likely to behave? Historically it is 1.5X, the industry decline, do you think that's the likely dynamic over the next 12 months or do you think it might be something demonstrably better or worse than that?

Susan Ivey

I don't believe it will be worse. I think that range is in the framework.

Operator

We'll take our next question with Adam Spielman of Citigroup.

Adam Spielman - Citigroup

Good morning. First of all, can I ask you about the dividend? In your statement, you reiterated a 75% payout ratio, but if you look at the midpoint of your guidance range, and take 75% of that, you get a figure below the current dividend payout on an annualized basis. I was wondering if you could tell me how you're likely to think about resolving that tension.

Susan Ivey

Our intent in putting it out that way, Adam, we have stated before we would be comfortable if it goes over the 75%, and we are committed to the 340.

Tom Adams

Adam, this is Tom. If you look at the pension piece, our cash pension contribution of $50 million which we made in April versus the $180 million of expenses that we're taking through the P&L, that differential actually, if you view it on a cash EPS basis which I know I'm piecemealing this thing, roughly brings the dividend around in the midpoint right at about 75%.

Adam Spielman - Citigroup

Okay. Thank you very much. Secondly, can I move on to smokeless, and particularly, can you tell me how big is the pouch segment of smokeless overall? How has that developed over time and what share do you have of pouches?

Susan Ivey

The category I think is about 7% of moist. It is growing actually. It has been growing at about 25% a year. I think we see moist consumers who want to use moist in a more discreet situation are moving to pouches. Grizzly, of course, has launched pouches into that segment over the last 14 months, and is very progressive.

Tom Adams

A little fewer than two share in total.

Susan Ivey

Our share is about two. The segment share is about seven. So, we see upside in that continuing. We've launched mint and straight pouches this quarter. They're performing very well. Again, it is putting that great Grizzly product into a pouch in a more discreet opportunity for adults to enjoy.

Adam Spielman - Citigroup

Do you think you have a different demographic using pouch as opposed to the regular MST products?

Susan Ivey

I think the broad demographic for moist, everybody understands, but I think situationally, the pouches are really used that way. So, people who find themselves in situations where they don't want to have the dip in their mouth are using the pouches at that time. A lot of dual usage in that category with people when they can't dip using a pouch. We see that growing.

Adam Spielman - Citigroup

Thank you very much. If I can quickly come on to Camel. Obviously, you said your market share was up 10 basis points, but Crush has been a huge success. I guess that means to say that some part of the Camel portfolio has been going backwards in the last 10 months, and I was just wondering if you could sort of say where and why and how?

Susan Ivey

We've delisted several styles of Camel and actually, as we speak, we're delisting Signature, focusing the portfolio on the core Camel styles. So, a part of this we've done to ourselves but we think it is right for the brand and the brand's positioning, and for its merchandising footprint to ensure that we are able to have the right amount of inventory of the right style.

So we continue to be confident in Camel's ability to grow, and to grow outside of its traditional cigarette portfolio with Snus, and as you heard today, we're going to test some Camel Dip.

Operator

We'll take our next question with Christine Farkas with Merrill Lynch.

Christine Farkas - Merrill Lynch

My first Susan is on the state taxes. You mentioned three states moved up this year, and there is probably a couple more that are getting closer. But, I'm just wondering, given your views of course that this is a regressive tax. Structurally, do you think that there is a possibility with that view along with stimulus dollars going to the states that in fact we don't see a much stronger push from the states on taxes? Could we be a bit surprised if this looks like a normal year of state tax hikes?

Susan Ivey

I hope so. You are right, that as the states receive other stimulus money and of course, the Federal excise tax is funding the SCHIP, which does provide relief to the states for some of their healthcare budgets. So, I think it is really depending on the attitude and the state legislatures on tax in general in this recessionary environment. I have to say, you know, we are pleased that it is only three so far. So, I hope that we are surprised, but obviously we have to be prepared and eyes open on these tax increases.

Christine Farkas - Merrill Lynch

Is there anything structurally different about the California proposal, for example, which has not been successful in the past? Anything different about the way they're going about it this year that would make it easier to pass?

Susan Ivey

I wouldn't say so, Christine. Obviously, if we find out more about that process, Morris can follow-up.

Christine Farkas - Merrill Lynch

Okay. Great. Moving to MST or to Conwood, the margins were up nicely year-over-year, but I know a year ago there were some rollout cost or cost investment. I'm wondering if you adjust for that spend a year ago, if it is possible to comment whether or not margins were up year -over-year?

Susan Ivey

I think the margins were still up. I think the other thing about it is you also have the overall dynamic of the shipment pattern in the quarter. So, you didn't ship any moist for two weeks in March. So, you know, it is difficult to do those kinds of year-over-year compares. But, obviously, we took pricing on Grizzly last year of a dime, and that's generated higher margins.

Christine Farkas - Merrill Lynch

Then just on the cost savings, if I could, Susan, or Tom, could you quantify perhaps how much were generated in the first quarter? And then looking at the $55 million run rate program by 2011 and the wording in your press release about $35 million this year, and then achieving $40 million, has this program been accelerated and did you generate $5 million in '08?

Tom Adams

We're going to generate about $35 million this year at R.J. Reynolds', and tat will actually build over the course of the year as we implement our programs that we announced last September.

Christine Farkas - Merrill Lynch

I believe there was also talk in your press release about, will have achieved $40 million in '09. Is that a run rate implying that you've achieved $5 million in '08? I'm trying to get the program timing.

Tom Adams

That's in total. That includes RAI.

Christine Farkas - Merrill Lynch

I see, RAI. About savings in the quarter, can you quantify that at all at this point?

Tom Adams

It would be less than 10.

Christine Farkas - Merrill Lynch

Less than 10. All right. That's great. Thanks so much.

Operator

We'll take our next question with Erik Bloomquist with JPMorgan.

Erik Bloomquist - JPMorgan

Just a few follow-on questions. With respect to the impairment charges, could you just tell us which brands those were taken on?

Tom Adams

Sure. At Conwood, the lion's share of that was on Kodiak, and the rest of it was on some of the loose leaf styles. At Reynolds, it was on Kool and Winston and [Dural] and Salem, and then some smaller styles. I will point out on the impairment charges, and you can see our balance sheet where we displayed the amount of trademarks that we have, our actual trademark valuations are probably a $1.5 billion higher than that, because you know, obviously the accounting conventions don't allow us to do the write-up the brand, but there is considerable value based on the brand building that we've done on our growth brand.

Erik Bloomquist - JPMorgan

Okay. Thanks. Then on the smokeless side of things, both in traditional MST and in Snus, do you have any sense for the degree for which you're seeing an increase in dual use between a smokeless product and cigarettes? Has that impact started to come through? Is that something we can look forward to as we get further into the year, and see more of the price impact and cigarettes coming through?

Susan Ivey

I think it is a good hypothesis, Erik. It is a little early. As you know there is a lot of dual usage anyway, and do those dual users move more to moist given the price environment; that should unfold. Also, does the moist category grow at a little bit faster rate than historically as a result of that? So, again, it won't be long for us to be able to determine exactly how those consumers are reacting. But dual usage is a big part of the usage base for moist, and therefore, that's not entirely likely in my opinion.

Erik Bloomquist - JPMorgan

Could you remind us what percentage of moist users are dual users roughly?

Susan Ivey

40% or something like that. It is a big number.

Erik Bloomquist - JPMorgan

Just a last question on the cost saves. The previous program prior to the September restructuring of last year, is it still fair to think that that's going to contribute $80 to $100 million this year?

Tom Adams

We've actually baked all of that stuff into the numbers, Erik. We're on track to deliver everything that we've talked about historically. They are frankly in the underlying numbers right now. We're not tracking them separately because they're already in.

Operator

Our next question with Ann Gurkin with Davenport.

Ann Gurkin - Davenport & Company LLC

I wanted to start with an update on progress in the Star case. I believe both parties are supposed to meet with the judge then maybe we're facing a trial. Can I get an update?

Susan Ivey

Sure, Ann. The trial is scheduled for May 18. As you know, we were pleased that the request for patent reexamination was granted. That was granted in February. We remain very confident in our arguments, and the judge in that case has agreed he won't enter the final judgment until we get the results of the patent reexamination. That gives us significant confidence.

Ann Gurkin - Davenport & Company LLC

Okay. Then if I can just get a little more commentary on the focus on Pall Mall? Susan, in your comments, you talked about the value proposition of the brand. It is my understanding you were very promotional behind this brand in the first quarter, and are you getting the list from consumers? Is this brand profitable? Can I just get a little more color on the emphasis on Pall Mall?

Susan Ivey

Sure, Ann. As you know, we have had Pall Mall as one of our growth brands in the portfolio really since the merger, and we talked about the value of having a strong value-oriented brand in that mix for just times like these, where there is economic pressure, where there is significant price increases.

Pall Mall over the last couple of years has used what we call a pulse promotion, which means that we promote it for a couple of months, and we generate high levels of trial, and Pall Mall has demonstrated that it has a tremendous an ability to convert smokers.

The reason for that is that Pall Mall truly is a differentiated value cigarette. It has more puffs than a premium cigarette. So, it is longer lasting and it is high quality, and Pall Mall also has a premium heritage name and positioning. So, Pall Mall has demonstrated that after these pulse promotions, of course, you lose a little bit of the gain, but the net result is share increase, and that's demonstrated. I think Tom said in his remarks, 6/10 of a share point.

We are in the process of a Pall Mall pulse promotion as we speak. We started that promotion at the inception of the new prices. Therefore, Pall Mall has a significant value just as consumers go into motion. And we saw the opportunity to leverage Pall Mall and to generate trial as consumers figure out where they're going to land.

So, we expect that promotion to be successful, and we will see how much that sticks as we back off of that promotion. But, Pall Mall is a strong brand and it is showing momentum, so we continue to be bullish about its growth potential.

Ann Gurkin - Davenport & Company LLC

Was it profitable as a brand in the first quarter?

Tom Adams

Yes.

Susan Ivey

Sure.

Ann Gurkin - Davenport & Company LLC

Okay. Then, secondly, if I could ask a question about the wholesaler's ability to rebuild inventory; are you hearing any difficulty in getting financing to rebuild inventory to prior levels or any kind of issues like that?

Susan Ivey

I haven't really heard that, Ann, but you know I might not know every situation out there. But generally speaking, we have seen the wholesale trade reload, and I think really probably the bigger question at the end of the day is what happens at retail and what become their standing inventory?

Operator

We'll take our final question. This is a follow-up with Nik Modi with UBS.

Nik Modi - UBS

My question was answered. Thanks.

Operator

Okay. At this time, this does end the Q&A session. I would like to turn it back over to Morris Moore for any additional or closing remarks.

Morris Moore

Thank you again for joining us today. A replay of this call will be available on our website at Reynolds American.com until May 29th.

Operator

One again ladies and gentlemen, this does conclude today's conference. Thank you for your participation.

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Source: Reynolds American Inc. Q1 2009 Earnings Call Transcript
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