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Altria Group, Inc. (NYSE:MO)

Q2 2009 Earnings Call Transcript

July 22, 2009 9:00 am ET

Executives

Cliff Fleet - VP, IR for Altria Client Services

Mike Szymanczyk - Chairman and CEO

Dave Beran - EVP and CFO

Analysts

Christine Farkas - Banc of America

Judy Hong - Goldman Sachs

Chris Growe - Stifel Nicolaus

David Adelman - Morgan Stanley

Chris Burritt - Bloomberg News

Nik Modi - UBS

Thilo Wrede - Credit Suisse

Operator

Good day, and welcome to the Altria Group second quarter 2009 earnings conference call. Today’s call is scheduled to last about one hour, including remarks by Altria’s management and a question-and-answer session. All lines have been placed on mute to prevent any background noise. (Operator instructions) Representatives of the investment community and media on the call will be able to ask questions following the conclusion of the prepared remarks.

I would now like to turn the call over to Cliff Fleet, Vice President, Investor Relations for Altria Client Services. Please go ahead, sir.

Cliff Fleet

Good morning and thank you for joining our call. This morning we will only be discussing Altria's 2009 second quarter and first half business results, and we'll not be discussing the status of tobacco litigation. Our remarks contain forward-looking statements and projections of future results. And I direct you to the forward-looking and cautionary statements at the end of our earnings release for the review of the various factors that could cause actual results to differ materially from projections.

As a result of the spin-off of Philip Morris International in the first quarter of 2008, our reported results for the six months ending June 30th, 2008, reflect PMI as a discontinued operation. Revenues and operating company’s income for PMI are therefore excluded from Altria’s continuing results.

Since Altria acquired UST and its smokeless tobacco and wine subsidiaries on January 6, 2009, US smokeless tobacco companies and Ste. Michelle Wine Estates financial results from January 6th through June 30th 2009 are included in Altria’s first quarter 2009 consolidated and segment results. For a detailed review of Altria’s second quarter business results, please review the earnings release that is available on our Web site, www.Altria.com.

Altria reports its financial results in accordance with generally accepted accounting principles. Today’s call may contain various operating results on both a reported and on an adjusted basis, which excludes items which affect the comparability of reported results. Descriptions of these measures as well as reconciliations are included in the earnings press release.

Now, it gives me great pleasure to introduce Mike Szymanczyk, Chairman and Chief Executive Officer of Altria Group, Inc.

Mike Szymanczyk

Thanks, Cliff, and good morning to everyone. As was the case with our first quarter, our second quarter results have folded pretty much the way we expected. Altria reported strong adjusted earnings per share growth of 8.7%. Our tobacco businesses continued performing well in what I describe as a challenging environment. Our cost savings programs remained on track. Our cigarette business delivered exceptional financial results. The UST integration continued to proceed smoothly. I think we remain encouraged by the initial results coming from our actions that enhanced the valuation of USSTC's premium portfolio and our smokeless business. And Black & Mild had another quarter of strong retail share growth in the cigar business.

Liens for the quarter were negatively impacted by a significant federal excise tax increase on tobacco products that took effect on April 1st, 2009. Because the ramifications of these tax increases were different by tobacco segment, the business trends for the quarter are a bit difficult to decipher. Dave will go into more detail on these impacts when he reviews business segment results. And we’ll try to provide further insight during the Q&A portion of the call.

However, three events negatively impacted our tobacco volumes for the quarter beyond industry performance that do not represent trends and need more explanation. First, during the early phases of the FET-induced of pricing dislocation in the cigarette business, PM USA experienced share losses, as some competitors spent aggressively into the FET, while we did not. Once price gaps normalized at the beginning of June, Marlboro experienced sequential retail share growth throughout the month. Marlboro ended June with a share of 42.4% which was the same share level as the first quarter. We also allowed our non-support brands to adjust to lower proposed FET share levels. Together these two actions turned out to be a profitable strategy for our cigarette business.

Second, USSTC executed an everyday low-price strategy on Copenhagen and Skoal and eliminated duplicate inventories caused by large quantities of value-pack promotions in the system. This is a one time adjustment.

And finally in our cigar business, Middleton integrated our cigar distribution system into the one we use for cigarettes. Thus reducing required wholesaler lead times. We also moved to zero day payment terms. These two steps have reduced Middleton cigar trade inventory system wide and should result in improved product freshness. So far, the impact of the FET increase on industry volumes is in line with our expectations.

In the cigarette category, the FET hike helped drive the average industry wide price for a pack of cigarettes up approximately 25% versus a year ago. To date, estimated cigarette industry volume adjusted for changes in trade inventories has decreased in line with historical price elasticity.

As I mentioned, PM USA did not spend into FET increase, but rather waited for the marketplace to settle. Price gaps widened to about 50% early in the second quarter. But we saw the discount category grow in April and May. The price gaps returned to below 40% by early June. In June, PM USA changed its promotional programs to focus on single-pack offers. The result of this plan was retail share loss during April and May, and rapid sequential retail share gains for Marlboro and sequential share losses for the discount category during June. PM USA promotional spending on a per-pack basis was essentially the same in the first and second quarters of 2009.

The UST integration is proceeding very well. USSTC sales force and one-to-one consumer engagement functions were combined with those of PM USA to create two new support organizations, Altria Sales and Distribution and Altria Consumer Engagement Services. Creating these companies, combined with other ongoing Altria cost savings initiatives, has enabled the integration to proceed quickly. 98% of the plan employs separations resulting from the UST integration have occurred. We expect integration cost savings to begin enhancing profitability in the second half of 2009 and beyond.

USSTC’s premium portfolio has responded well to the marketing changes implemented in the first half of 2009. USSTC's premium share stabilized sequentially as USSTC transitioned from multi-can value pack promotions to an everyday low price strategy on single cans to reset the brands' value of placement. As the next step, in the third quarter, USSTC will adjust the price gap of Copenhagen and Skoal in some States where price gaps remained too high and/or where particularly difficult economic conditions exist. Also, in the second half of 2009, USSTC will enhance its brand building equity programs to help return Copenhagen and Skoal to modest retail share growth.

Altria’s cost savings programs continue to proceed as planned. $25 million in cost savings were achieved across the Altria family of companies in the second quarter. UST integration savings along with savings from ceasing cigarette production in Cabarrus, which will occur by the end of this month as well as other SG&A cost savings programs, should further enhance profitability.

We remain confident that we will complete the $1.5 billion in cost reduction off our 2006 cost base as planned by 2011.

On June 22nd, 2009, the President signed the Family Smoking Prevention and Tobacco Control Act into law. The legislation provides the Food and Drug Administration regulatory authority over tobacco products. While we did not agree with every element of this legislation, including those that we believed crossed constitutional limits, we supported its enactment.

We believe this comprehensive national regulatory framework, implemented thoughtfully, can provide significant benefits to adult consumers by establishing a common set of high standards for all tobacco manufacturers and importers doing business in the United States, by providing a framework for the evaluation of tobacco products that are potentially less harmful then conventional cigarettes, and by creating clear principles for accurate and scientifically grounded communication about tobacco products to adult consumers.

We hope that the FDA will implement this new regulatory framework consistent with these principles, that we will work constructively with the agency to support its enactment. This regulatory framework will bring change for our tobacco businesses. And we have been preparing for this change for the past several years. Immediately after the President signed the legislation into law, Altria established a regulatory affairs group to oversee our future work in this area.

We remain very please with Altria and its operating companies 2009 performance to date. Our cigarette business continues to grow income in a challenging environment. The UST integration is proceeding very smoothly. USSTC’s premium MST portfolio is benefiting from our actions to enhance its value equation. Black & Mild continues to generate strong retail share growth. And our aggressive cost savings programs continue to enhance overall profitability. Altria remains well positioned to continue delivering strong shareholder returns.

Given Altria's strong year-to-date EPS performance, we are raising our 2009 full year guidance for adjusted diluted EPS to a range of $1.72 to $1.77, representing a growth rate of 4% to7%.

Now I’d like to turn the call over to Dave Beran, Altria’s Executive Vice President and CFO who will discuss Altria’s business segment results.

Dave Beran

Thank you, Mike. Let me begin with the cigarette segment which delivered strong operating company’s income growth. Reported cigarette operating company’s income increased 6.7% versus the prior year period, to $1.4 billion due the list price increases, partially offset by lower volumes as well as charges primarily related to Cabarrus facility closure. Excluding those charges, the cigarette segments operating company's income increased by 7.4% to $1.5 billion. Second quarter results were impacted by the April 1st increase in the federal excise tax. In the first quarter of 2009, trade inventories were substantially reduced to minimize four tax payments. And in the second quarter, the trade rebuilt inventories, though not back to their prior levels.

PM USA’s cigarette shipment volumes were down 6.8% in the second quarter, but are estimated to be down about 12% when adjusted for changes in trade inventories. PM USA estimates that total adjusted cigarette industry volume declined 8% in the second quarter. Overall, 2009 cigarette industry volumes have performed in line with PM USA expectations.

For the first half of 2009, PM USA estimates that adjusted total cigarette industry volumes declined 7%. PM USA estimates that its cigarettes shipments were down 9% on a year-to-date basis when adjusted for changes in trade inventories and calendar differences. When comparing PM USA to the total industry, the difference in volume decline can be attributed to volume lost during the period of price gap dislocation and share losses on unsupported brands due to higher retail prices.

Initial adult consumer reaction to the FET hike was consistent with our expectations. There was some adult consumer down trading to competitive brands, as some competitors chose to spend into the tax increase, driving a widening of the price gap between Marlboro and the lowest priced brand. This gap reached a peak of about 50% at the beginning of the second quarter. However, as the quarter progressed, price gaps closed below 40%. As price gaps closed, Marlboro’s retail share began growing again and ended the month of June at a $42.40 share.

The trade down from premium to discount that occurred in the first part of the second quarter was most evident among non-menthol brands due to less competitive activity in the menthol segment. Marlboro Menthol grew four-tenths of a share point in the second quarter. At the end of the quarter, PM USA began shipping Marlboro Blend No. 54 to continue building our Marlboro success in the menthol segment. Retail acceptance in initial adult consumer trial of this new packing had been very strong.

Overall, we are pleased with the second quarter cigarette business results. Profitability growth was very strong and Marlboro’s retail share performance returned to growth in June after the initial period of dislocation following the Federal Excise Tax increase.

Now let’s turn to the smokeless segment. USSTC’s actions enhanced the value equation when Copenhagen and Skoal, with all this price reduction of $0.62 per can that was effective at the end of the first quarter. As we anticipated, national net price gaps versus the leading discount brand closed to below 60% at the end of the second quarter. We are encouraged by USSTC’s premium retail share performance as its share began and ended the second quarter of 2009 at the same level.

Importantly, USSTC’s premium revenue share increased 6.6 share points versus the first quarter of 2009 as the company eliminated multi-pack deals. USSTC’s domestic MST volume declined 3.4% in the second quarter, but is estimated to be essentially flat versus the year ago period when adjusted for changes in trade inventories to discontinuation of multi-pack deals and the discontinuation of its Rooster brand.

The trade continued reducing inventory levels when USSTC’s products as the company transitioned from multi-pack deals to everyday low pricing, which eliminates the need for promotional inventory. USSTC believes that the long term growth rate for total MST industry volume remains at 6% to 7%. Reported operating company’s income for the smokeless segment was $177 million in the second quarter. When adjusted for exit integration and acquisition-related charges, second quarter smokeless segment operating company’s income was $213 million.

Now let’s discuss our cigar business results. Black & Mild reported another strong quarter of retail share growth. Black & Mild’s retail share was 30.4%, up 2.7 share points versus the prior year period. Black & Mild continued benefiting from the support on the Altria sales and distribution infrastructure of retail as well as the successful launch of Black & Mild Original Wood Tip earlier this year.

New products continue to be an important component of Black & Mild’s retail share performance. Middleton recently announced student line extensions that are expected to shift to wholesale in the third quarter of 2009. Black & Mild Wood Tip 1, and a new non-tip cigar product, Black & Mild cigarillo, which will be test marketed in the state of Georgia.

In the second quarter, cigar shipments were impacted by the FET increase on April 1st. There was no fore-tax with cigar inventories, so the trade increased inventories in the first quarter in advance of the tax increase. In the second quarter, the trade fully depleted this FET-related inventory build. Additionally, the trade further reduced cigar inventories in the second quarter as Middleton migrated to the Altria sales and distribution system. Middleton does not expect to recover volume lost to this one-time adjustment.

Second quarter cigar shipment volume was 270 million units, a decline of 23.8% versus the prior year period, but is estimated to have grown moderately when adjusted for changes in trade inventories in timing of promotional shipments. Middleton believes that the long-term industry volume growth rate from machine-made large cigars remains at 3% to 4%. However, the growth rate may have slowed in the second quarter. We will have a better understanding of the volume impact as the year unfolds.

Reported operating company’s income for cigars decreased 28% versus the prior year period to $36 million reflecting lower volumes. Excluding integration cost, operating company’s income was $40 million, a decline of 21.6% versus the year ago period. The first half of 2009, adjusted cigar operating company’s income increased 3.2% versus the prior year period to $97 million.

Let’s now turn to the wine segment. The wine segment’s second quarter results continue to show strong underlying performance but were negatively impacted by continuing wholesale inventory depletions and weakness in on-premise sales that includes restaurants and bars. As a result, Ste. Michelle’s second quarter wine shipments were down 1.5% versus a year ago period to 1.4 million cases. Ste. Michelle’s volume from wholesale to retail increased approximately 5% in the second quarter and the first half of 2009, due primarily to higher off-premise channel volume that includes supermarkets and liquor stores, partially offset by lower on-premise channel volume that includes restaurants and bars.

Retail volume, as measured by the Nielsen Total Wine Database for US Food and Drug increased approximately 12% in the second quarter of 2009 versus the prior year period. Reported second quarter operating company’s income for the wine segment was $9 million. When adjusted for acquisition-related charges of $6 million, adjusted second quarter operating company’s income was $15 million.

Let’s conclude with financial services. Reported operating company’s income in the second quarter increased $53 million to $83 million due to higher gains in asset sales, partially offset with the increase of allowance for losses of $15 million.

On June 1st, 2009, General Motors filed for Chapter 11 bankruptcy protection. PMCC leases various types of automotive manufacturing equipment to GM under leases which expire from 2012 through 2023. Automotive equipment under lease to GM represented approximately 4% of PMCC’s portfolio of finance assets as of June 30th, 2009.

As a result of bankruptcy filing, PMCC has ceased recording income on these leases. All other PMCC lessees are current on their lease obligations. PMCC has assessed its allowance for losses for its entire portfolio, including its exposure to GM, and believes that the allowance for losses of $315 million is adequate.

As you know, the jury in our LILO-SILO tax refund case in the Southern district of New York reached the verdict in the government’s favor. In that case, we were seeking a refund for taxes and interests we paid following disallowance by the IRS of tax benefits we claimed in the 1996 to 1997 years related to four LILO-SILO transactions.

There are critical legal issues involving these transactions that will be raised in post-verdict motions that will be filed by the end of July, and that we expect will be resolved by September. If necessary, depending on the resolution of these issues we will pursue an appellate strategy.

We have previously paid approximately paid $150 million of federal income tax and net interest related to disallow tax benefits for LILOs and SILOs for the years 1996 through 1999, including the four transactions that were subject of the July verdict.

The IRS has indicated to us that it intends to disallow tax benefits we claimed in the years 2000 to 2003, with respect to the same four leases plus other lease transactions characterized by the IRS as LILOs and SILOs. The total disallowance for the 2000 to 2003 time period for these leases in federal income tax and related interest would be approximately $1 billion.

If the IRS, in the future, disallowed the tax benefits for these leases for the period from 2004 until December 31st, 2009, the disallowance for that period in federal income tax and related interest would be approximately $900 million, taking into account federal income tax paid or payable on gains associated with sales of these assets during that period.

PMCC entered into no-LILO or SILO transactions after 2003. We intend to contest all these disallowances vigorously. Whether and when we make payments of these amounts will depend on the timing and outcome of future IRS audits and any related administrative challenges in litigation. LILO and SILO transactions represent approximately 36% of the net finance assets of PMCC’s lease portfolio.

Although there will be some likely impact on our reported earnings in the event of the an ultimate adverse outcome to these matters, management believes that resolution of the LILO-SILO matter will have no material adverse effect on our dividend policy or on our ability to satisfy our financial obligations.

Mike and I will now be happy to take your questions. While the calls are compiled, let me cover a few housekeeping items. Marlboro C-Store price gap versus the lowest effective priced cigarette averaged 42% in the second quarter. Marlboro’s net pack price was $5.22 and the lowest effective price cigarette pack price was $3.68.

The cigarette discount category’s second quarter retail share increased two share points versus the prior year period at 27.3%. The estimated average weighted cigarette state excise tax at the end of the second quarter of 2009 was a $1.15, and is estimated to be $1.22 at the end of July. Five states, including Florida, increased their SETs on July 1st. Through July 22nd, nine States and Puerto Rico have increased their cigarette excise taxes in 2009 with an average increase of $0.53 per pack in those nine States.

Our second quarter MSA and quarter buyout accruals were $1.4 million or $0.67 per pack. Of the $0.67, MSA represents $0.61 per pack and a quarter buyout represents $0.06 per pack. Copenhagen’s national retail price was $4.16 per can in the month of June. In the second quarter, CapEx and ongoing depreciation and amortization were both $69 million. And we anticipate their 2009 full-year effective tax rate on operations will be approximately 37.1%.

Operator, do we have any questions?

Question-and-Answer Session

Operator

Thank you. (Operator instructions) Investors, analysts, and media representatives are now invited to participate in this question-and-answer session. We will take questions from the investment community first. Our first question comes from the line of Christine Farkas of Banc of America.

Christine Farkas - Banc of America

Thank you very much. Good morning, everyone. I have some questions for smokeless if I could. You talked about premium shares stabilizing by the end of the quarter. First thing, could you comment on the category growth for the second quarter and/or the first half? And secondly, are you implying that the premium growth in June, for example, approached that of the first quarter? Can you just clarify what the share was, for example, at the end of the quarter and if you were referring to premium?

Mike Szymanczyk

Well, I think it’s kind of hard to characterize category growth given some of the movement in inventories that took place from the first half of the year. Our best estimate coming from USSTC is that they believe it continues to be running on about 6% to 7% category growth rate.

Christine Farkas - Banc of America

Okay.

Mike Szymanczyk

But best I think, they’ll look at those things over an extended period of time because things like large FETs and inventory movements and some of the changes that we made can kind of cloud the read. We’ve got a number of moving items going on relative to the smokeless business, which was our intention for the year.

We’re making lots of adjustments in that business. So we’ve adjusted the cost structures significantly. A lot of that has been done. We just have a little more to do in the second half. We’ve adjusted our list prices as a first step toward getting our value equation right. We’ve said, in the process of talking about this that we would take that a step at a time. We would do what was necessary, we thought, on a broad basis and then we’d look at hotspots that developed around the country or places where fabulous price reduction was inadequate to get to the range of gap that was going to be necessary. And so we couldn’t do that until after we’d taken the first step that was just completed in the second quarter.

And so now on the third quarter, we’re moving on to look at discreet particular areas and we’ll take a more surgical approach to getting things rights there. And really, that’s just getting pricing right. In the long run we want to build those businesses using equity tools and we’ll begin to do that as we move on through the second half. We’ve formulated strategies there, we’ve developed some programs and opportunities we think will benefit the brands on a longer term basis and certainly influence the outcome as we move in the 2010.

So I think you have to look at the smokeless category and our business, given the size of our business relative to the total category in 2009, as operating in a period of adjustment. I wouldn’t get to excited about trying to predict trends or re-trends during that period of adjustment because it’s hard to nail down numbers as trends. We’ve got so many things moving around. So it’s tough for me to give you an answer to that question that I don’t think is really answerable relative to trends right now.

Christine Farkas - Banc of America

Okay. Thanks for that, a follow-up on smokeless. So you gave us the price gaps now at the second quarter, were any changes in weight-based tax structures helpful in closing that gap in the quarter and the first half?

Mike Szymanczyk

I’m not sure there were any that influenced that. You’d probably see some of that take place the second half of the year as taxes goes, but you’ve got some offsets relative to Florida and I think was constant. If I remembered correctly, that worked the other way. So no, I wouldn’t say that the gap has been driven by that. I think it’s been driven purely by the changes in the price structure that we put in place as well as whatever other competitors did.

I’d say that that gap is still kind of moving because, as you know, the impact of the FET on many other competitive brands wasn’t reflected until late into the quarter. So you really haven’t seen that play out the gaps at this point. So that’s still moving and I think we’ll likely see a bit more narrowing of that in the third quarter.

Christine Farkas - Banc of America

Okay. A final question for Dave on your SILO-LILO comments about potential impacts not disrupting your ability to pay dividends or meet financial commitments. Do you have a comment on whether or not that would impact your plan for potentially resuming a share buyback in 2010?

Dave Beran

As we said earlier in the year, the Board will take that decision by the first quarter of next year and look at the total business, including the total impact of LILO and SILOs when they make the determination on future share buybacks. But just let me remind you that when we look at our companies, okay, and how we manage our cash flow, we’re always looking ahead a strong balance sheet and to make sure that we had a strong dividend policy. But specifically, on stock buybacks, we will make that call later on in the year.

Christine Farkas - Banc of America

Okay. Thank you very much.

Mike Szymanczyk

Just keep in mind that the Board did not say that it would resume share buybacks in 2010. It said it would re-address the subject in the first quarter of 2010.

Christine Farkas - Banc of America

Well, I understand, that was me. Thanks.

Operator

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

Judy Hong - Goldman Sachs

Thanks. David, just a follow-up on SILO-LILO here, in the billion dollars that the IRS intends to disallow between 2000 and 2003, if I understand it, you have to pay for it before you can litigate. Is that the case? And if that’s the case, when would the cash obligation be? You--

Mike Szymanczyk

Well, let me comment on that and then Dave can comment. Let me say there are several different options relative to that, so your assumption could be right, but not necessarily right. So it depends on which option you choose? Dave?

Dave Beran

And then, we also are still waiting both on the final outcome of the jury trial that we think will happen sometime in September plus receiving the actual final revenue agent’s report, which we would expect for the time period of 2000 and 2003, which we would expect to receive sometime in the next six months.

Judy Hong - Goldman Sachs

Okay. And so what are the other options that you could pursue here?

Mike Szymanczyk

Well, I’m not going to get into legal strategies, but there are several different approaches, so.

Judy Hong - Goldman Sachs

Okay. And then Mike, just in terms of on the cigarette buy, the narrowing of the price gap in June that you saw, and the subsequent share improvement that you saw in your brand, how much of that is driven by competitors that are backing off on their promotions, as opposed to your increased promotions on Marlboro? I’m just trying to get a sense of whether your promotional strategy has changed as the quarter progressed or just competitors kind of backed off in June.

Mike Szymanczyk

Well, as I mentioned, our spending rate per thousand for the second quarter was the same as it was for the first quarter, so I don’t think you can attribute that to an increased spending by us. I think you did see some lacking of the reflection of the tax in the marketplace, and in a number of cases, you even saw some spending in to the tax increase and that moderated as you got on through the end of May. And I would say that we would attribute it more to that than anything else.

We made some adjustment in our promotion plan on Marlboro. We moved from - where we do run on some packings or have run two-pack deals. We moved to a one-pack strategy because we felt like as pricing went up, particularly in this economic climate that was a better approach for our consumers. But at the same time we did that, we actually lowered the rate per pack that we were spending from the level we had when it was a two-pack deal, but broadened modestly on a lot of the activity we have. So we adjusted our strategy, but I wouldn’t say we made any dramatic changes in the amount of spending that were reflected in the quarter.

Judy Hong - Goldman Sachs

Okay. And then in terms of the menthol category, Mike, you talked about that category not facing as much price competition from the lower end or the trading down being more limited in that category. Can you maybe talk about the menthol category growth and within it, the new product that you introduced there? What is the -- how is that different from the Marlboro menthol line mentioned?

Mike Szymanczyk

Well, Marlboro Blend 54 really did not impact market share in the second quarter because they really didn’t hit the marketplace and started that impact until the third quarter, so the Marlboro’s menthol strength for the quarter was driven by other packs in the brand.

It’s a different taste profile and it seems to, among menthol smokers, seems to be very attractive to a pretty good segment of menthol smokers. So it kind of fills a bit of a void in the portfolio of Marlboro menthol SKUs, that’s why we decided to put it out in the marketplace. And so we’ll get a chance to get an early read on in the third quarter as it kind of unfolds, this structure, which is trying to give us, menthol consumers, health consumers an opportunity to give it a try.

Operator

Representatives of the media are now invited to ask questions. (Operator instructions) Your next question comes from the line of Chris Growe of Stiefel Nicolaus.

Chris Growe - Stifel Nicolaus

Hi, good morning.

Mike Szymanczyk

Good morning.

Chris Growe - Stifel Nicolaus

Hi, just a few different questions for you. The first would be that, if you look at the inventory rebuild, if you will, that occurred in the second quarter, I get somewhere around 2.2 billion sticks rebuild of it, are we in a level now that’s a good state of a level for inventory or are do we have any continuing stock problems for example like you had in Q1?

Mike Szymanczyk

Our stocks on Marlboro are still a bit higher than they were pre-MVT. I’ve spoken to people in the retail distribution, part of the -- retail part of the distribution systems, I would say that they’re still kind of finding their way in adjusting their inventory level. I think they pretty much recognize that cost inventories have gone up, but they tend to operate on the idea of wanting to satisfy demand in the category. And so you’ll see, I think, some continued adjustment in the inventory as the actual category buyer level begins to settle in on third quarter.

You know, typically when we see one of these larger excise tax increases, we’ll see a different volume and then a return of volume. And that return is on a slower curve out over several months. And so if you believe, as I do, that retail inventories tend to follow the actual out low volume for retail stores, you’re likely going to see those non-inventory levels continue to adjust a bit on through the third quarter and maybe even in the fourth. So I would say that’s not finished yet. It’s still moving around a little bit and that’s reflected in some out of stock -- increased out of stock levels on Marlboro in the marketplace.

Chris Growe - Stifel Nicolaus

Okay. Well, I have one more question for you, which is related to smokeless and the US tea business. You talked about making some second half adjustments, some like the Copenhagen price and some brand building programs as well. When you look at some of the net costing of US tea, are there other adjustments you’re making to help pay for this fuel or is this kind of cutting into the cost savings? Is that a fair way to look at it?

Mike Szymanczyk

I’m sorry, ask me that again. I’m not quite sure I understand.

Chris Growe - Stifel Nicolaus

I guess I’m looking at like you have $300 million of cost savings from US tea and you sent a portion of those back, as you did with the 62% decline or reduction in price in Q2. And now, you’re making a few more adjustments in Q3. It sounds like Copenhagen has a brand building adjustments. Are those - have you found more cost savings or a way to pay for those or will that cut into, I guess what I regard as net cost savings from US tea?

Mike Szymanczyk

Yes, we’ve always anticipated that we would have to make, as we do in the cigarette business, make some more localized adjustments in order to deal with particular circumstances. Yes, some circumstances were the past structure or the amount of tax in a particular state. As a variant, whether or not the gap falls in the range that we’re talking about.

You also have some circumstances in some states where you have a high unemployment, so the gap that you can sustain may be a little bit less. We had anticipated that that would be the case all along and so we factored much of that into our calculations when we were determining what we have to spend back into the marketplace.

You just can’t get there though until you do the first step. Otherwise, we’re just wasting money. So we had to make all these price adjustments, let that set in so that we could see where the gaps were and where the issues were, and then now we can move on to the next step, which in some cases may only be our particular brand or in other cases, on both brands, and then the majority of cases, there’s no more to be done. So no, it’s not new news. You shouldn’t look at it that way.

I think I spoke to this -- we've discussed it relative to strategies with US tea, that we used both of this price, but also localized by state or surgical approaches to dealing with the price gap today because it’s more efficient than simply doing it all with this price.

Chris Growe - Stifel Nicolaus

Okay. And then next -- one quick follow-up, if I could, for Dave and that is, is it -- sir, can you give us an idea what the tax rate would be, say in ’08 or ’09, excluding any LILO or SILO benefit. Is that something you could answer?

Dave Beran

No, I do not believe our effected tax rate will change at all. This is nothing more than the timing of tax payments. This $1 billion charge represents acceleration of tax payments and interest.

Chris Growe - Stifel Nicolaus

Okay.

Dave Beran

Not a change in the tax rate.

Chris Growe - Stifel Nicolaus

Okay, that makes sense. Okay, thanks a lot.

Operator

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

David Adelman - Morgan Stanley

Good morning.

Mike Szymanczyk

Good morning.

David Adelman - Morgan Stanley

Mike, I’m curious, first on the cigarette business. Certainly in the second quarter, arguably in the first half, you prioritized profitability over share. I’m curious, is that a reflection of sort of the tactical things happening in the marketplace or is there a more secular shift on how you are thinking of balancing profit versus share?

Mike Szymanczyk

Well, I would go back to the objectives that we stated relative to the cigarette business, which is to maximize earnings while maintaining modest share momentum on Marlboro. And I would say what we did in the second quarter is very consistent with that.

So we looked at discrete events in the marketplace. And so, we looked at it to say, "Well, what’s the most efficient way to manage around that event relative to how we’re going to spend our money?" And it seemed to us that the most efficient thing to do was to not try to deal with all of what was going on in a period of dislocation. But instead, to let the dislocation pass, see where we were, and then go back to the business of maintaining momentum on this key brand that we have, Marlboro. And we’d see where we adjusted to on the other brand, which we don’t spend a lot of money on.

David Adelman - Morgan Stanley

Okay. And then on the US tea -

Mike Szymanczyk

So that’s how we did it. I wouldn’t suggest that the second quarter represents any fundamental change in our strategy. It just says that that’s been the long term strategy. It’s not something that should necessarily you’re going to do, regardless of what’s going on around you. If it maybe points time or it makes a little sense to go ahead and let those more price sensitive shoppers shop and come back and then return to the brand, which is precisely what happened. I mean, it was - you saw this bunch of share growth in June, which you could see just stepped up every week once the gap was corrected, and the Marlboro business was very strong as it went through the month of June.

David Adelman - Morgan Stanley

Was some of the issue, Mike, in the early part of the quarter, actually the price promotion level, a competitive premium brands because the 42% gap you called out for the quarter on average is fairly narrow in a historical context for Marlboro to have lost share. So was some of the issue promotional spending on premium brands, which isn’t captured on that 42% number?

Mike Szymanczyk

Well, I think the 42% is basically irrelevant, in terms of looking at the business and that’s because it ranged from over $0.50 to $1.40 by the end of the quarter. So the average for the quarter doesn’t mean much. And April and May was driven by a number of factors, largely discount.

So it’s largely dragging your feet by some competitors in terms of reflecting increase, and in some cases, it was some big expenditures into the FET. So it’s only not reflecting, it was also spending into it pretty aggressively for a period of time. And there was share gain by those discount operators. And in particular, I think this one brand had very aggressive share growth behind very aggressive spending. Then as reflection of the tax played out and the gaps began to narrow, what you saw was equilibrium return. And then ultimately, the discount share began to decline, and the premium share began to pick back up. And Marlboro in particular, which kind of rested during April and May, came back very strong.

David Adelman - Morgan Stanley

And then Copenhagen and Skoal, are you surprised or a little disappointed that the $0.62 reduction wholesale, these prices weren’t alone sufficient to generate sequential share growth?

Mike Szymanczyk

No, and I said this at the beginning of this proposition that, to some degree, given my experience in the cigarette business, and remember I date back before Marlboro Friday. So I think it’s fair to say that when you go back that far and given the tools we have back then that the depth of the change in the business, which resulted in some significant share growth over a short period of time for the cigarette business and the Marlboro business, wasn’t the most efficient approach to it.

So as we looked at -- and said this before we did it, our objective was not to use price gap management to drive growth. It was rather to stabilize the share in these businesses, and then grow them, using brand enhancing approaches that really allow you to sustain a larger gap because you have a stronger brand equity. So we approached it differently, and it’s a step-by-step process.

David Adelman - Morgan Stanley

Okay.

Mike Szymanczyk

So we're stepping our way right through it because that’s the most efficient and the most profitable way to do it. And that’s what our objective is.

David Adelman - Morgan Stanley

Okay. Two last things, first, on SILO-LILO, thank you for the increased disclosure. Can you help us understand, if you were to approach the issue, just how you have to date, which is the IRS challenges, you -- you pay the money, you litigate, and you go through that cycle over time. In that hypothetical -- and then you -- the government prevails throughout. Under that hypothetical scenario, can you give us an assessment of this $9 billion you called out, what the phasing of those cash payments would be by year, approximately?

Dave Beran

I don’t think so. At least not right now.

David Adelman - Morgan Stanley

Okay, okay. And then lastly, as it relates to the FDA, what gives you confidence that they’re not going to mandate product specifications or product modifications that are going to impair the consumer enjoyment of your tobacco products?

Mike Szymanczyk

Well, it’s going to be an extended process here and I don’t think that any of us can predict exactly what things the FDA will focus on. I think they’ve opened up a web, a communication page. And so, you can comment on to the FDA. We've begun to communicate with them, but -- and we put some structure in place to engage with the FDA. But remember, they’re building an organization. They’ve got to put that together, and they’re going to take comments. They got to write a (inaudible). And there are some things they have to work towards implementing. And we’re focused on the things that need to be implemented, and engaging with them on how they want it implemented. But it’s very early in the process.

So I can’t predict what areas they’ll land on. What I can tell you is, whatever it is, it will be a level playing field. And so we’ll compete on that playing field to try to give our consumers products that they enjoy. And certainly, I would hope that the decisions the FDA makes, the ones that are focused on allowing consumers to have a choice to be informed, and hopefully, find ways to reduce harm through offering of products that help to do that.

David Adelman - Morgan Stanley

Okay, thank you very much.

Operator

Your next question comes from the line of Chris Burritt of Bloomberg News.

Chris Burritt - Bloomberg News

Hey folks, thanks for your time. On smokeless, now that you’ve had about six months to get a better idea of Skoal and Copenhagen, can you talk a bit on whether loyalty differs between snuff and cigarettes, and might loyalty in rival brands like Grizzly help explain some of the difficulty that you folks are having, taking share at this point? Thanks for your answer.

Mike Szymanczyk

Well, if you look at the loyalty factors on those brands, they’re slightly below Marlboro, but they’re certainly within a few percentage points. Call that less than five of Marlboro. Marlboro has a very high brand loyalty levels.

So I wouldn’t say that their loyalty factor is weak. I would say, "Well, the gap was pretty wide", and we saw this in the same kind of circumstance with Marlboro. And so we've narrowed it, but we didn’t narrow it as much here as we did when we narrowed it on Marlboro. And we think, as we researched and evaluated this, that there are some opportunities relative to these brands, in the way they’re positioned and their offerings that we continue to take advantage of that will help it grow. We’re just taking a pretty methodical approach to it.

We’re not trying to buy a business here. What we’re trying to do is build brands. So that takes a little more time. I would, kind of hastily point out, when somebody says to me, "Well, it’s been six months, and the train’s not going a hundred miles an hour." And I would say, "It’s only been six months and we’ve absorbed the company, taken on a massive amount of cost, reduced the sizeable amount of headcount, and repositioned the pricing in the marketplace. And we’re just getting started."

Chris Burritt - Bloomberg News

Got you. Are you able to explain how you might tap some of these opportunities for Skoal and Copenhagen?

Mike Szymanczyk

No, I won’t because I think that would be competitive sensitive information.

Chris Burritt - Bloomberg News

Thank you for your answers.

Mike Szymanczyk

You bet.

Operator

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

Nik Modi - UBS

Hi, good morning, guys.

Mike Szymanczyk

Good morning.

Nik Modi - UBS

Just one quick question, Mike, if you think about having -- now on US tea for about six months, and deep into your own cost cutting initiatives within the base PM USA business. I'm just curious on your perspective on -- thoughts on potential opportunities that will scale that cost as you have gone a couple of years into this program of your own doing?

Mike Szymanczyk

You mean overall or related to US tea?

Nik Modi - UBS

Both, both.

Mike Szymanczyk

Okay. Well, the US tea program first goes through the initial approach, which is taken out the identified cost opportunities to kind of restructure the business concerted into the overall operation to take advantage of the synergies that exist. So that’s what we could focus on with US tea as we move into 2010. We all kind of moved into the normal mode. We have it in all of our companies, which we expect identifying new and better ways to operate and become more efficient.

So yes, I would expect that this has become more efficient over time. And the same thing is true in the rest of our business, that’s how we operate. We’ve got a cost savings program that we put out through 2011. We’ve bumped it up a little bit this year in terms of what we expect to get. We continue to look for new better ways to do things, and as we uncover them, we put them on the table.

So that’s an ongoing part of the company’s strategic planning processes. We look at ways to improve processes to allow us to be more effective and more efficient, and nothing will be different about US tea in that regard.

Nik Modi - UBS

Thanks for the perspective.

Operator

Our next question comes from the line of Thilo Wrede of Credit Suisse.

Thilo Wrede - Credit Suisse

Good morning, gentlemen.

Mike Szymanczyk

Good morning.

Thilo Wrede - Credit Suisse

The 8% industry volume decline on an adjusted basis as you pointed out for the second quarter, is that the rate of decline that you expect for the rest of the year as well?

Mike Szymanczyk

That rate of decline represents the price elasticity on the price changes that took place in the second quarter. We would expect to see that historical price elasticity would hold -- would hold in the third and fourth quarter.

Thilo Wrede - Credit Suisse

So translated, that means unless there are more major price increases that a percent of volume decline should be what we should expect for the rest of the year?

Mike Szymanczyk

We don’t give forward-looking forecast on projected cigarette volumes going forward, especially in this year of dislocation. But let me just reiterate that what we’ve seen in the first six months is reflective of historical price elasticity. I don’t think we’ve seen anything unusual relative to historical price elasticity.

Now, what happens in the second half of the year, your guess is as good as mine. I mean we’ll watch and we’ll see what happens in the marketplace. But so far, the way it’s behaved is much with what the numbers would’ve said from other instances of tax increase or price increase in the marketplace that should have happened. That’s what’s occurred.

Thilo Wrede - Credit Suisse

Okay.

Mike Szymanczyk

But if it covers more than that or less than that as we go on through the next three to six months, I think -- you know what, it remains to be seen, but so far so good.

Thilo Wrede - Credit Suisse

Have you seen any changes in cross elasticity between cigarettes and smokeless?

Mike Szymanczyk

No, we have not at this point. But still, we’re talking about an FET hike that took place at the beginning of April and we’re only three months into it.

Dave Beran

It’s a little soon to be evaluating that, I think.

Thilo Wrede - Credit Suisse

Fair enough. Okay. And then one more question. The UST integration with the cost savings, the response from the brands to your price cuts, the overall progress of integration, would you say everything right now is going on track and is exactly where you thought it would be at this point?

Mike Szymanczyk

Yes, pretty much.

Thilo Wrede - Credit Suisse

If we progress on track and everything runs as smoothly as it has so far, when would you think to be able to tell us whether or not it’s going to be accretive or not? Do we have to wait until the end of the fourth quarter?

Dave Beran

Probably in January, when we’ll tell you about that.

Thilo Wrede - Credit Suisse

All right. No further questions then.

Dave Beran

That’s pretty tight.

Thilo Wrede - Credit Suisse

Thank you.

Dave Beran

All right.

Operator

Thank you. At this time, I would like to turn the floor back over to Mr. Cliff Fleet for closing remarks.

Cliff Fleet

Thank you all for joining us today. If you have any follow-up questions please call us at the Investor Relations Group of Altria.

Operator

Thank you. This does conclude today’s Altria Group second quarter 2009 earnings conference call. You may now disconnect.

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Source: Altria Group, Inc. Q2 2009 Earnings Call Transcript
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