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Executives

Morris Moore – VP, IR

Susan Ivey – Chairman, President and CEO

Tom Adams – EVP and CFO

Analysts

David Adelman – Morgan Stanley

Judy Hong – Goldman Sachs

Christine Farkas – Bank of America

Thilo Wrede – Credit Suisse

Ann Grukin – Davenport

Erik Bloomquist – J.P. Morgan

Karen Lamark – Federated Investors

David Winters – Wintergreen Advisers

Adam Spielman – Citi

Ted Spero – Private Investor

Reynolds American Inc. (RAI) Q2 2009 Earnings Call Transcript July 23, 2009 10:00 AM ET

Operator

Please standby, we are about to begin. Good day and welcome to the Reynolds American second quarter 2009 earnings call. Today's conference is being recorded. At this time, for opening remarks and introductions, I would like to turn the conference over to Morris Moore, Vice President of Investor Relations. Please go ahead, sir.

Morris Moore

Good morning and thank you for joining us.

Today, we'll discuss Reynolds American's results for the second quarter and first half. We'll also review our revised full year outlook. We will 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.

And now, I'll turn the call over to Susan.

Susan Ivey

Good morning.

As our results show today, RAI delivered strong performance across a broad front in the second quarter. The results were particularly noteworthy in a quarter that was marked by unprecedented increases in federal excise taxes on tobacco products and big shifts industry pricing, all during a time of economic recession. Even so, RAI's second-quarter results underscore the strength of the company total tobacco business model, growth strategy, focus on productivity and ability to build shareholder value.

Innovation continued to be an important element of RAI's businesses with the continued expansion of new products to meet changing consumer preferences. And RAI's operating companies did a great job navigating through this turbulent time. R.J. Reynolds delivered higher second-quarter operating income, margin and total market share. Conwood posted strong gains in volume, share and operating margin. Their key cigarette and moist snuff brands performed very well and testified the fundamental strength of these companies and the power of their brands. Our Santa Fe subsidiary also continued to gain volumes and share on its Natural American Spirit brand.

The second quarter had its fair share of challenges but as we move through the quarter we saw trade inventory, industry shipments and consumer purchases return to more normal levels. Our company's second-quarter performance contributed to higher earnings and marketplace gains for the first half. Based on these results and the clarity that we've gained on the impact of the federal excise tax increases, RAI has raised and narrowed its guidance for 2009. Excluding any trademark impairments, we now expect adjusted EPS of $4.40 to $4.60 for the full year.

During the quarter, federal regulation of the tobacco industry was signed into law. We would have preferred a bill that recognizes the significant differences in risks between tobacco product categories and implement harm reduction policies. Even so, RAI remains committed to reducing the harm caused by tobacco, and we remain confident that our companies can successfully compete in this new regulatory environment.

We have been preparing for this change for several years and despite the new restrictions that will be implemented over the next few years, our operating companies are well positioned for long-term growth. However, R.J. Reynolds is investigating grounds for constitutional challenge of certain provisions in the regulation. Also on the external front, there has been significant activity concerning state excise taxes this year and seen a weighted average national increase of about $0.15 a pack on cigarettes and a few states are still considering tax increases.

Turning to the NPM adjustment, we continue to pursue a parallel path to resolve disputed payments, either through negotiation with the state or through arbitration scheduled to begin in October. We have reached agreement with the state attorney general that the disadvantages of the MSA will be deemed to be a significant factor in determining NPM adjustments from 2007 through 2009. So that is a quick look at some external issues.

Now we will take a closer look at our company business performance during the second quarter. R.J. Reynolds Conwood and Santa Fe remain focused on strengthening their traditional businesses while developing and introducing innovative products that meet the desires of the adults who enjoy tobacco. R.J. Reynolds delivered higher earnings and operating margin as the company benefited from increased pricing and productivity. Those factors more than made up for lower cigarette volumes and higher pension and legal expenses.

R.J. Reynolds growth brand performed well in the second quarter delivering higher total market share. That performance was especially notable given the industry's large cigarette price increases, which are driven by higher federal taxes. Camel, R.J. Reynolds premium growth brand, continued to benefit from recent innovation. Camel Crush, which went national late last year, is enhancing Camel's position in the growing menthol category. Camel Crush offers adult smokers a fresh menthol taste available on demand. It does this by allowing smokers to crush a flavor capsule in the filter.

Beginning in August, that capsule technology will be expanded to Camel's core menthol styles, but instead of changing the cigarettes from regular to menthol, the capsule will offer adult smokers of these menthol styles the option of adding more menthol to suit their taste. Another innovation, Camel Snus, which has been available nationally since late in the first quarter has also performed well. At this point, it has three-tenth of a share point, and that is on a cigarette equivalent basis, which assumes that a Camel Snus is equal to a pack of cigarettes. Camel Snus has growing appeal and we expect it to build momentum over time. But keep in mind that the margin on a tin of Camel Snus is about twice the margin for Camel cigarettes.

We're also seeing a good consumer interest in Camel Dissolvables. Camel Orbs went into three lead markets in the first quarter and R.J. Reynolds will add Camel Sticks and Camel Strips to these markets this summer. These smokeless tobacco products were made from finally milled tobacco and they dissolve completely in the mouth. Adult female smokers find Camel Orbs much more appealing than other smokeless tobacco products. And women make up about half of all smokers, so that greatly expands the opportunity for Camel Dissolvable products.

Turning to Pall Mall, R.J. Reynolds other growth brand, in the second quarter, the company continued to leverage Pall Mall's growing appeal. R.J. Reynolds realized that price increases tied to the federal excise tax offered opportunities and the company seized the chance to reach consumers while in motion. Pall Mall's latest promotion ended in late may. It generated high levels of trial and conversion as adult smokers reconsidered brand choices in light of higher prices. Since the end of that promotion, many of those who tried Pall Mall have stayed with the brand. Pall Mall is a high-quality longer-lasting cigarette at an attractive price and that makes the brand especially appealing in the current economy.

Powerful brands and solid strategies were only part of the R.J. Reynolds story in the second quarter and the first half. You'll recall that the company reorganized last year and its new structure is providing more resources to deliver innovation and additional productivity gains. R.J. Reynolds people are focused on success and the company's many strengths make it a vehicle for future growth.

Turning to Conwood, I'm very pleased with its continued strong momentum in the second quarter. The company again delivered strong gains in moist snuff volumes, market share and operating margin. The company's second-quarter operating income was down slightly. That was due to Conwood's decision to temporarily absorb the federal tax increases on moist snuff and to lower margins on Kodiak. That reduction bought the price in line with competitive premium brands.

The tax increase also sharply reduced volume on roll your own tobacco and little cigars, which represented small portion of Conwood's business. The negative effect of these factors more than offset moist snuff volume and price gains. Even so, Conwood increased its overall second-quarter operating margin on the strength of the prior-year increase in price on Grizzly and higher pricing on the company's non-core products.

Now, let us look us volumes. Given the volatility in trade inventory levels between the first and second quarter, the first half provided better perspective. In the first half, industry moist snuff shipments grew but at a lower rate than historical trends because of trade inventory shifts. Nonetheless, consumer demand continued to grow at about 6% and demand for Conwood's products grew at twice that rate.

Grizzly, the nations number one moist snuff brand continued to drive Conwood's growth. This year as you know there have been significant reductions in the retail price of premium moist snuff product. This has further narrowed the price gap between premium and Grizzly's. In addition, Grizzly announced a price increase in June. The national average price gap at retail now stands at about a $1.35 a can. That gap has been cut in half since RAI brought Conwood in 2006. Even so, Grizzly's market share has grown by more than six percentage points in the past three years.

Grizzly's two newest pouch styles, mint and straight, were introduced early this year and are rapidly adding to Grizzly's success in the fast-growing pouch segment. You may recall that Conwood entered the pouch market last year when it went national with Grizzly Wintergreen pouches. The introduction of these pouch styles together with last year's national introduction of Grizzly Snuff demonstrate Conwood's ability to further enhance its performance by developing products that meet the desires of adults who enjoy tobacco.

These new products already represent more than 2.5% of the moist snuff market. And Grizzly's core styles also continue to grow. With Grizzly long cut Wintergreen recently becoming the nation's leading moist snuff style. During the second quarter, Conwood also took steps to improve its position in the premium segment. The company reduced the price on Kodiak to make it more competitive and to help stabilize Kodiak's performance. And Conwood enhanced its focus on premium with the introduction of two innovative styles of Camel Dip in Colorado and Florida.

Camel Dip is the first new premium moist snuff brand in many years and it offers the brand the opportunity to leverage Camel's heritage and equity with moist snuff consumers. Camel Dip comes in two styles, Wintergreen Wide Cut and Dark Milled, that feature innovative packaging and the category's first wide cut tobacco. Conwood has demonstrated its ability to identify and profit from changes in the industry and we're confident that the company is well positioned for future success.

So that is a quick update on our operating companies and Reynolds American's second quarter and first half performance. Tom will now give you some more details.

Tom Adams

Thanks Susan and good morning.

As you have just heard, RAI and its operating companies delivered strong results during a time of major industry change. I will discuss some numbers and focus mostly on adjusted results to provide perspective on our business fundamentals. The reconciliation of adjusted to reported results is in our press release which is on our website. I will point out that there was no difference between reported and adjusted results in the second quarter.

Starting with our second quarter earnings, EPS of $1.29 was up 4.9%. For the first half, adjusted EPS of $2.30 was up 3.1% over the prior year period and reported EPS of $1.32 was down 55.1% for the first half. Reported and adjusted results include a $0.20 per share negative impact from higher pension expense. Reported results also include non-cash trademark impairment charges of $0.98 per share from this year's first quarter and a prior-year again of $0.71 per share from the termination of the Gallaher joint venture.

Turning to R.J. Reynolds, the company increased operating income and margin in the second quarter. Operating income of $556 million was up 3.4%. For the first half, excluding trademark impairments, adjusted operating income of $1.015 [ph] billion was up 5.3%. R.J. Reynolds operating margins for the second quarter was 28.2%, up two percentage points from the prior-year period. For the first half, adjusted operating margin was 27.9%, up three full percentage points.

Driving those results were higher pricing, lower promotional expense, and additional productivity gains including benefits from last year's restructuring. I will point out that R.J. Reynolds first half results included about $90 million in higher pension expense as compared with the prior year period.

Turning to volume, R.J. Reynolds cigarette volume declined 6% in the second quarter and was down 8.1% in the first half. That was just above the first half industry volume decline of 7.1%. Now turning to market share, due to Pall Mall's especially strong performance, R.J. Reynolds posted higher market share in the second quarter. The company's total share was up 0.4 percentage points at 28.7%. For the first half, it was down 0.2 percentage points at 28.2%. The company's growth brands Camel and Pall Mall captured a combined second-quarter market share of 12.7%, up 2.6 percentage points.

Camel posted second quarter share of 7.5% in line with the prior-year period despite significant cigarette price increases driven by the higher federal excise tax. As Susan noted, the brand's latest cigarette innovation Camel Crush has captured market share of six tenths of a point, and that is with relatively low levels of support since its national introduction in the third quarter of last year.

R.J. Reynolds innovative new smoke-free tobacco products Camel Snus and Camel Dissolvables are also making good progress. Camel Snus was expanded nationally in the first quarter. In the second quarter, it achieved the equivalent cigarette market share of three tenths of a point. R.J. Reynolds value growth brand Pall Mall captured market share of 5.2% in the second quarter, up 2.6 percentage points from the prior year quarter on the strength of its latest promotion. Pall Mall is generating higher levels of trial and conversion while contributing to R.J. Reynolds earnings.

Turning to Conwood, we continue to be very pleased with the company's performance, especially in light of the challenges they faced during the first half. Conwood's second quarter operating income was $92 million, down 4.1% from the prior year period. Excluding trademark impairments, Conwood's second-half operating income of $176 million was down less than 1%. However, second-quarter operating margin of 54.1% was up 3.2 percentage points, while the first half operating margin of 52.4% was up 2.5 percentage points.

These margin improvements resulted from higher prices and volume gains on Grizzly moist snuff. Those factors more than offset the effective Conwood decision to reduce Kodiak's price and to temporarily absorb the federal excise tax increase on moist snuff. Federal excise tax increase also led to volume reductions on Conwood's other tobacco products. In contrast, Conwood's second quarter moist snuff volume grew 6.7%; for the first half, it was up 3.9%. However, consumer purchases of Conwood's moist snuff product have grown at about 12% this year.

The difference in these two measures is the result of adjustments in retail and wholesale inventory levels in the first half. Conwood's second-quarter market share of moist snuff shipments was 29.4% was up two percentage points. That strong performance was driven by a 2.2 share point gain on Grizzly which brought its market share to 25.4%. Grizzly's second-quarter volume was up 8.7% putting the total increase with the brand's first-half shipments at 7.1%. However consumer purchases of Grizzly have grown at twice that rate.

Now I will provide additional details on RAI. We ended the quarter with a cash balance of $2.2 billion. That was after MSA payments of $1.8 billion, a scheduled debt repayment of $200 million, and a $50 million contribution to the pension plan. With respect to our dividends, I want to reiterate our AI's commitment to returning value to shareholders through our dividend, which is $3.40 a share on an annualized basis.

And now taking a look at our guidance, as we announced today, we have increased and narrowed the range of RAI's guidance. We now expect full-year adjusted EPS of $4.40 to $4.60. This excludes any trademark impairment charges but includes our year-over-year increase in pension expense of $0.40 per share. Our first-half results and better visibility for the full year gives us confidence that our 2009 performance will exceed our earlier expectations and we feel very good about our outlook.

In closing, without a doubt, this is a challenging year with unprecedented tax increases, regulatory activity and fundamental changes in the tobacco industry's competitive landscape. But now that we're halfway through the year, we started to see the effect of many of these changes and the strength of our strategies and the resilience of our business is clear. Reynolds American's first-half results and our outlook for the full year highlights RAI's ability to continue building value share for shareholders as we move ahead.

Thank you and we will now turn to the Q&A portion of the call. Kristen, would you remind our callers how to get in the queue?

Question-and-Answer Session

Operator

Absolutely. (Operator instructions). We'll take our first question from David Adelman with Morgan Stanley.

David Adelman – Morgan Stanley

Good morning, everyone.

Susan Ivey

Good morning, David.

Tom Adams

Good morning, David.

David Adelman – Morgan Stanley

Susan, can you talk about the strategic logic long-term of focusing on a discount brand in the US market given not only the lower margin structures but also the inevitable impact of the cost disadvantage you are under whether it is versus (inaudible) manufacturers that have a carve out in the MSA or the companies that are inevitably going to operate here illegally at the bottom of the market?

Susan Ivey

Sure David. First of all, let me say that we are very pleased with the results of the Pall Mall post promotion and it was margin positive. So let us be clear about that. And we have talked about what we believe is the value to having a strong mid price offer in the market for the last five years. As prices continue to increase and consumers look for alternatives, Pall Mall is truly a unique value offer. It has grown in the last five years from 1.5 to over 5 share points and I believe the value of it actually in the overall profit pool is keeping the pricing spectrum that allows the overall profit pool to grow. And the Pall Mall promotion was successful, we gained a lot of trial obviously during the FET [ph] in post promotion period and a great number of those consumers are staying with the brand.

David Adelman – Morgan Stanley

Where do think the share like is likely to settle out under a more normalized promotional regime?

Susan Ivey

Well, we have done two pulse promotions a year on a Pall Mall for about the last three years and the post promotion was finished at the end of May. Of course, we gave back some in June, but it was over five shares in June. So we will see where it settles out David as we go into the third quarter, but significant gains in total terms.

David Adelman – Morgan Stanley

Okay. And on the smokeless side, Susan, how would you characterize sort of the magnitude of the change in the competitive environment because of the competitive premium price reductions? And in saying that, let us leave aside for the moment the financial impact of having to reduce price on Kodiak because that is just a permanent reset and the temporary absorption of the excise tax, to sort of look at it from a third quarter and going forward basis, how different is the operating environment for Grizzly than it might have been last year or the year before?

Susan Ivey

Well, I think the operating environment is different because the price gap has closed, but Grizzly continues to deliver outstanding results. And the value category obviously driven by Grizzly is now 50% of total moist, Grizzly has picked up 2.2 share points, and we have continued to close that price gap ourselves through incremental pricing. Grizzly has equity, it is seen as a great brand, a great product, at a good strong price. And so the environment is different because the price gap has narrowed but I think Grizzly is demonstrating its strength. That price rollback was at the beginning of the second quarter and the second quarter performance speaks for itself.

David Adelman – Morgan Stanley

Okay. And then just – thank you, and then just a two part question on the NPM adjustment dynamics, the 2.2 billion cash that was called out, does that include the disputed payment, the last one that you have retained? And also you think that the arbitration process for '03 will end up accelerating the resolution prospects – process rather for the remaining years?

Susan Ivey

Yes and yes. I'm hopeful about that. The 2.2 does include the 406 that we have withheld and we do hope that the arbitration process in October once everybody is lined up and there is a panel and they understand the facts will a accelerate future year resolutions.

David Adelman – Morgan Stanley

Okay, thank you very much.

Susan Ivey

Thanks, David.

Operator

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

Judy Hong – Goldman Sachs

Good morning everyone.

Susan Ivey

Hi Judy.

Tom Adams

Hi Judy.

Judy Hong – Goldman Sachs

Susan, just following up on Pall Mall and just you know if you look at the second quarter and the growth of the value brands in the industry, just how concerning is this trend and sort of maybe forcing the premium pricing to be under more pressure going forward?

Susan Ivey

Well, I think that we have – as I said we have implemented Pall Mall post promotions for the last three years and so there really is no change in that. This was a slightly higher level of value and it was during a time when consumers are in motion due to higher prices from higher excise taxes. And who knows where those consumers would have gone if they didn't go to Pall Mall when they were in motion. So I believe that the competitive environment will be relatively stable going forward as it has been and we have not seen significant growth in the non-big three, call it half a share point, but no run away gains. So I think we are returning to normal levels and Pall Mall is benefiting from capturing those consumers that were in motion at the time.

Judy Hong – Goldman Sachs

Okay. And in terms of your rate of volume decline on the cigarette side, you know it seems like now it is tracking closer to the industry that we have seen in years down, I guess your brands were down 8% year-to-date, industry down kind of 7%, is this now – are we getting closer to a point where you feel confident that your brands are actually going to see stabilization in terms of market share sort of in the near term than maybe you had anticipated?

Susan Ivey

Yes Judy. I think if you actually look back a little bit, RAI's market share, total market share has actually has been relatively stable for the last six quarters and we have delisted about 650 SKUs and we have gotten rid of a lot of our low to price sort of, what do we call that, private-label. And so I do think that Reynolds volume losses will be slightly ahead of the industry but certainly it has improved from historical trends and expect that to continue.

Judy Hong – Goldman Sachs

Okay. And then on Conwood side of the business, why is that a change in terms of how the inventory is moving in cigarettes versus smokeless, I mean in the first quarter, you had de-loading for both and then you got the cigarettes reloading in the second quarter, but in smokeless, it seemed like that really didn't take place and things like the inventory level still coming down. So Just curious what is happening with the inventory in smokeless that is different than on the cigarette side?

Susan Ivey

I think the biggest mover is the change in promotional tactics in terms of inventories and so lots of what has been done with multi cans has now been done with a price reset. And so I believe that we see that as pretty much a one-time event and that inventories are now at a new base. And as I said on the consumption basis, we have seen a growth in Grizzly up 12% in the second quarter.

Judy Hong – Goldman Sachs

Right, okay. And then on Camel Snus, it has got about 0.3 share equivalent cigarette share right now. Do you have a sense of where that is coming from, either traditional cigarettes or moist snuff, and do you have any sense from that perspective?

Susan Ivey

Yes, our research shows that it is primarily smokers and it is smokers who are using Snus when they can't smoke and I am – there is the occasional dipper who uses it when they don't want to spit, but really it is coming from smokers, and it is coming across the board in terms of source of brands. So Camel is slightly over index but not a lot.

Judy Hong – Goldman Sachs

Okay. And then just finally on the FDA, you have called out potential challenges that you might be raising with respect to the current FDA, can you give us some of color in terms of what are the areas that you're looking to challenge, and is it something that you are doing on your own, or is sort of industry doing it on a consolidated basis?

Susan Ivey

We are still in the preliminary phases, Judy. We won't be doing it alone. But I think it is best to talk about those challenges once they are made.

Judy Hong – Goldman Sachs

Okay, thank you.

Susan Ivey

Thank you.

Operator

We will take our next question from Christine Farkas with Bank of America.

Christine Farkas – Bank of America

Thank you very much. Good morning, everyone. A question if I could back to Pall Mall, is it fair to say that given the end of your promotion at the end of May as you have indicated that the share peaked earlier in the quarter rather than in June?

Susan Ivey

Yes. It peaked in May as it would because it was an April May promotion.

Christine Farkas – Bank of America

Okay. And the changes in share, is that about in line with what you would expect following the end of a promotion?

Susan Ivey

Yes, it is. As I said, we were in June over five share points and we have historically retained many of the smokers who tried Pall Mall in this promotion period. And the reason for that is it is a great cigarette, it has more puffs than anything even in the premium sector, so it really represents a strong value.

Christine Farkas – Bank of America

Okay. Thanks for that. And then moving to Grizzly, could you quantify how much of the growth if any but how much of that growth came from pouches launched earlier in the year?

Morris Moore

Pouch styles were about 1.3 share in total in the second quarter.

Tom Adams

Right. (inaudible) were launched, I think it was about two tenths of a share point, the two pouch styles that were launched in the first quarter.

Susan Ivey

Yes, Christine, that was not a big driver of Grizzly growth. I would say the new two new pouch styles launched this first – in the first quarter were just a few tenths.

Christine Farkas – Bank of America

Okay, great. And then with respect to the other tobacco categories, given the changes in the federal excise tax and the relative pricing and value to consumers, is there any change or do you anticipate any change to your own focus on those categories?

Susan Ivey

Well, I think if you think about the categories that were hit by the tax disproportionately, we think about roll your own and little cigars. And you know roll your own is down 40%, 45% and little cigars are down 25%, 30%. So I think that is inevitable. I believe we picked up probably our fair share of that in the cigarettes and so that is one of the advantages of being a total tobacco player.

Christine Farkas – Bank of America

Okay, thanks. And then Susan last question on guidance you talk about better visibility in the second half, did those comments relate to cigarette elasticity or competitor activity in the marketplace, where is the visibility coming from now that perhaps we are partially through that FET adjustment?

Susan Ivey

Yes, I think we are now three months plus obviously through the tax being absorbed in terms of wholesale and retail inventories and consumer off take. And so we feel as though what we have seen year to date won't be significantly different of what we will see going forward and that is assuming that the promotional environment is relatively stable which doesn't mean that it is not active but it is certainly it doesn't anticipate any wild swings. But I think we are pleased with the way we've come through the second quarter and feel good about the second half.

Christine Farkas – Bank of America

All right. Thank you very much.

Susan Ivey

Thanks, Christine.

Operator

We will take our next question from Thilo Wrede with Credit Suisse.

Thilo Wrede – Credit Suisse

Good morning, everybody.

Susan Ivey

Hi, Thilo.

Thilo Wrede – Credit Suisse

A quick question on the expansion of this cool crush technology for regular – sorry Camel Crush technology into regular Camel Menthol cigarettes, is that something that you're planning for (inaudible) and also expand it into those brands too?

Susan Ivey

No, not at this time. We will introduce the technology, it will be the first menthol brand in the market with this technology giving the consumer the opportunity to add a burst of fresh menthol whenever they want to do with smoking the cigarette. So, we're enthusiastic, we have seen great results with Camel Crush. It is sitting at about 0.61 style with relatively low promotion levels and so we want to give our menthol consumers the opportunity to experience this technology as well.

Thilo Wrede – Credit Suisse

But only the Camel Menthol consumers?

Susan Ivey

Yes, at this time.

Thilo Wrede – Credit Suisse

Okay. And the Pall Mall market share growth that you had, obviously that is – that is a positive outcome for Pall Mall but it makes your product portfolio on the cigarette side much more discount skewed. In the past I think you have cut back especially SKUs on the discount and is that a shift in your priorities now that you're going more after the discount market again?

Susan Ivey

Certainly not. Our focus is very much on our growth brand portfolio. Camel is certainly the most important brand in our stable on the cigarette side, but Pall Mall is in a great position in this economy with these price increases, and it is margin positive, and it has a great deal of marketplace strength. So utilizing that to even as it cannibalizes all other value brands is a good position to be in.

Thilo Wrede – Credit Suisse

Okay. And then one last question on Grizzly, how much growth of Grizzly is driven by the discontinuation of Rooster, do you have any sense of that?

Susan Ivey

I have no idea. Grizzly has of course demonstrated its growth for the last seven years. My guys here are saying it was tiny. I don't…

Morris Moore

Well, Grizzly is up 2.2 share points (inaudible) was about 0.2 shares.

Susan Ivey

Right, so nothing.

Thilo Wrede – Credit Suisse

Okay, thank you.

Susan Ivey

Thank you.

Operator

We will go next to Ann Grukin with Davenport.

Ann Grukin – Davenport

Good morning.

Susan Ivey

Good morning Ann.

Tom Adams

Good morning Ann.

Ann Grukin – Davenport

I wanted to first ask you about the statement in the release about trade inventories returning to more normal levels, are you seeing that across the tobacco portfolio, and are these levels we saw before the FET tax increases?

Susan Ivey

No, they have returned to more normal levels across the tobacco category, that is correct. But the absolute level of inventory certainly has decreased. Wholesalers have pulled back their inventories, retailers have pulled back their inventories, and I think those are stabilizing now. Obviously, the cost of carrying these goods has gone up substantially for our trade partners, and so they are balancing that with demand.

Ann Grukin – Davenport

Right. That helps. With the FDA legislation, is there any change in your strategy to launch new products in the other tobacco space?

Susan Ivey

No. I think we have begun this path in terms of innovation and launching products to meet the changing desires of adult consumers and obviously we will continue to do that and we will do that within whatever framework the FDA establishes.

Ann Grukin – Davenport

Great. And then last, if I missed this, I apologize, what do you expect the growth rate to be for the overall MST category for the year?

Susan Ivey

I think our view still is it will be in that 6% to 7% range in overall terms. I think we have to have this readjustment without the promotional cans in the pipeline but we are continuing to see consumption growth at those levels today.

Ann Grukin – Davenport

That is great. Thank you.

Susan Ivey

Thank you.

Operator

We will go next to Erik Bloomquist with J.P. Morgan.

Erik Bloomquist – J.P. Morgan

Hi, good morning.

Susan Ivey

Hi, Erik.

Tom Adams

Hello.

Erik Bloomquist – J.P. Morgan

Just wanted to follow up a little bit on the smokeless business and in particular was curious if you could quantify or discuss in more detail the dual users. You mentioned it a little bit with respect to Camel Snus, but I was curious given the steep increases in cigarettes relative to the more modest increase for smokeless, if you have seen an increase in uses there, and if that was perhaps part of the strong consumption growth at Grizzly's you have seen?

Susan Ivey

To be honest with you, Erik, I don't have that kind of level of detail. After this excise tax increase, I don't have specific buyer studies that would confirm or deny that. I certainly think the hypothesis is a good one and very logical in many states where moist is significantly lower priced in cigarettes. But I really can't answer the question. Grizzly of course has just continued on its growth path as it continues to capture a large share of people either coming into the category from cigarettes or trading as prices increase.

Erik Bloomquist – J.P. Morgan

Okay, thank for that. And then with respect to FDA, now that it is past, is there a real threat that they will force products that were recently launched like the Orbs, Dips, and Strips to be considered new products under that legislation? And so with that possibility that those products have to be pulled from the market or is that risk relatively modest at this point?

Susan Ivey

Our position is very clear. These products are very similar to other moist type of style of products and so we will continue to evaluate these Dissolvables in the lead market. As I said, the Orbs will be joined by Camel Sticks and Strips in the summer and will continue to determine how consumers react to these products and determine our next step from those signals.

Erik Bloomquist – J.P. Morgan

Okay. And then last question was kind of going back to this whole question of premium relative to discount mix, on my numbers, you had about 63% premium of your total cigarette volume in Q1 that went down to about 58% in Q2. Should we expect that to rebound in Q3, Q4, or are we looking at a lower level of premium relative to the overall cigarette volume portfolio?

Susan Ivey

Well, if we are growing total market share, then I suspect the mix may be altered. So we're very focused on Camel in that premium segment but Pall Mall share growth, a great deal of which we expect to retain, obviously will impact the total portfolio, but we are very pleased with that result.

Erik Bloomquist – J.P. Morgan

Okay, great. Thank you.

Susan Ivey

Thanks Erik.

Operator

We will take our next question from Karen Lamark with Federated Investors.

Karen Lamark – Federated Investors

Good morning. I wonder if you could quantify the retention that you talked about once you stop the pulse promotion, could you just comment whether or not it is more favorable or less favorable than your past promotions, and then I got a second question?

Susan Ivey

I will tell you Karen we are just, we have one month of share after the promotion stopped and we are pleased with the retention rate and they actually over the past three years those retention rates have always been pretty strong. So it is a little bit early for me to say, I will certainly be able to talk more about that in the third quarter. But as I said the market share of Pall Mall peaked in May and came – then the promotion was over in June, and the brand was still over five share points. And remember in the first quarter, it was 2.9. So we are pleased with that result.

Karen Lamark – Federated Investors

Okay. And then separately, with greater confidence in the update and guidance, is there any change in your thinking about the timing of buybacks? Thanks.

Tom Adams

We will continue to look, if you see we have accumulated a fair amount of cash on our balance sheet, and we are looking at a number of things, and a portion of that, we will use for this FET floor tax that I think is due around 1st of August. We will be looking at the pension fund and then we will be looking at as well as some CapEx to increase capacity at Conwood. But yes certainly, share buybacks and other types of vehicles to get money back to shareholders is what we will be considering.

Karen Lamark – Federated Investors

Thank you.

Susan Ivey

Thank you.

Operator

We will go next to David Winters with Wintergreen Advisers.

David Winters – Wintergreen Advisers

Hi, just wondering if…

Susan Ivey

Hi, David.

David Winters – Wintergreen Advisers

How are you, Susan?

Susan Ivey

Good.

David Winters – Wintergreen Advisers

Thanks for doing a great job, really appreciate it.

Susan Ivey

Thank you.

David Winters – Wintergreen Advisers

just curious, I mean is there any studies that get done on the federal and the state level at which raising taxes actually doesn't produce more revenue?

Susan Ivey

Yes. There are studies and there is a point where things tip over. Obviously, it depends also on neighboring state tax rate and it depends on how the Native American reservations, how they are established in a state, because of course if they don't pay state tax and a tax increase drives volume there, it can actually produce a negative revenue result. We certainly actively take that information forward to the states when they are considering tax increases.

David Winters – Wintergreen Advisers

Thank you.

Operator

We will go next to Adam Spielman with Citi.

Adam Spielman – Citi

Hi everyone. A couple of questions if I can. First of all as you look out to the next 12 months of the US market, do you think there is any danger at all that the historic up trading that we have seen, the growth of premium brands, obviously, Camel, but Newport and Marlboro as well, will actually stop – start seeing collectively those brands start to lose share relative to some of the cheaper brands?

Susan Ivey

I mean we have seen obviously that the premium segment here has declined slightly but you know we are still sitting here today with industry premium of 74%. So that is very strong and I believe we have to see what happens yet in this economy. If we stop seeing job losses and the economy stabilizes, then I don't think that there is any reason to believe there would be big shifts from premium. The desires of adult smokers to smoke the premium products in the marketplace today is still very strong.

Adam Spielman – Citi

Thank you. But given this possibility of a small shift, I mean it doesn't need to be a big shift, but I mean it could be a small shift, you know that 74 could be easing down, or could be easing up, and I guess if you have to guess which it was, which would it be?

Susan Ivey

Well, it is down about a share point since the tax the premium segment. So if that continues then you know that is a slight decline, and that is slightly different from prior years. But we are – I expect actually fairly stable.

Adam Spielman – Citi

Thank you very much for that. Can I come back to the question about the Pall Mall margin, you said that it is positive, and by that, do you actually mean to say that it is profitable but am I right to think that also as you replace some of your other value brands with Pall Mall, would I be right to assume actually that it is diluted, you are getting more margin on some of your other products, GPCs and Doral than you would for the equivalent volume of Pall Mall or is that assumption wrong?

Susan Ivey

You would be right except that – Doral donates a little bit more than its fair share to Pall Mall but the rest of the portfolio is either fair share or slightly below actually in terms of Pall Mall shared build. So I think you have to think of it in an overall context, the growth of Pall Mall is not coming strongly from us, if you will, other than in some states with Doral, and so in overall terms as was demonstrated in the second quarter, our margins are up.

Adam Spielman – Citi

I see. Okay, thank you very much.

Susan Ivey

Thanks, Adam.

Operator

We will go next to Ted Spero [ph].

Ted Spero – Private Investor

Hi. This is Ted Spero. I am just a retired person that has some stock in Reynolds American.

Susan Ivey

Welcome to the call.

Ted Spero – Private Investor

Okay. I wasn't sure if you would take on the speaker phone, they said something about it. Yes. You have a debt load of like 4.3 billion, something like that?

Tom Adams

That is right.

Ted Spero – Private Investor

Okay. Is there any chance that that can be refinanced at a lower rate that would help earnings out?

Tom Adams

Actually our rate right now are all in rates probably at about 5.5% and it is very competitive, it is actually better than market rate right now.

Ted Spero – Private Investor

Okay, all right. So you get a pretty good deal on that. The share count, did you reduce the share count in the quarter? Shares outstanding?

Tom Adams

Well, year-over-year, our share was down because of the – our number of shares outstanding was down because of the share repurchase program that we had last year, but there were no activity of that in the quarter.

Ted Spero – Private Investor

Okay, all right. And then on the company's dividend policy, is it still the policy to put out a certain percent of the earnings for the dividend?

Tom Adams

We target about 75% of our net income to be returned to shareholders in the form of a dividend which is currently at $3.40.

Ted Spero – Private Investor

Right. And then when the opportunity may present itself it may get increased in the future I would assume?

Tom Adams

That would be our intention over the long-term, yes sir.

Ted Spero – Private Investor

But I think it hasn't been going up perhaps because you went more to like growth with Conwood thing where that picked up a large chunk of the debt and that perhaps put an effect on the dividend?

Tom Adams

Actually, the Conwood acquisition has been accretive to our earnings, so it would be increasing.

Ted Spero – Private Investor

Yes, I know that. All right, so it has been accretive regardless of the interest payment.

Tom Adams

Yes, sir.

Ted Spero – Private Investor

Okay, I see. So (inaudible) finance that way. Okay, have a nice day. And maybe we will – may be it will turn to summer, I don't know how it has been there, but here it is cloudy and rainy all the time.

Susan Ivey

Oh dear (inaudible).

Operator

(Operator instructions). We will go next with a follow-up from Thilo Wrede.

Thilo Wrede – Credit Suisse

Tom, actually I have one more question for you, you just said that in August you will have to pay the FET floor tax, can you elaborate a little bit on that, why you have to pay the floor tax and how much?

Tom Adams

Yes. As you may recall back at the date of the FET enactment on the 1st of April, everybody who held the inventory whether it was manufacturers, wholesalers or retailers, had to remit those monies to the government and they are due I believe on August 1. Of the amount that we would owe is roughly probably in the neighborhood of a couple of hundred million dollars and so – and we actually got that money when we sold the inventory. So we have been holding that money during this period and will remit that to the government. And other manufacturers wholesalers and retailers are similarly situated. The only variable obviously being the amount of inventory they held at the time.

Thilo Wrede – Credit Suisse

Okay, that is helpful. Thank you.

Tom Adams

You're welcome.

Operator

This will conclude today's question-and-answer session. At this time, I would like to turn the conference back over to Mr. Moore for any additional remarks.

Morris Moore

Before we end the call, I would like to draw your attention to a change we're planning on the public distribution of company news including earnings. Starting January 1, 2010, RAI's website reynoldsamerican.com will be the primary source of publicly disclosed news about RAI and its operating companies. In this way RAI will comply with its disclosure obligations under the Securities and Exchange Commission's Regulation FD. Thank you for joining us.

Operator

This does conclude today's conference. Thank you for your participation.

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Source: Reynolds American Inc. Q2 2009 Earnings Call Transcript
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