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Lorillard Inc. (NYSE:LO)

Q2 2009 Earnings Call

July 27, 2009; 10:00 am ET

Executives

Martin Orlowsky - Chairman, President & Chief Executive Officer

David Taylor - Chief Financial Officer

Nathan Elwell - Financial Dynamics

Analysts

David Adelman - Morgan Stanley

Judy Hong - Goldman Sachs

Thilo Wrede - Credit Suisse

Nik Modi - UBS

Adam Spielman - Citigroup

Operator

Good morning, ladies and gentlemen and welcome to the Lorillard Incorporated second quarter 2009 earnings conference call. My name is Dan and I’ll be your coordinator for today. At this time all participants are in listen-only mode. We’ll be facilitating a question-and-answer session towards the end of today’s conference. (Operator Instructions)

I would now like to turn the call over to Nathan Elwell, from FD. Please go ahead.

Nathan Elwell

Thank you, Dan and good morning to everyone. By now you should have received a copy of the company’s second quarter 2009 earnings release. If you have not, please call our offices on 212-850-5600 and we’ll be happy to send you a copy. Speakers we have on today’s call are Martin Orlowsky, Chairman, President and Chief Executive Officer; David Taylor, Chief Financial Officer of Lorillard Inc.

Before we begin I would like to remind you that some of the comments made on today’s call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company’s earnings release and other filings with the SEC.

I would now like to turn the call over to Martin Orlowsky. Please go ahead.

Martin Orlowsky

Thank you, Nathan and good morning everyone. As our press release reflected this morning, we’re pleased to report strong second quarter 2009 results, despite the impact of the increase of the federal excise tax and the overall economic environment.

As also mentioned in this release, we are retaining a cautious outlook regarding shipment performance for the balance of 2009, due to potential lingering affects of the federal excise tax increase and continuing state excise tax increases and their ultimate impacts on the industry.

The second quarter of 2009 was somewhat exceptional in terms of its results for Lorillard as replenishment of wholesale inventory levels following the federal excise tax increase; a solid pricing opportunity for Newport; substantial growth from Maverick, our discount brand; and the continuation of our core strategy of balancing profitability with Newport’s market share performance combined to deliver excellent results.

In addition, the second quarter of 2009 reflected lower wholesale inventories than the prior year quarter; fairly substantial competitive menthol brand price promotions; the early stage of the new competitiveness menthol brand line extension and the new pricing dynamic rated by the FET increase.

All of these developments in our opinion tend to distort to an extent comparative performance measures for the second quarter of ‘09 versus the second quarter of ‘08. Nonetheless Newport gained 0.29 share points of the domestic wholesale market for the second quarter of ‘09 versus Q2 ‘08 reaching a total of 9.87%.

Comparing the same periods at the retail level as measured by our retail database, the brand increased its share by 0.44 share points to 10.38% of the market. Lorillard’s total domestic wholesale market share for the second quarter of ‘09 versus the second quarter of ‘08 was up 0.69 share points and for the same periods of comparison was up 0.86 share points at the retail level for a total share of 11.81%.

Newport’s share of the retail menthol segment was essentially flat for the first six months of ‘09 as compared with the same period a year ago at 34.6% of the segment. Both wholesale shipment and retail volumes were influenced in a similar manner by the variables I already mentioned. For the second quarter of ‘09 total Lorillard domestic wholesale units were up 2.1% versus the second quarter of 2008.

Driven by Maverick unit volume growth of 68%, while Newport’s volume was off 1.2% comparing the same periods. Newport in particular was affected by wholesale inventory patterns as well as general industry dynamics. For the first six months of ‘09 total Lorillard domestic wholesale shipments were down 2% compared with the same period last year adjusting for one less shipping day in ‘09 versus ‘08.

As we’ve often stated, Lorillard will continue to pursue a core strategy of balancing profit and Newport market share. We will continue as well to assess marketplace trends; competitive actions Newport brand performance and make appropriate adjustments to the brands promotional approach to the market as warranted.

To repeat my earlier comment regarding our near term industry outlook, we do not think the market has necessarily reached a point of equilibrium in terms of the effects of the pricing dynamic and competitive activity. Under any circumstances, Lorillard will attempt to achieve the best possible balance between profitability and market share performance.

Now I’m going to turn our comments over to David Taylor, our CFO and Executive Vice President.

David Taylor

Thank you and good morning, everyone. I’ll spend a few minutes reviewing the numbers and then we’ll open the line to questions. Net sales for the second quarter of 2009 were $1.519 billion, compared to $1.07 billion in the second quarter of ‘08.

Excluding excise taxes, net sales increased $147 million or 16.6% from $886 million to $1.033 billion. This increase of $147 million is the result of an increase in units sold combined with the impact of higher net average selling prices, partially offset by a somewhat less favorable mix.

As Marty mentioned, total units shipped in the quarter increased by 2.1% due largely to the partial restoration of inventory levels at our wholesale customers after the disruption surrounding the April 1 increase of excise taxes. The major factor driving the increases in sales and margins was the higher unit prices in the 2009 second quarter compared to the 2008 second quarter.

Sales promotion costs, accounted for as reduction in net sales, were slightly higher in the second quarter of ‘09 than in the second quarter of last year, although basically flat on a per pack basis. Gross profit increased to $111 million to $554 million or 53.6% of sales excluding excise taxes, from approximately $443 million or 50% of sales excluding excise taxes in the second quarter of ‘08, as a result of the impact of higher selling prices and higher unit volumes.

Cost of goods increased over last year due to higher raw material costs, primarily tobacco and wrapping materials, higher pension costs and the impact of using LIFO to value our inventory. The calculations of which are affected by the excise tax increase in ‘09. Amounts due under the State Settlement Agreements increased as a result of the inflation factors in the agreements and our increasing unit volume.

Selling, general and administrative costs increased approximately $7 million to $98 million in the second quarter of ‘09, compared to the second quarter of 2008. This increase is primarily the result of higher legal fees, which were approximately $3 million in the second quarter of 2009 than the prior year period. As in prior quarters, this increase in legal cost is primarily the result of higher defense cost for the Engle Progeny cases underway in Florida, among other things.

In addition, increases in other administrative costs, including pension costs, compensation, and other costs associated with operating as an independent public company contributed to this increase. Operation income increased 29.5% to $456 million from 44.1% of sales excluding excise taxes in the second quarter of 2009, from $352 million or 39.7% of net sales excluding excise taxes in the second quarter of 2008.

Net investment income was $1 million in the second quarter of ‘09 compared to $6 million in the second quarter of 2008. This $5 million decline was the result of lower average yields in 2009 compared to 2008. In addition, interest expense totaled $2 million in the second quarter of 2009 compared to $1 million in the prior year period. This increase is the result of interest expense on the recent $750 million senior note issue.

Our effective income tax rate for the second quarter of 2009 was 37.1%, as compared to 39.2% in the second quarter of 2008. This decrease is primarily due to the impact last year of the separation from Loews on the manufacturer’s deduction and the deductibility of certain expenses. The net income for the second quarter of 2009 was $286 million or $1.71 per share, compared to $217 million or $1.25 per share in the second quarter of 2008.

The impact of the lower share count in 2009 contributed $0.06 per share. The company also announced today, that the Board of Directors has approved an additional $750 million share repurchase program. This is in addition to the $250 million program that was announced in May. Under that program as of July 24, the company had repurchased 3.6 million shares at an average purchase price of $68.05 per share for a total of $243 million.

With that, I’d like to open the line for questions. Operator, could you help us with that?

Question-and-Answer Session

Operator

Your first question comes from David Adelman - Morgan Stanley.

David Adelman - Morgan Stanley

Marty, can you quantify the extent to which trade inventory builds from the end of the first quarters through the end of the second quarter benefited shipments this period?

Martin Orlowsky

Well, from the first the second quarter, go ahead, David.

David Taylor

Okay. So we did report a 2.1% increase in Lorillard shipments and adjusted for any kind of trade inventory change. We think that is actually a decline of roughly seven-tenth to 1%.

David Adelman - Morgan Stanley

Then the comments you made, Marty, both in the press release and in your prepared remarks regarding the lingering effect of the federal excise tax and the threat of state excise tax increases. Are you any more concerned than you would have been three months ago about those issues?

Martin Orlowsky

No, I’m not any more concerned. I just think it would be premature to reach any firm conclusions. I believe when we spoke last in about the potential of the excise tax increase, or even before that I said that, it would take several months before we would see the ultimate effects of that and I think, I believe I said that it would go through the third quarter of this year and I still continue to believe that.

I don’t think we’ve yet seen the full effects where certain brands might establish themselves relative to whatever the pricing dynamic effects are on them. So though in those terms, I’m not changing what I said before, I just think it would be premature to say today that this is the way it’s going to look.

David Adelman - Morgan Stanley

Can you characterize the competitive environment during the quarter both in general sense, and as it relates to menthol?

Martin Orlowsky

Well, I think specifically as it relates to menthol, it has continued to be fairly price competitive. We have not seen any substantial changes in terms of the competitive brand promotional patterns two in particular, are very active.

We also, as a referenced saw the beginning at the latter point of the second quarter of shipments entering into the pipeline in support of Altria’s Blend 54 promotion and once that takes effect it will be probably one of the lowest priced brands in the marketplace. So, I would describe the environment as a continuation of a fairly aggressive position by several of our competitors in the menthol category.

David Adelman - Morgan Stanley

Is there anything in particular you would attribute your ability to generate sort of an accelerated, net price benefit and still grow shares on Newport?

Martin Orlowsky

I always say excellent management does that, but I think it’s a combination of what we’ve talked about in the past, the strength of Newport’s brand equity position in the marketplace, obviously first and foremost, supports the opportunity for Newport to perform as it has.

I think our targeted promotional approach, which is not similar to some of our competitors with respect to how and where we promote and how much we promote. So, I think it’s a combination of the brand’s basic strength fundamentals and our disciplined promotion approach itself.

David Adelman - Morgan Stanley

One last thing, as it relates to the now disclosed target of 1.5 times debt to EBITDA, in the absence of an acquisition, should we just anticipate that overtime borrowings will escalate and that those funds will go toward share repurchases?

Martin Orlowsky

I don’t think I would anticipate anything. We’re saying that that’s a general guidepost. We have not, our board hasn’t authorized anything. I think we’ve often said that, we will weigh and assess marketplace conditions as we go forward marketplace conditions include a number of variables.

So I would not make any assumptions going forward other than that this is sort of a guidepost, but that’s about as far as it goes. We’re not announcing anything in any firm context.

Operator

Your next question comes from Judy Hong - Goldman Sachs.

Judy Hong - Goldman Sachs

Martin if I look at the menthol share of the industry looks like the share accelerated in the second quarter. Can you just talk about maybe some of the factors that drove the menthol segment share to accelerate in the second quarter?

Martin Orlowsky

Yes. I think it is a byproduct of promotional product going into the market during the quarter, as I already mentioned toward the end of the second quarter there was a list as a result of pipeline volume coming in for Blend 54, the Marlboro menthol line extension and pretty active overall use of promotional units by some of our competitors, which tends to hike the overall segment itself.

Judy Hong - Goldman Sachs

Would you think that just given Newport’s share in the menthol segment in the quarter was flat-ish I mean is that something that you’re focused on in terms of trying to accelerate that Newport share within menthol segment?

Martin Orlowsky

No, I think I said there are two factors here. One, the whole second quarter, first half, as I indicated in my remarks are somewhat distorted when you make comparisons to a year ago given all of the activity that took place between the first and second quarters related to the excise tax increase in particular for one.

Secondly, we’re seeing, but I’ll describe as somewhat unusual activity in the form of a line extension coming into the mix that tends to distort the segment universe itself. So, I don’t think if we look at the second quarter, or the first quarter for that matter, I don’t think we’ve seen necessarily a set of conditions there that would cause us to be overly concerned that Newport is not demonstrating its opportunities to grow segment share.

I think the overall market share speaks for itself; Newport continues to outperform the industry’s standards or benchmarks. So I would not overreact to a set of numbers related to either the second or first quarter of this year.

Judy Hong - Goldman Sachs

Then as we look out in the second half of this year, can you give us some perspective on your volume outlook given pretty tough comp that you’re facing in the second half of this year versus last year?

Martin Orlowsky

I think I’ll refer back, Judy, to what I said in my statement. We remain cautious and we will monitor it.

Judy Hong - Goldman Sachs

Then David is there anyway you can sort of help us in guiding kind of the timing of the share buyback program that you’ve announced and you’ve done the $250 million in one quarter basically and as we think about the $750 million buyback that you’ve announced today, how we should think about the timing of it?

David Taylor

Judy, I don’t think I can give you much assistance as to how fast that $750 million will be spent in the market, it’s going to depend on what does our share price looks like and how aggressive we want to be, those questions are still open here, so I don’t think I can give you any firm guidance about put the timetable that we’ll spend that’s it.

Operator

Your next question comes from Thilo Wrede - Credit Suisse.

Thilo Wrede - Credit Suisse

A quick question on Maverick, given that it’s a discount brand I would assume that the margins on Maverick are a little bit lower than for Newport, with that assumption, should we have concerns about Maverick growing much faster than overall volumes for the company and therefore margins being diluted?

Martin Orlowsky

I think there’s a bit of an overreaction to the mix change, if you will, due to Maverick’s growth. For one, we’ve long stated that we will always manage Maverick, so that it does not lose any money on a fully loaded basis and it hasn’t since its inception and we’ve taken several price increases over the last 16 months to 18 months as a form of demonstrating our point of view with respect to how to manage that brand, number one.

Number two, with the increase in volume Maverick is actually improving its margins. So, on a fully loaded brand contribution basis, it’s actually adding more profit on that level than it had in prior quarters. Two, the brand, I’ll leave it at that. Obviously, it’s a lot less than Newport, without question.

Thilo Wrede - Credit Suisse

Then a question on FDA regulation and what your expectations are there going forward. Does that seem that the industry have on the Scientific Advisory Panel? Do you think that actually gives you some kind of influence on that panel or is that purely ceremonial that you are represented on the panel there?

Martin Orlowsky

Thilo, I’m not going to comment or speculate on how the panel is going to be affected and who is going to do what. All I’m going to say about FDA is that, we’ll be fully prepared to comply with the FDA regulations whatever they are.

We are confident that on the menthol issue from a scientific standpoint that there is a little to no evidence to suggest that menthol is any more unique to the cigarette product and than the cigarette product itself. So I’m not going to comment or speculate on mindsets of people in the future.

Thilo Wrede - Credit Suisse

Then just one last question, can you give us an idea of what you expect for your tax rate for the full year?

David Taylor

Thilo, I think the first half effective tax rate is probably a reasonable proxy of our expectation for the year.

Operator

Your next question comes from Nik Modi - UBS.

Nik Modi - UBS

Just two quick questions, Marty, if you can talk about the trade down and give us some perspective maybe on how things progressed? As the FET went in and just the sticker shock and then kind of did you start seeing consumers start migrating back up the value chain from deep discount to premium as the quarter progressed, any phenomenon there? Then just the second question, in terms of wholesale to retail sales. Did Newport outpace its wholesale to retail or the consumer takeaway versus what you saw from the shipment side?

Martin Orlowsky

The first part of your question, I think again it’s premature and would be difficult to read the data currently or even just following the excise tax increase, determine any particular trend. Clearly, there was movement to down trading, but also creating an additional dimension of noise on that level was a very active and aggressive price promotion approach on the part of Camel and Pall Mall. I never could figure, how to pronounce it take wither way.

So yes, we’ve seen some down trading take place, generally speaking in the industry and clearly Maverick’s growth is somewhat of a reflection of that sort of thing. So I think it would be too early to reach any conclusion again. We’re going to need some amount of time pass through before, as I indicated a couple of times earlier, before we see any sort of real pattern set in and adjustment, whatever that maybe to consumer purchase patterns.

David Taylor

Nik, that the wholesale to retail shipments were obviously better numbers than the manufacturer to wholesale numbers for the second quarter, because of the dynamic of our wholesale customers were in general building their inventory levels during the quarter. So those numbers were better, yes.

Nik Modi - UBS

Can you share with us magnitude just generally, so we can understand?

Martin Orlowsky

Our second quarter wholesale to retail share was up 0.44 and our shipment share was up 0.29. So we see a much stronger result. We have a 10.38 according to our database. 10.38%, this is Newport, share of market versus a 9.87% share of market on the wholesale level. Sequentially, we were up at retail between the first and second quarters, we’re up about a quarter of a share point on shipments and a little less than two tenths at the wholesale level. So we’ve seen a slightly stronger numbers at the retail level.

Let me point out too that, to some extent the retail universe or environment wasn’t necessarily affected in the same manner going into and coming out of the federal excise tax increase on April 1. I think there was a much more dramatic affect at wholesale at the end of the first quarter in terms of a de-load, if you will.

Therefore, it would have been a greater degree of response or reaction in the beginning of the second quarter. However at wholesale, as we pointed out, the inventory levels the absolute inventory levels are lower in the second quarter of ‘09, than they were in the second quarter of ‘08.

On the retail side, there was obviously loading going on going into the excise tax point of change, but we didn’t see the same sort of order of magnitude of adjustment; it was a little less disruptive at retail. So we’re doing well at retail I think is the bottom line, and did well in the second quarter.

Operator

Your next question comes from David Adelman -Morgan Stanley.

David Adelman -Morgan Stanley

Just one follow up question. Leaving aside the user fee for the FDA, can you characterize the materiality, or lack thereof, of your estimate of the ongoing compliance fee and the cost of complying with the remedy in the Department of Justice lawsuit assuming that determination is not reversed on appeal? Thank you.

Martin Orlowsky

Well, I’ll deal with the DOJ issue first. It’s not substantially material as far as we know unless there’s a change. As I know you’re aware, there is yet to be a final determination by the court as to that remedy. So, there will be a hearing at some point to deal with that issue.

Nonetheless, what we know or taking into account what we know or what we don’t know, we don’t believe it will be material in nature on that level. As far as compliance with FDA, that we have already spent the past six to eight years preparing for the eventuality of FDA regulation and have made a number of changes in our operating environment, in our operations group, the production side, R&D we’ve invested a fair amount of money in systems and procedural changes in anticipation of FDA.

So I think that, obviously I don’t know what, literally what those regulations will be, I don’t think the FDA at this point knows what they will be literally, but I don’t believe, unless there’s something radically new introduced into the mix, that we will sustain any substantial charges. As I said, we’ve already made huge investments in dealing with this issue on an anticipated basis.

Operator

Your next question comes from Adam Spielman - Citigroup.

Adam Spielman - Citigroup

As you look into the future and I do recognize, obviously there are considerable uncertainties, but is there any particular reason to think that either the revenue per thousand or indeed your margins are going to vary particularly going forward from where they are from the high point that you’ve achieved in this just last second quarter?

Martin Orlowsky

Well, I’m not sure I, when you say any reasons. Our second quarter results are what they are.

Adam Spielman - Citigroup

Absolutely, I’m just trying to see if there’s anything I should be aware of, or your investors should be aware of, that means to say that as we look forward the revenue per thousand or your margins will be lower in the following four quarters let’s say than they are this quarter, but is it foreseeable at the moment?

David Taylor

Adam, if the mix trends continue, in other words, Newport’s units declining and Maverick’s units increasing, you’re going to see a decline in the overall revenue per thousand, because Maverick sells at a lower price and if those trends continue, and they probably will, you’re going to see a lower revenue per thousand and that will have some impact on margins, but there’s nothing, else in terms of dramatic cost environment shifts that we’re aware of.

Operator

At this time there’re no further questions in queue. I would now like to turn the call back over to Nathan Elwell for closing remarks.

Nathan Elwell

Thank you, Dan and thank you everyone, for joining us today. This concludes Lorillard’s second quarter earnings conference call. We look forward to talking to you next quarter. Thank you.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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