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Lorillard, Inc. (NYSE:LO)

2013 Investor Day

June 27, 2013 9:00 am ET

Executives

Robert Bannon - Director of Investor Relations

Murray S. Kessler - Chairman of the Board, Chief Executive Officer and President

Neil L. Wilcox - Chief Compliance Officer And Senior Vice President of Product-related Regulations

William True

Ronald S. Milstein - Executive Vice President of Legal & External Affairs, General Counsel and Secretary

David H. Taylor - Chief Financial Officer and Executive Vice President of Finance & Planning

Jim Raporte - President

Randy B. Spell - Executive Vice President of Marketing & Sales

Analysts

Nik Modi - UBS Investment Bank, Research Division

Robert Bannon

Okay, we'll go ahead and get started. Good morning, everyone, and thank you for joining us today for Lorillard's Investor Day Presentation. I'm Bob Bannon, Lorillard's Director of Investor Relations, and we'd like to welcome everyone who's joined us in person today, as well as those who are participating by our audio webcast.

Today's agenda will begin with a detailed review of our strategic plan and a business overview by Murray Kessler, Lorillard's Chairman, President and Chief Executive Officer. Then following a short break, we'll provide an update on the current regulatory environment by Dr. Neil Wilcox and Dr. Bill True. Then Ron Milstein, our Executive Vice President, Legal and External Affairs and General Counsel, will provide an update on litigation activity. Then our Executive Vice President, Finance and Planning and Chief Financial Officer, David Taylor, will discuss our recent financial performance and future financial strategy. We'll close the formal presentations with concluding remarks by Murray, and then we'll be happy to answer any questions you may have at that point. We'll also be serving lunch for those who are present and able to join us for that.

But before we begin, I'd like to call your attention to our Safe Harbor disclosure in the presentation, and remind you that some of the comments in today's presentation 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 today's presentation and in the company's other filings with the SEC. Also Lorillard reports its financial results in accordance with U.S. Generally Accepted Accounting Principles. Reconciliations of adjusted operating results to reported results are included at the conclusion of today's presentation.

Now it's my pleasure to introduce Murray Kessler. Murray?

Murray S. Kessler

Good morning, everybody. Good morning. So we've got a lot to cover. Today, we'll break it up into the various portions, but I wanted to start by grounding everybody. A lot of familiar faces here, people were here 2.5 years ago when we first introduced the strategic plan. Some people here for the first time hearing the Lorillard story or came somewhere in between.

So let's step back 2.5 years and we came and had a meeting like this, and we've said we have this new vision for the company to responsibly bring Newport Pleasure to all adult smokers, and we went through a process of explaining what that was that responsibility of sort of the starting portion of our company and that's responsibility to the law, responsibility to each other, responsibility to our shareholders, all of our stakeholders, responsibility to our adult consumers, that our called to action was to bring and bring things with excellence through the supply chain and across the entire value chain. And that what we bring is Newport Pleasure, and Newport Pleasure was our symbol in our great company of doing things the right way. It wasn't the Newport brand or the Newport advertising campaign. It was just our way of saying the Newport brand has been so successful because of all the things we do well, so when we do anything going forward, can we answer the question that it brings Newport Pleasure. And who do we bring it to? We bring it to all adult smokers, which was a drastic change in our frame of reference from where we were before because we were very, very focused on, as you'll see and I'll re-explain here in a minute, the full flavor, menthol market, east of the Mississippi and major cities. And we said, well, maybe that's a little too narrow. We could start to broaden, which meant we could go geographically, we could start to look at other product lines, we could even start to look at some adjacencies.

And then in doing so, we thought that a company that had performed incredibly well. Over the long term, we could continue to do well and sustain that level of performance because people always ask, "How long can Newport keep gaining share and doing so well, as well as even accelerate that level of performance?" And that our promise along the way, because we're a company that doesn't give guidance, is that we would consistently outperform our competitors and deliver a double-digit total shareholder return as measured by the EPS yield -- the EPS growth and the dividend yield.

We then said 3 strategies. These seem like simple boxes, but they guide everything we do. We said job 1, we wouldn't take the eye off the ball, lots of people worry about that, that are protect and grow our core business was job #1. Two, that because we were so focused in the past, we had spent some money to build out process and capabilities, and as part of the presentation today, you're going to see, and I'm pretty excited to see, we're now starting to enjoy some real dividends from building out process and capabilities. And then carefully, carefully, we would pursue close-in adjacencies and make sure we weren't diluting our brand along the way.

And we sort of started with that protecting grow the core with this basic premise. This is a chart from 2.5 years ago. If you look at it, that broke out the cigarette market into the various segments. And what you see at the heart of our business and the strength within the market is in the premium full-flavor menthol market, we're a 74% share. We are, by far, the market leader in that segment, and that is the driver of the company's profitability. And our ability to sustain that in a segment that, over time, had not declined as fast as the rest of the industry is what was giving us the outperformance. So that had to continue.

Likewise, as we build out the process and capabilities, there was a whole lot of whitespace in this category, because you see sort of the entire Lorillard company in the middle of the chart, but the biggest cigarettes segment, we weren't competing in. And this was an important discussion 2.5 years ago because all of the other major tobacco companies were going to total tobacco strategies, going into smokeless, going into cigars and broadening. And it was our rationale at the time, as they were doing that, made sense for them. They're great companies, but they had to, because they already competed in every segment of the cigarette industry with multiple entries. And you could see their names present there, and generally speaking, there's 3 or 4 product lines within each of those for them. They had penetrated that category as far as they could they needed to broaden. But not us. We were still a small enough share and there were so much whitespace and incremental volume opportunity, we could stay a cigarette pure play. Look at adjacencies carefully, but that -- there was lots of running room for this company. So we'll update you on that.

Then we identified 4 key priorities for careful adjacent expansion. One, that we could begin to build Newpoint share geographically. I oversimplify to say west of the Mississippi, it's not that clean but start to broaden out to other areas. Two, that we could invest to breakthrough in non-menthol; three, we could strengthen our less than full-flavor menthol franchise; and four, we could opportunistically pursue non-cigarette adjacencies.

So here we are 2.5 years later, that if you look at, we started implementing Newport Red. It was launched at the end of 2010. The geographic expansion was launched at the end of 2010. All that was done couple of months -- 3, 4 months before the presentation. Our earnings per share has accelerated significantly, and our retail market share gains have also accelerated. They were great before and they're even stronger since. So the performance of the company against the execution has been super.

And we have taken very seriously our #1 goal, obviously, we have to make sure we make a great product and reward our consumers. But we believe, at the end of the day, our job is to reward shareholders, make a lot of cash, give it back. And since going public, we've doubled our dividend, bough back a lot of shares. Net-net, since going public, we returned $7.3 billion in cash in a short amount of time, and proud of it.

We continue to consistently outperform peers. If you look over the last 5 years, with a 41% increase in net sales and 64% increase in adjusted EPS. And all of that has resulted in the last 2.5 years in a $4 billion increase in a market cap of the company. We've said simply, we've made additional $4 billion for those who have invested with us. And I don't think it goes unnoticed that all of that growth came with regulatory overhang on menthol built into this price. So I mean, given the fundamentals there, it could even be higher than that. So we're real proud of that track record as well.

So why did that happen? We think there's kind of 8 key reasons for it. I'm not going to read them all now. I'll work through them one at a time. So let's start with the first one. Newport full-flavor menthol in the core continues to remain stable despite increased menthol competition. Again, refresher course for anybody who wasn't here. We are not made like the other cigarette companies. Our product portfolio is extremely different. Again, at the heart of our business, we're 80% menthol and we're almost 90% full flavor, which is the direct opposite of our 2 competitors. This is important because when you talk about price competition and what's going on in the marketplace, those 2 companies tend to interact much more closely. And some analysts have done great jobs doing correlation analysis and statistical regression that show that we don't interact as closely. That's important in this stability discussion.

More importantly, as those segments where we compete have historically, over the long term, declined at a much lesser rate than the rest of the industry. So we are a 74% share in this big component that faces less price competition generally speaking over time where we're more insulated from it. And over the last 7 years, you could see in total between the core and the non-core, it's almost been relatively stable, while other segments have declined 20 billion, 17 billion, 20 billion units each and had significant declines.

So if you look at that in this year, the year started out, people have already asked me, the industry softened up a little bit this year in the first quarter. The full flavor segment continues to outperform, continues to outperform by 2, 3 percentage points. But overall, the industry softened in the first quarter. I don't see it getting much better in the second quarter. I think you're going to see continued good performance by Lorillard. And I'm not going to speak to any individual brands, but if we were seeing a 2% to 3% decline in the industry this year, we're calling it more the 4% decline this year. And again, that's industry-wide, and we'll talk about Lorillard in a little bit.

Our market share, that 74% back 2.5 years ago, is a 74% share today. So again, full-flavor menthol, heart of our strategy, outperforming. Lorillard holding its share in -- significant leader share, and that's despite a whole lot of competition. And we attribute that mostly to sort of the core equity. Newport is a spectacular brand. I showed you a Net Promoter Score a few years ago of 63%, which in the world of Net Promoter Score, is off the charts. We just rated the study again about a month ago. It was at 61%, they're not statistically different numbers. But I mean, remember, the benchmark here is like 14% or something as a normal number, and the total category was a 57%. Before it's 51%. I still don't think that's statistically different, but there's been more discounting in the category than there were a few years ago. And then we did a new measure. We fielded an ongoing tracking study, which is -- should give us some measure of loyalty, which is a simple question, and it says, out of your last 10 purchases -- if you're a Newport consumer, out of your last 10 purchases, how many were Newport? If you're a Marlboro consumer, out of your last 10 purchases, how many were Marlboro? And when you index that, Newport had like what 80-something percent that were all Newport was the highest in the industry.

So every way we measure loyalty, Newport wins. And we believe that the start of that is on product. I'm not going to show you the actual stores, but we test all the time our product in the marketplace with consumers, and when you test among all premium menthol consumers on a blind basis, Newport Menthol wins on almost every single measure. It wins on fresh tasting, in wins on pleasure to smoke, it wins on consistency, it wins on smoothness, it wins on the finest tobaccos, refreshes you, savors, full-bodied smoke. And we only lose in one area, and that's that it's frequently on sale, and we're okay with that.

I think it's worth a moment of discussion. There are lot of people think that's it's the menthol that makes Newport taste so great. Menthol is a component to it. But the blend is very proprietary, and it's sort of like when you taste Heinz Ketchup versus another ketchup or Hellmann's mayonnaise versus something. It has a unique taste to itself. So we went out and say, well, what if we ask a Newport smoker to blindly taste non-menthol cigarettes. Leading brand of non-menthol cigarettes, the second leading brand of non-menthol cigarettes and Newport non-menthol cigarettes. Don't tell them which it is in the table, and hands down Newport smokers because of all those familiar attributes pick Newport. And again, they win on overall satisfaction and strength of taste, and they think that they -- because it's a very full-bodied smoke, they think that the competitive brands are too weak.

It's a very highly differentiated consumer, also leading to the sort of the score stability of it. As much as we're broadening out today, Newport SKUs more male, large metro, Northeast, African or American, you can see different product portfolio, different consumer base, different product. Hopefully, you're getting the message here.

So while competitors have dramatically increased their discounting in the last 2.5 years since we smoke, and remember, 2.5 years ago, our competitors in the premium full-flavor menthol or in the premium menthol segment sold about 1 in 4 brands at a discount to the most common price sold. So I'm talking about not just sort of the buy downs that are used to set the everyday price, there are special promotions, where you'll see on a store when you go in and it carries $1 coupon, et cetera, our competitors put about 1 in 4 2.5 years ago when it's, today, almost 1 in 2. So they've gone from 27% of their volume to 45% of their volume trying to discount and take volume from the Newport brand. And despite that and all of that heavy discounting, while the menthol segment continues to grow, Newport's share of menthol has continue to grow and total Lorillard's share of menthol has continued to grow right through it, and we did it with next to no discounting.

There were some discussion about last year. But at the end of the day, if you look at through 5 -- June 1 of this year, 5 months, 95% of our volume on Newport has been sold at the everyday full price, while 54% of the #2 menthol brands has been sold at the full price and 59% of the #3 menthol brand has been sold at a full price. We think that's pretty impressive, meaning Lorillard isn't changing its efforts to focus on brand building. It's the way we build our brand.

We've refreshed print advertising. We're more aggressive. We've improved our capabilities on direct-mail, reaching out, sending coupons to competitive users, getting them to try and enjoy and learn about the benefits of the Newport franchise, expanding product offerings like Newport Smooth Select. But make no mistake about it. We believe, first and foremost, our job is brand building. We'll talk about that later on electronic cigarettes as well. And it's all about keeping your brand relevant, right?

So how do you measure relevance, which is sort of the hot brand in the category, and Newport's clearly the hot brand in the category and has been in time. We're -- this is numbers from NSDUH, so it don't match up exactly with our market share numbers, but close enough. We're just under a 15% shares total Lorillard. You'll see that the green bar is our market share, growing every year, and our share of 18 to 25, legal age to 25-year-olds at a much higher level and continuing to grow over time as the brand becomes more relevant, which bodes well for the long-term future, as the green line hopefully catches the yellow line.

Second -- so the core job 1, feels good to me. Second, we started geographic expansion. Some simple numbers, it's hard to give you much detail on this. But in total, Newport in those areas, where we weren't supporting, we're declining 5%, they're growing 5.5%. Our market share was a 4.3%, it's 5%. That's a big jump starting from a low base. In total, Lorillard, because it wasn't just Newport that we were expanding geographically with, we were declining 1%, up 19%. Market share of 5.5%, almost up 2 share points to 7.3%, and it was driven by a total company approach.

So the one that was talked about is we eliminated the price disadvantage on Newport. We didn't go in and start trying to underprice our competitors west of the Mississippi. We were priced above them, we were just milking it, and we just said we're going to put it at market price, so we eliminated the disadvantage, and that cost money. In doing that, we got the brand growing again. Today, we're making more money in those markets than we were originally when we started the process. A second component of that is, once we started promoted, we can get merchandising plans. We went out and we've added 32,000 merchandising plans. Everybody understands how those works, you sign. If you -- we'll put you on promotion if you sign the contract. In that contract, you agree to give us our fair share of space, you agree to put our new products in, you agree to put up our point-of-sale and we pay you and you get RDA payments at the store level and you get our promotions. That's the bargain. So that opened up an entire wave of merchandising contracts with us, which then allowed us to build distribution on Maverick and allowed us to build effectively [ph] that added the 2 share points west of the Mississippi. So that's been going great.

And speaking of the last one, Newport Red. We launched Newport Red and we have gone from nothing to a 5 share of the full flavor non-menthol segment and in our core markets, where we have strengthened our sales organization to a 9% share of the non-full flavor, non-menthol segment. And just to put that in some perspective, we don't detail on quarterly calls and I won't after this either, but it's just under about a 1 share, so slightly better than a 0.9 share. That was 5.7% of our volume last year 2.2 billion incremental units for this company. And as I've said, it sourced from competitive premium brands, purchase intense are high and we have been gradually, over time, being able to work the price up, the price is up 35% from the time we launched it, so we're making a lot of money on Newport Red as well. And like Newport Menthol on a blind basis in this unique niche that we've carved out, because it's a -- our products are very robust, full flavor, Newport people that have chosen Newport Non-Menthol smokers preferred, on a blind basis, for overall satisfaction, taste, strength of taste and smoothness.

So we're getting ready to give this presentation. We have all of our slides done, and 2 days ago we get a note from -- a call from -- at about an hour before you heard about it, from the FDA, that says after rigorous review process that they're approving the 2 items that we had submitted for approval, and no, the other 4 were not ours. I don't have no idea who the other 4 were. So we quickly put this into the presentation, printed the materials that are on here. And in the back of the room and are on the displays, not true. I told you for years that we're ready to go on that. But this is the biggest segment in the category. This is much bigger than full flavor. The non-full-flavor, non-menthol segment is over 30% of the entire cigarette category, and we don't sell one cigarette with Newport in that segment. This is a huge opportunity for this company. So make no mistake about it. We are so proud of what our regulatory group did to be the first to get approved. We are so proud to be able to get going again with what was a stall in our strategic plan, and this is an exciting opportunity for the company.

As I said, they've been deemed substantially equivalent by the FDA and authorized for marketing. This is product that has been tested; that has addressed the concerns of our less than full-flavor efforts in the past; it's got a white tip; it's got overall satisfaction ratings higher than the leading brand; packaging has all been testing; it will be line priced right along at that competitive price with Newport Red; and the timing is such that, if I say go tomorrow, which I did, take -- but you're going to make the product, you got to go sell it to retailers, you got to get it worked into the shelves and all that, you can expect some impact of that, you should start seeing that in shelves in the fourth quarter. So build it in tomorrow.

eCigs, another area where we went out and we started to look adjacently. So 2 years ago, what we said, we said, job 1 was full-flavor menthol cigarettes, one step, start looking at things like red and gold and doing that, but we could carefully evaluate and see what was going on, and maybe we would go 2 steps into other OTP if the opportunity presented itself. One opportunity caught our attention, and that was in e-cigarette sales, because we're sitting back, you look at MST, everybody has said, Murray, you came from running the biggest MST company in the world. Do you -- that's probably a logical place but it didn't make sense to me, given my knowledge of the strength of those brands and the marketplace and barriers to entry. But here was eCigs doubling, doubling, doubling, getting a lot of attention from analysts, getting a lot of attention from consumers, press. So we've said, "Let's take a look at it."

You see the CDC puts out a report right about the time we were looking in 2011 that said nearly 6 of 10 adults were aware that, that was growing rapidly, and that 21% of adult smokers had tried an eCig in 2011. So we feel that our own research to sort of ask -- to see how true that was, and we found out national Internet study, that 94% of smokers were aware of eCigs, 23% had tried, right about that same 21% number that they showed, and that 5% were using it 3x a day or more, and that's what we defined as used regularly. So if you divide the 5% by the 23%, even at that stage, and the products are getting better all the time, you were dealing with about 22% repeat and a couple million consumers at that point.

Now just -- I'm sort of out of sequence here in the presentation a little bit, but just to update you on that, we did that same study 3 weeks ago, and that number has grown to virtual 100% awareness of e-cigarettes, trial has gone from 23% to 43% and use regular daily has grown to 11%, so repeat has grown from 22% to 26%, and that means there's roughly 4 million people out there that are using e-cigarettes as we speak today. Certainly gets our attention.

We also look at who's buying them and they have broadscale appeal. Now I use charts to show all these, but I'm in a consumer packaged goods for 35 years. It's very -- few new products I have ever been involved with my career that catch on and are forming a new industry like this. This is real. And what you see is it has broad scale appeal on age, sex, income, education, geography and importantly, for us, which is part of our thinking in terms of sort of what role does it play in terms of that responsibility area and public health, all of the volume coming from existing tobacco usage. So that feels pretty good to us.

And then when you say -- and you go out and you survey those consumers again and say, "What's it's doing to your existing tobacco consumption?" 20%, 1 in 5 say, "I completely switched." 36% said, "I'm using significantly less." And when you do the math on it, how much was sold, you come to a number that this year, it's pretty easy to estimate that 2.5 billion sticks of cigarettes won't be smoked this year here in lieu of e-cigarettes. And that gets to be a pretty encouraging number, well, for 2 things: one, from a public health perspective; but two, from my perspective, this going to be a digital camera and it's going to revolutionize this industry like digital camera did the film. I'm not going to sit back here and say "No, no we're just selling film. We're going to be on the leading edge of technology."

And I believe, others may not, I think the industry has softened up some this year, and I think e-cigarette is contributing to it. If you just do the math, this year, with what sold at retail, you were able to sort of quantify that 30 million equivalized pack in the first quarter affected the trend by 1% in the first quarter. I think it's continuing in the second quarter, and that doesn't count Internet sales and other areas as well.

So again, I'm building the case of why we were getting interested and was it just us seeing this public health benefit? No. Tobacco harm reduction is gaining momentum. I've been involved in tobacco harm reduction because I believe Smokeless Tobacco and products like Skoal and Copenhagen and Snus all play a role there as well. So I've been involved with it now since 2000 with UST and Altria. And it's gaining discussions, momentum. There are still resistance from many in the public health community, but there's more and more people. And I believe the FDA -- with the FDA supervision, this will gain traction over time. But at least the Tobacco Products Scientific Advisory Committee acknowledge the continuum of risk, and these products fall on the lower side, still to be proven with the FDA. We got to partner with them to do it. But it's common sense that they fall into that category, and there are lots of sources now coming out in writing and talking about that. So whether it's American Council of Science and Health (sic) [American Council on Science and Health] or Harm Reduction Journal or the American Association of Public Health Physicians or what I think is a great move by our competitor with NJOY of getting Dr. Carmona, U.S. Surgeon General, to join their board, I mean, I was there in the July 2004 hearings in Congress when he said there was no potential for harm reduction. That's a big paradigm shift for that man, and it's meaningful that he is now seeing the potential for e-cigarettes.

So why are people looking at that and saying that? Let me -- in our study, again, I'm prebuying at this point. We went out and we continue to do this work today, you study the vapor. So this is an analysis, a Lorillard analysis, a work in progress, which will hopefully, with some fine detailing, be published sometime in the fall. But as the starting point, so let's compare the inhaled vapor of a e-cigarette to the inhaled vapor of a leading low-tar cigarette, because that's, at a starting point, where most of the e-cigarette consumers were coming from, from low-tar cigarettes. And we said, let's do -- let's use the Canadian intense method because that's what you use for cigarettes, and let's try to equalize this to make it as fair a comparison as possible. And since e-cigarettes don't deliver nicotine as efficiently as a regular cigarette, we'll compare [ph] 9 puffs of a regular cigarette to 99 puffs, so 10x the level of puffs, the most severe test we could sort of put ourselves under.

And here is what we found as a starting point. On the right-hand side, the cigarette; on the left-hand side, blu eCig. 34% of the inhaled vapor is carbon monoxide. There's no combustion that carbon monoxide goes away completely. 41% of the inhaled vapor is flavors and combustion bi-products, which is where the TSNAs and a lot of the bad stuff is the tar, which is basically too small to even measure on the chart. Let me give a little more detail on that. The levels are so low that you get into nano part's [ph] idea. My scientists will give you the numbers on here. And these charts , we went down as far as you could go through the instruments, but let me give you the top line. At least 98% less constituents from blue versus the cigarette, with a 10:1 higher puff ratio test, at least. Most of the instruments we got to, you virtually eliminate the combustion products so they shouldn't actually even be present. It's just that the instruments were so low -- or the levels are so low, our instruments can't read any lower. So we've got down to the lowest possible point the current instrumentation of cigarettes can get to, and you still didn't detect anything, but we can't prove it until we have better instrumentation, which we bought new analytical methods, which we're quantifying. Bill, I think I'm accurate in saying that. So we could see how -- we think a lot of this, you're going to get down all the way to 0. But the point is, just from a common standpoint, you're basically dealing with 5 ingredients. You've got water, glycerine, some flavorings and nicotine. And it's our company's point of view and shared with many, that nicotine is not the problem. Nicotine is like caffeine. The problem is the delivery method and the combustion.

So after careful evaluation of the category that this was an adjacent opportunity for Lorillard, Lorillard then studied the brands, and found blu to be the best brand in the category. We tested the products that one on a -- as a superior product had the highest brand awareness, so unique and proprietary positioning; a well-rounded portfolio with rechargeables, cartomizers at retail and at all different areas; and it was a real opportunity to partake this great brand and for Lorillard to go out and be the clear leader in the industry. We paid $135 million, went to work with a fantastic blu team and married it with the great teams at Lorillard, and we've gone from $8 million in sales the quarter before we bought it to $14 million, to $39 million, to $57 million, built retail distribution from 12,000 outlets to 80,000 outlets. Probably at the end of the first quarter or second quarter, there'll be, I don't know, roughly 100,000 outlets that continues to grow our market share from 11% to 40-plus percent. We're a few points higher than that. To be clear, lots of people claim to be #1 in this segment, lots of people claim to be #1 that haven't sold anything yet in this segment. We are by far the #1 player in the category. All you got to do is -- we publicly report our sales. Ask anybody else what their actual sales are, and I confirm that by a couple other areas.

Here's our breakout of our business by segment. Most people sort of focus on disposables or they might have a rechargeable, or they're just in convenient stores. 40% of our business is convenient stores, 29% is food and drug, 14% is Internet, 10% is tobacco stores, and you've got places like Walmart and others making up the other component of it. Half our business is disposables, and half of our businesses is the rechargeables and cartomizer business, which is all repeat business. And you have a sample of that in front of you.

And then we went out and we did a survey when we bought it. We did the survey again a couple of weeks ago, which asked awareness, and we've spent a lot of money building the brand. Back then, we were the leader in awareness with 50%. Today, 86% awareness among current eCigers of blu eCigs, by far the highest in the industry.

And then we asked quantitatively, this is a survey question now, you go randomly, pick e-cigarette consumers out there and you say, "Which brand do you use most?" And you could see the way the numbers -- blu continues to grow. And again, very similar to what we see at our EXCEL database at retail and verified with our actual publicly disclosed sales numbers. And again, blu is the category leader by far.

So why is that happening? Let me tell you. There's lots of discussion of technical portions of this. I'll give you some explanations of why we're the technical leader in this industry, but in my humble opinion, brand building is job one in this category. It can't be nerdy or uncomfortable to use this product. It has to be socially accepted. The FDA can do a lot to do that. The message on public health -- from public health on harm reduction has to come from them. We have to build this as a big brand, like a Red Bull builds their brand or any other brand builds their brand, and that's where we focus our effort. And it kicked off with an award-winning campaign that has been playing and breaking through mass media and catching attention on national television, and I'd like to show you that commercial now.

[Presentation]

Murray S. Kessler

Stephen Dorff has done a great job with us in the campaign. You may see other celebrities in the near future.

Interesting story. We didn't go and say, "Boy, who would be a great person to represent blu?" Stephen Dorff called us and said, "I love this product. I'm engaged. I want to be your spokesperson. I have the idea for the commercial." He helped write it. He's that passionate. We've had numerous other people do the same thing, reaching out to us. I've never seen anything like it, actually. And you see that campaign. You see it in broad-scale print, where we have a full distribution of print. Television stations that in the beginning said, "No, we won't run this commercial [indiscernible] come back and said, "Yes, we want it. Please bring it to us. We'll run it." Where -- if you're watching IndyCar racing, you see the blu eCig car running Indy, you see the LiveNation music festival reaching hundreds of millions of people across the country sponsored by blu eCigs. Other music festivals, other venues, sampling that's being done across the country. This is a full-blown, consumer-based brand-building marketing effort, and that's what gives you that 80%-plus awareness and those kind of numbers that I showed you in the consumers' survey. So you can actually measure the difference and what impact you're having.

On the product, there's just no doubt we're at the forefront. blu vapors, they live the product. This isn't something they just discovered and started working on. They understand how this product works and the benefits of it. Our product taste wins in blind taste tasting. It's a superior product. It's got superior value in the number of puffs in it. It uses digital chip technology. It's -- the e-liquid is made in the United States with Johnson Creek, our partner. It's got a unique feature in the product, and I'll go through it in a second and I'll explain it more in a second, on, on-the-go recharging. It's got state-of-the-art quality controls, and it has consistent nicotine delivery over time because it's got recharging on-the-go, and this is just to show you that -- some of the questions -- does the nicotine puff count go down over time? And the answer is no. The reason I stopped it at 280 is when we did the test, we didn't think we needed to go any further than that. But you don't lose nicotine delivery after 280 puffs on our rechargeable units, and it probably goes up further than that. So it's a heck of a value.

I gave each one of you that's here today a sample of the rechargeable kit, a tremendous value. Within this, you get a recharging unit. Now this is different than everybody else. Maybe a couple of smaller guys might have this. But in general, this product itself, this case itself is a recharging unit. So you charge this at night, you might not need to charge it again for a few days. You get 2 batteries in here, not 1 like most competitors do. You put -- within that -- let me get the one that's full -- you get 2 batteries, you get 5 cartomizers, you get the charger. So what I have inside of here is the e-cigarette that I smoke. All I do to recharge my spare is drop it in, I shut the door, and it's recharging while I'm on the go. So I'm never in a situation where I run out of charge. If I'm a smoker, I want to smoke when I want to smoke. And you can see it's now recharging the second battery by the lights blinking on it, et cetera. And when it's done blinking, it's done. So when I start to lose strength, it takes me about 4 seconds to replace it. I don't need to go find a charger, I don't -- it's a huge portion of the convenience of the product.

The value it's going to sell, we originally sold our original one for $60. This one is more like a cellphone, it's very slim. If you compare the 2, it fits neatly in your pocket. That's something that consumers asked for, for it to be neat and tidy. You don't have to worry about putting a disposable or something or worrying about the sanitary aspects of it, of stuff getting -- putting it in your mouth and putting it on a desk or anything else. It has a neat compartment to go through. Like I said, it has a charger indicator that sell for almost half the price. And within that charging unit, again, 5 cartomizers like 7.5 packs of cigarettes. If you're in a market, $6, $7, it's like $50 worth of cigarettes on your initial $34 post to purchase, plus 2 batteries and the charging -- and the recharging case. This is a heck of a deal.

Why would we make almost no money on that in the beginning? Why? Because we see this as a razor-and-blades model or a printers-and-ink model. We make great margins on the cartomizers and over time, we want as many of these kits in the hands of folks as possible and that they're then enjoying and buying our rechargeable units.

Technology. I can't stress enough the quality of the team we have out in Silicon Valley who are e-cigarette experts. They work everyday on bringing new technology, and we are hopeful that the FDA and their deeming regulations doesn't stifle innovation. Because these products can get better and better at a very rapid pace. And I'm hoping, if they really believe in harm reduction, that they'll embrace that this can't be the sort of slow-moving substantial equivalent, especially on the technical side of this. But our guys are constantly working on unique juice storage and delivery, new component technologies, longer battery life, custom processors with proprietary algorithms, redundant battery safety features. Automated assembly is a big area of focus and will contribute to significantly higher margins over time and intellectual property comparison.

The acquisition has already been accretive. What we didn't -- it wasn't a high hurdle. We didn't pay that much money for it. But I cautioned everybody on the last call -- I cautioned out. I'm investing in this. This is a big idea for this company, and don't start trying to put a lot of operating profit from this right now, especially with new competitors and all that. I'm going to invest to build this brand right now.

Next one, just take the few before we've grown sales $700 million over the past couple of years. You look at how much of that came from Newport Red, blu eCigs and geographic expansion and you get to 50% of the growth the company has had in the past couple of years has come from new strategic initiatives we talked about.

So what's that mean? This is my favorite chart. Remember a couple of years ago, I said, "Lorillard is different. It's able to be stable or slightly growing in the cigarette industry when other people are declining and diversifying." And 2 years ago I showed you the chart that said: during the prior 5 years, Altria had declined 45 billion sticks of cigarettes, that's bigger than our entire company; Reynolds had declined 30 billion sticks; and Lorillard had grown 2.2 billion sticks during the same period of time.

So it's 2 years later, our 2.2 billion has now, adding 2 years, has grown to 4.3 billion; Altria's 45 billion has declined to 51 billion, down an additional 6 billion sticks; and Reynolds' 30 billion has gone down to 39 billion, down an additional 9 billion sticks. We're different.

Next, process and capabilities are made with much of the investment behind us. I can talk a whole lot about this. You'll see it in action from some key leaders in the company in a few minutes. We spend a lot of time, effort and money preparing for FDA. We had catching up to do with that. We have basically completed that work. We gave ourselves the capability on new products, how to modernize, and we're spending a lot of money on information technology, how to build out a government relations organization -- we sort of left that to our competitors in the past -- and became a more communicative company.

I said a few years ago that we had weaknesses that we had to fix and improve on, that when it came to the core, we were pretty good across the board but that we didn't have good product development work in our ability to expand. We've given ourselves that capability and to evaluate adjacencies. Our sales force was always outstanding. Brand marketing, great in the core but not as good geographically. Direct mail, we didn't even try to reach out to new consumers. And regulatory affairs, I'm being generous to say yellow because we complied with the science, et cetera, but we didn't have a regulatory affairs group and a compliance group the way we do. And all that -- there was some pressure and I heard from some shareholders, "Boy, you've made some higher-capital investments and you've made some SG&A increases, granted a good portion of this is legal expenses associated with angle. [ph] But underneath that, we still made investments and spending in this company. And I can sit here today proudly and say, boy, was that money well spent. Because here we are now with the first 2 products being approved from a substantial equivalent basis, from a crack team that was able to put together, as Bill demonstrated to you, incredible submissions, which is a huge business opportunity for this company that will dwarf these kind of spending levels over time, and the entire blu eCigs opportunity, as well as the other growth that you saw. So I appreciate your patience as I invest it some, but I think you see it's money that I hope you believe has been money well spent.

We continue to defend our freedom to operate. These guys will talk about that, but we're very engaged in the menthol debate, the NPM settlement, leading the way in reasonable eCig regulation. We've had successful FDA inspections, won with graphic warnings case, are aggressively suing TPSAC because we believe they're biased and conflicted. These guys will go into more detail, but it's part of protecting and growing the core.

And finally, we've lived up to our promise to continue to reward shareholders by making our balance sheet work harder. Our leverage has gone from 1x to 1.8x right now, within the range of our sort of target of 1.5 to 2x. Long-term debt, we've added a couple of billion dollars of debt, increased our dividend payout range to 70% to 75% and continue to pay a robust dividend yield. And we've lowered our weighted average interest rate on debt to just slightly under 5%.

So here's my message. Lorillard is winning company that's got the best fundamentals, hands down, in the industry and has had so for many years, and shareholders have been rewarded for investing in the company. It's not just over the long term, it's been in the midterm when you look at our returns, and that is despite -- I don't know what the multiple impact is of the menthol related -- but it's something, right? That said, it could even be higher. And look at the kind of returns we've given despite that. We still have lots of running room. This strategy has lots of legs, lots of opportunity.

And in summary, from sort of the business review part of it -- portion of this, this is a company that continues over the long term to deliver superior results, and they continue to do it with great people throughout our organization despite the competitive environment. We will gain market share again this year for the 11th consecutive year. I'm willing to put myself out there based on -- as you'll see, we'll gain share again in the second quarter.

We're launching adjacent new products to accelerate growth, continuing to be first and best in e-cigarettes. We intend -- we are the leader by far, and we intend to be the leader in eCigs. We will always remain focused on tight cost control. And as always, we put shareholders of Lorillard first.

So if we didn't have any of the regulatory issues, I'd say thanks for coming, but we do. Because otherwise, it's like a no-brainer to put all your money in Lorillard. So why don't we take about a 15-, 20-minute break after the business, and we'll come back and you'll get to hear from the 2 guys that run those programs for us on the regulatory and science part of the business and to give you a chance to see some folks from Lorillard. Okay? We'll be back soon.

Robert Bannon

So we'll start back up at 10:15, okay? Thank you.

[Break]

Robert Bannon

Okay. We're going to start back up. And for the second half, you're going to be hearing from a couple of folks that you probably have not heard from before, you may not be familiar with. The first is Neil Wilcox, who has spent 13 years at the FDA previously, and he's a science and regulatory expert. Following him, you might recognize Bill True from his days with TPSAC and his involvement with the TPSAC committee. But as I said, we're going to start with Neil, so I'll turn it over to you. Thanks, Neil.

Neil L. Wilcox

Thank you, Rob, and I'm pleased to have the opportunity today to give you an update on the regulatory environment. And I better have the remote.

We'll be updating the regulatory environment by looking at a few items. First of all, we'll look at Lorillard's preparations for FDA regulations, which we've been doing extensively for some time. Our corporate compliance infrastructure. As you're well aware, the Center for Tobacco Products has a new director, Mitch Zeller, and we'll talk a little bit about what kind of impact his position as a new director may have on the industry.

We're excited now to talk about substantial equivalents. A week ago, as we were preparing the slides, they were a little bit different than what we're going to present now because we have such good news, as Murray has alluded to. What is the status of e-cigarettes' deeming regulation? And then finally, we'll look at menthol, the constant concern that we all have on what's happening with menthol. And Dr. Bill True will update you on the science perspective with menthol.

So what has Lorillard done to ensure regulatory compliance? First of all, we established the Department of Corporate Compliance. That was actually done 2 years ago when Murray hired me as the first Senior Vice President and Chief Compliance Officer for Lorillard, and I embarked on building a team by recruiting first some individuals from within Lorillard and then we went outside and found some more, focusing on expertise, a foundation of excellence and expertise and leadership. And quite frankly, I'm very proud of the team. They are a great team to work together and understand how to work with each other, as well as FDA, and I think that's been part demonstrated by their success in getting our SE eCigs authorized.

We first looked at corporate policies and procedures to make sure that they supported what needed to be done to make sure that we meet or exceed federal state and local regulations and requirements. We are establishing a culture of FDA compliance. And in a company that's 250 years old, over 250 years old, and heretofore was not regulated by an agency like FDA, it is an interesting path to get people to understand what needs to be done and how they need to think about going about their jobs. Each individual needs to be a leader and not necessarily have to be told by the supervisor in terms of what needs to be done because what we try to do is teach them the why. Why does FDA require you to do the following? And hopefully, as they understand that, they'll learn how to behave and act in a way that will support what FDA requires.

We've invested considerately over several years in modernizing the manufacturing facility, and we'll look at that first. We've implemented modernized equipment for what we call NTRMs, or non-tobacco-related material detection. One of FDA's highest priorities is to make sure we don't have foreign material in our product, and that's true of any FDA-regulated product. So to that end, we have to do everything we can to make sure that anything that might be in the tobacco, we take out. And we do that through advanced screening systems that we've installed, state-of-the-art sorters, as well as detecting metal with microwave and magnetic detectors so that we do the best we can to ensure anything that shouldn't be in there doesn't get in there. And as it does, FDA would consider that an adulterated product.

We've installed a significant number of engineering upgrades; robotic palletizers for each make or complex; state-of-the-art dryers; RFID, or radio-frequency identification systems upgrades so that we make sure that as we blend the product that we add ingredients and so forth, that it's done correctly, and the RFID systems ensure -- add to ensuring to that; we've upgraded blending and menthol systems, the cigarette maker and rod-making complexes; we've added many new ones. And overall, all of these improvements do a number of things. But in particular, they help us track and trace product from beginning all the way through the process, which again is another requirement of FDA. And also, it adds to our ability and our competency in change control. Anything that we change, we have to document and make sure that it's within certain specifications, again, as required by FDA.

We continue to build our processes and systems capabilities with a tremendous IT modernization initiative that will upgrade all of our IT equipment because again, FDA requires us to be able to -- we have to validate certain systems as part of the requirement in the act. We have to make sure that we can produce documentation when FDA requires it so that we can show FDA on paper that we're doing what we say we do, and that's a very important tenet with FDA compliance.

FDA now requires us to submit data on HPHCs, hazardous and potentially hazardous constituents. Those are the chemicals that are in cigarettes in the tar that lead to certain diseases. We now have to submit up to about 20 -- data on 20 constituents. Very soon, FDA will be implementing requirements for us to submit data on up to 93 constituents, and this represents a lot of sophisticated testing. When that happens, the external resources, in other words, the laboratories who do this kind of testing, are going to be really challenged to meet the requirements of the tobacco industry. So in anticipation of this, we have added equipment in our research and development department so that we'll now do that testing in-house. We'll have reliable data with new equipment, and we'll be able to, therefore, meet that requirement.

We've upgraded our pilot plant so that we can produce products that we are doing research on without having to shut down a line within manufacturing and deter from that capability. So we've done a tremendous amount of effort in modernizing and preparing our equipment in R&D and manufacturing for FDA. Our manufacturing, IT and R&D are, therefore, well prepared for meeting FDA regulations.

FDA has a requirement to inspect registered tobacco facilities every 2 years. So in anticipation of this, we hired outside consultants to come in and do an audit of our -- both our manufacturing and our R&D facility, and they audited against what we perceive to be GMP requirements when they finally are promulgated. So in doing so, they identified many areas, and they call them gaps, and we've been filling the gaps ever since.

In addition, we've done a tremendous amount of training. I mentioned that people have to understand the why when FDA does certain regulations and has certain requirements. Well, when FDA inspects your facility, they ask many questions of individuals. They'll just walk up to an individual who's on the manufacturing floor and they'll say, "What are your work instructions," and be able -- they'll have to show them work instructions. And we have the -- we're in process of training so people know how to respond to FDA under such circumstances. We've done our own internal audits and many practice inspections. These preparations served us well because a year ago, FDA showed up at our doorstep, and they have inspected all of our facilities.

During the inspections, FDA not only tours the facility of course and approach people, ask questions and so forth, but they also ask us to provide documentation for a number of things. I mentioned that our IT system has to be able to show that we're doing what we say we do. Well, this is when the truth comes out. And FDA will say, "Show us certain documentation." We provided FDA during their inspection, they were there about 5 days, over 5,000 pages of documents. Such things as standard operating procedures. We provided them 127 SOPs. Work instructions for workstations, they ask for work instructions for every single workstation in our manufacturing site.

One of the things that we're required to do is once a year, submit registration for all of our facilities that have been registered to update FDA. In addition, we have to submit product listings and ingredient listings. During the inspection, FDA said, "All right, show us a list of all of your products and a list of all of your ingredients in your products." So we pulled that documentation together and what they're doing is they know what we submitted, as part of our annual requirement, and then on top of that, they wanted to see if we could pull up, retrieve the same information that we submitted. So it's an interesting process. Again, show us that you're doing what you say you do.

Bills of materials, another type of material they ask for. And on average, we were able to provide the documentation they asked for within 2 hours. As a result, in a word, the inspector said that we were outstanding. During the wrap-up session, they said that we had exceptional preparation, targeting specifically our ability to provide quality of information in the efficiency of our responses, in other words, the logistics that we had planned to be able to prepare and meet the requirements of inspection they were quite impressed with, and they said that we had, "a high level of sophistication."

This is also an opportunity for FDA to get to know the industry better because FDA is new to us, and they often say that the industry has a learning curve. Well, they have a learning curve as well, and they're in the process of learning about the industry. And we feel, and they admitted, that they felt they learned a lot at our place. Obviously, this is an opportunity for us to get a better idea on what we're going to need for GMPs when they are implemented. As a result, we feel that we are ready to meet regulatory challenges.

Mitch Zeller, the new Center Director for the Center for Tobacco Products. Obviously, as you understand, he's an outspoken tobacco control advocate, no secret there. I met Mr. Zeller for the first time when I worked at FDA. I was in the commissioner's office as his Director of the Office of Science for the commissioner. And at that time, it was the mid- to late 90s, they brought Mitch Zeller in to head up Dr. Kessler, Dr. David Kessler's task force on tobacco. David Kessler was Commissioner of Food and Drug at the time. That whole effort failed in the end because FDA was not authorized at the time to regulate tobacco products. That came obviously in 2007.

From FDA, Mr. Zeller went through the American Legacy Foundation. And after being there for a while, he went on to be a consultant and lobbyist for Pinney Associates, where he worked primarily with the pharmaceutical industry on nicotine replacement therapy-type products. It appears that Mr. Zeller supports harm reduction, in part by his approach to and statements on nicotine. He is, in every opportunity has -- he talks about reevaluating the role of nicotine with the regulations. And what are the effects of nicotine were not delivered by smoke burning tobacco in other words. And by saying so, I think he's saying what is the role of nicotine in harm reduction. As you know, many of the public health community believes that you either quit or die. It appears in the past that FDA had a similar position unlike, say, the U.K., which is a very strong advocate of harm reduction. And by some of Mr. Zeller's comments, it appears that maybe he has some understanding and agreement with that.

A few weeks ago, Murray Kessler and Ron Milstein and I met with Mr. Zeller shortly after he came on board, and it was a very constructive meeting. He was engaged. He has lots of good questions. We talked -- the meeting was scheduled for an hour, and we went quite beyond that as we talked. And quite frankly, we got quite along -- we got along well with him. We enjoyed the meeting, and it has created a great foundation for us to continue working under his leadership in FDA, because that relationship is important. Obviously, we don't agree with everything they do. They don't agree with everything we do, but we respect each other. I think that's clear, and it's important that we work well together.

It's no secret that Mitch Zeller will be more aggressive, we feel, in his regulatory agenda. He has stated, though, on several occasions that he will follow the science. And of course, this follows statements made by Margaret Hamburg, the Commissioner of Food and Drug on many occasions. And it has been the policy of FDA, for as long as I can remember, that they want to support the science and make decisions that are based upon a good scientific rationale.

Well, what Mr. Zeller has learned and has stated so after becoming the center director is that there is a regulatory framework within which he has to work. And people have said to him, "Well, you've made the following statements. You've published articles in the past with certain statements." And he said, "Remember, everything I said before no longer applies." He said, "I am now an FDA employee. I have to work within their regulatory framework." And any decision he and his team make will need and must be based upon good, sound science and supported by appropriate rationale.

He has stated on several occasions that the Center for Tobacco Products has 3 priorities: SE submissions, deeming regulations and menthol. Although no friend of tobacco, Mr. Zeller will likely drive decisions and reduce a lot of the uncertainty. And though we may not like all the decisions, but compared to the first 2 or 3 years of the center, at least we're having decisions come out now as evidenced by earlier this week and what happened, and that is a benefit for all of us.

FDA announced its first decisions on new tobacco products. We're pleased to say these are copies of the order that we received for the 2 products on Tuesday of this week. So obviously, that was a great day for us. Lorillard is the first and only company to have new products deemed substantially equivalent and authorized for marketing. FDA made history with the first-ever premarket authorization for 2 new tobacco products, and they have stated that those are the only ones they have approved to date.

Our SE submissions went to FDA in October of 2011. And during the almost 2 years since then, we have been very proactive working with FDA. We've met with them several times, talked with Dr. Ashley, the Director of the Office of Science. We've met with his teams. We've gone to their webinars. We've put in hundreds of hours not only on the original submissions, but in November of 2012, we received 7 questions from FDA asking for additional information for our SE products.

To show you the level of detail that FDA has gone to in making sure that our product is substantially equivalent, to answer those 7 questions, we had to submit over 3,600 pages of documents. And that's amazing. It's unbelievable. We felt, at the time, they're not -- they don't want the products to be substantially equivalent. They want them to be identical. So that was really hard to understand. But in the end, obviously, we submitted the right information.

A quote from Mr. Zeller's press release this Tuesday is here, where they talked about Newport Non-Menthol Gold Box 100s and Newport Non-Menthol Gold Box as being the first products that they have authorized for marketing.

So we'll move on to the current status of e-cigarettes and deeming regulations. As you know, 2 years ago, FDA announced that they will be -- they intend to regulate e-cigarettes. And that's fine. But the biggest concern that we have, and quite frankly, public health organizations, other countries and the regulatory agencies around the world are all concerned that regulatory agencies may be overzealous in their regulation and may overregulate. For instance, if they do and they put in a substantial equivalent standard and make it as difficult to introduce new products to the market, then they will clearly have the potential of preventing public health benefits that would come from electronic cigarettes, inhibit technological advancements and stifle product innovation. With that said, we agree that electronic cigarettes should be regulated. We want to make sure that the products are safe, that they are of adequate quality and we want to make sure that we prevent underage use.

Mr. Zeller appears to support e-cigarette's harm reduction potential based upon comments that I alluded to that he has said. We anticipate that deeming regulations are expected this year. We've been waiting 2 years, but I don't know. Well, I just think they're going to come this year. We really don't know. Maybe not. We waited a long time wondering if they'd still ever act on SEs and they finally did as well. When they do issue the deeming regulations, we think there'll be draft regulations allowing for comment. And in the beginning, it would not surprise us if their initial plans to regulate will be somewhat restrictive. We say that because of the way they're regulating tobacco products and cigarettes in general. With that said, if they do, we are prepared to vigorously respond with the harm reduction strategy to FDA, assuming they'll have an opportunity for us to submit the document. And our approach, we know, is strongly supported by many organizations around the world. The U.K., for instance, is very vocal on their support of e-cigarettes as harm reduction. And we think that public pressure will demand flexibility and allow for continued improvements. It's clear, though, that one -- even if they deem e-cigarettes as a regulatory product this year, it will be some time before final regulations are promulgated.

In summary, Lorillard's compliance infrastructure is well established. We have successfully passed routine inspections. We are well prepared for GMPs to be implemented. We have an excellent rapport and communication with the FDA and the Center for Tobacco Products. We have received the first and only SE orders for tobacco products to date. We look forward to working with FDA on electronic cigarettes, and Lorillard is well prepared for all regulatory requirements and actions.

However, what about the potential for regulatory action on menthol? To address this from a scientific perspective, Dr. Bill True, our Senior Vice President of Research and Development, will now give you some update on what are our feelings on that. Bill?

William True

Thank you, Neil, and good morning. It is my distinct pleasure to have an opportunity to talk with you this morning about the science of menthol in cigarettes. And the conclusions and perspectives that I share with you today are a result of a tremendous amount of analysis and hard work from our research and regulatory teams at Lorillard.

What I wanted to do first was start by talking about what sound science means to us. You probably heard that there was, on all sides of the debate, talk about the value of following the science and using sound science to reach conclusions. Yet I haven't really heard a very good definition of that explained. So from a Lorillard point of view, this is very important to us. And principally, we start with having study designs that are robust enough to be able to answer the questions at hand. The scientific method is driven by hypothesis and by developing experiments that have the potential to generate the data to support or conflict against those hypothesis, but it needs to be spelled out in advance. And when conclusions are drawn, they need to be complete -- clearly explained in supported by the data. There's a tremendous amount of literature out there in the science of menthol in which there are conclusions stated, either in the abstract or at the end of the paper, that don't appear to be tied to the actual data that's continued in the paper.

Reproducibility, fundamental tenet of good science. You ought to be able to access data, access the results from a particular study and other scientists ought to be able to reproduce that and come up with similar results.

Full transparency is key. It's important that all the data that's used is disclosed. It's important that all corrections that are made from the data, any of the statistical treatments that are made for data, just like in your industry, that those are clear and obvious for everyone else to be able to see. And certainly, study limitations. It's important to explain what those are as well.

Overall, when you're looking at a series of work that can be done and have multiple studies, the weight of evidence across those multiple studies can sometimes be the most pivotal aspect in terms of drawing a conclusion. So for us at Lorillard, this is what we mean by sound silence -- sound science, and much of the comments that I make today will be reflected in -- on these premises.

Now if you look at the science related to the individual risk component, and these sciences are very directly measured. They're measured by sophisticated analytical techniques, and you get real and hard data from these sciences. And the science is clear on these across all these categories that menthol cigarettes are not more dangerous than non-menthol cigarettes. Areas of epidemiology, biomarkers, toxicology, chemistry or smoking topography all come in very, very clean.

Going to a little bit more detail on a couple of these. Epidemiology is very well known. It's been one of the most commonly used sciences across the study of health effects of cigarette smoking. And if you look at the time period prior to the TPSAC report, there are a number of epidemiology studies, again, in this category, probably one of the most widely studied areas. There were quite a few studies that were done. None of them had reached a statistically significant result. Although there were a couple of papers that indicated that in certain subgroups they were showing an indication towards a near protective effect of menthol use as opposed to non-menthol use. But it wasn't until after TPSAC, and actually, coincidentally, I think it was virtually days after the TPSAC report, the Blot analysis was published. And this was the first study, epidemiology study, of menthol use in cigarettes to statistically be significant in determining that menthol had a protective effect.

Now I love to claim victory and I love to say that this is the most significant result that we've had and, in some cases, it is. But if you go back to my fundamental premise, the overall weight of the evidence still leads me to have to conclude that menthol smokers do not have a higher risk of lung cancer. I'm not going to say protective yet, because I don't think the weight of evidence is quite there yet, but clearly, it's not higher than non-menthol cigarettes.

If we look at biomarkers of exposure. The Philip Morris total exposure study was the largest exposure study that's ever been conducted on biomarkers, almost probably 10x the number of subjects in the study as any other with good geographic and demographic representation. And from the study, we found, again, that there was no difference in the biomarkers of exposure across this very large study population. And this is very significant because biomarkers are very, very directly measurable and they take into account any differences in the way that an individual might puff on a cigarette, the puff intensity, the puff duration and so forth, and all these come and factored in because you're actually analyzing the subject's exposure directly.

Another important aspect of the total exposure study is that, to the best of our knowledge, it's the first large study ever to examine the biomarkers of harm. And once again, the conclusion of this study is that there is no difference in the biomarkers of harm between menthol and non-menthol smokers. So overall, if you look at those areas of science that deal with the individual risk component, I don't think there's been much debate. In fact, I think TPSAC and others have pretty much come to the agreement that there is no difference between menthol and non-menthol cigarettes in those hard sciences.

We start to look at the behavioral sciences. Obviously, there's been some considerable debate. And what I want to talk with you a bit about this morning is that if you consider the weight of evidence of the studies done across a wide group of studies that the science here as well does not support a difference in public health impact between menthol and non-menthol cigarettes, whether it's African-American incidence levels, initiation, cessation, youth smoking, particularly among African-Americans, and the transition to established smoking.

So if we start with overall smoking incidence. Despite the overwhelming preference African-Americans have for menthol cigarettes, their smoking incidence is actually lower than that of whites. So said another way, the smoking incidence for whites who have a strong preference for non-menthol cigarettes is higher than that of African-Americans. So one has to ask themselves, if menthol was truly playing a role in initiating smoking at a greater rate than non-menthol cigarettes, wouldn't you see it amongst the African-American population that has a very strong preference for menthol cigarettes? And you just don't.

And if you look at 3 different studies that have been done, NHIS, NHANES, NSDUH, the white non-menthol smokers starts smoking earlier than African-American menthol smokers, and they do it about 1.5 years on average earlier. As well, the youth smoking rate for African-Americans is about 1/2 that of whites. So once again, I'll ask the same question, if menthol was causing initiation at a greater rate than non-menthol, wouldn't you expect the African-American youth to start smoking at an earlier age and have a higher youth smoking rate? But they don't.

And another pretty clear misunderstanding is that although some people think that menthol cigarettes are an African-American cigarette, in fact, the majority of menthol smokers are white. So a quick recap here, that if you look overall, white non-menthol smokers have the highest smoking incidence rate. They have the lowest or the earliest age of initiation and they have a youth smoking rate twice that of African-Americans. Is that consistent with menthol having an effect on initiation? I don't think so.

So if we shift now and look across all demographics, over the last decade, the market share of menthol has increased, as you can see on the top line. At the same time, the youth smoking rate has declined consistently and substantially. So again, I'm going to ask, if menthol was playing a role in youth initiation and transitioning a higher rate than non-menthol, would you expect to see such a decline in the youth smoking rate while going along with the increased market share gains in menthol? And I think no.

If you look, again, across state-by-state basis, the market share versus youth smoking rates, some of the highest youth smoking rates happen in markets with very low market share of menthol. And if you look on the left-hand side of the chart, those states that have the highest market menthol share have amongst the lowest youth smoking rates. So there's clearly no correlation between the availability of menthol and youth smoking.

And there's a brand-new study that's been published by Oxford Economics looking at the same question internationally, and the same trend occurs here. Those countries with the highest menthol market share have amongst the lower youth smoking prevalence. And in fact, on the left-hand side of this chart, you see a number of countries that have some of the highest youth smoking prevalence with none or virtually no menthol in the market.

I know many of you probably heard a contention that menthol makes the poison go down easier. Catchy, but not true. Fortunately, one of the first studies that has taken a look and actually asked questions to real consumers for the reasons why they smoke menthol or non-menthol cigarettes. In fact, non-menthol smokers say they choose their cigarette because it's less harsh on the chest, less harsh on the throat and non-menthol cigarette smokers think that their product is less harmful than menthol smokers.

So what we've been saying all along has been borne out in this survey, and that is menthol smokers have a taste preference for menthol, and they choose their product based on taste and not because of any of these other allegations.

Overall, if you look at the studies that have been done in the area of cessation, we conclude there's no difference in the overall risk or the overall rates of quitting from menthol and non-menthol smokers. And we work in conjunction with Covance, who's one of the best organization in the world in terms of statistical analysis and reviewing papers and so forth, and they helped set up a matrix, which would specify certain areas of adequate methodology that would be used in the various studies. And basically, 2/3 of the studies that had adequate methodology show no difference in menthol -- show no difference in cessation rates between menthol and non-menthol. In fact, even if we remove the filter of Covance's analysis, still, about 60% of the studies that have been done still suggest that there's no difference between menthol and non-menthol on quit rates.

If we move to the area of initiation, actually, no studies based on Covance methodology are adequate -- are deemed adequate. And there's some mixed results amongst these. Some of the reasons why none of these were deemed to be adequate would be, first of all, as I go back to my -- one of my first slides, no study was designed to evaluate the effect of menthol on initiation. Secondly, the studies have been cross-sectional studies. And what I mean by that is these studies are a snapshot in time where they interview youth and many of their answers in the surveys are based on recall. And the most powerful way to track something as complicated as initiation, experimentation into transition to full-time smoking is to conduct what's called a longitudinal study, where over a series of years, you go back and survey the same population over again and follow and track them to determine how this goes. And again, none of these studies have the benefit of that, and that's a key reason why none of them have adequate methodology.

In fact, I think FDA and TPSAC, in a large degree, support that. One of the FDA authors of a white paper concluded that there's a paucity of data topic, and a lack of data prevents further conclusions on the role of menthol cigarettes in the initiation of smoking. Very powerful statement and very true. Even in the TPSAC menthol report, a couple of comments that I have highlighted down here, suggest the fact that they really be looking for more information and that following participants, which is that longitudinal study, would be something that would be very important for us to understand before we draw conclusions.

There's been some work published since the TPSAC report, I think about 100 different studies overall. And a couple of them very, very positive in terms of the statistical significance that we've shown in epidemiology. But if you look at the studies overall, there really isn't a whole lot of new information that can be gained, and the weight of evidence from the menthol research since TPSAC doesn't support any change on that weight of evidence one way or another and certainly doesn't give any basis for disproportional regulation of menthol.

So going back and thinking about the fact that prevalence is not higher for African-Americans who smoke menthol, the fact that whites start smoking at a younger age, they have a youth smoking rate twice that of African-Americans and that all of the work that we've looked at here in terms of cessation and initiation are clearly inconclusive at best, how did TPSAC reach the conclusion that they did?

And the simple answer is they wanted an outcome, they knew an outcome they wanted to have, they found a model, and they found a paper that would help support their model. Let me take a little bit of time to walk you through that.

So Professor Mendez was asked by the TPSAC to create a model, so they can help gain an understanding of the quantitative impact of menthol cigarettes on public health. And they were looking for an overall rate of kind of model depth over a period of time in a world where menthol exists and in a world where menthol doesn't exist. So he provided that model, and TPSAC agreed that they provide inputs to this model. Now they said that they've been looking at certain specifications for model parameters, best estimates, lower bounds and so forth, but the issue was they never clearly explained the source of most of those inputs that they gave to the model. And no calculations were provided for anyone to go back and determine exactly how they arrived at those, with the exception of one, one TPSAC estimate that we're aware that can be tied to a very specific study, and I'll tell you a bit more about that.

Again, the behavioral studies that were relied on by TPSAC as they were evaluating and coming up with some of these inputs all fell short in terms of adequate methodology as determined by Covance. And some of the reasons stated by Covance for why these studies might have flaws would be the fact that they didn't use valid measures to study the -- to measure the study endpoint. The statistical rigor might have been lacking in some fashion or not very clearly explained. The lack of generalizability or the fact that it might have been focused too much on one subgroup and not a generalizable finding that you would expect over total population health in general. And the study was not designed to measure the effect of menthol on smoking behaviors. That was a very, very common theme to that. So clearly, in many cases, the conclusions in some of these studies were not supported by the data that were contained in them.

So the one paper that TPSAC did rely on was Nonnemaker 2010. Now Nonnemaker was able to find the data set from this ALLTURS data set. And this data and the questionnaire that was used are not publicly available. And despite repeated attempts by Lorillard to access this data from Nonnemaker and others, we've not been able to get this data. It is a longitudinal study, which means it did track subjects over time, but it was a longitudinal study that was sponsored by American Legacy to understand the impact of the truth campaign, all those commercials you see on TV, the truth campaign on smoking initiation, and it wasn't designed to study the effect of menthol. They did ask some questions about menthol, but even described the limitations of the study. They do have to rely on some recall of these subjects because that's not the way the study was originally designed.

Secondly, although I'm calling it Nonnemaker 2010, it was an unpublished study at the time that TPSAC received it and reviewed it, and in fact, in its form, was never published and was TPSAC's sole basis for a key input into the Mendez model. Furthermore, it was published later in 2010 with different conclusions. So that caused a great deal of concern for us, and we wanted to understand a little bit more about what was going on.

So first of all, if you read both versions of the text, Nonnemaker gives you the impression that the data set used from this ALLTURS data was a very, very large data set, because in fact, there were 47,000 students that were interviewed for their study. But if you look at the Nonnemaker 2010 column, of the 47,000, only 35,000 completed wave 1 or the first visit from the study and only a little over 16,000 completed all 3 waves. But the most dramatic impact of this chart is somehow out of over 16,000 subjects in this study, only 479 were included. 97% of the data was not evaluated by the study, only 3%. And if you look at the numbers with that experiment with menthol, 161 in African-Americans who experimented with menthol, how can this data set be representative of anything meaningful? As we all know, African-Americans probably account for up to 40% of the use of menthol. And by here, we're showing, what, 10.

When we go back and look at the right-hand column of Nonnemaker 2012, we see that it's included a few more people. So keep that in mind. The relative ratio of those that experimented with menthol and the African-Americans with menthol remains about the same, but somehow we found another 150 people he was going to included.

Well, what does that do? Well, by somehow finding another 150 people to include, he was able to take this key factor, which is this rate, this rate that menthol experimenters progressed to established smoking, a 68% that occurred in 2010, which is the information that TPSAC had, I want to remind you, that was not statistically significant. By adding 150 people to the analysis, he was just able to squeeze by, okay, to develop a statistically significant result. And for those of you that are unfamiliar with confidence intervals, the reason why the first result in 2010 is not statistically significant is that the confidence interval contains 1. You notice by adding 150 people, he was able to shift that by 0.005 point. So it just becomes statistically significant. So these different data sets were used between 2012 and 2010. And although there's some explanation of the rationale for the selection of 2012, there's actually no discussion about why there's a difference between those selected in 2010 and 2012. This seems very suspicious to me.

So furthermore, when you look at some additional anomalies that exist between the 2 studies from Nonnemaker, there were subjects obviously excluded in 2010 that were included in 2012. So that's very obvious. But in 2012, he also inappropriately eliminates one group from the denominator of the calculations. And that one group, believe me, when you look at the modeling, is enough to affect that statistical result. Another thing is that some smokers are not accounted for in any group. So these differences likely explain why the 2012 results became statistically significant when 2010 was not, and there's not enough transparency in either publication for us to be able to go back or reproduce, understand the data sets involved, and be able to figure out why these conclusions came the way they did.

Now turning to the Mendez model, and the impact of this input from Nonnemaker to the Mendez model. One of the key things that was very influential in TPSAC's decision was this model prediction of excess deaths due to menthol. And if you look at this in a lot of detail, I'll walk you through it, this just simply is not credible. So first of all, the 2010 progression rate is 68% greater for menthol smokers was the key input. Now I'll show you a bit more detail on the next slide, but what you end up calculating from the Mendez model, that in order to make this work, the proportion of non-menthol experimenters who become established smokers, this transition rate, 56% of non-menthol experimenters become established smokers.

For menthol experimenters, 93% of the experimenters become established smokers. So please take a moment to stop and think about this for a minute. What they're claiming is that out of 100 menthol smokers, 93 of them become established smokers, and that's contrary to all the established reports from CDC, from the Surgeon General's report, from NASDA, that reports that 1 in 4 experimenters go on to become established smokers.

Now why wasn't there an outcry about this? Well, the 56% and the 93% were never discussed by Mendez or by Nonnemaker or by TPSAC, only the outputs of the model. So you had to have the ability to go back and recreate the model to understand where these numbers came from. In fact, another discrepancy, is that if you read the body of the text in Nonnemaker 2012, he admits that the transition rate from menthol smokers -- for menthol experimenters to full-time smokers is 14.89%. So there's internal inconsistencies all over the place between the use of Nonnemaker in this model.

So I'm going to show you a part of the model that leads to most of our issues. Now as with everything else, Mendez gave presentations. He showed a lot of calculations. I mean, he definitely is a model wizard. I give him a lot of credit for being able to -- to able to work in this field and then do the kind of work he does. But when he gave his presentations, he only showed you what we wanted you to see. So there's a lot of calculations I don't think a lot of people fully understood. But what he did do is he did provide the outputs on the right. But if you let me, for a moment, just walk you through this a little bit.

So we started off with the world of all potential experimenters, of what has to be 100%. And Mendez didn't describe, it's shaded in yellow -- he did estimate that the proportion of experimenters in the real world is about 30%. And that's fine. So we have 30% experimenters. He then inputted that the proportion of menthol amongst experimenters was 45%. Now some people have claimed that that's alarming, we should be concerned about that, but you hang on for a minute and follow me through this. I'll show you that whether that number is 45, 15, 90, 100, it doesn't matter to the output of this model. The only thing that matters is those that transition to regular smoking. So we're going to leave that as is. So we have these 2 boxes, the one in green and the one in red, 13.5%, 16.5%, and those are basically the percentage of menthol experimenters and non-menthol experimenters.

Now Mendez never showed 93% and 56%. What he showed you is that there's a why for them and there's a why for then. And if you keep going down the line to the right, you end up with an initiation rate of the current world of 21.8%, which is an addition of the menthol initiations and the non-menthol initiations. And this counterfactual world where menthol doesn't exist, he has an initiation rate of 16.7%.

So what has to be done is, I guess, from what I understand, probably intermediate algorithm, not super complex. By having 21.8%, you're having 16.7%, and knowing you have the inputs on the left-hand side of the purple box, the 13.5% and the 16.5%, this is a simple algebraic equation. And the only result that can come out of this equation, to drive the 20.8% and the 16.7%, is a 93% transition rate of menthol experimenters to full-time smoking, absolutely ridiculous.

So at the end of the day, the difference in progression of those menthol experimenters, based on this 93%, and even the non-menthol experimenters is a 56% to establish smoking, this accounts for 91% of the excess deaths that were reported by Mendez. And this was obviously a very key driver in the conclusion that TPSAC led, that menthol cigarettes have an adverse effect on public health in the United States.

Something a little bit more interesting, as you kind of dig into the model that I wanted to share with you, it's how impossible this model really is at the end of the day. And I did explain a moment ago, confidence intervals, basically those intervals that give you the range of where the real data lies. It's typically referred to as 95% confidence level. And actually, if you look at the upper confidence level of the paper that was published in 2012, it actually leads to impossible results. So the upper confidence level would actually suggest that the progression of menthol smokers, the full-time smoking versus non-menthol, 3 -- at a rate 3x greater, 3x greater. That's not borne out anywhere in any of the other data that we've seen earlier today. It's not borne out in market share. It's not borne out anywhere, but 3x greater. And then for every 100 menthol experimenters, 116 would progress to established smoking.

Okay. Now does anyone wonder why this model was never fully explained? Is there any wonder why TPSAC worked very hard to drive a result, to find a model, get a paper that they are able to identify some interesting results, that hadn't been fully validated yet, and then drove the conclusion that this was going to have such an adverse impact on public health? Yet, it's truly unfathomable that a result like this could happen.

So overall result, TPSAC's conclusion was not based on sound science. We have no other conclusion to come to other than this is product of a biased and conflicted panel. It relied on a single model that was not well explained or well understood. And it was an overreliance on a single study, a single flawed study for inputs to the model. And we're very hopeful that the FDA will be much more science-based in their evaluation of menthol going forward.

And we're also hopeful that the FDA will consider the countervailing effects of the disproportionate menthol regulation would have as they are required by law. It's well-known that the black market will be significant. It's very easy to self-mentholate, increase youth access, and counterfeit cigarettes will be made as they are already, but even at a greater rate to supply the demand in factories with unknown ingredients, ungrown -- unknown cleanliness standards and certainly, not FDA-inspected.

Now TPSAC themselves only devoted 3 pages of their report to this subject, and they basically punted and said, we think this is FDA's purview to go ahead and take a look at. So today, we haven't seen any publication out of FDA. So if anything has been conducted, we haven't seen the results of that yet, but we certainly hope that that will take place. And we don't believe that the FDA will ultimately ignore the many major government bodies that have warned about the contraband risks and other organizations that have come out to caution the government on this.

So going forward, we're continuing to wait on the announcement from FDA on menthol, whether they published the peer review or started to announce their position on menthol. Should be happening any day now.

We're very encouraged by the fact that the FDA and NIH paired up together to fund PATH studies, and these basically are the studies that are an output of many TPSAC comments and of course, ours, that some of these areas of behavioral science that have such inconclusive and mixed results need to have more study, with well-designed studies in order to ensure that we get a better insight into the overall conclusions. This will take place over the next several years. And if these studies are well designed, if these studies are peer-reviewed appropriately, then we're very confident that we'll see exactly what we've already seen in the earlier data that I've shown, and there will be not a significant difference between menthol and non-menthol cigarettes.

So we continue to believe that the science of the menthol is very, very clear. At this stage in time, that the basis for regulating menthol cigarettes differently from non-menthol cigarettes is not there, and Lorillard is fully prepared to respond to any further FDA action on menthol, with data such as this and others that we have done to sell our case.

And now, I'd like to turn it over to Ron Milstein, our Executive Vice President of Legal, and Chief Counsel, for an update on litigation.

Ronald S. Milstein

Thank you, Bill, and good job. Good morning. Glad to be with you again. I'm going to update you on our litigation environment. The last time we met, a couple years ago, I think my presentation would have been a little longer, and maybe I would have had some more things to talk about. But I'm happy to say that we have continued our history of successfully managing our tobacco litigation. And last year, we successfully completed a transition from one national law firm to another. We've used -- we had used Shook, Hardy & Bacon for over 50 years to do our product liability defense, and we had to move to a new firm, Hughes Hubbard & Reed, to do that same thing for us. I'm happy to say, that transition was extremely smooth. We did not miss a beat. We continue to defend our cases, and we do so efficiently, and we do so very well.

All of the challenges I'll talk to you about this morning are clearly manageable, in our opinion. There's nothing new. There's nothing really different. Tobacco law is what it is, but we believe that more of it is manageable.

I'm going to talk this morning about different categories of product liability litigation, and then I'll mention some other litigation we have with the FDA. The individual product liability litigation are those cases brought by individuals claiming injury from smoking and health. That is a category that's been with the industry for many, many years. And right now, as you'll see, it is on a decline.

Class actions are those kinds of cases that the courts have conglomerated into one setting or one form, to adjudicate the claims of thousands or millions, in our case, consumers and other entities that have tried to bring class actions against us.

Health care reimbursement cases involve states, tribes, those Indian tribes, insurance companies, all sorts of folks that came to us in the '90s, really, with these kinds of cases. They're, for most part, over. They culminated, many of them, the state cases culminated in the Master Settlement Agreement in 1998.

And finally, Kent filter is a category of cases that only Lorillard has. It's unique to us because it has to do with a product that only we made and produced in the 1950s

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Lorillard by individuals. Most of these or many of these are, in fact, dormant, inactive cases that have been filed for years and years. There's really no -- not much action on them.

The one exception is a case called Evans versus Lorillard. It was brought in the Superior Court trial court in Boston, Massachusetts. And in December of 2010, it resulted in a jury verdict against the company for $35 million of compensatory damages and $81 million in punitive damages, extremely high, even for a tobacco case, and I think the highest in Massachusetts history in a personal injury case.

Just recently, a couple of weeks ago, on June 11, the Supreme Court of Massachusetts, which took the appeal from the intermediate level court, reversed the punitive damage verdict of $81 million and awarded a new trial, sent it back for a new trial, on punitive damages only. We don't know right now what that new trial will look like, what causes of action, what torts will be the basis for the punitive damage retrial. All of that will be settled, we think, by the court, by the parties in the next several months, perhaps a year. But right now, the compensatory damages verdict that was upheld will be set aside or will not be dealt with by that retrial, and we will have to wait to see how that sorts out in the court system.

We're assessing right now our options to go back to the Massachusetts Supreme Court for a reargument on some of these key issues, where we think they just either got it wrong or didn't understand what they were doing. And we'll, of course, consider further appeals when we can to other courts.

There are 2 additional individual cases that are set for trial this year, one in New York and one in California, and we intend to defend both of them. They've been around for at least 10 years each, and we are geared to defend those.

West Virginia, I put up here because many of you know, it's been around for about 15 years, a case that was brought by individuals and consolidated by the court in West Virginia into one form and basically, it involved a multiphase trial where they were going to try common issues of liability in the first phase and then if the industry lost, we would have follow-on cases, almost likely or not quite. But what happened here is that the 600 individual cases that were tried for common issues resulted in a defense verdict. The industry won. The entire case against these claimants, except for one very narrow claim, made about a vintage cigarette and failure to warn about or instruct how to use the vintage cigarette in the 1970s. Lorillard was involved with 31 of these cases out of the 600, that is 31 smokers claimed they smoked our product. But none of the cigarettes made by Lorillard during that time period had vents -- ventilation holes, so we don't expect to be involved in any of the follow-on cases, if in fact they take place in West Virginia.

We also don't know right now what the appeal situation is going to be, the plaintiffs who have a right to appeal. We don't know if they can appeal right now, or they have to wait for the results of at least one of the follow-on cases before they appeal it. But of course, the industry will be monitoring that. All of the companies were involved in this case.

Engle, you all know what I think about Engle. We've made tremendous progress in whittling down the number of Engle cases, from 2008, when we had over 7,500, to now where we're down to about 4,500. And the reason that the numbers have declined so drastically has to do with motions to dismiss that were granted, with voluntary plaintiffs, dismissals by the plaintiffs, and with good legal rulings, as well as some settlements that have been undertaken by the industry and Lorillard for nominal amounts.

I'll give you a little idea of the record of the industry and the record of Lorillard here. As you see, the industry has been to trial and verdict in about 100 cases. We have only been involved in 13 trials. While we have lost 10 of them, our losses are quite small in number, in dollar number, compared to the industry. The range there, it's not a typo. The industry's losses have resulted in judgments against the companies for $1,400 to about $70 million in a single case. And Lorillard, similarly, has a very wide ranging of losses here from $4,500 to about $33 million. We really only have a couple of cases that involved millions of dollars. Most of our losses have been quite small under $1 million. And all of them are on appeal.

There will be 4 Engle trials, or at least there are 4 Engle trials scheduled for the rest of this year throughout the state of Florida. And there are appeals pending, major appeals pending, not in Lorillard cases, but in the other industry cases in the Florida, 11th circuit -- I'm sorry, the Federal 11th Circuit, as well as the U.S. Supreme Court, where a Certiorari petition was filed in a case that was decided by the Florida Supreme Court a couple of months ago, the Douglas case.

To date, I'm happy to report that our losses or payments in judgments in the Engle progeny matters have only totaled $15,500 by Lorillard. So after 5 years of litigation, we are very, very proud of our trial record.

I'm also happy to report Lorillard does not have any class actions against us. We're not a defendant in any of the Lights class actions that are still going on across the country, against mostly Philip Morris and some against Reynolds, and we have not been a defendant in that and are not right now a defendant in that.

In health care reimbursement cases, the only one left is really the DOJ case, where -- that stemmed from allegations that we were complicit with other companies in RICO violations. Remember in 2006, the judge in that case issued an order, amongst other things, and the order she demanded that we do corrective advertising on television and in newspapers. We're now in mediation with the special master in that case, we're trying to figure out what that all means and the details of that mediation with the details of the plan to go ahead with the corrective advertising should be wrapped up, we think, shortly. We've estimated that the cost of that to the company will be about $20 million, and we actually did reserve for that in our financials in the first quarter this year.

Kent filter, again, unique to Lorillard, no other company has this problem. It has to do with putting an asbestos element in a filter in 1952. It was only on the market for 4 years. It was a good idea at that time. We've gotten a lot of claims from smokers claiming that they developed mesothelioma from the asbestos element. It is not a smoking and health case, it's not a tobacco and health case. This is purely an asbestos case. We also have claims, not only from smokers, but from workers, who worked in our plant and in the plant that made the asbestos filter. And those claims are occurring on a regular basis as the last standing deep pocket in asbestos litigation, we find that we're getting many, many suits on this. We have about 60 pending right now.

The good news is when we fight them, we win them. Since 1991, we've been to trial in 22 cases and we've won 17 of them. When we lost, it was a range of $140,000, over $2 million, not, I bet, your company kind of case. And we think that we will continue to see these, at least until the claimants who are now in their 70s and 80s finally go -- finally die. There are several trials scheduled in this matter, and we do settle these cases, again, they're not smoking health cases. We settled these cases and we think the settlement strategies kept the legal fees down.

Other litigation. We have 2 cases that I want to talk about, one is actually over, but the first case, building on what Bill True talked about with the FDA and the TPSAC panel, the first case was brought by Reynolds and Lorillard together in Washington, D.C., claiming that the TPSAC panel was biased and conflicted. I don't think that this is any news to anybody, that most of or some of the team members to that panel have worked for pharmaceutical companies, had gotten money from pharmaceutical companies for consulting. For years, they were all very strong long-time anti-tobacco advocates. If you really paid attention to the TPSAC proceedings, I think you'll agree that it was not a fair and impartial scientific panel. They had a result in mind and they reached it. But our suit is aimed at showing that they need to do that process over, because it was tainted. And we did survive a motion to dismiss by the government in that case, claiming that we had no standing to bring the case. The court said, no, they have standing, let's go to discovery and let's go to trial, and we think that will happen maybe early next year.

And finally, the graphics warning suit. Big victory for the industry. The case is over. We won it completely. The court in D.C. basically said, FDA, you cannot do what you did in putting these warnings on the packs, you didn't have the scientific basis for it, you didn't have the research, go back and do it again if you're going to. But right now, the court said that it's a violation of our First Amendment rights for them to have done this in the way that they did it. And the FDA did not appeal that case, so that case is over.

So in summary, while Engle is a risk, I think David Adelman put it really well. It's like a leaky basement, it's manageable, it's a pain, it's there, we've got to deal with it, and we are dealing with it rather successfully. The company is doing well in defending all of its litigation and all of the case categories are on decline except Kent filter, which is kind of flat in the rate of filings for obvious reasons, as I've described. And all of these cases, all of the litigation for the industry and for Lorillard are manageable at this point.

So thank you. With that, I'd like to introduce David Taylor, our Executive Vice President of Finance, and CFO.

David H. Taylor

Thanks, Ron. So the title of my section is Financial Guidance, (Lorillard-Style). So why do we call it Lorillard-Style? Because most of the people in the room know that our philosophy is that we don't give guidance. We haven't, and we don't intend to change that practice. We think that it promotes longer-term decision-making and longer-term thinking. We don't have to meet quarter-to-quarter Street estimates or our own estimates, even year-to-year. We want to make the right decisions for the benefit of the business long-term. Now we recognize the issues this practice causes for many people in the room, in terms of building expectations year-to-year. So we will talk about some of the factors that impact our financial performance, so that you guys can build your models and come up with the right answers.

So first, volume, what's going on with our volume, what's going on with industry volumes. You can see that for the periods leading up to 2009, and the period subsequent to 2009, the total -- and I left 2009 out because of the increase in federal excise tax settlements' unusual downward impact. As you can see, the industry shipments have been declining in the roughly 3% neighborhood. And in 2012, you saw a very small decrease of 2.3% likely because of very little state excise tax increases during 2012 and very little manufacturing -- manufacturer pricing.

In the first quarter of 2013, industry shipments, this is an industry shipment, industry shipments actually declined 6.2% in the quarter. But as we look at our retail data, that shows a decline, shipments from wholesalers to retailers, of 4.9%. So if we want to get an idea of what's going to happen in 2013, that's leads to the way we see the industry starting out. We're operating under the working assumption that the industry shipments will decline roughly 4% for the whole year. So we'll see how that turns out.

But as you know, Lorillard clearly doesn't work on that trend. Over the past several years, you've seen Lorillard shipments actually increase while the rest of the industry is declining. And we believe that we can continue that record of outperformance when it comes to volume. And so we would expect, no matter what the industry does, that we will outperform that by a few percentage points.

Now we'll talk a little bit about the capital allocation policies, decisions and other guidance that we've given to the Street before. Our dividend policy is that we expect over the long term to pay out roughly 70% to 75% of our earnings in the form of dividends. And you can see the annualized dividend rate increasing every year since the spin from Loews and increasing dramatically from $1.23 to $2.20 on an annualized basis. So that's the primary use of the cash generated by Lorillard. We're going to give 70% to 75% of it back to you in the form of dividends.

What else do we need our cash for? Capital expenditures have been rather modest for our business. They've increased a little over the past few years. Murray and Neil described some of the uses of that cash. But going forward, we think that $70 million to $80 million in CapEx is probably the right number, still pretty modest for a company our size. We've used cash for other things. We've bought blu in 2012 for $135 million, and we have and will continue to invest in working capital in order to fund our growth, both at blu and in Lorillard.

So over and above that, we've got excess cash. So far, using that cash for share repurchases has been the most attractive use. And we have used cash both from operations, as well as cash from incremental borrowings as we've levered up the balance sheet for share repurchases. And we've paid out in the form of dividends and share repurchases over $7 billion since the spin from Loews. Currently, we are operating under a $1 billion share repurchase program authority. And as of a weak ago or last week, we had roughly $815 million left to spend on share repurchases.

Let's talk about leverage. You can see that we've been increasing our debt levels steadily since the -- since going public. And we've said that our target leverage number is roughly 1.5 to 2x EBITDA in terms of gross debt to EBITDA. I don't really think that, that policy or that practice of that range is going to change given the current set of circumstances. We want to protect our investment grade ratings, and we know that, that range is appropriate to do that. Currently, we're at roughly 1.8x. Let's gives this a little bit of room underneath that 2x number, but as we grow earnings, we might well expect to see incremental borrowings from there, still within that 1.5 to 2x number.

In the past, we've outlined various different scenarios for what the company's EPS growth rate would be on the long term, okay? This is not news to most people in the room. And so what we've tried to do is outline various different environments and different things that impact our long-term growth rates, some of which are in our control, some of which weren't in our control. And so the scenarios are, if the industry continues to be highly promotional, where there's crowded product introductions that compete with us, where there's a low level of price realization, like we saw in 2012 and, frankly, headed into 2013 as well, if we -- if that environment were to persist, if we were to not introduce any new products, if we only repurchased shares from excess operating cash flow, not any incremental borrowings, and if the profit contribution from blu remains modest or limited profit contribution, you'd expect mid single-digit EPS growth rates over time. Now there's various factors that would cause that to go up. If only the competitive environment changed, such that we might see the same kind of price realization that we saw in the years leading up to 2012, you'd see high single-digit earnings rates, same other scenarios, just a difference in the operating environment. But adding to that, if you got back to that sort of normal historical pricing, if we were able to introduce new products, if we had additional leverage-driven share repurchases and if blu eCigs were to really become a meaningful part of our profit picture, you'd see double-digit EPS growth rates.

So where are we? Am I going to tell you? Not exactly. I'm not going to tell you exactly. But are we still in a heightened promotional environment? We are right now. Now just from the function of lapping various other promotional activities that happened in 2012, the back half of 2013 might look better from a standpoint of price realization for us, but that remains to be seen. So far, we have not seen a sea change in the promotional environment in cigarettes where we're competing. New incremental products. You know that's going to happen. It's going to happen, and you'll see it by the fourth quarter of this year. You've already heard that. Additional leverage-driven share repurchases. We just issued $500 million worth of debt in May, and we've earmarked that for additional share repurchases. So we're putting that to work in terms of reducing the share count. And so far, we haven't seen a huge profit contribution from blu. And you've also heard not to expect it in the short term. We're going to invest a lot of the earnings generated by blu back in the brand building exercises and expenditures to build that brand as big as we can before we seek to realize a whole lot of profits from it.

So some positive factors are in place that I just described, share repurchase program, the authorization to market Newport Non-Menthol Gold. And that partial settlement of the NPM issue earlier this year provides liquidity, some levels of liquidity, some more for others than us and some continuing earnings benefit, not a whole lot, and some more for other competitors than us; I want to remind everybody that the obligations for the Tobacco Growers Assessment are scheduled to expire in the third quarter of 2014. We expensed roughly $118 million for that obligation in 2012. It's scheduled to roll off in 2014. And the current working assumption that we're under is that it will roll off, and that will roll to the bottom line. And many people have commented and threaded about blu eCig's margins. What's going to happen to these margins? And how is that going to impact Lorillard's margins? I shouldn't do that. But I do need to tell you that significant opportunities for cost savings in the supply chain are available to us. They've been identified, and we're working against that -- against those initiatives in order to protect those margins at blu. I did say in the last conference call, if you recall, that we might see some short-term margin pressure as we rolled out this new, more affordable pack. Murray said that we don't make a whole lot of money on it, roughly breakeven at the price point. But what we want to do is get that in as many people's hands as we can so that we can make better margins on the sale of RICO cartomizers. So you might see some shorter-term margin pressure as a result of that introduction of that product. But over the long term, we think that we can protect very healthy operating margins at blu.

Our incentive plans align with shareholders. Our short-term bonus plan is a balance between Newport share and operating profit. We can grow Newport share at the expense of operating profit. We can grow operating profit at the expense of Newport share. But the annual bonus plan, the way we maximize our short-term earnings potential, is to protect both, and then we think that's best for the long term. Our long-term incentives are paid in common shares with a 3-year vesting, and those shares are variable based on EPS targets that we have working against us. So the long-term compensation is common shares, just like our shareholders, and it's variable based on EPS targets.

So summarizing guidance, Lorillard's style. I think you've heard as much specific guidance out of me as you're going to. But we believe all the elements are in place to continue our fantastic history of financial results superior to that of the industry and superior to that of many other consumer products. We're poised to accelerate that growth from new products and from e-cigarettes. And as always, Murray said it before, we remain committed to rewarding shareholders with cash returns in the form of dividends and share repurchases.

Murray is going to come back up and finish.

Murray S. Kessler

Yes, just one statement here and then we'll go into the Q&A. I want the major message you have heard from everybody today is fundamentals, fundamentals, fundamentals. Lorillard has delivered over the long-term industry-leading fundamentals. Everything you've heard, the news from the FDA, et cetera, our strategy is working, and it's now -- if it was slowed a little bit, it no longer is. And with Newport Non-Menthol Gold and with blu eCigs, this company is poised to continue to have great success. And hopefully, you got to meet some of the folks that are behind the scenes and hear from them the scientific rigor and why we believe science is on our side, and we'll continue to fight that battle. And I'm sure it will be there for a while, but we ultimately think we win. I understand it's a concern. I understand sometimes with headlines, people like to read things into what are the meanings, et cetera. It's -- those are going to be there for a while, but we think, clearly, the data is on the company's side, and we will be very aggressive on that front. We've got a great team at every level within the organization. As shareowners, you should be proud of what everyone does every day to make your company grow and be profitable. And you should also take a lot of comfort in knowing that we are a shareholder-friendly company, and we look at all the time of how we can create value for you.

And with that, myself and the rest of the team, we also have here Jim Raporte, who is the new President of blu eCigs. Jason Healy is the Founder who stayed on with us. Jim came from years at PMI and is helping to make operationalized and make blu a bigger brand. We have Randy Spell, who's our Executive Vice President of Sales and Marketing. He's probably the best sales and marketing pro in the industry, in my opinion, by far. And Houghton Lewis is here to -- from the treasury side of the business. So we got lots of folks here who can answer your questions, and I'll be your moderator and direct.

Nik?

Question-and-Answer Session

Nik Modi - UBS Investment Bank, Research Division

Murray, can you just talk a little bit about the -- you said you invested in innovation and capabilities. Can you kind of talk about what that exactly is in terms of what you've done? Because clearly, before you arrived, the innovation wasn't really a big part of the Lorillard business model. So I'm just curious why is Newport Gold getting better consumer response now than maybe test in the past and why is Newport Smooth doing as well as it's doing, if you can just kind of help us understand what's going on.

Murray S. Kessler

Maybe Bill and I will both try to answer that. There's different elements of it, right? So there's a process element to it. And I've had great success in my history of following something that comes out of sort of ISO 9000 or 9001, whichever, which is the stage and gate new product model, which sort of organizes and prioritizes strategic priorities and then going to the various acceptance levels and action standards and meeting it and putting in that rigor into the organization. From a staffing standpoint, we went out and we hired top talent from other consumer packaged goods industries to run that with all of our great tobacco scientists but like out of craft and others. Now on the marketing side, I hired the person who ran the innovation program back at UST for me from -- so the new products team. And we set and formed an entire new products team to work on that as opposed to it being a hobby for the core team. And we kept the core team separate, and that was a capability. Then we started spending the money on the research, putting in the analytical models, giving them the scientific equipment, building a pilot plant facility that would allow them to do all those things instead of having it 2 in the morning when the plant would spare 20 minutes for them to be able to run our product, to be able to do the experimentation. All that work is not even fully completed. So it was the ramp-up of a complete program. Do you -- can you say why you're being more successful than in the past in the testing? Or did I leave anything else?

William True

Well, sure. I mean, I think you did an excellent job of taking the macro view of all the thing that have changed over time and fundamentally with Murray's perspective and his experience and drive for new products and innovation, which, quite frankly, we didn't have a lot of that push in the earlier years that I was with the company. So we begin to rethink how we try to solve innovation. And we got rid of some old beliefs, we got rid of some barriers that were in place and we just took a fundamentally new approach to attack each of these new product models. And I think if we have the opportunity going forward, you'll see, with future product introductions, a great stream of new innovation from us.

Murray S. Kessler

Yes. And on the eCigs side, I mean, those guys are so creative. They're just full of innovation. It's in their DNA. Do you want to, Bob, do me a favor and pick who's next in the question, so I don't -- [indiscernible] anything. Okay.

Unknown Attendee

Just curious if you can share how you're thinking about Newport Non-Menthol Gold. On one hand, the category, obviously, is pretty big. And on the other hand, I think to Nik's point, the Newport flavor was really more of the full flavor that led to the competitive strength for the Newport brand. So when you say compare Newport Red with Newport Gold, can you get to a 5% share with Newport Gold, you think? And then how you're thinking about -- from sort of a promotional pricing perspective, would you adopt a similar approach that you did with Newport, you'd go out with an introductory promotional offer and then take the pricing over time? Just curious how...

Murray S. Kessler

Yes, we wouldn't go deeper than Red is now. It'll be priced along with that. But that's lower than traditional Newport, and we're not the ones who dictate that price. I mean, that segment is competing with special blends and all of those, and I happen to think there is still a lot of room for pricing in our industry. And as those come up over time, I'd like to see the industry get rid of this middle segment back up to just a premium segment, but we're a follower there. But yes, we will give great introductory price to keep it competitive. There's 2 sort of schools of thought. One, we had to fix the product, and we've done that. So you just can't sell a [indiscernible] cigarette with a core tip [ph] and some of the flavor profiles that had before. So we've addressed those and gotten good consumer acceptance scores. But it is a truthful answer to say we have not been as good at less than full flavor in the past as we've been, as evidenced by our result. So you can make an argument that it'll be less successful than Newport Red for that reason. On the other hand, the segment is 3x as big. So even if you're less successful, it could be just as big because you got 1/2 a share point instead of a share point. Tenths of share points to our company is very significant, meaningful incremental volume. I can't tell you today whether it's 1/3 of a share point, 1/2 a share point or a share point. I can tell you, all the discipline and all the work and everything we learned that made the failure of Newport Red in the past a success this time has been applied again in this launch, and we'll see how consumers felt.

Unknown Attendee

And then just second question is on the electronic cigarette category. I guess there are some recent studies that have been done to clearly show the switching from conventional cigarettes into electronic cigarettes. At the same time though, I think there is a pretty significant number of the electronic cigarette users that quit after a year. So you're basically taking those people out of the category in its entirety. How do you sort of think about that going forward. If you do have enough consumers, smokers switching from conventional to electronic cigarettes and the length of people staying in the category is actually much shorter versus conventional cigarettes, is that a risk...

Murray S. Kessler

Do we have that data, Jim? I mean, you're sort of telling me data that I don't think we've seen a lot of.

Jim Raporte

No, we don't.

Murray S. Kessler

No?

Jim Raporte

We don't.

Murray S. Kessler

I mean, I have to do more work on that area. I mean, from one side, the public health groups would love that, right? We don't position this, to be clear, as a cessation product. We don't go out and sell blu eCigs as a way to quit smoking, to exit tobacco altogether. We position it as a better alternative. That's more convenient, that maybe one day we'll be able to attach health claims, too, and that you can smoke inside, pervades inside and enjoy it and get rid of the -- we don't say get rid of the carbon monoxide. What we do say, get rid of the odor, et cetera. So I understand your long-term algorithm. It's -- but from my perspective, I've been asked on margins or on cannibalization. This is real and it's big, and it's a big opportunity. We're not going to sit back and watch it. And I think we'll get the margins equal to where it is on cigarettes. I think the repeat business is strong today. And I think the product is still, as much as the innovation that's come along, 20% of what it could be. So in terms of those issues, when you get the nicotine delivery and some of those other areas back up to where this thing is 80% as good as it can be, they'll probably -- you'll even see higher levels of repeat. There's a long way for this category to go.

Unknown Attendee

Murray, on the issue of menthol regulation, you spent a lot of time -- Bill spent a lot of time talking about TPSAC, refuting TPSAC. But ultimately, what matters is what the FDA thinks about menthol. And I wanted to know what your reaction was to the menthol-related commentary in the substantial equivalence approval of Newport Gold. They talked about issues involving initiation, the level of dependency, the relative levels of quitting. So what's your reaction to those comments? And what, if anything, do you think that foreshadows with respect to the totality of menthol regulation that the FDA made, ultimately putting some plates in the market?

Murray S. Kessler

Let's not answer them. I'm going to turn that over to Neil in a second. The reason I'm going to turn that question over to Neil is because he came from inside the FDA. And over the past 2 years, there's probably been about 14 of these examples where a paragraph gets written or there's a revision coming on a report. And I always go -- first thing I do is I go to Neil and say, "Before I overact to this -- and he hasn't been wrong once yet on it. There's no pressure. I also want to say before he speaks, every slide you saw here on menthol existed in this presentation before 2 days ago. We didn't put this presentation together on menthol and the concern over -- and deal with the issue on initiation because of that publication. It's been well-known. You've documented it, others have documented it, that through TPSAC and through early discussions on FDA, that the area -- that they agreed on the hard science, that the area that they would focus on was this behavioral science and initiation. And that's no surprise. That's why it was built into the presentation because we believe it was predicated on false data, and that even on those areas, the support doesn't support a difference. So with that context, that this whole presentation was done for what has been long known as an issue and us not being that relatively surprised about the presentation. Let Neil talk to you about the context of the way we submitted our SE application, why they answered it the way they did and sort of what the implications are.

Neil L. Wilcox

Thanks, Murray. First of all, I appreciate and understand the concern over comments like that. And I would be quick to refer you to Mr. Zeller's comments in his briefing on Tuesday, where he said that their memo outlining the review process and conclusions for the order they gave for the SE submission, those comments are focused strictly on that submission and that submission only. And that's the context of the comments. Remember that the predicate product that we used had menthol in it. We took the menthol out, and therefore, FDA felt compelled and mentioned several times during their -- throughout their summary document that they did not conduct a review from a public health perspective. Remember, they have the public health standard. They didn't apply that standard to menthol and the impact to menthol because there was no menthol in it. So why did they make a comment like that? Well, FDA, apparently, is still working on a premise that came out of TPSAC because they mentioned in their summary statement for that document that current studies support the premise that menthol may lead to initiation, prevent cessation, add to addiction or whatever. That is the premise that they continue to work on until more data are available. So until that happens, that is their position. And as Mr. Zeller said, this is not foreshadowing, it's not representing any current policy or position or any future position either, but simply, their current approach based upon their premise that came out of TPSAC, which we think the past studies will refute just like the other data we've shown you.

Murray S. Kessler

We think they are very careful on their words to use premise. And that -- within the body, you can't just take one line here or one line there. When you read the social science review, he said, "The predicate product had menthol in it." They took it out. Menthol has this premise of an issue. This doesn't have it, no problem. We didn't review the menthol science. They said it twice throughout their report. Personally, this issue makes people nervous. I get it. But I don't personally think anything new came out of those comments. Now, the other line of questioning that people said was, and I've heard this morning and I just can't comment on it, is do you think it's going to be easier to get non-menthol products to market while they're operating under this premise than menthol markets? And do you think that's good for Lorillard? I can't go down that path. We think that whether it's a menthol product or a non-menthol product, if the science prevails and you show that the product is substantially equivalent, they ought to deem it substantially equivalent. And we'll see how that plays out over time. Is that fair as well?

Neil L. Wilcox

Absolutely. Yes.

Unknown Attendee

Just to follow up on that. If the FDA currently works on this premise that menthol leads or has a likelihood of leading to more initiation, then how does the process work to overturn that premise? Is it the peer-reviewed study that we're all waiting for? And if so, how do you know that the peers that review the study don't have the same agenda that TPSAC had?

Murray S. Kessler

Well, there's lots of ways -- it doesn't mean they agreed with it. I mean, I -- we know they have a premise on their website about e-cigarettes and they're not safer and that they have to do deeming regulations. And we don't believe they -- that they always take a sort of starting and give -- it doesn't mean they agree with the premise. They'll do the peer reviews. Hopefully, they'll do it more honestly than TPSAC did. There'll be court findings on TPSAC. If the court sees things our way, they're going to have to go back and redo those TPSAC hearings and justify that data because otherwise, we're -- there'll be other sources of litigation and things like that. They're a science-based organization, you can see how thorough and methodical. And we just have to hope they go through that process correctly. But there are many avenues. But I wouldn't read anything in it at all. Do I think the FDA starts with a bias that stated in their mission statement that, over time, they're trying to rid the world of tobacco? Yes. I mean, they're not -- that's where they start. But my honest answer, and this is probably going to be controversial and picked up, this is a waste of time. This is the wrong thing to be working on. The world could be changed by focusing on tobacco harm reduction. There is an opportunity for this FDA and this leader to come out to embrace harm reduction and to start shifting products and recognizing that smokeless tobacco and e-cigarettes and other ways into it. Instead of fighting the industry the whole time, align the interest of public health and align the interest of business together like it's been done in many other industry to drive business success and reduce deaths and improve public health and fundamentally change things. So back to my film example, would you want to put up -- what impacted negatively the film industry more? New technology that drove us in a different direction or putting a bunch of restrictions on how you can sell film and make film and demonize filmmakers and -- so, I mean, there is a huge opportunity at hand, and I hope that we can shift to this dialogue to where it belongs.

Unknown Attendee

I'd like to follow on, on that, if I could. I have a second quick question. But the first one would be that, are we -- is the length of time it's taking for deeming regulations -- is the FDA at a point where they can consider relative risk statements? Or what do you think it'll take for them to allow for a relative risk statement for products?

Murray S. Kessler

Well, the relative risk statements -- Neil, one of you guys, help me out on the MSRP (sic) [MRTP] product. I'll talk about why I think the regulations are taking a while, but Bill do you -- or Neil?

Neil L. Wilcox

Well, in terms of -- Bill mentioned MRTP, you mean the modified risk tobacco product?

Unknown Attendee

That's right.

Murray S. Kessler

This is wrong. Normally, that would fall under the MRTP.

Neil L. Wilcox

Yes. If there is a claim related to tobacco products, then it would fall either under a new product or the -- possibly under the modified risk tobacco product, which has 2 pathways, one is reduced exposure and the other is actually reduced risk. As far as the deeming regulations and why there's a delay, I certainly don't know. Undoubtedly though, the worldwide pressure of this being put on all regulators to recognize the potential in e-cigarettes, I believe, could be part of this delay. And maybe they're deliberating over this, maybe not. But I think that if they follow the science and allow the science to go forward, then the deeming regulations will allow e-cigarettes to reach their potential in harm reduction.

Murray S. Kessler

So there's a difference between getting to the point where they'll allow you through a very cumbersome modified risk tobacco product process to actually make a health claim, which is different than setting up the rules of how you regulate, which would allow -- if they wanted to encourage it while you're doing that, which would be less restrictive in marketing, less substantial equivalence testing on a state level, less restrictive in taxing, in smoking bans and all those types of issues that you're challenging that would allow this to continue to progress without actually -- until they actually get to the point where they think they have the science to make specific, this is safer. Those are both important and separate issues. We are hoping for the latter right now, which is designing a regulatory scheme that allows this to grow and not be overly restrictive, not put in substantial equivalence testing that takes 2 years to get something approved in a category that should be every couple of months new innovations in technology coming. Be a little more restrictive on the liquid. I don't have a problem with that. That's where the consumer is going in but not on batteries and technology and all those types of things. Does that make sense?

Unknown Attendee

It does. If I could have one quick follow-on or one quick question. It will be the geographic expansion for Newport out West, if you will. Has that mostly been completed?

Murray S. Kessler

We have Newport Non-Menthol Gold because that's where the -- we're back in gear. Bonnie [ph]?

Unknown Attendee

Murray, I have a question on your e-cig portfolio and how you see that evolving in the near term and in the long term in terms of either further segmentation whether it be by brand, potentially different line extension, and importantly, technology? And how willing are you to make acquisitions, capabilities you might not have or do this organically? Kind of what are your thoughts there, near term and then longer term?

Murray S. Kessler

You want to? You're the President.

Unknown Executive

[indiscernible], let me try to address the first part of that. Let's talk about what we've got right now. The number of stores Murray mentioned, we're in currently, roughly 100,000 [ph] stores. We've had robust growth every month. We don't see that slowing down much at all. And in addition, in the existing stores where we are currently, we know there's a lot of repeat purchase, as well as new customers coming in. There are other directions that we could go in terms of flavors to your point about line extensions. And those are probably the biggest opportunities short term.

Murray S. Kessler

I would say building on that, I don't see any reason why this couldn't be a global brand. And whether we do that organically or acquired -- they're all small company. So that's just a question of economics and what David tells me the best way to get in there and we would evaluate those. And we're approached by those all the time. But I don't -- the restrictions that keep us at U.S., this is the big idea. It wouldn't surprise me if we were somewhere internationally over the next 12 months. I hope so, but we'll see how it -- how the evaluations do. Technology, I think what you'll see us do with the starter -- the sort of the on-the-go rechargeable kits is you sort of, think of it as sort of a phone, right? Once you have one, you have one. So there needs to be 2.0, 3.0, 4.0. And they need to be bringing the technology further and further along. So every, call it, 1.5 year or 2 years, it has to reinvent itself so that this rechargeable kit is light years from the last one. You don't have to screw in the charger to have WiFi capability and low-energy bluetooth and things like that and probably interact with your phone. And there's all kinds of levels of technology that will bring it to, as well as make improvements and actual product delivery, et cetera. And then you can build up the line with accessories and all kinds of things with that. But I would say the basic model will be we have a long way to go to build out distribution on the full line. There's a depth of distribution opportunity. There's a global opportunity and there'll be generations of product improvement over years to come. And whether we do that organically or internationally, we got to figure that out because we don't have international operations. Hey, Jane [ph].

Unknown Attendee

Murray, going back to Bill True's presentation in Slide 100 and that was the slide menthol smokers do not have higher risk of lung cancer. What does that cause the 4 studies post-TPSAC to be lower than the average prior to that? And then your conversations with the Zeller and/or TPSAC, do they accept these studies of these recent years?

Murray S. Kessler

Well, I'm going to let the scientists answer that question. But I will tell you on the conversations we have with Zeller, it was an e-cigarette conversation. Yes?

Unknown Executive

Yes. I think when you look at epidemiology studies across the board, there's always a cohort or group of individuals that are studied. And they're typically in a local geography even though there can be large numbers of individuals and more of a local geography. So these shift from place to place over time. You get different study populations that could have slightly different results on that basis. And that's why when you look at a science like epidemiology, you can never look at one study. And on our fear all along with TPSAC and with FDA is that they don't have anything convincing right now. So let's wait for that one next study that gives a result that we can hang our hat on to do something disproportionately with menthol. But the reality with epidemiology is you're always going to have a slightly different balance. You even see a couple of the results earlier. We're just over one; met most of them, we're under one. But it's a result of the different cohorts that are used and the time that's being followed for the study subject.

Unknown Attendee

So dramatically changed from the past, are these better studies? Were they broader studies? And again, has TPSAC reacted to these and wondering why does it happen?

Unknown Executive

Well, the review of menthol from TPSAC is done. So once that the report was issued, to the best of my knowledge, there hasn't been another conversation. Certainly, not a public meeting where menthol has been discussed by TPSAC. And we really don't have a regular opportunity to go in and just have a 2-way dialogue with FDA. Typically, on a scientific issue like this, there might be any sort of a rule making that would allow us to submit to the public docket. But in terms of a back-and-forth conversation...

Murray S. Kessler

There was a suggestion that menthol has potentially a protective effect. That's not our company's position, Jane. We do not take -- we take the position that the general weight of evidence as there's no different. We were frustrated that the biggest study and that sort of really put this idea forth was published 48 hours after the TPSAC report was done and was clearly done prior to that. So that didn't feel good to us but....

Unknown Executive

And what we can say is that, that Blot study was an extraordinarily large population. So it had very good subgroup analysis. It was one of the better studies that's ever been conducted in this field. So we feel very good about the result in that particular study. But again, as a weight of evidence, we'll still take a level line on it.

Unknown Attendee

Thank you. My question has to do with e-cigarette as well. I was very interested in the chart on the demographics in terms of the user base. I recognized it's 2011. So maybe a little bit dated. But what stood out to me is the proportion of higher income users. So do you think that's evolved over time? Relative to the general smoking population, it looks like e-cig users do over-index in terms of being higher income. And how important are lower price points in terms of then driving protection higher, if it is an income issue?

Murray S. Kessler

Do you think -- from your perspective, where are we on demographics, and how would you answer Vivien's question? Because I wasn't going down that path. What I saw was initially -- and it's changing all the time because the awareness of this thing is just so broad, and the media coverage is so high that I'm not even sure the demographics you had last week are close to the demographics that you have this week. But initially, it looked like people that were less than the full flavor. Low-tart consumers were the most willing to try this that they had sort of gone from -- to low tar and would even go to the no tar.

Unknown Executive

Right. But it's -- we took a pretty close look at that as well because we wanted to figure out, in fact, is this higher income something significant? But what we concluded was it's still very broad-based demographics, including income. And it might be slightly higher in income than the overall population because it's adults 35-plus that are already well established, but that's pretty much it. It's still broad based.

Murray S. Kessler

I'll give you some anecdotal data in store. When we went to sell the store sales force, the first reaction was, well, I'm not going to -- we have a lot of strong Newport stores in inner cities and lower income areas as well. And they said well, it's not going to sell there, or at least, that's what my retailers are pushing back on. And they ended up saying, but, this is a new one, go ahead and put it in and we have a relationship. And they were shocked that it sold -- it sells everywhere. So I mean whether it's a bodega or out in the suburbs, that's what my bigger comment was on the demographic slide. It's sort of selling everywhere with good movement. And it's not get distribution and then it sits there. It's -- this thing is moving. You go, you walk into stores, you see it's bought back. It's -- there's only a couple left, and you can just see movement in the section.

Unknown Attendee

Can you quantify what your same-store sales growth might look like for...

Murray S. Kessler

I can quantify places like our biggest retail chain that went out fast that, despite going national, continues to grow month-to-month and year-to-year, despite they were the only retailer and now it's available everywhere. We had our own internal projections that our online business would drop off significantly once we went to retail, and it didn't. It continues to grow. So I mean, it feel -- and we have numbers of accounts now that have been out in place for years that are continuing to sell and grow. And we have others within the 6 months of distribution built. Sure, some of them the last few months, it's just pipeline, but you have others that are now October, you're 6, 7 months later, and it's moving. So it's not a load. They're certainly part of the $57 million, and the first quarter was initial distribution build and somewhere underneath there is the real ongoing number. Jim's also right though that we have a lot more stores to build. And then with underneath it, a lot of stores just take disposables in the beginning. Then they see it's selling, then they want the rechargeable kit. Then they take a couple of flavors, they want more flavors. So to build out the line, distribution will be part of our numbers for a few years.

Unknown Attendee

And just one final question then. In terms of the distribution, what you're seeing, at least, in terms of the mockups from Altria and Reynolds, is that both are showing a willingness to give up some shelf space, take up the slotting for their e-cigarettes as they launch them. Are you also willing to do that?

Murray S. Kessler

We have gone with the -- I don't know what their approach is. What -- our approach is what you saw on the lobby here. We're trying to create a section and a category. So we have -- we provide the merchandising unit. We provide RDA payments. We don't tie it to our merchandising contract. We had a -- first off, it's not always the same buyers. And there was a real fear that big tobacco was going to come in and squeeze and muscle and all that, and we don't do that at Lorillard. So we went in and sold it on its merits, put in a beautiful merchandising units, advertise and support it. And for those who will resist it in the beginning, they come back and we have places that we're going to wait and see, come back begging how quickly can you get it to us, customers are coming in the stores. We build towers that separate section and a home for it. We want 4 of that tower, a certain amount of primary visibility. And it will allow others on the tower as well, so we're not putting it into our cigarette section.

Unknown Attendee

On -- back on e-cigarettes, you had mentioned in one of the slides that you expect somewhat -- I forget the exact language, but somewhat strict regulations to be proposed. Can you give a sense of what those -- how you envision that? And what makes you -- what shapes you're thinking on that?

Murray S. Kessler

What shapes my thinking on it is that I think it's been in draft for a long time. And I think what Neil said to you is that popular opinion and the world is evolving so quickly on it that a lot of it was probably already written first. And it's just the sense I got from meeting with the FDA. I mean they were actually encouraging saying, "Look, this will be a first draft, and it's going to be a work in progress. And there's going to be a lot of input to it." And I just took that away from [indiscernible], and so that's just my instincts on it. I think we see that on a state level. Like we'll go in and you'll see a proposed OTP tax or e-cigarette ban. And then when you go talk to people, it was sort of a knee-jerk reaction. And then you start showing them all the data, and they're like -- like they didn't even know what it was that they were voting on. And then when you go and you share all the information and talk about it, you've seen almost every state back off, you have seen every state back off. And say, "Wait a minute, we need to find out more about this." We're the ones who are pushing for minimum age. So the minimum age allows you [indiscernible] everywhere is -- Lorillard's behind that. And because if our target is smokers and smokers have to be of legal age, then we should be willing to support that.

Unknown Attendee

And obviously, owning blu gives you -- puts you in these conversations with people like the FDA, which was part of the benefit of...

Murray S. Kessler

Right, exactly.

Unknown Attendee

If you're thinking about international expansion, possibly as soon as within 1 year, have you already begun some of those conversations with things like the EU tobacco directive or...

Murray S. Kessler

Sure. Niel just got back last week from meeting with the MHRA. What was your discussions with the MHRA?

Neil L. Wilcox

[indiscernible] and we'll be regulating e-cigarettes. And their attitude, their approach, was so incredibly refreshing. Although they want electronic cigarettes to be regulated as medicinal product, they made it crystal clear that they support harm reduction, and they feel electronic cigarettes have a tremendous role in harm reduction. And they called it a, "pharma-light approach". In other words, all we have to do is bridge the difference between pharmaceutical products on the market like inhalers. They call them inhalators that deliver nicotine. Electronic cigarettes deliver the nicotine separately. So we just have to show what the difference is in the nicotine delivery. They said they don't want big studies, then they said like maybe 20 people. And they said it will be a very quick path. And we said, what do you mean quick? They said, less than 70 days. And we did the same thing, [indiscernible] what. And they said, guaranteed. Yes, they're ready to go, lock and loaded. Now since then -- and they said the decision was coming out this month. And as you heard, since then, they have delayed decision to wait to see what the EU is doing. And again, I think this is part of the wait-and-see attitude that some agencies are taking to see what is really the right approach. So even if they do go the pharmaceutical route, they're going to make it a pathway that is not so onerous as say, the MRTP pathway is currently designed here.

Murray S. Kessler

And that's not to say we're going to England to -- Britain, that's just to say. We're trying to talk with agencies around the world and be informed and be involved in these discussions because we now are being viewed around the world as a leader in this industry. And other major tobacco companies want to sit down and talk to us about strategy on that. So i said it was going to give us a seat at the table, and it has.

Unknown Attendee

And do you have any markets in mind particularly developed or anywhere or...

Unknown Attendee

I want to make sure that David doesn't feel left out from the Q&A session, so I'm going to ask you a question. David, you've very eloquently laid out the algorithm that could get us to perhaps a low-double digit return to shareholders. Now my question is if we get some good news on menthol from the FDA, would that imply that you could revisit for a second time your leverage metric and perhaps go more in line with the rest of the industry? Or would you still like to see a little bit more diversification in your portfolio and reduce your reliance on the Newport menthol product before going to the same metric as your peers?

David H. Taylor

Well, clearly, the whole controversy and feud are around menthol. Rating agencies see that and worry about it. But there are other factors that cause rating agencies to look at Lorillard a little different than other of our competitors. We're smaller. We're relying on a single product more than other of our competitors are. We're relying on cigarettes. Now, granted blu changes that conversation some, but remember how small blu is right now in terms of profit contribution. So if all those dynamics were to change over time, we might be able to revisit that. But just good news on menthol -- which by the way, I don't think suddenly the clouds are going to blow away on menthol. But just that alone, I don't believe would change rating agency's views, but it is a positive factor belief and we would talk about that.

Murray S. Kessler

In fact, some of the rating agencies have actually, I think, came out and said if there was not good news on menthol, it wouldn't change....

David H. Taylor

Wouldn't change the rating.

Murray S. Kessler

It wouldn't change the rating.

Unknown Attendee

Coming back to the global angle. I mean if you could talk about the difference between say, the Lorillard e-cigarette approach and then the approaches from some of the global competitors. For example, Philip Morris with a tobacco-based product, some of the BAT products that are just inhaled nicotine. What's -- how you see those evolving? How you see the difference in meeting that consumer demand and also satisfying the regulator, particularly if many of the countries outside of the United States, do you pursue kind of a medicalized approach, which...

Murray S. Kessler

You're getting way, way, way ahead of where we are, way ahead. I'm not going to comment on PMI's approach or all that. We had some of those meetings. e-cigarettes , as they are now, are selling around the world. This is not a U.S. phenomenon. It is happening everywhere at the same time. We'll come right over here. Next [indiscernible].

Unknown Attendee

Murray, I have some other e-cigarette question for you, actually 2-part question...

Murray S. Kessler

We sell a lot of cigarettes.

Unknown Attendee

You do?

Murray S. Kessler

Somebody has got to ask Randy a question.

Unknown Attendee

Anyway, Mitch Zeller has said in the past that he wants to reduce the addictiveness of cigarettes. Why would you want to allow e-cigarettes to contain nicotine and continue addictiveness for users? That's probably one of the question. The other part of the question, the commercial you showed us emphasizes the smoke-anywhere approach. What's your level of confidence that 2 years from now, you can still run the commercial and e-cigarette users can smoke anywhere versus a worldwide [indiscernible] smoking bans as we do for cigarettes?

Unknown Executive

Well, that depends on how the FDA embraces the potential for harm reduction. That is the key question right now, right? I mean if you want to jump on this opportunity and understand that this can help reduce smoking and save lives and de-normalize smoking, then you're going to embrace it. It can go either direction. When we model out our business, we model it under a very severe regulatory scheme and a middle range and a one that's supportive one. So I mean, we'll -- I don't have those answers today. The opportunity exists if you want to really have an impact and change things. Now, the part that gives me -- that we kept saying in the presentation, appears to Mitch Zeller, appears to or has suggested is he has had some discussion, and it's in the early stages. And we will see how it plays out. And there has been some discussion at the FDA and among the public health community. Although potential recognition that nicotine's not the problem. That's not widely embraced yet, that's what needs to be fully fleshed out. If you ask Murray Kessler's personal opinion, nicotine's like caffeine. There may be some variances to it. It's not the problem that nicotine's addictive. It's that nicotine's addictive in a cigarette that has combustion and that has all these issues in it that causes harm. So the separation of them is what gives permission to have different sets of rules. People like nicotine. People are addicted and don't want to quit. This is an alternative that provides a solution with -- that's lower on a continuum of risk.

Robert Bannon

Okay, we have time for maybe 1 or 2 more questions.

Unknown Attendee

Two questions, if I may. On blu, what progress have you made in gaining distribution with major drug firms? Not drug firms -- excuse me, drug chains.

Murray S. Kessler

One of the drug chains is our largest customer.

Unknown Attendee

Thank you. The second cigar question is could you update us on Newport's progress, west of the Mississippi since 2 years ago?

Murray S. Kessler

That slide, I had in the presentation. Newport and -- total Lorillard has gained almost 2 share points West of Mississippi. And Newport itself was about half that. I can't remember the number, Randy. Any other comments on that?

Randy B. Spell

[indiscernible] I don't have a mic, so I will speak loud. The only thing I'd add to that is keep in mind, the [indiscernible], basically, we are talking East of the Mississippi and West of the Mississippi. If you remember the slide he showed, he showed Newport full-flavor menthol had a share in our core markets of 74% of the Newport full -- of the menthol full-flavor market. Don't miss the fact that Newport is also -- menthol full flavor is the #1 brand West of the Mississippi in the full flavor segment also with a 41 share of full flavor menthol. So what we have done, someone mentioned early about geographic expansion, what we've done is we've increased our promotional exposure geographically. Not necessarily the exposure and distribution of the brand. As Murray alluded to, we were at a price disadvantage, and we closed that gap in all of the major markets West of the Mississippi. We couldn't be more pleased with how it's going. We're excited about Newport non-menthol because of the brand equity on Newport is very strong out West. The brand is well known. This brand will have some potential there because keep in mind, less than full flavor, non-menthol cigarettes do most of their business West of the Mississippi. So this will be another Newport that will afford this even more opportunity to grow our adjacency strategies in the western portion of the United States.

Unknown Attendee

A quick question for you on menthol and a degree in which a menthol ban in the EU, will that influence the FDA and the U.S., you believe, or what effect could that have on their...

Murray S. Kessler

Well, look, it's got a long way to go. I think most markets in the EU have -- it's like banning clothes here. It's almost virtually nonexistent. My bias on the EU's regulatory policy when it comes to tobacco is heavily grounded, and why the heck would you have a ban on smokeless tobacco and Snus in the EU when it's clearly down the continuum of the risk. And Sweden has the lowest smoking incidence in the world, lowest lung cancer rates, and they allow it. It absolutely makes no sense. So I don't think their regulatory policy is going to influence this. This is going to be a science-based approach with our laws and our regulatory structure. And I think they've got a long way to do it -- to go to get that through as well.

Robert Bannon

Sure. One more.

Murray S. Kessler

Last question. Make it a good one.

Unknown Attendee

Thanks for squeezing me in. David, as we think about a little bit of a longer timeframe, how should we think about your credit rating? Do you expect to sort of stay in the mid-BBB range? Or as your product portfolio evolves, your potential geographic footprint evolves, should we expect that you should trend more in line with something along that high BBB?

David H. Taylor

I'd like to say that, that would be the case, and it would be a longer-term discussion based on the same factors that I just described [indiscernible]. There's a lot of things that would go into that, into that rating. We're comfortable where we are. And -- but we want to protect that, so we're not going to do anything intentionally that would cause that to be in jeopardy.

Murray S. Kessler

Well, thank you -- for everyone's interest in Lorillard. Thank you for coming this morning. We'll be around for a little bit, the management team, if we can enter any individual questions. Thanks to you to those listening on the webcast. And again, thank you for your interest in Lorillard.

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