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Lorillard Inc. (NYSE:LO)

Q3 2009 Earnings Call

October 26, 2009 10:00 am ET

Executives

Martin Orlowsky - Chairman, President & Chief Executive Officer

David Taylor - Chief Financial Officer

Nathan Elwell - Financial Dynamics

Analysts

Nik Modi - UBS

David Adelman - Morgan Stanley

Adam Spielman - Citigroup

Judy Hong - Goldman Sachs

Chris Growe - Stifel Nicolaus

Erik Bloomquist - JP Morgan

Andrew Kieley - Deutsche Bank

Christine Farkas - Banc of America/Merrill Lynch

Thilo Wrede - Credit Suisse

Operator

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

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

Nathan Elwell

Thank you, Ann and good morning everyone. By now you should have received a copy of the company’s third quarter 2009 earnings release. It can be found on the company’s website, www.lorillard.com under news releases. Speakers’ we have on today’s call are Martin Orlowsky, Chairman, President and Chief Executive Officer; and David Taylor, Chief Financial Officer of Lorillard, Inc.

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

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

Martin Orlowsky

Thank you. Good morning, everyone. Lorillard’s overall performance during the third quarter of 2009 was positive in terms of total domestic wholesale shipments outperforming the industry compared with the third quarter of 2009, a decline of 6.1% versus the industries 12.6% decline. Several factors affected the comparison between the third quarter of ‘09 and ‘08 particularly, that impacted the Newport brand.

Below a unit volume in the third quarter of ‘09 is compared with the third quarter of ‘08 was impacted by the decrease in wholesale inventory units during this year’s third quarter while last years third quarter saw builds in wholesale inventory units. This dynamic impacted the domestic industry as a whole, but had a more significant impact on Newport shipments.

In addition, the 2008 third quarter included shipments of units to support buy some promotional programs, while there were no such units in this year’s quarter. As a consequence of all of these factors Newport’s domestic wholesale units in quarter three ‘09 were down 9.8% versus the third quarter of ‘08.

However, the brands domestic shipment share reached 10.1% of the total market, an increase of 0.31 share points, comparing quarter three ‘09 with the third quarter of ‘08 respectively. Adjusting for these factors to get an idea of the underlying trends, total Lorillard units would have been down a little over 1%, while Newport units would have shown a decline of roughly 4.5%.

We believe Newport’s relative strengthen the marketplace was clearly evidenced by the brands share gain quarter-over-quarter, even taking into account the unfavorable comparative factors impacting the third quarter of ‘09 versus third quarter of 08. Maverick, our discount brand continued its growth at the wholesale level with an increase of 52% in the third quarter of 2009 versus the same quarter in 2008, achieving 1.25% wholesale shipment share an increase of 0.53 points.

Total menthol segment share of the wholesale market during the third quarter of ‘09 was 28.9% an increase of seven tenths of a point over the third quarter of 2008. Newport’s share of the menthol market was 34.6% in the third quarter of ‘09 up slightly over the third quarter of ‘08.

Lorillard’s retail market performance during the third quarter of 2009 as measured by wholesaler shipments to their retail account largely mirrors the wholesale market results that we’ve just mentioned. Overall, Lorillard was up 0.76 of the share point in the third quarter of ‘09 versus ‘08, achieving 11.89% share of the retail market. Newport’s retail share comparison of the same period was up 0.26 of a share point reaching 10.29% of the total retail market.

As has been Lorillard’s longstanding strategy, we will continue to monitor the market and determine the optimal approach to balance Newport’s brand performance and profitability. In today’s marketplace, quarter-to-quarter results may vary to an extent. However, Lorillard will continue as well to manage the business with long term shareholder value and not under over react to short term factors.

Now, I’m going to turn it over to David Taylor, who’ll review our financial results.

David Taylor

Thank you, Marty and good morning everybody. I’ll spend a couple of minutes reviewing the numbers after which we’ll open the line for questions. Net sales for the third quarter of 2009 were $1.419 billion compared to $1.125 billion in the third quarter of ‘08. Excluding excise taxes, net sales increased $17 million or 1.8% from $936 million to $953 million.

This net increase of $17 million, which works out to about 6.8% on a per pack basis after we adjust for the promotional units in 2008 and it also reflects the impact of higher net average selling prices, which was partially offset by the lower unit volume and a less favorable product mix as has been the recent trend due to Maverick’s significant growth.

The impact of this mix shift on the arithmetic average net unit pricing should not be ignored. As you know, Maverick carries a substantially lower list price than our full price brands. It remains profitable for us just not at the same level as Newport, obviously. With this recent trend of Maverick sales growth as a percentage of our unit volume continues you should expect that our net average revenues per pack will continue to be negatively impacted.

As Marty mentioned, the lower unit volume as compared to the third quarter of 2008, was impacted by changes in wholesale inventory units during this years third quarter, which may have disproportionately impacted Newport. The primary factor increasing the sales and margins with the higher unit pricing in 2009 third quarter compared to the 2008 third quarter. Sales promotion costs accounted for as a reduction in net sales were slightly higher in the third quarter of 2009 than in the third quarter last year.

Gross profit increased $18 million to $488 million or 51.2% of sales excluding excise taxes from $470 million or 50.2% of sales excluding excise taxes in the third quarter of ‘08. This was the result of the impact of the higher selling prices and weaker mix I mentioned a minute ago, lower unit volumes and increases in certain costs.

Increases in cost of goods over last year, include higher raw material costs, primarily tobacco and wrapping materials, higher pension costs, the new FDA fees, and the impact of excise tax increase on our LIFO inventory valuations. Amounts due under the State Settlement Agreements decreased as a result of the lower unit volume, but increased on a per unit basis due to the inflation and other factors in those agreements.

Selling, general and administrative cost increased $8 million to $96 million in the third quarter 2009 compared to last year. This increase is primarily the result of higher legal fees, which were approximately $5 million higher in the third quarter of 2009 than in the prior year period. As in prior quarters, this increase in legal costs is primarily the result of the higher defense costs for the Engle progeny cases that are currently underway in Florida among other things.

In addition, the SG&A expenses in the 2009 third quarter reflect a $4 million increase in certain pension costs compared to the 2008 third quarter. Operating income increased 2.6% to $392 million or 41.1% of sales excluding excise taxes in the third quarter of 2009 from $382 million or 40.8% of net sales excluding excise taxes in the third quarter of last year.

Net investment income was $1 million in the third quarter of ‘09 as compared to $5 million in the third quarter of ‘08. This $4 million decline is the result of the lower average yield available to us in 2009 as compared to last year. In addition, interest expense totaled $15 million in the third quarter of 2009 compared to $1 million in the prior year. This increase is the result of the interest expense on the recent $750 million senior notes issued.

During September 2009, we entered an interest rate swap in order to modify our exposures to changes in interest rates. This swap effectively changes the interest rate on a $750 million senior note to a variable rate. That variable rate will be calculated going forward based on LIBOR plus 4.58%. As of September 30, that rate was 4.871%.

Our effective income tax rate for the third quarter of 2009 was 37.7% as compared to 38.5% in the third quarter of 2008. This decrease is primarily due to the impact last year of the separation from loads on the manufactures deduction and the deductibility of certain expenses.

Net income for the third quarter of 2009 was $235 million or $1.44 per share compared to $237 million or $1.38 per share for the third quarter of 2008 or a 4.3% increase. The impact of the lower share count in 2009 contributed $0.07 per share. The $750 million share repurchase program that the company recently announced is currently underway and under that program as of last Friday, October 23, the company had repurchased 4.1 million shares at an average purchase price of $74.18 for a total of $306 million.

With that, we would like to open the line for questions. Operator.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Nik Modi - UBS.

Nik Modi - UBS

Was there one less shipping day this quarter? I know that there was one extra shipping day last year?

Martin Orlowsky

The number of shipping days this year and last year was the same, for the quarter.

Nik Modi - UBS

Then inventory adjustments you talk about the FIFO. Can you just or the LIFO or FIFO, can you just give us some perspective on how much that hit the margin and how much longer this is going to impact your cost of goods?

David Taylor

Well, the impact of LIFO is a complicated thing to calculate and I can’t get into all of the detailed calculations on the phone, but it impacted us by about $2.5 per share and it’s an annual calculation so we’d expect roughly that same impact to hit us in the fourth quarter as well.

Nik Modi - UBS

Then just quickly it seems like the promotional environment has been pretty team? Have you want the elimination of all free goods out of the market by some of your competitors?

Martin Orlowsky

Well we’ve seen it in one sense in terms of literally buy a pack and get a pack free, that’s no longer a factor so free goods as such as no longer in the system; however we have seen a continuation of dollar off promotions that is the equivalent of buy a pack and get a pack free. So while in a sense the promotional message and the incentive factor still out there.

Operator

Your next question comes from David Adelman - Morgan Stanley.

David Adelman - Morgan Stanley

Could you quantify the in volume terms, the reduction or your estimate of the reduction of trade inventory of Newport as you went through the third quarter?

David Taylor

Yes, the change in the trade, wholesale inventory patterns between the third quarter of ‘09 and third quarter of ‘08 probably accounted for about 3.5% of Newport is declines.

David Adelman - Morgan Stanley

Are inventories now at sort of an unprecedentedly low level in the trade?

Martin Orlowsky

I don’t know about unprecedented, it’s at a low level, certainly the lowest it’s been in a while, but I can’t ask a question in the context you raised it. We do know that through the third quarter that it was substantially lower than it had been in the past with a historical point of reference here.

David Adelman - Morgan Stanley

I’m I correct Marty from the second quarter to the third quarter you did increase Newport promotional spending somewhat and from the second quarter to the third quarter Newport’s retail market share was down slightly are those true statements?

Martin Orlowsky

When you said we did increase it slightly, we didn’t call at, I don’t recall the actual number, but it was increased between the third and the second quarter. However our volume on sequentially at retail between the second and third quarter, we were up 1.2% in the Newport volume wise in quarter three versus quarter two of ‘09 and down slightly on market share that’s been very effective.

David Adelman - Morgan Stanley

Not to make too much out of that, but is there something going on in the backdrop? Are you seeing a lingering effect of the excise tax increase or was there a different promotional context in the industry in the third quarter than in the second?

Martin Orlowsky

I don’t know if I’d say it was a different promotional sort of framework in the third quarter. I think it was more or less a continuation of the same. The biggest difference in the menthol segment, I believe in the third quarter one would have to attribute to Marlboro 54, because that took full effect in the third quarter. They only had a couple of week or so worth of wholesale shipments in the third quarter with no real discernible impact at retail in the second quarter.

So they were some degree of very deep discounting on Marlboro 54, although I will add I don’t think it had a very substantial overall effect negatively on Newport, because I don’t think the scope of that program was such that it would. So I don’t know if I’d say there were any differences, we did increase our spending modestly and I wouldn’t necessarily sort of describe it as earth shattering in nature.

Operator

Your next question comes from Adam Spielman - Citigroup.

Adam Spielman - Citigroup

Are you able to quantify the impact of Maverick on in terms of the sales per unit volume, because I know you said that it’s having a significant impact, but I really want to get my hands around how significant it is and I was wondering if there was anyway you could help me with that?

Martin Orlowsky

It does have a significant impact on the net average. I haven’t tried to reduce the mix shift to a actual impact per unit, Adam, but to give you an idea at wholesale excluding excise taxes, Newport sales for roughly twice a Maverick unit. So a little bit more than twice actually and so when you’re looking at projecting volumes and sales you really need to try and project those volume trends separately and estimate the impact on gross sales that way. I’m sorry I don’t have it on a per unit basis.

Adam Spielman - Citigroup

If I could ask another question, as we have come out of the end of a third quarter, would it be fair to say that the situation within menthol. Now I’m talking about the brand equity of Newport is really very similar to where it was before, in other words I guess I’m asking does the interject of A. Marlboro Blend 54, and B. The innovations we’re seeing from Camel Menthol. Do you think they’ve made any real difference to the menthol category as a whole?

Martin Orlowsky

No, and I will say that I don’t think Camel Crush is a menthol product to begin with. So I wouldn’t attribute any impact or effect from the Camel side. 54, well obviously is a pure menthol product. As I said earlier, I don’t think that it had an appreciable impact in the marketplace.

Operator

Your next question comes from Judy Hong - Goldman Sachs.

Judy Hong - Goldman Sachs

Just in terms of the difference between your shipment numbers and your underlying numbers in the quarter, if you look at Newport, I think down 4.5% underlying and down close to 10% reported. Are the same factors in place that could affect the fourth quarter reported shipments numbers, because I know the last year in the fourth quarter your volumes were pretty robust and I’m just trying to gauge how much of the faster of the similar dynamics could affect the fourth quarter shipment numbers?

Martin Orlowsky

It’s very possible. Just some extent, we will have that affect. Although, I will say I don’t think that it will be, I’m going to guess that it may not be the same order of magnitude, but it will be some of that there.

Judy Hong - Goldman Sachs

Then Marty, I think on the last quarterly call, you had a little bit of a cautious tone just in terms of the industry consumption outlook going forward and so I was just wondering if you sort of think about kind of the long term consumption trend post, as you lap the FET driven price increases. Do you still think that we can get back to the historical trend rates? Are there any factors that make you a little bit more cautious on kind of reverting back to the consumption trend before the price increases?

Martin Orlowsky

I think clearly state excise tax increases can and might have a negative impact on consumption going forward given the fact that base price if you will of a pack of cigarettes is certainly a lot higher than it was pre-federal excise tax increase. So I think, depending on the makeup of the state excise tax, changes as we move forward, that’s a possibility and that could affect the trend lines pre and post. I also think it depends on promotional activity and pricing as it might relate across the board not just in the premium segment.

So if all things remain equal and we don’t see any big surprises I think we could get back closer to the pre-excise tax increase trend. I don’t know if it would be exactly at the same level though. I think there might be a bit more deterioration in the numbers in the future. Now this is not based by any sort of super computer analysis. This is just me and so but that’s my opinion without looking out ahead.

Judy Hong - Goldman Sachs

Then just in terms of share buyback the $306 million that you’ve done in the quarter, is that sort of a good run rate as to think about the pace in which you can complete that $750 million the program that you have in place?

Martin Orlowsky

It might be, Judy, but it depends on what the share price is.

David Taylor

We want more shares in at lower prices. Given where the share price is right now who knows.

Operator

Your next question comes from Chris Growe - Stifel Nicolaus.

Chris Growe - Stifel Nicolaus

I just want to ask a couple of quick questions, a bit of follow-up. Just to be clear on the inventory levels, do you think those need to build a little bit from here are you seeing problems with the overall inventory levels at the current level?

David Taylor

You mean from the wholesale perspective?

Chris Growe - Stifel Nicolaus

Yes.

Martin Orlowsky

They had to go through a major adjustment coming out of that excise tax increase and I think we’re seeing it evolve if you will to the point where it’s going to meet their demand factors and so as we all know the industry was down considerably. So I think that, it’s a reflection of where the business is without question.

The only thing that could affect inventory levels and this is not a revelation would be any sort of speculative buying that a wholesaler might engage in terms of anticipating a price increase, but I don’t think it will have a short term impact. Generally speaking, I think they’re probably where they need to be to satisfy demand.

Chris Growe - Stifel Nicolaus

So wouldn’t Q4 still have lingering effect from inventory levels just being higher a year ago and plain simple lower this year?

Martin Orlowsky

Yes, I think so, but as I said before, I don’t think the order of magnitude would be that great. It would be similar to the third quarter versus the third quarter of ‘08. It will be some slight effect of that possibly.

Chris Growe - Stifel Nicolaus

Then I heard there was pricing put in place with one of your competitors. Have you announced anything to the rate by chance?

Martin Orlowsky

No, we haven’t.

Chris Growe - Stifel Nicolaus

Just to be clear and my final question for you on kind of the competitive level of activity in menthol seems high. So would it be realistic to assume that you want to maintain a more aggressive promotional level into the fourth quarter whether it’s Blend 54 or maybe some of the Camel menthol products or you have L&M bold coming out, are those factors that cause you to change your point of view on promotional levels in the fourth quarter?

Martin Orlowsky

I’m not sure. I’m just with your first part of your question. Are you saying that will we keep up a higher level of promotional activity?

Chris Growe - Stifel Nicolaus

Yes, you had a little higher promotional level in the third quarter versus second quarter…

Martin Orlowsky

No, one thing, we’re not going to speak to what we’re going to do, so I really can’t give you a good answer to that question. I’ll give you my answer, which won’t be too satisfying for you. We adjust as I’ve always said, based on competitive actions and brand trends, Newport brand trends, so other than that I really can’t give you any insight.

Chris Growe - Stifel Nicolaus

If I could ask one final one for David on the tax rate, where should that shake out for the full year rate?

David Taylor

We think that it’s that 37.7.

Operator

Your next question comes from Erik Bloomquist - JP Morgan

Erik Bloomquist - JP Morgan

A question on Maverick, I wonder if you could discuss the competitive environment for that and if there’s any change you anticipate to the drivers of that growth, obviously it’s coming up against its very strong growth last year, but if there’s anything within the environment that’s operating that’s different or you see as changing going forward?

Martin Orlowsky

Not that I’m aware of, no Maverick continues to benefit from its price point obviously. I can’t really give you a better answer than that. We’re not aware of any changes necessarily.

Erik Bloomquist - JP Morgan

Then secondly, could you just update us on where things are at with Triumphs news?

Martin Orlowsky

My best answer to that is the Latin phrase, status quote. Its Triumphs new is performing inline with its competitive adventives, which is pretty flat and it’s not showing any real dynamic growth and it’s no different than the category is frankly.

Operator

Your next question comes from Andrew Kieley - Deutsche Bank.

Andrew Kieley - Deutsche Bank

I just wanted to understand I think you said you that, you thought the trade inventory destock impacted Newport differently. So, I just wanted to understand what you meant by that was that relative to the peer group or just wanted to understand that?

Martin Orlowsky

Relative to the industry, we think that the dynamic probably impacted Newport more than it did the industry as a whole and if that’s what you would expect with high market share brands that move quickly. This is not new or different anytime there’s I need for the loading or deloading, Newport tends to have a disproportion or tends to be disproportionately affected for the very reason that David indicates and that is it has high share, high movement.

So when a wholesaler might want to increase their inventory levels for at reason they’re going to disproportionately load on Newport’s because they can move it out faster given its share of market, so we’ve always experienced higher degree of effect when a load or a deload takes place.

Andrew Kieley - Deutsche Bank

Then secondly just wanted to ask the retailers proven back inventory it seems like they’re also cutting back SKUs and I was wondering if you could talk about are you seeing within your brands a cut back in the number of SKUs or facings that you get at retail?

Martin Orlowsky

No we have not occurred.

Andrew Kieley - Deutsche Bank

Then lastly just for David. Could you give us maybe the duration of the rate swap that you entered and then as we see debt rates come down does that change your thinking at all about the timing of how you return to cash to shareholders or what the capital structure should look like?

David Taylor

Two parts, first the duration of the swap is the same as the duration of the notes and so we are going to account that qualifies as the short cut accounting method so the P&L will reflect the economics. As rates come down we’re going to continue to watch what the credit markets look like and availability of debt to us and react accordingly, obviously lower rates would get us to look more aggressively that, but I can’t give you a real projection about when we might enter the debt markets again.

Operator

Your next question comes from Christine Farkas - Banc of America/Merrill Lynch.

Christine Farkas - Banc of America/Merrill Lynch

David, if I could just get a housekeeping item out of the way, the FDA fees probably pretty minimal, maybe near $2 million, could you confirm what that was in the quarter?

David Taylor

Yes, it was minimal line $2.5 million, pretty small.

Christine Farkas - Banc of America/Merrill Lynch

Marty with respect to the industry volumes down 12.6% I just want to confirm is that a number adjusted for inventory or not adjusted for inventory?

Martin Orlowsky

It’s not adjusted number.

Christine Farkas - Banc of America/Merrill Lynch

Would you have an estimate of how much you think the industry was down adjusted for inventory?

Martin Orlowsky

Little over 10%.

Christine Farkas - Banc of America/Merrill Lynch

Finally just on the Puerto Rico volumes, which fell about 14%, 15% I just wanted to confirm there was a tax hike there, correct me if I’m wrong. Is this the kind of magnitude we’ll see for the next couple quarters or something else in Puerto Rico?

Martin Orlowsky

No, it was totally related to the tax change, how long it might last, I don’t know, but the fact is that the decline is related to the tax increase.

Christine Farkas - Banc of America/Merrill Lynch

That was implemented in the third quarter correct?

Martin Orlowsky

To be honest with you, I don’t remember exactly.

Christine Farkas - Banc of America/Merrill Lynch

Then actually finally on the FDA, I know it’s difficult to tell and there maybe a report or a planned report coming next year, to your knowledge, how is the timing going on the selection process and the discussion process? Do you have any insight as to the progress on the menthol study that the FDA would be reviewing over the next year?

Martin Orlowsky

Let me answer the last part of your question first. There’s no menthol study per se. The committee will review existing menthol studies and they have about a year by which they have to report out whatever their conclusion recommendation is. So it really doesn’t allow for a time to conduct long term studies. So we fully expect that the committee will review existing data regarding the menthol question for one.

The first part of your question about how it’s going, it’s really difficult. We’re not aware of the committee having been constituted yet, during their processes, doing that and I think they’ve made public announcements to that effect and so nothing of any substance as I know today has occurred with respect to the committee per se.

Operator

Your next question comes from Ann Gurkin - Davenport.

Ann Gurkin - Davenport

I just have one question. Can you help us with an outlook for leaf and wrap cost for 2010?

David Taylor

Leaf and wrapping for 2010?

Ann Gurkin - Davenport

Yes.

David Taylor

Yes, we’ll continue to see upward pressure, Ann, some of which is underlying and some of the increases in wrapping costs in 2009 are a result of changing product design to be lower propensity cigarettes, which are slightly more expensive for us to produce, but we will continue to see some upward pressure on those input costs through 2010.

Operator

Your final question comes from Thilo Wrede - Credit Suisse.

Thilo Wrede - Credit Suisse

Do you see different market share developments for Newport between the Western half of the country and your core market in the Northeast?

Martin Orlowsky

What do you mean by different?

Thilo Wrede - Credit Suisse

For example, faster market share growth for Newport out west or across the market share growth in the Northeast, any differences in trends there?

Martin Orlowsky

We haven’t seen any difference.

Thilo Wrede - Credit Suisse

Then MSA accruals, I think you’re running a little bit ahead of the rates that I would have expected for the year. Is that a fair assumption?

Martin Orlowsky

What accrual, I’m sorry.

David Taylor

No, I don’t think we’re running ahead of the rate that you would expect for the year, no.

Operator

(Operator Instructions) There would be no further questions. This concludes the question-and-answer session and I would now like to turn the meeting back to Nathan for close remarks.

Nathan Elwell

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

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This concludes the presentation and you may now disconnect. Have a good day.

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