Lorillard's CEO Discusses Q4 2013 Results - Earnings Call Transcript

Feb.12.14 | About: Lorillard, Inc. (LO)

Lorillard Inc. (NYSE:LO)

Q4 2013 Earnings Conference Call

February 12, 2014 9:00 am ET

Executives

Murray Kessler – Chairman, President, Chief Executive Officer

David Taylor – Chief Financial Officer

Robert Bannon – Director, Investor Relations

Analysts

David Adelman – Morgan Stanley

Bonnie Herzog – Wells Fargo

Chris Growe – Stifel Nicolaus

Judy Hong – Goldman Sachs

Ryan Oksenhendler – Bank of America Merrill Lynch

Thilo Wrede – Jefferies

Vivien Azer – Citi

Michael Lavery – CLSA

Tom Mullarkey – Morningstar

Operator

Ladies and gentlemen, good morning and welcome to the Lorillard Inc. Fourth Quarter and Full Year 2013 Earnings conference call. My name is Brent and I will be your operator for today’s call. All participants are in a listen-only mode and a question and answer period will take place at the end of the call. Should you have any problems during the call, please press star and then zero for the conference call operator. As a reminder, this conference is being recorded for replay purposes.

At this time, I’d like to turn the conference over to your host for today’s call, Mr. Bob Bannon. You may begin, sir.

Robert Bannon

Thank you, Brent, and good morning everyone. I’m Bob Bannon, Lorillard’s Director of Investor Relations, and joining me on today’s call are Murray Kessler, Lorillard’s Chairman, President and Chief Executive Officer; and David Taylor, its Chief Financial Officer. By now, you should have received a copy of our fourth quarter and full-year 2013 earnings release. It can be found on the company’s website, Lorillard.com under News Releases.

Before we begin, I’d like to remind you that some of the comments 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 in other filings with the SEC. Also, certain financial information such as adjusted net income and adjusted earnings per share that will be discussed on today’s conference call is presented on a non-GAAP basis. The description, most directly comparable GAAP measure, and reconciliation between the non-GAAP and GAAP measures are provided in the company’s earnings release, which is available on our website.

I’d now like to turn the call over to Murray Kessler.

Murray Kessler

Thank you, Bob, and good morning everyone. I’m proud to report that Lorillard delivered industry-leading financial results, its 11th consecutive year of cigarette share growth, and established itself as the clear leader in the electronic cigarette category in 2013. Its results for 2013 are highlighted by 11% consolidated adjusted EPS growth, the best in the industry; 8% consolidated adjusted operating income growth, the best in the industry; 5% consolidated net sales growth, the best in the industry; a 14.9% share of combustible cigarettes, up 50 basis points versus a year ago, the best in the industry; and a 47% share of e-cigarettes. Importantly, these results were achieved while the company made significant and purposeful investments, especially in the fourth quarter, to launch new products, further expand our e-cigarette business both in the U.S. and abroad, and implemented control measures to limit fluctuations in wholesale inventory in advance of anticipated price increases.

While these planned investments and control measures somewhat moderated fourth quarter adjusted EPS growth, which was up 4% versus a year ago, they were the right thing to do for the business and will positively affect 2014 and future years. Lorillard will always make the right decisions for the long term, and it is precisely for this reason that the company has outperformed the S&P 500 by over 100 percentage points since going public in 2008 and why the company consistently grows market share year after year.

Let me go into more specifics for the quarter and year, starting with combustible cigarettes. Lorillard’s domestic fourth quarter cigarette volume decreased 1% versus year ago, which compares favorably to industry domestic wholesale shipments which declined 6.2%. The control measures Lorillard put in place to limit wholesale inventory building in advance of price increases had a negative impact, as expected, of about 150 million units. The broader industry also had some unfavorable inventory comparisons.

Adjusted for inventory fluctuation comparisons, total Lorillard volumes were up slightly and the industry declined about 4%. Newport domestic wholesale shipments were up 24% for the quarter versus year ago on an unadjusted basis, and up 2.3% versus year ago on an adjusted basis. Strong Newport growth is attributed to the continued stability of full flavor menthol and accelerated growth of non-menthol tracing to the Newport Non-Menthol Gold launch. Domestic volume of Maverick, the company’s discount brand, declined 7.9% for the quarter.

On a yearly basis, I think it’s pretty remarkable that total Lorillard cigarette volume declined only 25% and total Newport volume actually increased 0.6% versus year ago in an industry that experienced accelerated declines, down about 4.5%. As we have said before, we believe e-cigs have had about a 1% negative impact on cigarette sales volumes. We continue to expect the industry to decline at the 3 to 4% level as we don’t think the e-cig drag will be as significant next year now that national retail distribution of e-cigs exists in the base year.

Because Lorillard cigarette volumes so far outpaced the industry decline, the company had a great year in market share. Likewise, fourth quarter market share results were also outstanding, in fact the strongest increases of the year according to our Excel database, which measures shipments from wholesale to retail and is unaffected by wholesale inventory fluctuations. Specifically, total Lorillard market share reached a record 14.9% for the year, up 0.5 points versus year ago. Fourth quarter share was also 14.9%, up 0.7 points year-over-year as the company did not experience its typical fourth quarter sequential reduction in share. We attribute that to the incremental benefit of Newport Non-Menthol Gold, which added just under 30 basis points and helped total Newport achieve a 12.7 share in Q4, up 0.8 points, and a 12.6% share for the year, up 0.6 points.

While Newport Non-Menthol Gold had a positive impact on the quarter, the results on the introduction have been mixed. Distribution is excellent. Consumer feedback on the product is outstanding; that is, we think we finally got the product right for a less than full flavor offering. But trial of this new product has been slow to occur, which we believe is due to competitive offerings and Newport’s inherent perception as a full-flavor brand. Net-net, we are confident in Newport Non-Menthol Gold becoming a meaningful contributor for Lorillard but it will take longer than we might have hoped to build trial; and is always the case, we will take the long-term perspective.

Of critical importance, Lorillard’s menthol business remains robust. Compared to last year, Lorillard’s total share of menthol increased 1.6 share points to 39.9% in Q4 and increased one full share point to 40.3% for the year. Newport’s share of menthol enjoyed similar gains, up 1.6 share points to 36.7% in Q4 and up one full share point to 37.1% for the year. It is the strength of the core Newport menthol business that allows us to invest in growth initiatives for our future and continues to be the primary driver of our superior operating performance, so the strength shown in these volume and market share trends are what give me confidence in our ability to continue to deliver our stated goal of a double-digit total shareholder return in 2014 and beyond, and which is typically a higher level of EPS growth than our competitors, just as it was this year.

Turning to electronic cigarettes, net sales for electronic cigarettes finished at $230 million for 2013, almost a four-fold increase versus year ago. This was almost entirely from blu e-Cigs, as our recent acquisition of SKYCIG only contributed about $4 million of net sales in the quarter. I’ll discuss SKYCIG in a minute.

blu has been an incredible success story for Lorillard and, frankly, has caught the attention of many around the world. Besides delivering$ 226 million in net sales or over $400 million at retail in its first full year, blu has clearly established itself as the e-cig category leader, achieving 47% share of the U.S. market. We think the e-cig category was over $1 billion in retail sales in 2013 when taking internet sales into account. blu delivered about $7 million in operating profit in 2013 despite about $5 million in fourth quarter supply chain write-offs associated with the rechargeable kit transition and despite the fact that we are investing to build trial and awareness.

I continue to encourage you to think of this business as break-even for the first few years. That’s because this is a business worth investing in. blu is leading the way in this emerging category and we intend for it to stay that way. It’s also because we believe e-cigs may be the greatest harm reduction option ever presented to smokers. Accordingly, we believe we have only scratched the surface on how big the category can be as the majority of smokers have yet to try an e-cig and many of those smokers who have tried earlier versions that did not perform as well as what is on the market today.

I am very encouraged by the consumer feedback, retailer feedback, and sales trends on blu. Now, some might be concerned the fourth quarter e-cig category in blu sales growth flattened sequentially. We have a different perspective. For the first three quarters, our sales and therefore those of the category, as we are half of it, were flattered by pipeline inventory as we built distribution to almost 130,000 stores by the end of Q3. In the fourth quarter, there was no significant distribution build for blu nor significant increase in store count for the category; therefore, fourth quarter sales were pure consumer pull, and since we experienced strong cartridge refill sales, we believe a large percentage of this consumer pull was repeat purchase.

We think industry sales will continue to grow as e-cigs continue to gain in popularity, technical advances improve product performance, and increased marketing support comes from additional competition. My only caveat to this belief comes from the pending regulation on e-cigs. These regulations have the ability to either help the e-cigarette category grow if the regulations are reasonable, or stifle growth if the regulation is draconian and mirrors that of combustible cigarettes. We hope common sense will prevail with FDA and they will recognize the massive harm reduction potential that exists with e-cigs, but we will see. Regulations on e-cigs can come at any time.

Briefly on SKYCIG, we’re going through the same process we did on blu after we purchased it. We are preparing our expansion plans, taking the necessary regulatory precautions, and optimizing the product portfolio before we commence our rollout throughout the U.K. and other western European markets, as appropriate. The only decision I’m willing to share at this time as it affects the financial statement is that we have concluded that we will be transitioning the SKYCIG brand to blu. Both the SKYCIG team and the blu team have concluded that our best opportunity is to make blu a global brand, and that rebranding needs to happen quickly in order to maximize our rollout and marketing investments. We expect the rollout to commence midyear.

So in conclusion, I’m pleased that Lorillard was able to deliver 11% adjusted EPS growth in 2013 while continuing to robustly gain market share of its stable volume base, despite industry trends that further softened. I continue to be amazed by the strength of the Newport brand. It’s strong fundamentals are the engine that allows us to deliver superior financial results while investing in our future. Those investments have already begun to pay off with a successful geographic expansion of Newport Menthol, the successful launch of Newport Red, and the successful expansion of blu e-Cig, and likewise we expect further investments to help us successfully expand Newport Non-Menthol Gold and globally expand blu. But to be clear, these investments are upside opportunities as it is the strength of the core Newport franchise that is the basis for our continued forecast of a double-digit shareholder return as measured by EPS growth and the dividend yield in 2014 and beyond.

With that, I’ll turn the call over to David Taylor, our Chief Financial Officer, to review the financials in more detail.

David Taylor

Thanks Murray, and good morning. After a few comments, we’ll open the line for questions.

We had a strong fourth quarter and finish to 2013. Consolidated net sales for the fourth quarter increased 2.3% over last year and 2013 annual sales increased 4.9% over 2012 to approximately $7 billion. Our reported results include some items both in 2012 and 2013 that tend to mask the underlying performance and make comparisons of reported results less meaningful. I’ll therefore be addressing our adjusted results, which excluded the impact of these items. The details of these adjustments are included in the press release in the section entitled, Reconciliation of Reported GAAP to Adjusted Non-GAAP Results.

Adjusted operating income for the fourth quarter increased 1.8% from last year to $523 million and fourth quarter adjusted EPS increased 3.8% to $0.82 per share. Our annual adjusted EPS increased 10.6% to $3.12. The quarter played out just about the way we expected and described when we spoke on our last conference call.

Looking at the results for traditional cigarettes, net sales increased 1.4% from last year’s fourth quarter as a result of the higher average net selling prices which more than offset the decline in wholesale shipment volume. As you heard, the changes we implemented in the fourth quarter to eliminate some of the historical fluctuations in wholesale inventories that happened in advance of anticipated price increases had the effect that we aimed for, and those wholesale inventory positions were substantially lower than they would have been absent those changes. Of course, as we outlined last quarter, that dampens volume comparisons to last year’s quarter when those inventories had built at wholesale.

Net sales for cigarettes calculated before excise taxes on a simple consolidated basis increased 4.2% from last year, reflecting the various pricing actions that we have taken. These higher net selling prices drove the improvements in adjusted gross profit and adjusted margins in the quarter. Adjusted gross profit for cigarettes in the fourth quarter rose 3.7% to $643 million, and adjusted gross margins improved to 38.1% of sales from 37.2% last year.

Tobacco settlement costs have been impacted by a number of factors, both this year and last, most notably, the ongoing impact of the NPM settlement earlier in the year. The settlement cost per thousand units sold in the fourth quarter was consistent with the accrual rate that I gave you in last quarter’s call – approximately $36 per thousand units.

Adjusted selling, general and administrative costs for cigarettes in the fourth quarter increased $4 million or 3.5% from last year’s fourth quarter, primarily as a result of increased advertising, marketing and other costs arising from the introduction of Newport Non-Menthol Gold. The strong net price realization combined with good cost containment resulted in an increase in fourth quarter adjusted operating income of $19 million or 3.7% from last year’s fourth quarter.

The cigarette segment once again demonstrated its fundamental strength, finishing 2013 with net sales up 2.4% and adjusted operating income up 7.6% to over $2 billion. This sort of performance in the core of our business is the continuation of a story that you have heard many times, one of a particularly strong brand in Newport which outperformed its competitors in a declining cigarette market and commands premium pricing. The franchise is clearly healthy.

Now as we look at electronic cigarettes, we’ve expanded Lorillard’s presence internationally in this rapidly changing market with our fourth quarter acquisition of SKYCIG, a U.K.-based e-cigarette business, and the results in the fourth quarter include the operation of SKYCIG. Net sales for electronic cigarette segment totaled $54 million, which includes $4 million of SKYCIG sales, compared to a total of $39 million in last year’s fourth quarter. The segment generated an adjusted operating loss of $3 million as we have continued to invest in marketing and advertising behind the blu brand. We indicated that we expected blu e-Cigs to operate at a near break-even level in the short term, and that’s really what we see here.

The quarter included a $5 million supply chain related charge arising from the write-off of certain amounts of inventory, much of which can be traced to the introduction of our new rechargeable pack in the summer of 2013 and other supply chain modifications in an effort to reduce operating costs. We realized some ongoing cost reductions which partially offset this charge in the quarter, and efforts aimed at supply chain optimization will continue going forward.

In addition, reported results include the rather rapid amortization of the value assigned to the SKYCIG trade name in the acquisition. That value is being amortized over an 18-month period as we have now determined that we will rebrand the product offering as blu during 2014 and the SKYCIG brand has a limited life. The rebranding effort will not only involve this non-cash amortization of the SKYCIG brand value but will also involve ongoing investments in advertising and marketing initiatives to establish blu as the top-of-mind brand name in the U.K., a process inherently more difficult than we experience here in the U.S. It is for these reasons, among others, that we have consistently guided you not to build significant profit expectations for our electronic cigarette business in the short term.

Some other things – the adjusted effective tax rate for the year was 37.2%, as we indicated in last quarter’s call. We continued our share repurchase program during the quarter, repurchasing approximately 4.6 million shares at a cost of $228 million. That leaves approximately $314 million to be utilized under the current $1 billion authorization. Share repurchases for the year totaled $795 million. The combination of share repurchases and dividends paid totaled over $1.6 billion returned to shareholders in 2013.

So as we look into 2014 as it relates to the various earning scenarios that I’ve outlined in the past, we think we are in a normal pricing and competitive environment as evidenced by the net price realization we’ve seen over the last few quarters, which I had characterized as the normal organic growth scenario. If you may recall, that scenario on its own would likely put us in a high single-digit EPS growth range. We are, however, getting some EPS benefits from our leverage-driven share repurchase programs that can further improve forward earnings. However, we have yet to realize the other upside earnings opportunities that we’d previously described. Those would include the earnings upside associated with new cigarette introductions, and as you’ve heard, that may be slower in coming than some of you have modeled in 2014. We continue to believe that our entry into the Non-Menthol Gold segment holds significant promise for the long-term prospects of the business.

In addition, we do not expect any meaningful earnings upside from our electronic cigarette business in the short to medium term. We expect to stay in the investment mode in e-cigs for the foreseeable future.

So in summary, we had a strong finish to 2013 and we enter 2014 with solid fundamentals that will continue to sustain us, and also some exciting opportunities in both cigarettes and electronic cigarettes. We’re confident we can continue our track record of rewarding our shareholders by creating significant value on their behalf.

Brent, we can now take questions from call participants.

Question and Answer Session

Operator

Thank you. This will begin the Q&A portion of the call. [Operator instructions]

Your first question comes from the line of David Adelman with Morgan Stanley. Please go ahead with your question.

David Adelman – Morgan Stanley

Good morning everyone. Murray, first on Newport Gold, did you compromise at all from a design perspective the taste of the product to enhance the prospect of FDA approval?

Murray Kessler

No, is the answer. The product that we exactly consumer tested and had worked for a number of years on is exactly what we submitted for FDA approval, and I’m really—you heard my comments. I’m not happy with the level of trial we got, but the product—we’ve already gotten back repeat among people that have tried the product. There’s definite purchase interest among people that have tried the product in the 70’s. The top 2 box was in the 90’s. I actually think for the first time we have delivered a product that scores incredibly well. This is not a product challenge, because I would have liked to see a higher share level out of the gate. It was more of an awareness and people understanding that we sell a gold product, which you and I have talked a lot about at conferences openly in the past. This is new turf for us.

So we’ve got work to do of getting people to try the product and understand that Newport can make both a non-menthol product and then one step further away, a less than full flavor product, but it is not a product itself issue. That part is very encouraging.

David Adelman – Morgan Stanley

Okay. And then as it relates to your domestic blu e-cigarette sales, did you internally envision the sequential decline in revenue? Was that something you expected in the fourth quarter?

Murray Kessler

Yeah, I would say for the most part because as we were modeling it, you had two things going on: one, the distribution build leveled off. You know, the whole thing has been a little bit of guesswork because it’s a brand-new category as we were going along, but we knew we hadn’t hit our sort of peak at 130,000 stores at the end of the third quarter, plus you had in the way we measure wholesale to retail. And the way we ship it is you had the entire changeover, so you had a lot of pipeline load in the third quarter, and then you know that we lowered the price. So the wholesale price was significantly lowered, so all those were modeled in.

I think—you know, I realistically could have hoped for a little bit more in the fourth quarter, but it’s not surprising.

David Adelman – Morgan Stanley

Okay. Lastly, Murray, what’s a realistic range of expectations for maybe e-cigarette category sales growth in ’14 versus ’13?

Murray Kessler

Boy, that is a hard question to answer. We’ve seen some test markets of competitors where there’s more spending in those, where in one of those the category quadrupled. And I’m delighted that while share changes around, my prediction that all boats would rise, that sequentially our business got stronger at a much higher rate than the rest of the country in those markets, so it depends how fast competitors, how much marketing support (indiscernible) investment. But I think you can see more investment and it’s clearly reacted to that. We have technological advances coming in the year that I also think build it, and the other part of it that I can’t really get a strong handle on is that I believe the eGo Tanks are also gaining in popularity, and that portion of the business is driving the phenomenon but you don’t see that in the retail numbers, and creates a challenge for us to get the performance of the more cigarette-like version of it, which we sell, improve the performance to get it as good as the eGo Tank.

So there’s a lot going on, but I do not—I think we have just scratched the surface on how big this can be, and you have to be real careful not to just look at month-to-month sales. This is real.

David Adelman – Morgan Stanley

Okay, thank you very much.

Operator

Your next question comes from the line of Bonnie Herzog with Wells Fargo. Please go ahead with your question.

Bonnie Herzog – Wells Fargo

Good morning. My first question is on Newport Gold. I was hoping you could give us a sense if Gold’s performance has improved so far this year, and what your expectations are for the brand long-term. Maybe try and quantify for us what’s the real opportunity, if you could.

Murray Kessler

Well I think long term, I haven’t backed off what I’ve been saying all along, that this is the largest segment of the industry and we don’t participate in it, and it took us three times to get Newport Red all the way right, so it’s a big opportunity for the company right now. I’m still optimistic that it’s a share point or north of that; but in the short term, we have changes that we need to make in terms of getting trial and awareness. I don’t think any of these changes, for anybody who is on the call who is worried that there’s going to be some kind of severe price competition, that’s not what I’m talking about. I’m talking about basic consumer understanding that people just aren’t aware that Newport makes a non-menthol, less than full flavor cigarette, so it’s in advertising and communication, possibly packaging, some of our trial activities.

But I’d say—I’d still call it kind of where it is, a third of a share point in the short term, and then once we get those things right and you’ll see those tests start to occur – some of them have already started – that we build the opportunity in the long term. So I’m a little disappointed that we have to do that work. I hoped it would have caught on, but the time is different now than it was a few years ago. There are more competitors at that price point than there were a few years ago, and we need to do our jobs and get that trial.

Bonnie Herzog – Wells Fargo

Okay, that helps. Murray, I’d like to ask you about what appears to be a slight slowdown of the e-cig category, and what do you think might be driving this? And also, how do you—or how much of an impact do you believe some of the increased bans on e-cigs in public places are having on the category, if at all?

Murray Kessler

Well I don’t—yeah. I don’t think it had any impact yet because a couple big ones that have passed haven’t even been implemented yet. So look, I think the slowdown is just the natural ebb and flow of a brand-new category where you had a massive amount of new distribution built primarily by us and then that finally leveled off, so now it’s moving to repeat purchase. You know, the press every day the pendulum swings back and forth, and there is incredible media coverage on e-cigs for sure on television and print and covers of Business Week and everything else. So the awareness of e-cigs is growing – some is positive, some negative. That’s why I’m hopeful that the FDA will recognize what I believe is one of the greatest harm reduction opportunities ever presented to a smoker and they’ll want to get behind it and support it.

But that’s going to be a big driver of how big this can get, and then I think there will be additional competitors and while that will have some effect on our market share, it’s going to be good for the industry and why I’m glad we were there first, and we’re going to participate in it. Finally, I do think vap shops and the eGo Tank business is also creating a lot of growth that you’re not measuring, and internet sales are not measured. So I mean, this phenomenon is happening broadly. You see people—you go into a restaurant or bar, you see people with e-cigs now, so it’s growing in popularity. I’m a believer. I think it’s going to be quite significant.

Bonnie Herzog – Wells Fargo

Okay. Then I just want to go back to something you were talking about earlier with regards to blu’s revenue. I understand you’re continuing to invest heavily behind the brand and the business, really to build it; so I guess I’m trying to reconcile why blu’s revenue dropped sequentially despite the increased spending behind the brand. Does this concern you, and then are you planning on increasing your spending behind this brand this year, and how are you measuring the effectiveness of your advertising?

Murray Kessler

Well, we measure the effectiveness of the advertising the way everyone traditionally does. I don’t have the numbers exactly in front of me, but I think awareness, unaided brand awareness of blu went from the 30’s—and I had this in the investor presentation I think, but went from the 30’s to the 80’s in terms of unaided brand awareness and first choice. We have a whole bunch of diagnostics on equity, net promoter scores – all of that, and I can share some of that at CAGNY again if it would be helpful. But all of those measures of building a brand have grown dramatically, and blu leads the industry by far in all those measures.

But I don’t think you can underestimate, it’s hard to—you know, when you’re putting in new distribution from 10,000 stores to 130,000 stores and you fill the shelves, a large—a meaningful percentage of that revenue in the prior quarters was that initial pipeline build. So I think if you could cleanly strip it out, which is hard for me to do, you’d see the brand sequentially grew; and again, where competitors are investing as well, you see the brand sequentially grow.

So I think it’s a normal life cycle. I’m excited about the brand and the category. I think the pricing of the new kit makes it more accessible, and we will continue to innovate and bring more technology. Our investment level has been, at least in the U.S, has been one that allowed us still to—you know, we’re not investing at a loss. I mean, we still made $7 million with blu in 2013, and it absorbed overhead so you probably absorbed—on a fully absorbed basis, $7 million or $8 million of corporate overhead, so probably made about $15 million and it had about $5 million of supply chain write-off. So while we’re investing, the business itself generated $15 million to $20 million in 2013. It’s not at a loss. I’d say the investment levels will maintain right where they are right now, although we’ll measure to what happens with increased competition.

Bonnie Herzog – Wells Fargo

Okay, thanks so much.

Operator

Your next question comes from the line of Chris Growe with Stifel. Please go ahead with your question.

Chris Growe – Stifel Nicolaus

Hi, good morning. Just two questions for you. I wanted to ask first of all, to kind of follow on the question on blu, is the continued expansion of the rechargeable kits and certainly hitting a pretty high level of distribution for the product, would you expect it to sequentially decline again into early ’14? I’m not trying to get guidance on quarterly sales, but just to understand the effect of those kits and how that could keep working against the dollar revenues of the brand.

Murray Kessler

I’m looking over at David for a second. I mean, you’ve had the old kits at the higher price in the first half of the year, so relative to that, but you’re selling a lot more of the new kits than you’re selling the old kits.

David Taylor

Chris, I don’t think I’m going to be able to give you guidance on the trends in early 2014. First, I wouldn’t do it; but second, it’s a really tricky thing because we are building distribution so rapidly in the first half of ’13 and now we’re selling a somewhat different product range. So in terms of dollar sales, I hesitate to try and give you that.

Chris Growe – Stifel Nicolaus

That’s fine. Thank you.

Murray Kessler

Keep in mind, this is not—you know, sort of that leveling was a category phenomenon. It wasn’t blu. blu gained sequential market share in the fourth quarter among consumers, and so did the category take a little bit of a pause? Yes. How much of that was relative to the other things going on in the marketplace with areas that we’re not measuring, because we measure a small percentage of this category? As I have answered already a couple times, it’s a factor, but this isn’t it for the cig category. It’s not even close, unless the regulations were draconian.

Chris Growe – Stifel Nicolaus

Sure, okay. And then I just wanted to be clear on—or I have a question about the blu performance in states where Vuse and MarkTen have been launched, in test market or actual launch. I know we’ve gotten some data – I think you made a quick comment about it before – but is that something where as more and more states get added, does blu’s spending pick up a bit in those states to try and get in front of those launches, competitive launches?

Murray Kessler

Well, I can’t speak to what I might do in the future, but I would say—so in the test markets so far, we’ve just watched them. We haven’t done any unusual behavior. The same plan that was national was the same plan in those test markets, and unlike the total U.S., I can tell you from the third to the fourth quarter we had almost a 30% sequential increase in one competitor’s test market, and the category tripled in that area. We saw strong growth right through it, which again gets to sort of the building awareness of the entire e-cig business. In a second competitor’s, it was very small and, frankly, didn’t have much impact.

Chris Growe – Stifel Nicolaus

Okay. Then just a quick follow-up for David, then, on shipping days and inventory adjustments. If I’m correct, you’ll have a little bit of an inventory benefit in Q1 in the cigarette business – is that correct? Anything unique to the quarterly flow of volumes is all I’m trying to figure out here.

David Taylor

The number of shipping days is the same in this year’s first quarter as last year’s first quarter. We entered the year with what I said before – with a little bit better inventory position than otherwise would be, so that should be a bit of a tailwind ’14 versus ’13. But I can’t predict what wholesale inventories will do at the end of the first quarter. I cannot predict that, either industry-wide or rollout.

Murray Kessler

You know, there are so many factors that go into. We’ll obviously be very transparent on the effect of that, but you also have had storm after storm and wholesalers having to manage through those issues as well, and retailers and all that. I will say that from what I see at retail so far, wholesale shipping to retail, I haven’t seen a significant change in trend. That’s not a U.S. and inventory question. I’m sort of responding to some things I’ve seen written to me. It seems like the category is performing just as we’ve seen.

Chris Growe – Stifel Nicolaus

Okay, that’s helpful. Thank you.

Operator

Your next question comes from the line of Judy Hong with Goldman Sachs. Please go ahead with your question.

Judy Hong – Goldman Sachs

Thanks, good morning. Murray, so your outlook for the cigarette category in 2014 being about 3 to 4% decline, which is a little bit of a moderation versus 2013. Despite the fact, you still sound pretty bullish about the electronic cigarette category growth and so forth, so I’m just trying to understand what drives some of that modest improvement year-over-year. Based on your experience now with the electronic cigarette category, is it your view that some of that impact on the conventional cigarette category is becoming more modest just because you’re not seeing a lot of the switching, or if there are any other observations that you can make as it relates to the interaction between conventional versus electronic cigarette category.

Murray Kessler

To be clear, I’ve never met an e-cigarette consumer who hasn’t switched from smoking and hasn’t said they’ve either completely switched or reduced their consumption, so I believe it has an impact. I’m just doing math, and the math that I’m doing says there were about 100—with what I can measure from Excel, there was about 150 million packs of equivalent—you know, on a comparable basis to cigarettes done. You know, the industry sells about 13 billion packs. Assuming all of it is a one-for-one trade, it comes out to roughly a 1% impact. And if you look at that, that is almost—almost all of that was incremental 2013 to 2012.

When I go forward, unless you saw a similar doubling of the entire size of the category and another 150 million packs, which is hard to say right now prior to seeing what happens with competition, there’s got to be a lesser effect just because the amount of (indiscernible) packs sold won’t be as many. If the category grows 25%, it should have a quarter of a point or third of a point impact on cigarettes. If it doubles again, it would be another point, and that’s why I’m saying 3 to 4%. I’m just doing math.

Judy Hong – Goldman Sachs

Okay, got it. Okay. And then just in terms of the deeming regulation, obviously the FDA proposal has been sitting in the OMB for some time now. It sounds like maybe there’s some dialogue going back and forth between the OMB and FDA and potentially maybe a more scaled down version that could come out from this exercise. Anything you’re hearing on that front?

Murray Kessler

Yeah, we’ve heard a little bit, and I just read an interview with Director Zeller within the past few days that said they did have pushback from OMB, so I’m not sure it’s actually sitting in OMB anymore or it’s been returned to the FDA. I don’t have clarity on this. I’m just trying to read the tea leaves from reading interviews, et cetera; but it seems to me there was some pushback and they’re doing additional work on it, otherwise it would have been out there already.

Now, I’d be speculating just like you’d be speculating on what that pushback is. Generally speaking, the OMB deals with issues that affect the economy, not public health, so they would have to be questions about relative—you know, possibly internet sales, possibly vap shops and Ego. I mean, I’m guessing, but I do know from what I’ve been told and what I’ve read that there is that pushback and back and forth between OMB and the FDA, so that has slowed things down.

Judy Hong – Goldman Sachs

Okay, and then my last question just on the Newport brand, if I look at the Green performance that’s been very strong, and the Red performance has also been relatively steady over the last two or three quarters, so just curious to kind of hear from you on maybe the interaction between Red and the other—sorry, the interaction between Gold and the other brands, if there has been any cannibalization or the Gold launch is actually strengthening the broader Newport franchise. And secondly, just wondering why you’re doing—you’re taking a little bit more of a measured approach in building Gold’s trial, which is a little bit different than what you did with Red.

Murray Kessler

Well, I think we went with a pretty similar launch plan on Gold and Red across the board. I just think the competitive set is very different. Those special blends from one competitor weren’t down at that price point at that period of time a few years back. There’s additional new brands that have been launched, so I don’t think we were less aggressive but I think this is a harder hurdle.

It was a hurdle for Newport Red that we made a non-menthol, but we had virtually no less than full flavor business. I don’t make any excuses – I’m still very optimistic, but it is more communication needs to be done than was done in the past, so there’s work to do.

As it relates to your first question, about 10% of the volume by the source of volume study we did came from Newport Red. That’s why I’m closer to the 3/10ths of a market share point than some have modeled, because there’s a little bit (indiscernible), and you see our numbers, you saw that the total impact on Red was positive and the total impact on the entire franchise was positive. But these are small numbers relative to what drove the financial performance and will continue to drive the financial performance, which is a remarkably stable Newport full flavor menthol business and a category, you know, once again in an industry, inventory assessments aside, that declined 6.2%. It’s amazing, and you couple the pricing that’s associated with the industry with that kind of stability, and that’s what drives that strong operating result.

Judy Hong – Goldman Sachs

Got it. Okay, thank you.

Operator

Your next question comes from the line of Ryan Oksenhendler with Bank of America. Please go ahead with your question.

Ryan Oksenhendler – Bank of America Merrill Lynch

Good morning guys. Murray, I was curious – in terms of what you’re saying in terms of trial and repeat for blu, can you give us an update on those numbers? There was some commentary yesterday from your competitor about the category for e-cigs isn’t taking bigger share because repeat purchase isn’t that good, and for you guys, being such a large part of the category, that would be impacting you guys. If you can give us a breakdown kind of what your volumes were for kits versus cartomizers, that’d be very helpful.

Murray Kessler

I don’t have the exact numbers but the repeat business is as measured by—you know, the disposables, there’s a big piece of repeat business associated with disposables, but I don’t think there was a huge trial bump in the fourth business, and that business is steady as you go, and carts are something like 30%, 30 – 40% of the business. Now remember as a percentage, the competitor who you’re referring to doesn’t make disposables, so that’s just a question of math – of course the carts are a much higher percentage, they don’t make the other form that is a large portion of the industry. But that business has been steady and I believe the repeat business has been excellent, so I just fundamentally disagree.

I think that if you want my take on a difference, and you’d have to probe them on it, the level of spending and investment and negative investment versus that product and our product are very different. We’re trying to make money along the way.

Ryan Oksenhendler – Bank of America Merrill Lynch

Got it. Thanks guys.

Operator

Your next question comes from the line of Thilo Wrede with Jefferies. Please go ahead with your question.

Thilo Wrede – Jefferies

First question I have was about SKYCIG. You’re spending somewhere between 50 and $100 million—or you spent 50 to $100 million on that acquisition with pretty much all of that going to goodwill and intangibles. Why was that the better option to enter the U.K. market instead of just starting to import blu and advertising blu and selling it online just like SKYCIG that’s being sold?

Murray Kessler

Well SKYCIG is in very limited distribution right now, and when I say we’re going to evolve it, we’re not going to discount everything that’s been done at SKYCIG and the equity. I mean, we’ll do it the way anybody else—I’ll show you some images of that at CAGNY, but it will be transitioned in with both brand names on there for a while, so we can take advantage of it. But I will tell you that SKYCIG folks, when looking at the synergies that exist by capitalizing on everything that’s been done in the U.S., which is actually known around the world, when we would go in with retail presentations and have initial discussions, they wanted blu. So from our SKYCIG team’s perspective, they just think they’ll be able to have incredibly more success without losing what they’ve done so far.

So I think it will be a positive move. We won’t lose any consumers or just throw it away; it won’t happen in that direction, but there will be tremendous savings on advertising, on point of sale, on merchandising – all the learning on the product designs which were already close, that will take the best of both worlds. And I would say it’s going to be a two-way street because they have done some very creative things and some very smart things from a technology standpoint that we will also bring this direction.

Thilo Wrede – Jefferies

So in hindsight, you’re still saying it was the right way to enter the U.K. market? And I know it’s early days.

Murray Kessler

I would say we could have done it the other way. We had modeled that out and it would be two years from now, and by that period of time we think that our ability to get in there and do a meaningful leadership or major player position would have been gone for the company. Right now, we are able to leverage the administrative group, the technology, everything that’s been done, use similar products, and we will be rolling out throughout the U.K. by midyear, where that would have been a year to two year’s delay for that, and at that time while BAT is rolling out national and other brands are rolling out, we would have missed the opportunity in the second-largest e-cig market in the world.

Thilo Wrede – Jefferies

Okay, that’s helpful. Thank you. And then another question I had was on Gold. I get that the—you know, you don’t have the full flavor image and there’s a lot of competition, but to me it sounds like you need to drive more trial. Is that just a matter of lowering the price, or is it a matter of sending more direct mailings to people in your mailing list? What can you really do to drive more trial, given the restrictions that you have in terms of marketing?

Murray Kessler

Well, there’s many things that you can do, but you’re on the right track. No, it’s not just dropping price. I mean, I don’t particularly have an interest in selling a product that doesn’t make a profit and it’s just purely price driven, but it is getting out and then sampling, and databases is our primary driver of it. There are things we can do with a lot of restrictions around the MSA from an event standpoint. I think we can be much stronger in our communication. We tested it all up front, but the reality of it is going back and talking to consumers that haven’t tried the product. We still haven’t broken through from an awareness standpoint, so will it take some investment over time? Sure, but it will—I think it will be invisible to you on the street on a relative basis.

Thilo Wrede – Jefferies

Okay, and then last question I had – and I apologize if you addressed it in the prepared remarks. The slide positive volume that you talked about on an adjusted basis for the fourth quarter, is that relative to consumer takeaway or is it relative to what you would have expected wholesaler orders would have been if you wouldn’t have got the restrictions in place?

Murray Kessler

I’m not sure I’m understanding your question, but our consumer takeaway was stronger than our wholesale shipments because of the measures we took. So as measured at retail, that’s why you saw such strong share gains – that’s all consumers buying products, so we had a very strong quarter from a consumer takeaway standpoint, better than shipment.

Thilo Wrede – Jefferies

Okay, thanks a lot.

Operator

Your next question comes from the line of Vivien Azer of Citi. Please go ahead with your question.

Vivien Azer – Citi

Hi, good morning. My first question has to do, Murray, with your comment earlier in Q&A about e-cigarette consumption patterns with consumers. I’m just trying to reconcile it with a data point you offered at your analyst day where you said 44% of e-cigarette users do not reduce their cigarette consumption at all. So are you seeing a shift relative to what you guys offered in June, because I thought I heard you say you’ve never met a consumer that doesn’t switch entirely or cut back.

Murray Kessler

Yeah, that’s a fair pushback. We haven’t done additional—I haven’t met a consumer who hasn’t said that, but you’re right. That original research that we did, which is now probably a year or so old, is the latest. I don’t have new data from that, that said about 20%, I think, switched entirely and about 40% cut back significantly, and about 40% continued on, so I think that’s a fair pushback. You know, I’m out in the field a lot and I’ll stand behind my statement of the people that I’ve met, but in general this has a reduction on consumption. These are smokers who are using the product.

Vivien Azer – Citi

Yeah, totally agree. Thank you for the clarification. Given the dialogue around the sequential decline in sales, I was wondering if maybe you could offer some perspective on what your volumes did in the e-cig business on a sequential basis so that we can get a feel for the impact of price mix, or the negative mix, really.

Murray Kessler

They were basically flat, without the benefit of any pipeline.

Vivien Azer – Citi

Sure, yeah. No absolutely – that makes a lot of sense. Lastly, as you kind of talked about draconian regulation, where would you place indoor bans on e-cigarette use on the spectrum of disruptive regulation?

Murray Kessler

It’s draconian.

Vivien Azer – Citi

Yeah, but the most of all the scenarios?

Murray Kessler

Well, I’m not going to prioritize one versus the other, because the things that worry me are requiring SE approval with the technological product. I mean, in order to ramp this up, which will be the key driver because there are some people that are thrilled with the performance so far and there are many others that think it needs to get better, and I see from my group in Silicon Valley, (indiscernible) generation after generation. You know, I have line of sight to multiple leapfrog technology improvements going forward. If I had to go through an SE approval process like cigarettes to slow that down on the technology portion of the product, that would be a very draconian and have a very negative impact. So that’s one example of draconian regulation, so maybe that’s the best example.

Marketing restrictions – you’re not going to get indoor bans out of the FDA, but I think that is a kneejerk reaction of everybody so desperately waiting to hear from the FDA on how to perceive this. So we—there were a number of indoor ban restrictions that were discussed across the country last year at the state and municipality and city levels. Those all kind of got pushed back because they knew deeming regulation was coming. Now with deeming taking longer and longer and longer, you’re starting to get some kneejerk reaction, so we’re hopeful that the FDA will provide some clarity on this soon, and in a reasonable manner.

But you know, if you take an e-cigarette and you tax it like a cigarette and you put a smoking ban on it, you will significantly enhance trial or you’ll take away the reasons for the people who are using them in the first place, and they will go back to smoking cigarettes, which is completing illogical to me from a public health perspective.

Vivien Azer – Citi

Understood. Thank you very much.

Operator

Your next question comes from the line of Michael Lavery with CLSA. Please go ahead with your question.

Michael Lavery – CLSA

Good morning. So just to clarify, I understand for Newport Gold there’s a lot of levers such as direct mail or point of sale and things like that, but is the price point right for trial, or is that one of the adjustments you are considering making?

Murray Kessler

Well, I’ve been very careful in the way I’ve chosen my words. Will we test price incentives and all that as part of a mix of trial? Of course. I just don’t want anybody to be nervous or spooked in that there’s going to be some price war triggered out of the Gold segment. It’s too small and it’s only one portion of the equation, and we’ll be very careful in any of those measures that we take.

So will we look at price? Of course we’ll look at price. We’ll look at everything, but I don’t see it being disruptive, is the point I’m trying to make.

Michael Lavery – CLSA

Okay, that’s helpful. In terms of where it’s done relatively better than others, have you seen a geographic difference? Is it stronger in your core markets or it is underperforming or outperforming there? How does that look regionally?

Murray Kessler

Well, our business always does better in our core markets across the board, but the awareness trial issue of consumers understanding that it’s a less than full flavor product, I’d say is a broad scale issue and we’ll get after it.

Michael Lavery – CLSA

And then just on e-cigs for the brand conversion that you’re talking about in the U.K., you mentioned the costs associated with that. Is that primarily the brand impairment or is it just ordinary marketing to build awareness for the blu brand, just as you would have done here? What’s the right way to think about what you’re up against there?

David Taylor

Well, it’s both. We’re amortizing that SKYCIG brand over 18 months, so that charge that we took in the fourth quarter will repeat itself for the next year and a half, but that’s not all the impact on the financial segments. We will also make investments, cash investments in advertising and other marketing initiatives in order to establish blu as the top-of-mind brand, so that takes some money and investment in the U.K. And gaining distribution in the U.K. will be inherently more difficult than gaining distribution in the U.S. because we were able to take advantage of our existing sales force and distribution network here, where we have none internationally.

Michael Lavery – CLSA

And how quickly are you looking at the rest of the EU? Are you simultaneously considering moving into new markets on the continent, or is it do this in the U.K. first, get that established, and then start to move from there?

David Taylor

Well, we’re looking at various different countries on the continent, but we want to do the U.K. first and then move it to the continent. But the landscape is changing pretty rapidly in various western European countries, both regulatory as well as the usage of the product, and we don’t want to be left out completely in the cold, but we’re going to approach the U.K. first and then move to the continent. But we’re looking at those now.

Murray Kessler

It will be very deliberate, and we know it worked here and we want to prove to ourselves that it works, and we’ll start with the U.K.

Michael Lavery – CLSA

That makes sense. And then you mentioned that they have some proprietary technology that you could—that you’re planning on bringing to the U.S. You also mentioned some technological advancements on blu that are coming this year. I realize you probably don’t want to show your hand too much, but can you give any sense, are those nicotine delivery-related, are they flavor related, is it additional features above and beyond the ordinary use of an e-cigarette? What’s the right way to think about some of those things that you’ve got coming down the road?

Murray Kessler

The answer is yes.

Michael Lavery – CLSA

All of the above? Okay, thank you. Thank you very much.

Operator

Your final question comes from the line of Tom Mullarkey with Morningstar. Please go ahead with your question.

Tom Mullarkey – Morningstar

Good morning guys. I have a question regarding your thoughts on e-cigs and harm reduction. If you look at your online sales for blu, do you find that repeat purchasers eventually reduce their nicotine levels with a cartomizers that they buy, or if you don’t have that data, can you give maybe a mix of the cartomizers that are no nicotine or low nicotine SKUs?

Murray Kessler

We have not reported on that, and I just can’t answer that question sitting here. No nic is a very small portion of—very small portion of the business. I thought you were going to ask about repeat on the internet, which is all repeat. One hundred percent of our internet sales are repeat, and we know those consumers may come back in all the time. But I’m not—you know, we have studies in place and studies that we’re fielding that will be specifically addressing those kind of harm reduction issues and not in an anecdotal manner like that, that will be controlled longitudinal-type studies that measure people’s performance. Some of those have been published, and we’re involved with more that are going into the field as well as we are fielding research and studies that we’ll try to share some of it as it goes along on things like environmental—second-hand vapor and things like that which basically has no constituents in it at all. It’s similar to room air and is nothing like a cigarette as we try to challenge some of these indoor vaping bans that make no sense because there is nothing in the vapor, other than appearance.

So I understand your question. I think it’s a good question. I don’t think a financial conference call, though, is the place to dig in too deeply on harm reduction, and we want to keep that to a science-based discussion.

Tom Mullarkey – Morningstar

Okay. Thanks, Murray, for that. Can you provide any update for your fourth quarter efforts to expand into non-core geographies and your expectations for 2014, if they are any different from what you mentioned in your analyst day midyear?

Murray Kessler

No, no different. They continue to perform beautifully and grow share. You know, they’re smaller in general. Remember, we’re 14.9 share nationally. That’s a much more significant share in core markets than it was when we started down around the 4 share in the other markets, so they’re continuing to gain traction and they represent a long-term opportunity, and those businesses continue to perform beautifully. We are making—not only growing but we’re making more money in those markets today than we did when we started the process, so it’s been a real success story for the company and I expect that to continue. It’s a contributor to the stability of our Newport full flavor menthol business.

Tom Mullarkey – Morningstar

Thanks guys.

Operator

Thank you. There are no further questions in the queue at this time. I’d like to turn the call back over to Mr. Kessler for any concluding remarks.

Murray Kessler

Well look, I think you need to step back and really marvel a little bit at Lorillard’s long-term performance. The company has continued to perform and outperform year after year, and 2013 was one of the best year’s we’ve had. We delivered double-digit EPS growth, well above our peers, gained market share for the 11th consecutive year, and made a lot of investments and good decisions for the long term. Our track record on new initiatives and new products has been outstanding, and we have a 90% success rate, and we’ll get Newport Non-Menthol Gold right. I’m confident in it as well, and I’m a believer in the e-cigarette business.

I think the future for the company is very bright. I’ll share some of those long-term successes and why I think Newport and the Lorillard company in general succeeds over the long term next week in CAGNY, and I hope to see many of you there. Thank you for your interest in Lorillard.

Operator

Thank you. This concludes the Lorillard Inc. Fourth Quarter and Full-Year 2013 Earnings conference call. For a replay of this call, please dial 855-859-2056 in the United States, or if dialing internationally dial 404-537-3406. The conference ID number that you’ll need to enter to join the replay is 35102157. Again, the conference ID to join is 35102157. Thank you. You may now disconnect.

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