Lorillard, Inc. (NYSE:LO)
Consumer Analyst Group of New York Conference Call
February 18, 2014 05:30 PM ET
Murray Kessler - Chairman, CEO and President
Neil Wilcox - Chief Compliance Officer
David Taylor - Executive Vice President and CFO
David Adelman - Morgan Stanley
Well, thank you. Let me save the best for last here, Lorillard is presenting this evening. And we thank them for their sponsorship of dinner and continued sponsorship of the CAGNY Conference. So thank you in advance. You can enjoy some warm weather outside as well. So Lorillard has been growing strongly in the U.S. tobacco category not only with its leading Newport brand on the Menthol category, but also its leading e-cigarette brand blu.
So here to present for the company is Chairman, CEO and President, Murray Kessler. Now I’m going to turn to Murray now for the presentation. Thank you.
Good afternoon everyone. Let me just quickly give you the, this works -- encourage you to make sure everybody has read all of our disclosure statements and what we’ll be doing over the next period of time, as I’m going to review the business a little bit. I’m going to do a little differently than I’ve done it in the past.
And then joining me will be Neil Wilcox, who is our Chief Compliance Officer to talk about the regulatory environment; David Taylor, our CFO to talk, give you a financial update. And then during the Q&A period we also have our General Counsel, Ron Milstein and Randy Spell, our Executive Vice President of Sales and Marketing and the group of us can answer questions, both here and afterwards if you could join us for dinner.
Okay. So, if you don’t know the company, those of you who have been here and have seen me present before have heard a story of over a very long period of time that my predecessor before me that Lorillard is a company that consistently performs well, year-after-year, year-after-year, year-after-year. And so doing has built the number two cigarette brand in the United States with Newport Menthol cigarette, total Newport brand, the number one menthol brand in the United States and the number one electronic cigarette very quickly in the United States with blu eCigs.
And if you look at that track record of share growth, you’d be searching long and hard throughout the presentations you have seen through this conference and will continue to see to find the brand as big as Newport that grows market share year-after-year-after-year and in fact 2013 was our 11th consecutive year of market share growth and we fully expect that the year we’re at, we’ve just started will be our 12th consecutive year of market share growth. And if you turn that into volume, remember cigarettes are a declining industry, declining around 3% to 4%.
So if you go back, all the way back to 2005 through today and you look at the volume performance and the category that’s declined somewhere between 2% and 4% each year, our volume is actually bigger today than it was back in 2005, we’re 4 billion sticks bigger as a company than we were then. And remember we’re only got a 40 billion stick company and so that’s about 10% growth during that period of time.
Well conversely, they are two players in the cigarette industry in the United States; the biggest category player has declined 56 billion sticks during that period of time. And the second biggest player has declined 43 billion sticks during that same period of time and both of those declines were bigger than we are as a company.
Because our volume is stable and we have been able to do that consistently over a very long period of time and the industry is in decline, our competitors overtime have had price increases to offset those kinds of declines and because we have the stable volume base we were able to capture that profitability increase and outperformed as we outperformed the S&P 500, you can see our performance over the past dozen years that we’re up six-fold to the S&P 500, again consistent, consistent, consistent performance.
And as a public company we’ve only been public since mid 2008, so just a little over five years. Our enterprise at the time that we went public was $12 billion it’s $21 billion today so a $9 billion increase in shareholder value during relatively short period of time. So what I wanted to do for those of you who are new to the story and I know you like to look and cover quarter-to-quarter, but we are a long-term consistent success story. And when I first joined the company I made a point of trying to talk about the differences of why Lorillard succeeds over the long-term and I wanted to reiterate that today now that I have been in the company about three years because I have come to appreciate it even more.
Six primary reasons why Lorillard wins consistently over the long-term and I will go through them in more detail, but let me just rattle them off here. We are a very focused company on our core business. We have a passion for brand building. We have a very lean cost structure mentality notwithstanding that we are sponsoring the dinner we make an exception every once in a while. We are pursuing adjacencies, but very close into the core and we do it without distracting ourselves from what we know makes the profitability on our core menthol business. We are a shareholder focused friendly company and we recognize that people make difference isn’t just something you put on a slide to make yourself feel good that people really do drive the performance at Lorillard. So let me walk you through each of those.
Newport brand, which is a primary driver of our company has $6 billion in net sales and $10 billion in retail sales that makes it one of the biggest brands in the United States, put that in perspective Newport as a brand is bigger than Coca Cola Classic in the United States at retail. And in that category with hundreds and hundreds of SKUs, two of the top five fastest moving SKUs in the category are Newport.
The importance of that to the company is 75% of our sales and 85% of profit come from not just Newport, but come Newport full-flavor Menthol cigarette, I’m even getting more focused because this is what drives our business model. And within that, it's not just full-flavor menthol cigarette, it's the full-flavor menthol cigarette primarily in urban areas East of the Mississippi, it’s the heart and core of our business, and that group where we're at 73% market share consistently overtime, is the most stable segment of the entire cigarette industry.
So, over 2008 to 2013 our five year compound annual growth rate has been declining just at about 1% and if you took that piece of the category, the balance was declining; the rest of the industry was declining about 5%. And that business model that I spoke about and we also relentlessly keep a very, very narrow product line.
So, if you take our entire company, there are only 43 items offered in the company in cigarette business. And that you can see as a third of what, basically a third of what our competitors have and if you take it down to just a biggest brand for each of them it’s higher in Newport lines as 16 SKUs and maybe 2 or 3 or all of the volume. And that's just a fraction. What that does is allow us to have extremely efficient manufacturing, long manufacturing run, extremely focused sales force and with that comes tremendous consistency in retail space and focused brand management.
So, the first thing you need to know about Lorillard if you are thinking invest in Lorillard is understand we are a very focused company that's what we focused on. And the hell of how we do it is brand building. We are all day everyday thinking about how we passionately build brand equity. And we do that through a consistent advertising campaign with Newport pleasure that has been running for over 40 years that's distinctive and recognizable and has proven messaging. We relentlessly and passion make sure that we have a differentiated product that is superior to everything else on the marketplace and is cigarette and cigarette and cigarette, they are not all the same, they have very different taste profile and Newport is a very recognizable different full flavor unique taste. And consumer prefers taste and blind taste. Thinking them from a merchandising standpoint, we are sold in 275,000 locations with great visibility and we have a fantastic sales force dedicated to that and I believe they have the best relationship in the industry.
So what we’re doing, on brand building ultimately gets measured in a brand equity score that I prefer to as a net promoter score, a lot of companies use it and for those of you who aren’t familiar with a net promoter score, you go to somebody and you say rank one to 10, and being the highest, would you be like laid a recommend Newport to a friend. If you are nine or a 10, we consider you a promoter of the brand, if you are seven or eight, you are neutrally just through that score out, and if you are one to six, we consider you a detractor.
We take the promoter subtract out the detractors, you got a net promoter score and Lorillard the Newport brand comes out with a 61% net promoter score which is above the cigar average, cigarette average, chewing gum average, the overall CPG average is almost three times higher than the overall CPG average at 23% a very, very strong and powerful brand equity. And when you have very strong and powerful brand equity and you focus on with brand building, you don’t have to discount as much. And Newport is virtually an undiscounted brand. 97% of Newport full flavor volumes is sold at an everyday retail price and compared to our menthol competitors, the number two menthol brands out there is about half the volume is sold at it’s regular retail price and the number three brand about 63% a dramatic difference.
So when you are focus on the brand and the product quality and build equity and get a strong net promoter score and you do all those things that build that brand up there, you don’t have to discount, you went up commanding a premium price. And Newport is the most expensive cigarette of the mainstream cigarettes on the market. And this just average to retail pricing so you can see that not only are we the highest price market and command the highest price on the market for the last three years that the Newport brand is slowly been increasing an average retail price, while our competitors’ average retail prices over the past two years have been virtually flat.
And then if you go through that same litany again and you build that brand and you don’t discount it, you have virtue brand royalty, your brand becomes more and more relevant. And that’s what the really exciting part about the core businesses for Newport is that our relevance is growing.
So if you measure market share on that 11 consecutive years I showed you. And this is a different stores, this is a national survey on drug using and health showing our market share having grown from about 12 to 15 pretty close to the measures that we show. If you look at the 18 to 25 age group, you can see we are well ahead of that having grown from 19 to 23. So then in theory overtime with a relevant brand your 15 approaches the 23 bodes well for the long-term future of the brand okay.
So brand that’s focused on equities that commands the premium price that is very hot and relevant today is the core fundamental reason of why you invest in Lorillard. Everything else I will talk to you about today is upside opportunity of that but that’s the reason and the stability and their growth and the engine and the financial engine for this company.
Now within that we don’t get lazy we operate with a very lean cost structure, we are the number three in size, as I said here we’re significantly smaller than the top number one and number two cigarette in the U.S. but despite that back we have lowest controllable cost per pack and we have the highest operating income per pack. So I mean philosophically at our organization there is a emphasis on controlling cost and doing things in a down sized reasonable manner and because of that you never have seen Lorillard have to do the massive cost savings are restructuring projects because it’s inherently in our structure.
Four, we are pursuing growth opportunities but we are very focused at keeping those closed end and we are also very focused on not distracting from the core, the way we do it. But we focus on four areas, building Newport share in non-core geographies so that great brand I told you about East of the Mississippi is our opportunity West of the Mississippi and we’ve been working hard against that. Two, trying to make our way into the non-menthol segment. Third, I talked a lot about full flavor menthol, we are not so good at less than full flavor menthol, we are not even close to number one in that area so strengthening that. And then fourth, opportunistically pursuing non-cigarette adjacencies and we’ve done each of them.
Geographically this has been a home run for the company, three years ago we started, we took markets that were declining, they were profitable but they declined in profitability each year. A few years later we've had complete dramatic reversals in volume trends, those markets are growing, their market shares up a couple of share points and they are significantly more profitable than they were a few years ago. So, geographic expansion was one of our first strategic initiatives and was acute success.
The next was Newport non-Menthol Red, full flavor non menthol business and we had tried that a couple of times in the past on successfully. We got it right. We got the product right and today it's almost a share point for the company, $2.5 billion sticks for us, that's a lot. And we've been able to ease the pricing of every year, we launch with a very attractive introductory price. And today that price is 35% higher than it was when we launched and we're making significant operating profit in the non-Menthol segment. And this was 46 billion sticks within the total industry that we had a zero share in prior to the launch of Newport Red.
Likewise our initial effort to strengthen our less than full flavor menthol business, we made only some small moves here, but we launched smooth selected. Been about two-tenth, three-tenth per share point with very little support has done extremely for the company, didn't get discounted at the level is that we needed to do on Newport Red, when we first launched, so very profitable right out of the gate. And this is the first touch at it, but it's helpful, get back to (inaudible) of the business growing again. And there will be more news to come here, although for those of you who are following our industry, there is a very challenging process to go through from an assay standpoint to get approval, to bring improvements to the market, but you can be rest easy knowing that we are canceling them and we have new initiatives lined up for years to come.
We were the only company to get approval on an FB basis to launch a few products and our next phase was in the non-Menthol segment with new more non-Menthol Gold. I'm on the call last week I talked about Newport Non-Menthol Gold that we had tremendous distribution, we have had great feedback from consumers that have tried it, but our trial levels were lower than I like. And I’m pretty clear on the reason why and we’ll be tackling those issues going forward. I don’t think it’s a massive price issue, I think there is a confusing issue that we are just not known as a full flavor or as a lessen than full flavor company and certainly not a less than full flavor, non-menthol company. So we’ll be working on that.
This opportunity is huge for the company; it’s the biggest segment in the cigarette industry. And as it stands today, we have a zero share in that segment; it’s 84 billion units. And we will, as we always do, we’re committed to the long term and I’m confident we will get this right and a little bit significant contributor for the company.
Likewise our entry in eCigs has been another success and I’m very purposefully letting you see that, that we strategically over the past few years have about 90% success record in these strategic initiatives, whether it’d be Newport Red geographic expansion, Smooth Select or blu eCigs, the company has sort of one right after another has launched some great successes. We paid a $135 million about a year and half, two years ago to buy blu eCigs at the time that world thought eCigs wasn’t much of an opportunity.
We rolled it out from 10,000 outlets to 136,000 outlets. We turned on national television and friend, made some product improvement and enhancements and put quality controls in place and increased manufacturing capacity and have begun to build brand awareness in a tremendous and meaningful way. We had two celebrities that are spokes people for our brand and Stephen Dorff and Jenny McCarthy and I have been in consumer package goods marketing for 35 years. And it’s the first time that the celebrity endorsers come to us. And both Stephen Dorff and Jenny McCarthy because they believed in blu and liked the product, wanted to be representative for the brand and there have been plenty of others. Likewise, we go out there and our same effort and passion for brand building and not only with Jenny McCarthy and Stephen Dorff but we reach out to events to help build and create awareness for this brand; and I will just give you a little sampling of what that looks like.
So, if you look at the brand building efforts that we have taken on blu in just a short period of time over the year and half, we’re now up to 80% awareness of blu, just a simple question if you ever heard of blu eCigs and those are -- that’s a big score. And then if you look at the sort of the incidence measures of how the category is doing, this is a recent incidence study we just did that compares eCigs from way smokeless tobacco to Snus. 47% of adult smokers have tried at this point an eCig versus 24% for MST or 16% for Snus, 24% have used in past three months, 15% used in the past seven days, so divide the 15 by the 47, you will see that you have got 30% of the people that have ever tried that’s using it on a weekly basis at this point. So the question is repeats; the repeats are there. And it’s a question over time of the amount that is replacing cigarette consumption. But clearly, this has had an impact and I estimate that impacted about 1%, accelerating the cigarette decline by about 1% but some big numbers.
I also think you could read the 47% and say how big can this be if half have already tried it, but a lot of these folks have tried it in earlier generations of the product. It has gotten better and better and better over the past three or four years and will continue to do so because I still think from a technology standpoint eCigs are only about 30% of the way there.
And what we do is we ask definite purchase interest from somebody who tried the product four years ago for the first time versus three years, versus two years versus one year and you see dramatic increases in definite purchase for people who’ve tried more recent generations.
And you take all that brand building and the same thing, the same way we do and build the Newport brand over time and you find the same kind of success rate in blu which was very low shared about a 10 share, when we bought the brand, it’s today just under a 50% share of the U.S. market and again selling in just over a 130,000 retail outlets.
We also completed another e-cigarette expansion, our first step in global expansion with the acquisition of SKYCIG. We bought SKYCIG because it gave us capabilities to be able to have a platform to grow on it. It’s not the first of a series of acquisitions, but this group had a demonstrated track record of bringing innovative products to market and they did in a blu like way; it even looks like blu. And it provides like I said a platform for further geographic expansion. And importantly, if you know me, I’m a huge believer in tobacco harm reduction and it gives Lorillard, not only a seat at the table in the United States on harm reduction, but a seat and the table and harm reduction in the world.
Now we have gone to work on SKYCIG and I announced during the earnings call that we think the biggest opportunity is to evolve SKYCIG to blu and build a global brand. So, you’ll see we’ll be launching in UK, mid-year, roughly mid-year and it will be transitioning blu from SKYCIG in the beginning and eventually the SKYCIG will go away as we rebrand and eventually it launched to additional markets and there will be some investment involved with that, but we think that's an investment that’s worth making because we believe electronic cigarette is a global phenomenon.
Shareholder friendly policy, this one is easy as you know at all, we believe our job is to generate as much cash as possible and give it all back to shareholders. We’re focused on generating cash flow, we payout 70% to 75% of our earnings in dividends, the dividend growth is tied to our earnings, a couple of people in the hallway here they ask me when is your, last year you announced your dividend during your earnings release that's timing of board meeting, I still make a 100% guarantee that our board meeting is in the next two days. So presumably that would be when you would see our dividend increase which is always in the first quarter.
From a capital spending standpoint, we don’t take much capital for the size corporation we are we have one manufacturing facility, access cash from operations beyond the dividends that we payout. We generally redirect after capital back into additional share repurchases and we’d increase leverage along the way as well to further increase share repurchases. And while we don’t give guidance, we try to be a very transparent group and tell you like it is at all times within, so you have a clear understanding of our business.
When you take those dividends and look at what we've done in terms of dividends and in terms of share repurchases, we've reduced our shares outstanding since going public by 30% that $5 billion in share repurchases and through that 70%, 75% dividend policy growing along with our earnings increased, we had a 79% in dividends paid before anything that might happen in the next couple of days.
And then finally and recognizing that people make the difference. We’ve actually, we are actually a very stable company, but we made so many, some significant changes. We have many talented people within Lorillard. And we have changed out about 40 positions, 40 management positions over the past three years. And I am happy to say that we stuck a great balance, it’s been about half of those changes have come inside the company and about half of those have been bringing in some fresh and new talent from outside the company.
The second way I look at net promoter score and I look at it from a brand equity standpoint, but I also look at it as a measure of commitment within the organization. So we ask the same question to our employees that we ask to our consumer. With the consumer I say, how likely are you to recommend Newport to a friend? With company on the measure of commitment, I say how likely are you to recommend Lorillard to work as a place to work?
And generally speaking bench markets in the industry say, a high performing company has a 23% net promoter score as a measure of commitment among employees, when we started our strategic plan about three years ago that number was 32%, we did it again at the end of 2012 and that number doubled to 65% that’s my way of saying, our organization is full of passionate people that are focused on building the Newport brand on blu eCig they love working at Lorillard and there are driven just exceed and build value for you.
And they’re rewarded for building value for you in a couple of different ways. On the short-term and I want you understand sort of this natural friction we build in on purpose is sort of a flip balance between market share and operating earnings, they directly work against each other, but you got to do both on 40% operating profit, 40% market share and then 20% individual goals and then from a long-term standpoints of senior executive, 50% to 80% of their compensation comes in stock and they have shareholder requirements, they have to hold it for a long period of time and there is performance elements to that tied to EPS.
From a governance standpoint, we have a very passionate and committed board that makes sure that our governance stays strong. We have a declassified board, majority voting, no hedging policies, stock ownership requirements; we have a lead independent director, no employment agreements among our employees and no change in control for [ourselves].
So for us, we are just about performing for the long-term. So again, if you add all of those elements up, I think you can start to see why a company could year-after-year-after-year succeed not have a good than a bad year, it’s year-after-year-after-year outperforming. And for us, we measure that by a double-digit total shareholder return, that’s my commitment to you as measured by EPS growth and the dividend yield. And we get that by focusing on the core first that’s what we do, how we do it is brand building we do also by managing a lean cost structure we do it with incredibly talented people, we’ve carefully reached for growth and then we generate a lot of cash and we give it all back to you.
So for that you should be running right now because there has been a little dip in the stock and it’s a buying opportunity, but some of you would say yes but I get nervous about the regulatory front because anybody who follows the Lorillard story knows that we outperform on fundamentals, but people worry about the menthol issue or they worry about [deeming] regulations on eCigarette sort of put those concerns at ease.
I introduce to you, Neil Wilcox our Chief Compliance Officer. Neil?
Well, good afternoon and I am going to give you an update on the challenging role of FDA regulation as it now applies to the tobacco industry. Fundamentally there are two primary issues that give some worry on the long-term success of Lorillard. First is the perspective of FDA on the potential for menthol to have an impact on public health. Second is the deeming regulation, the electronic cigarettes that we expect quite frankly any day now.
As you are well aware, about a year ago, Mitch Zeller became the second Director for the center for tobacco products. He has no friend to tobacco, but in the past year he has shown that he has driven decisions going forward and he has reduced uncertainty in regulatory arena, which we appreciate a great deal.
He has stated on many occasions that the regulatory framework with which he has to work and FDA is quite confining and this is a good thing because when you're not in FDA, you can pretty much stay whatever you want, but when you're in FDA you have rules that you have to follow and he has acknowledged that and he is working within those rules and has stated that he has committed to follow the sign.
So, what's the status of menthol and cigarette? Last July 2013 FDA published two documents one was the PSE, which is the preliminary scientific evaluation on menthol, the other was the advanced notice of proposed rulemaking. The [PSE] was FDA's statement on their concerns and assertion over the potential impact of menthol on public health. They agree with us that menthol is extremely safe from a hard science perspective. There are just tons of data on that. Where we differ with FDA is they feel there may be an impact on behavioral signs with menthol specifically with initiation dependent and substation that there may be some connection between menthol and those behavioral sciences.
The ANPRM was merely a series of questions that FDA asked the public on Menthol and ask the public to respond with information that FDA may be able to use in the future with making decision. And in response to that enquiry by FDA about 175,000 comments were submitted to a docket and FDA is committed to reviewing each and every one of them.
Lorillard’s view on the PSE assessment is well known. We feel that the PSE is fundamentally (inaudible). It lacks in transparency, particularly as it applies to data and criteria that were used to select studies from which the data were used to make their assertions. FDA’s conclusions were - at best, the data that they (inaudible) do not come from strong scientifically based studies. FDA used an interesting freight, based as that menthol is likely associated with these behavioral concerns that they have. They admitted that they could not find a nexus between Menthol and it’s behaviors, in other words no causation, no cause will affect just a likely, in other words in assertion and assumption.
Remember that FDA is a conservative regulatory body that’s just their nature and when it comes to public health, they have to take the conservative road and say to all of us. We are concerned that these effects maybe there. And now it’s up to the science to prove that and that’s why they ask for additional information. During in the writing of the PSE they ignore some studies that were well controlled and scientifically based, while at the same time sticking data from certain studies that were not peer reviewed in the published which we found kind of interesting. All-in-all scientific activities did not support the PSE. One might ask so what’s going to happen with FDA in the future. We are confident there is no action on FDAs, excuse me on menthol for some time.
Mr. Zeller has stated that the center for tobacco products has met the congressional mandate on menthol. They form [Tic Tac] Tic Tac produced the report on menthol. FDA published the PSE and the ANPRM and they are done. And Mr. Zeller last fall in more than one talk that he gave stated that very, very clearly they don’t have to do anything now, their obligation is done and they need more information.
As latest this past January, January of 2014 Mr. Zeller made several quotes in a interview that he had for he said that he would not try to pre judge any potential action because he is simply in the information seeking mode at this time, in other words they don’t have enough data. They want more evidence, they want more information before any potential action to be taken and the potential really important here because they don’t have to take any actions whatsoever.
Lorillard’s position is well known. And we feel our position on menthol and its relationship to these behavioral sciences is obvious and that is the scientific basis is supportive. And there is no reason to treat or regulate menthol cigarette any differently than non-menthol cigarette.
Further to FDA’s point as they are in the information seeking mode is the fact that they have funded the past studies as the population assessment in tobacco and health studies which will involve over 40,000 people over several years asking several questions on behavior related to tobacco including menthol. It points outs that no decision is going to be made to do anything for some time, because FDA has not only funded the past studies they funded several other studies and created intellectual and research centers all over the country. In any event we are fully prepared to respond to any action FDA may try to take on menthol.
So what’s the situation with deeming regulation of the electronic cigarette? As you know they are going to come out anytime now. And quite frankly we support regulations for e-cigarettes in certain areas in particular; minimum age purchase, laws restricting the sale of e-cigarettes to minors is appropriate, product quality and safety must be highest priority with these products. However any decisions that FDA make on a regulatory basis must be again from a sound scientific perspective and proportional with a potential for harm reduction in electronic cigarette.
Regulation should also allow certain freedom; the freedom for us to market, retail and online availability to make sure that we can send material to our adult consumers so that we can inform them on attributes and the advantages of the product. Flavors certainly should be, flavors that are attractive to adult, the adult smoker should be allowed and flexibility in enabling technological development. This is particularly important electronic cigarette because just in the past couple of years, the technology has increased substantially and in the next few years we can see the potential for tremendous technological development. And then if FDA treats electronic cigarette as the cigarette in their regulations, they will stay for innovation and that quite frankly will have a major impact on public health in itself.
We feel we are well positioned for opportunities. We have the FDA expertise. I'm very proud to say that we are the only company to get the potentially prevalent authorization for a new cigarette product. As you might well imagine there are two dimensions that, there is the fact that you need to have the scientific information there presented in a way that is well understood by FDA. But there is also an art to that science as well into submission that FDA will authorize.
FDA's mandating to the Food and Drug Act to follow the science. In other words they must use data from well controlled studies to make their regulatory decisions and we have shown FDA and so have others that there is a data simply aren't there to regulate menthol at this time.
E-cigarettes quite possibly may represent the most important harm reduction potential in the history of cigarettes. And there are millions of people around the world that have testimony to that effect and hopefully the regulators are listening to them. Most importantly, electronic cigarette regulation must be intelligently flexible.
And in summary, we have great communication with FDA, we meet with them frequently and have established a great relationship over the last two or three years. As I said, the only SC orders to be issued for cigarettes, we have achieved. We look forward to continuing working with FDA and electronic cigarette regulations. And we have communicated our views that are indeed show robust science behind Menthol and the lack of effect of Menthol on behavior. We are well prepared for our regulatory requirements and actions as FDA moves forward. Thank you very much.
Now, I’d like to introduce David Taylor, our Executive VP and Chief Financial Officer. David?
Thanks Neil. Don’t worry, I’ll try and go quickly through it. Murray has already explained Lorillard’s formula for success that has remained unchanged for decades. And it still remains unchanged with industry leading fundamentals in terms of volume and pricing combine that with a lean cost structure and our focus on returning cash to shareholders. It all adds up to remarkable story, and remarkable story is delivered like this.
Net sales over the past five years increased 7.3% on a compounded annual growth rate, operating income of 7.5% for year and EPS of 12.8% per year. And what does that allow us to do? It allows us as Murray said, earn cash and give it back to our shareholders. Cumulatively we’ve given back roughly $9 billion since we were spun off from Loews in June of 2008, in the form of both dividends and in share repurchases.
2013 is no exception, another in the long series of successes, net sales up again 7.2% this year, operating income up 7.8%, EPS up 10.6; all terrific performances in a very difficult market.
Now, bank a lot of cash and what do we do with it. Capital expenditures are reasonably modest as Murray indicated. We expect those to be now $70 million to $80 million per year neighborhood moving forward. We’ve made a couple of small acquisitions in the e-cigarettes space and Murray indicated we’re not on an acquisition base in e-cigarettes, we bought blu to get into it and we bought SKYCIG to give us a launching pad for global expansion. We don’t see a series of further acquisitions. And we will fund the working capital necessary to fund those kinds of growth initiatives but also we do with our cash.
First and foremost and primary we give back our shareholders in form dividends. Our dividend policy is to payout roughly 70% to 75% of our earnings on a long term basis to our shareholders. You see that annualized dividend rate increasing at roughly 12.5% compounded rate over that period that we spun from Loews.
And what else do we do with the cash? After dividends and then kind of capital needs, we have earmarked all that cash for share repurchases, both operating cash as well as the proceeds from borrowings as we have levered up the balance sheet over the last several years. As I said, a total of $9 billion in those two forms.
And we are currently involved in $1 billion share repurchase authorization which is not yet complete. As of December 31, 2013, it was roughly $314 million remaining on that program that will get expended in 2014.
As I said before we have levering up the balance sheet since the spin from Loews. Our target leverage is between 1.5 and 2 times, EBITDA we do that because we know we need to be in that neighborhood to protect our investment grade ratings. And so we don’t see a fundamental change to that currently without some fundamental change in the environment. Right now, we are at roughly 1.7% -- 1.7 times EBITDA in terms of leverage ratio. So, there might be a little bit room to go up. The weighted interest rate on that $3.5 billion of gross debt is just under 5%.
In the past, even though we don’t give specific earnings guidance, in the past you’ve heard me describe various different earnings scenarios that might be appropriate for Lorillard depending on our environment, depending on what we are able to accomplish. Let me just go through those again. The one on the left, in the event that we were in another very competitive promotion environment, one that’s characterized by lots of crowded product introductions with heap discounts and lots of discounting by the major players in the industry that sort of heightened promotional environment, if we had no new products, if we were only buying shares with operating cash flow and there was no profit contribution from our electronic cigarette business, you might see us as a mid single-digit EPS grower under those kinds of circumstances.
Now the same kind of circumstances in sort of a normal pricing environment, one that we were able to realize net pricing similarly the way we have been to in 2013. I would call that more of a normal rational competitive environment. That’s where I think we find ourselves now.
But if we were in that environment with no new products, share repurchases only from operating cash flow and no contribution from electronic cigarettes, just like the first time that would put us in the high single-digit EPS growth neighborhood.
Now there is upsides to either of these scenarios and that is if we get meaningful profit contribution out of new products, if we are able to use the proceeds for incremental borrowings to increase for all those share repurchases and if we were to get a meaningful contribution in terms of profit out of our electronic cigarette business, all those are individual and combined upsides to that high single-digit EPS growth rate and that put us in the double-digit earnings growth rate.
So where are we? As said before, we think we’re in a sort of a rational competitive environment where we would expect to see normal pricing realization. We still don’t see a significant contribution in short-term from our electronic cigarette business. I think we’ve been clear and consistent about that, we’re still in investment mode there.
We do have the benefit currently of the additional leverage driven share repurchase program that we’re involved in now. And we do have new products and we are bullish on those in the long-term and we’ll get those right. But currently, there is not going to be a significant huge profit bump from that new product introduction line.
So, we also have these positive factors in place that I just described. Share repurchase program was increased with the proceeds of the $500 million debt offering that we did last May, that partial settlement of the NPM dispute provides us as well as the rest of our competitors, some liquidity and continuing earnings benefit moving forward. The obligations under our Growers Assessment will end for us, just like the rest of the competitors in the third quarter 2014 and we incurred charges of a $120 million in 2013 for that Growers obligation.
And there are opportunities to improve the profit in our electronic cigarette business. So where are we? We think that all the building blocks are in place to continue that long track record of superior financial results in our industry.
We’re positioned to deliver robust earnings growth moving forward and we remain committed to rewarding the shareholders with cash returns.
And with that any of the panel would be happy to answer questions.
Thank you. I had a few related questions on e-cigarettes; the first would be that as we’ve seen the deceleration in the growth rate of the category, which you’ve addressed already, are there any changes that you are making to the product maybe to better address what consumers are looking for? And then I guess related question would be without getting into competitive launches, you see competitive launches from views, the brand that product maybe to be enhancing the growth rate of category, do you see an acceleration to category in ‘14?
Well, from my perspective, I don’t believe we've seen a deceleration of the category. I think you saw a heck of a lot of within the context of the category growing this year, there was huge distribution builder, there were no e-cigarette companies national a year ago and now there is. So, part of what we were doing as we were growing the business is consumers buying it on everyday basis, but part of it is every time he went into from 10,000 to 130,000 stores you put in get six vanilla flavoured, six regular of the rechargeable pack you put in three SKUs, six or eight of them in for the first time for the rechargeable kit and then you put in probably 24, 36 of the disposable units and to 130,000 stores.
So within the context in the second, third quarter a lot of that robust growth was just [building] the pipeline. So I think if you strip that out, you’d see that it continued from a consumer full standpoint for each and every quarter. I do think the second part of what you said is right that more competition right now is our friend. Will we have 40 AHR, probably not and it doesn’t really matter in a test market that we've seen with competitors with a whole lot of spending our volume sequentially grew at a faster rate that it did in the rest of the country to fight that competition and that's because the category tripled in those markets.
So, I think right now we are carrying the whole load of building the industry with more spending; it will help it grow more. And I think there is lot of it you can’t measure right now, because there is internet sale and there is [ape] shops and net, net and I am not pretty portrait person. This isn’t (inaudible) this is a real phenomenon.
Will it get better the other part on the technology absolutely? Was a lot of that initial trial on earlier versions that went so good? We are probably on blu 2.0 right now, I have line of sight to 3.0, 4.0, 5.0 those will be coming in every four, five months, you will start seeing significant improvements in areas that consumers want the product to improve. So I think it’s an existing future, I don’t think it’s a straight line, there will be flows, but I am pretty convinced that this is a big idea.
Nick [Moody] from the Press-Core, so few questions. First Murray the fourth quarter was pretty bad for consumption broadly speaking across consumer, but looks like Newport actually hung in there pretty well. I just wanted to get maybe some thoughts from you on the state of the consumer, your core consumer towards the back consumer?
And then the second question is on Newport Gold. Is there particular area of the country where Gold over indexes, I mean now that any learnings we can take away from which consumer group is kind of migrating towards and where there is opportunities to kind of get more cloud? Thanks.
Well, on the first standpoint, we had a very good quarter with Newport in the fourth quarter. We gained significant market share, we normally dipped in first quarter market share, we didn’t regained, I don’t remember the exact number, but I think we gained the full share point in menthol; we gained 0.6, 0.7 share points on the core menthol business. And I think our fourth quarter consumer takeaway on the Newport brand grew year-over-year in history that declined about 4%. I can’t speak to the other industry. We always kind of operate uniquely off to the side. And that was the whole point of my presentation that the focus on the brand and the relevance of the brand and the uniqueness in the demographics and the uniqueness in the geographies that helps that be so stable overtime. And I don’t see anything changing to disrupt that, non-Menthol Gold I had higher hopes coming out of the shoot for, because I felt like we got the product right and I still feel that way, but from an awareness standpoint it’s very low.
So I think it’s still a question of advertising better communication and breaking through. I don’t think it’s a deep discounting kind of a solution, so there is probably packing changes, advertising changes, more aggressive direct mail and things like that and you will see those kinds of things happen overtime, but it’s a long-term play. So I wouldn’t get you disappointed with the performance in Newport non-menthol gold right now, people got excited about it. But the point is there is a 90 billion unit segment that’s not going away and it’s there for us to carve a very small share goes a very long way for us and we’ll get it right.
How about mark it little bit further back, David Adelman.
David Adelman - Morgan Stanley
Murray just as a follow-up on Newport Gold, when Newport Red was launched its price gap to Newport Menthol was much wider I think than Newport Gold’s price gap is today, because Newport Red you have taken the pricing up overtime and now Newport Gold is at that level. How much of the issue with trial and awareness is simply that there is not as much of a featured discount with the launch?
Well I would go a step further to say it’s not just the price gap versus Newport but there is also more competitors at that price point. Well, we went with Newport Red we are at kind of a sweet spot and a number of competitors have also put products at that price point. So, we can experiment with some pricing. I'm sure that will be part of the testing, but I fundamentally think it's a bigger issue than just the price.
We have a lot of research in the field right now and we'll share that research as time goes on. But I just when I'm out and I'm talking. I know it's anecdotal and anecdotal is in fact so that's why we have all the research fielded. And I talked to store owners and all that, people don't know what it is yet. And it's difficult in the cigarette industry, because we can't do television and limited print but we can be a lot stronger than we were.
So, I think I've got some real clear on ideas on what we need to do and those will be happening, but you can't do those, if you don't have a good product. And the repay purchases among the people that try it within the 9 days on top two bottom.
So, we've got the product right and we'll make adjustments and like I said the opportunity is not going away. But in the context of why you should invest in Lorillard I think fraction compared to what you have heart gone for years, which is the core full flavor and Newport stability that generates the EPS growth and the returns on all that cash year after year after year. And that's just a remarkable story.
Right behind you Murray?
Ray I have two questions. First can you remind us what you're spending or marketing spend plans are behind blu for this year? And then as you were talking about Gold, are you planning on stepping up spending behind the brand to try and increase awareness behind that?
And then my second question has to do with your ability to build the global e-cig brand especially as you're competing with companies such as Philip Morris and their distribution. So help us better understand, how you're going to accomplish that? Thank you.
A lot of questions? The blu eCigs I won’t, what I said is we’re managing it towards the investment basically towards a breakeven and we can’t because the core Newport business is so strong. We can make the investment to grow that business. Well, I haven’t given specific numbers, I mean we’re up with the 82% awareness levels, normally be at an area, time right now or you might be able to pull back a little bit I doubt that. We’ll probably stay at the same kind of levels we’re at, because we've got multiple new competitors coming in and we’ll adjust our plans like we always do at our levels.
We will make the decisions for what's right for the brand and not for quarterly earnings, because we think the opportunity is so huge long term, but I don’t think that's going to have a meaningful impact one way or another on the numbers we will deliver in that coming year. The old are probably, they are already multiple tested that has started adjusting things. And there will be some other changes coming and we’ll make sure it’s a proposition that builds value for shareholders. Again I don’t think in 2014 one way or another you are going to see that have a meaningful difference on earnings.
The third one could take some more meaningful investment and that’s launching into the UK. That's the second biggest market, it’s actually more overdeveloped than it is here and we need to go fast.
So that will take some investment, I’m not prepared to tell you what that level of investment is today and we will manage it out, we go along to see what kind of success, but I’ll tell you they are excited about the blu brand. We've made the decision to modify and use blu, because we went into major customers and they all said we want blu. And they all have heard about the success in the U.S. and it’s globally known. So which is why we are using both brands at the beginning an old transition overtime. So that will be a bigger investment. But net-net, that doesn’t change the financial scenarios that David just outlined for you.
Maybe we could come here Thilo.
Murray, when you were here two years ago, you talked about Newport’s Menthol Lights as a growth opportunity; you’ve talked about it again today. The experience of Newport Gold has reduced your new ideas how much that could do for you or do you automatically believe Newport could be a [lifetime]?
Well, the segment is much smaller, but it’s also closer to our sweet spot, right, it’s a menthol brand. I mean I got two consumer hurdles to get over. One, they think Newport’s menthol and second, they think it’s full flavor. We are already out with both. So I’ll probably be a little bit more cautious after this learning with Newport Gold. But having said that, it doesn’t -- both of those opportunities, I am still excited about.
And I don’t talk a lot about it but Smooth Select sort of under the radar at a higher price is a good contributor already and it’s had a meaningful impact.
On e-cigarettes, you’ve got -- you even mentioned that the cost savings opportunity is clearly not your sort of final steady state optimal structure. How quickly can you use some of those levers? And then on the pricing side you said you got visibility to sort of 3.0, 4.0; are those likely to be similar price for the product today or would it have more upside in the premium direction or is it -- have lower costs, what is the trajectory of it?
I think -- well, maybe David should go at that one.
Well, in terms of the cost reduction opportunities in e-cigarette, we have been working on those all through 2013, we will continue to work on them in 2014. I hesitate to quantify them, what the opportunities are but we can clearly get more efficient in the supply chain in electronic cigarettes, no doubt. And in terms of what 2.0, 3.0, and 4.0 look like in terms of price point, I don’t think that decision has been made at this time.
No I don’t think it’s been. But if I had to answer the question right now, there is so much opportunity to take cost out of the supply chain like any other new technology product; it’s probably more about that than it is raising prices right now.
And I think we have time for one more.
Let’s take one more, yes. Vivien?
Vivien yes and I just want to point out that the entire management team will be available at dinner, so we look forward to talking to you then as well.
Thank you. Murray if you think about the e-cigarette category evolving as new competitors enter the space, it looks like there is kind of a fracture occurring in the category where there is two different kind of platforms, like your platform which is disposable and then kits and then you have got Reynolds and Altria going with kind of a solo platform. Can you help me think about how you guys are thinking about evolving your platform, do you need to converge your two product offerings to be kind of cost competitive in terms of offering value to the consumer?
I didn’t think you were going to say -- I don’t personally think the Reynolds platform, the Altria platform and our platform are that different. I think that they are both similar; they are all a similar structure. We have a broader kit with a rechargeable; they all have cartridges that get added back at the top of it. We also offer a disposable. I thought you were going to say about the eGo Tanks. The eGo Tanks is a different platform. So I think from a performance standpoint whether it’s -- and I can’t speak for Altria or Reynolds but when I think of technology, those eGo Tanks are gaining traction all over the world. If you walk down the streets of Paris, you are going to walk back vap shop, after vap shop after, vap shop; if you walk in Greensboro North Carolina, now our little town there is 4 or 5 vap shops that have opened up in the past few months. And the reason for that is that the Tank has much stronger battery power, creates a lot more vapor and it’s also a pretty cost effective way to do it.
So, when I think of technology, I don’t really, I understand I hear the hype that those guys talk about, but to me the technology gap has to get to where I can give you that same kind of performance in this that you can without a eGo Tank, because this is a more familiar form deals, I’m walking around with some magnet from your [next] at 400 bucks that like the size of a microphone.
So, to me that’s where I focus and I think about from a technology standpoint. And then separately, I think all of us would tell you that the nicotine delivery has still got a long way to go. But it’s not unrelated; the amount of battery power and vapor you’re able to generate gets that nicotine out of the cartridge and into the person. And that’s -- they all work hand-in-hand. And then you can get the particle size and things like that. But the first job is you’re still leaving way too much in the tank itself.
So, I’m being a little bit technical but there is just so much more for them to go. And I think it’s a mistake for anybody who is covering this industry right now to -- I think when you evaluated you say -- you see the leveling off. I don’t think that’s a prediction of the future, it’s a question of the next quarter’s earnings or et cetera. So, I don’t disagree with you, because I think it’ll have ebbs and flows, but I do think it’s a mistake if somebody reads this quarter versus last quarter and as the growth starts, because I just think we’ve just scratched the surface.
And I think whether it’s different technologies you’re hearing about, finally for the first time in years, there is a whole wave of -- different ways of skinning this chat that’s a ground floor around the world and we’re going to be part of it.
Well, thank you Murray, thank you Lorillard for dinner. We’ll leave it there, bring those things with them and we’ll exit the room. Thank you again.
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