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Reynolds American, Inc. (NYSE:RAI)

Q2 2010 Earnings Conference Call

July 23, 2010 10:30 am ET

Executives

Morris Moore - VP, IR

Susan Ivey - Chairman, President & CEO

Tom Adams - EVP & CFO

Analysts

Chris Growe - Stifel Nicolaus

Thilo Wrede - Credit Suisse

Judy Hong - Goldman Sachs

David Adelman - Morgan Stanley

Adam Spielman - Citigroup Investment Research

Christine Farkas - Bank of America/Merrill Lynch

Ann Gurkin - Davenport & Company

Karen Lamark - Federated Investors

Operator

Good day, ladies and gentlemen, and welcome to the Reynolds American second quarter earnings conference call. (Operator Instructions). I would now like to introduce your host for today's conference, Mr. Morris Moore, Vice President of Investor Relations. Please go ahead.

Morris Moore

Good morning and thank you for joining us. Today we’ll discuss Reynolds American’s results for the second quarter and first half, as well as our revised outlook for the full year. We’ll discuss our results on both the reported and adjusted basis. A reconciliation reported to adjusted earnings is in our press release, which is on our website at reynoldsamerican.com. Joining me this morning are RAI’s Chairman and CEO, Susan Ivey and our CFO, Tom Adams.

Before I turn the call over to Susan I need to cover the Safe Harbor provisions. During the call, we’ll discuss forward-looking information. When we talk about future results or events, a number of factors could make results materially different from our projections. These factors are detailed in our press release and SEC filings. Except as provided by federal securities laws, we're not required to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

 

I'd also like to remind you that RAI's website is our primary source for publicly-disclosed news about our company, and we encourage investors and others to sign up for e-mail alerts, when news about the company has been posted.

 

And now I'll turn the call over to Susan.

Susan Ivey

Good morning everyone. As we reported today, RAI delivered strong second quarter performance. I’m very pleased with these results, especially in light of last year’s unusually strong second quarter. Our operating companies key brand performance, productivity gains and promotional efficiencies drove RAI’s adjusted earnings and margin higher, demonstrating our continued momentum in delivering sustainable business growth. The strength of the second quarter results is especially impressive given the distortions in trade inventory levels in the prior year period.

In last year’s second quarter, wholesalers and retailers rebuild inventories on cigarettes and moist-snuff after they significantly reduced first quarter inventory ahead of the federal tobacco excise-tax increases. Even so, both of our reportable business segments continued to benefit from the underlying strength of their business strategies and key brands.

Based on this performance, we have increased our earnings guidance for the full year. RAI now expects 2010 adjusted EPS of $4.90 per share to $5.05 and increase from our previous guidance of $4.80 to $5 per share. This excludes second quarter charges related to the amounts closing of two cigarette factories and the expansion of R.J. Reynolds field trade-marketing organization to serve American Snuff to their services agreement, as well as first quarter charges related to changes in federal healthcare laws and Canadian government settlements.

Among the highlights of the second quarter, R.J. Reynolds posted higher adjusted operating income and a significant increase in adjusted operating margin, as well as further improvement in both of its growth brand, Camel and Pall Mall. And the American Snuff Company again increased moist-snuff volume led by growth on its powerful Grizzly brand. In addition, RAI’s Santa Fe subsidiary delivered excellent performance with second quarter gains in earnings, volume and share.

Before I provide more detail on our business performance, I would like to give you an update on a few additional items. The expansion of R.J. Reynolds field trade-marketing organization is going smoothly and exchange should be essentially completed by the end of the third quarter. As RAI announced in April, this strategic move offers us many efficiencies and enhancements, both internally and in our operating companies' ability to serve the retail trade.

As we reported in May, RAI operating companies are also taking steps to improve cigarette manufacturing efficiency and expand moist-snuff production capacity. Two cigarette factories will be closed over the next year and American Snuff is expanding its smokeless tobacco, processing and manufacturing capacity.

On the regulatory front, I’m pleased to report that RAI’s operating companies have fully met all requirements to date under the new regulatory structure administered by the US Food and Drug Administration. We now have structures in place across our operating companies to ensure comprehensive FDA compliance while effectively competing in this new environment.

And on the legal front, as you are aware in late June, the US Supreme Court denied both the government and the tobacco companies' request to hear appeal on the Department of Justice Law Suite. While R.J. Reynolds was disappointed that its application was denied, the denial of the government's application was a positive development as it eliminated the risk of financial damages in this case.

With respect to the Engle progeny cases, R.J. Reynolds has had a number of losses in these cases thus far. Although we are disappointed with the losses, we are not surprised of the outcomes and the finest attorneys are bringing their best cases to trial first. The company is in the process of appealing these cases and we fully expect to ultimately prevail.

Now let's take a closer look at second quarter performance. R.J. Reynolds and American Snuff continued to build their key brands, while investing in innovative cigarette and smokeless tobacco products to meet the changing preference of adults who enjoy tobacco. R.J. Reynolds focus on its growth brand and ongoing productivity improvements continued to build strength throughout its operation in the second quarter. The company generated higher adjusted income, adjusted operating income and margin while delivering growth brand volume and share gain.

Despite a very strong prior year quarter, R.J. Reynolds increased earnings and the company's second quarter adjusted operating margin was significantly higher. R.J. Reynolds total cigarette market share was down from the prior year quarter, driven by losses on its private label brand, which the company continues to deemphasize, as well as some losses on support brand. In that context, I would point out that some of that volume decline on support and private label brands has shifted to Pall Mall.

R.J. Reynolds' two growth brands Camel and Pall Mall delivered strong performance in the second quarter with gains in both cigarette volume and share. These brands now account for more than half of the company's total cigarette volume and share.

I am pleased to report that Camel performed well in the second quarter with increases that reflect the recent packaging and product upgrades in the brand's menthol style. These styles now offer R.J. Reynolds innovative capsule technology, giving adult smokers the unique option of more fresh menthol flavor when they want it. And Camel Crush uses the same technology to offer adult smokers the choice of regular or menthol with each cigarette. And consumers say they like having a choice of fresh menthol whenever they want it.

As a total tobacco brand, Camel is further improving and expanding its innovative offerings with the upcoming introduction of two new Camel Snus style as well as additional refinement to Camel Dissolvables.

Camel Snus, the company’s first smoke-free product, was expanded nationally last year and its share is holding steady. Camel Snus have moved away from its introductory promotional offers to a simplified pricing strategy, and this will help R.J. Reynolds to focus more on consumer engagement and education of the Snus proposition. This summer, Camel Snus is introducing two new styles, Robust and Winterchill. Packed in larger pouches, these new products offer tobacco consumers a richer, more full body tobacco taste. Robust and Winterchill have performed very well in their initial test markets and appeal to both current Snus users who want more will take and moist-snuff users who like the convenience of a spit-free product.

R.J. Reynolds expects these new styles to strengthen the brand’s leaderships in this small but growing category. All four styles of Camel Snus have also been upgraded to feature bold new packaging and are being sold in stores nationwide.

Also building interest is Camel's new line of dissolvable products; Orbs, Sticks and Strips. Introduced in three lead markets last year, Camel Dissolvables are making further product and packaging improvements based on feedback from adult tobacco consumers. We’ve also learned that a broad range of adult tobacco consumers have a high level of interest in this new product concept.

So Camel is improving its overall demographics for long-term growth and I think it’s evident from Camel’s performance that the brand continues to build momentum. It’s clear that R.J. Reynolds' focus on leveraging the Camel brand to drive innovation in growth is delivering results.

Turning to Pall Mall. R.J, Reynolds’ second growth brand. Pall Mall continued to perform extremely well in the second quarter with strong volume and share gains from both the prior year quarter and this year's first quarter. As high unemployment continues to depress consumer spending, more adult smokers are finding great value in Pall Mall.

Pall Mall sells at an affordable price but the brand offers much more than that. The cigarette differentiates itself from other value brands with high quality, longer lasting advantages. And more than half of those who try the brand stick with it. Even with more moderate promotion levels Pall Mall continued to generate strong trial and conversion.

R.J. Reynolds continues to drive productivity improvements across its business. The company further streamlined its portfolio of cigarette products in the second quarter and has reduced its number of styles by almost 25% this year, with these reductions coming from its private label brand. And in R.J. Reynolds efforts to gain additional manufacturing efficiencies, the company will consolidate cigarette production from two older factories into its largest facility, over the next year.

So as R.J. Reynolds enters the second half of the year, I think it’s clear that the company’s strong product offerings and strategies are serving it well, in this changing tobacco environment and it positions the company for long term sustainable growth.

Turning to American Snuff. American Snuff made solid progress in the second quarter, increasing moist-snuff pricing and volume, despite continuing high levels of competitive promotional activity. It’s important to note that the company’s second quarter earnings and volume comparison were also somewhat distorted by the rebuild of trade inventories in the prior year quarter. American Snuff adjusted operating income and margin were down from the prior year quarter primarily from declines on roll-your-own and other non-core tobacco products that more than offset moist snuff gain. The company's total moist snuff shipment volume increased in both the second quarter and the first half of the year. Moist snuff category volumes were up about 9% in both the second quarter and the first half. However on the consumer off-take basis, we believe the moist snuff category volume was about 6%.

This is because moist snuff industry volumes were inflated by the high levels of competitive promotional shipments. Also contributing to this increase was a change in the way a competitor reports shipments which excludes return products. American Snuff share of shipments in the second quarter was in line with its prior year quarter and well ahead of this year's first quarter.

Grizzly, American Snuff's flagship brand, again drove the mixed company's performance with strength on its core style as well as new product introduction. And Grizzly is delivering growth while continuing to maintain low promotional levels. Grizzly is also generating strong gains in the fast growing pouch segment. The brand now accounts for almost one quarter of all pouch sales after entering the segment only 2.5 years ago, and Grizzly now has the number one Wintergreen pouch product in the market today.

Also adding to Grizzly's appeal among a broad base of moist snuff consumers is the recently introduced Grizzly 1900 Long Cut. A natural product with a traditional long cut, Grizzly 1900 Long Cut has performed well since its introduction earlier this year. American Snuff continues to focus on enhancing Grizzly's brand equity and value to consumers. The recent addition of embossed metal lids is improving the brand's quality perceptions among moist snuff consumers.

Turning to American Snuff's premium Kodiak brand, even though Kodiak share of shipments has experienced a modest decline in the first half of this year, the brand's volume has increased despite being significantly out promoted by other premium moist snuff competitors. Camel Dip the company's latest premium introduction is bringing innovation to the moist snuff category and is performing well. Camel Dip which leverages Camel's authentic heritage was expanded to selected outlets in 10 additional states earlier this year and continues to build momentum. Overall, American Snuff continues to show strength and resilience in a challenging environment and we expect that performance to continue to improve in the second half and beyond.

So that's an overview of Reynolds American progress in the second quarter. Our operating companies remain intensely focused on driving a profitable growth by strengthening their key brands, improving efficiencies and investing in cigarettes and smokeless tobacco innovation, which will meet the changing preferences of adult tobacco consumers. And now, Tom will provide you with a few more details.

Tom Adams

Thank you, Susan and good morning. During my discussion, I'll focus primarily on adjusted results to provide perspective on our underline business. Reconciliations of adjusted to reported results are in our press release which is on our website. I think it's clear from our results today that RAI and its operating companies have made substantial progress in the second quarter and first half. Let's look at those results in more detail.

On a reported basis second quarter EPS was $1.17 per share, down 9.3% from the prior year quarter, due to charges of $0.15 per share related to the plant closings and expansion of R.J. Reynolds field trade marketing organization. Excluding those charges, RAI’s adjusted earnings per share increased 2.3% in the second quarter from the prior year quarter to $1.32. These results include charges of $0.03 per share related to the [Loop Tax] legal judgment.

For the first half of 2010, adjusted EPS was $2.43 per share, up 5.7%. Adjusted operating income excludes second quarter charges related to the plant closings, and expansion of R.J. Reynolds field trade-marketing organization, as well as first quarter charges for the change in federal health care laws and Canadian government settlements. The adjusted results also exclude trademark impairment charges in the first quarter of last year.

First half reported EPS was $1.45 per share, up 9.8% from the prior year period. I’m pleased to report that Reynolds American continued to see improvement in its adjusted operating margin, which was driven by gains in our operating companies pricing and productivity. For the second quarter, adjusted operating margin increased 1.3 percentage points to 30.1%, and for the first half it was up 0.7 percentage points to 29.4%.

Now turning to R.J. Reynolds performance. R.J. Reynolds second quarter adjusted operating income increased 2.2% from the prior year quarter to $568 million, despite a very strong prior year quarter. This reflects higher cigarette pricing, productivity gains and lower promotional spending, which more than offset lower cigarette volume. For the first half, adjusted operating income rose 2.3% to $1 billion. Adjusted results exclude charges related to the plant closings and expansion of R.J. Reynolds field trade-marketing organization as well as trademark impairment charges in the first quarter of 2009.

R.J. Reynolds second quarter adjusted operating margin was significantly higher at 29.3% up 1.1 percentage points from the prior year quarter. This increase was mainly driven by higher pricing, productivity and promotional efficiencies.

Now turning to total cigarette market share, R.J. Reynolds' total second quarter cigarette market share of 27.9% was down 0.8 percentage points from the prior year quarter. This was largely driven by the losses on its de-emphasized private label brands which now represent a total of only six tenths of a share point.

Turning to cigarette shipment volume, R.J. Reynolds' second quarter cigarette shipment volume declined 9.5% compared with an industry decline of 7.1%. However, excluding private label brands, the company’s volume performance was better than that of the industry with the decline of 6.9% in the quarter and 3.9% for the half. R.J. Reynolds' first-half cigarette shipment volume was down 6.3% compared with an industry decline of 4.9%. Camel and Pall Mall each reported second quarter cigarette volume and share gains. Those two growth brands now account for more than half of the company’s total share and volume. Their combined second quarter market share was 14.8% up 2.1 percentage points. Camel's second quarter cigarette market share of 7.8% was up three tenths of a point from the prior year quarter. Camel’s menthol styles including Camel Crush increased half a share point to 1.8 share of market in the quarter. Camel also continues to make progress as a total tobacco brand. Camel Snus remained stable at three tenths of a share on a cigarette equivalent basis and on a moist snuff equivalent basis; Camel Snus had a second quarter share of 3.5%.

Now turning to Pall Mall, which continues to deliver excellent performance. Pall Mall increased its second quarter market share to 7% that was up 1.8 percentage points from the year ago period and up 0.5 share from the prior quarter. So that is our R.J. Reynolds key results.

Now turning to American Snuff. American Snuff's second quarter adjusted operating income was $85 million down 7.1% from the prior year quarter. That decline was due to lower volume on roll-your-own and other non-core tobacco products which more than offset higher moist snuff pricing and volume. American Snuff also had higher second quarter costs relating to the timing of promotional spending and FDA compliance.

First half adjusted operating income was $169 million down 3.8% from the prior year period. Adjusted operating income excludes second quarter charges primarily related to severance costs associated with field trade marketing changes as well as prior year trademark impairments.

Turning to moist snuff volume and share, American Snuff’s total moist snuff shipment volume grew 3% for the quarter, for the first half which eliminates the impact of trade inventory fluctuations; the company's moist snuff shipments increased 7.1%. As Susan mentioned, industry shipment were up about 9% for the quarter and the half while consumer off-take was up about 6%.

American Snuff's share of shipments for the second quarter was in line with the prior year quarter at 29.4%. Grizzly's second quarter shipment volume increased by 4.2%. For the first half, the brand continued to outpace industry consumption with a 7.6% increase. And Grizzly's share of shipments increased slightly to 25.5% in the quarter.

The brand also improved its position in the fast growing pouch segment, accounting for nearly 25% of all pouch sales in the second quarter. Share of shipments for American Snuff's premium Kodiak brand declined 0.2 percentage point from the prior year quarter, and Kodiak's volume was down 5.5% in the second quarter but up 2.6% for the half. So that's an overview of American Snuff. Now we'll take a look at productivity.

As part of our operating company's continued efforts to improve productivity, we announced in May that two older cigarette factories will be closed over the next year, and production will be transferred to R.J. Reynolds' tobacco manufacturing center. This will further increase the company's manufacturing utilization and efficiency. During the first half of this year, R.J. Reynolds generated $14 million in incremental cost savings from its 2008 and 2009 restructuring programs. That will build the $25 million for the full year.

As Susan said, the company is also continuing to make great progress in streamlining its cigarette portfolio. Since 2004 R.J. Reynolds has reduced its portfolio by 75% to 180 brand styles. In addition, American Snuff is expanding its smokeless tobacco processing and manufacturing capacity by investing in new facilities in Memphis and Clarksville, Tennessee. We expect capital expenditures on these projects of about $130 million this year with an additional $70 million to complete them next year.

Now turning to RAI’s balance sheet. Reynolds American ended the quarter with cash balances of $1.6 billion, after making its annual master settlement agreement payment of $2 billion in the second quarter. I would note that on July 15, the company repaid $300 million in debt from cash, bringing our leverage ratio to 1.6 times debt to EBIDTA. RAI is committed to maintaining a strong balance sheet and to returning value to shareholders. Our 75% dividend payout ratio currently stands are $3.60 per share on an annualized basis.

So in closing, based on our solid operating and marketplace performance in the first half, Reynolds American has increased its forecast for the full year with an adjusted EPS range of $4.90 to $5.05. This excludes charges related to the plant closings, expansion of R.J. Reynolds field trade-marketing organization, changes in federal healthcare laws and Canadian government settlements.

Thank you, and now we’ll turn to the Q&A portion of the call. Ally will you remind our callers how to get into the queue?

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Chris Growe of Stifel Nicolaus. Please go ahead.

Chris Growe - Stifel Nicolaus

Hi. I just had a couple of questions for you. The first one is just to be clear on the smokeless tobacco, I guess American Snuff profitability, was there any distortion year-over-year in the roll-you-own for example the way that inventory shifted around that would have distorted profits in this quarter that wouldn’t continue going forward?

Tom Adams

Well with the federal excise tax increase there was their higher first quarter volume and lower second quarter volume as it ran off but going forward we would expect, I mean it will still be under some pressure but it should be more in line with what we're seeing in the second quarter.

Susan Ivey

Yes, I think the key thing to remember with American Snuff's profitability which is clearly driven primarily by moist is that we only have the price increase for one month in this quarter and we will have that dying price increase going into the second-half. So we're expecting continued improvement in financial results in American Snuff.

Chris Growe - Stifel Nicolaus

That’s where I was getting at. Thank you. I guess I am just trying to understand how that year-over-year shift might have affected and sounds like that was a big factor and plus you know the pricing is coming up. So it's good. And then a quick question on the [Loop Tax] case, I'm saying it the right way. You had a bond posted for that already, is that correct?

Tom Adams

That is correct and that bond was released and with respect to it was like $15 million.

Chris Growe - Stifel Nicolaus

Okay and my final question just would be relative to the balance sheet at a place where it would seem like you could consider some share repurchase. I thought I’d just revisit that and see if there is thoughts on how we should look at that for the remainder of the year, perhaps in 2011?

Tom Adams

Well, I mean we're always looking to increase our shareholders value and we're doing that primarily through increasing our earnings and our guidance and our 75% dividend pay-out ratio. Share repurchase is something that we do have in our tool box, it is something that we'll consider but we do have some other needs of our capital like I mentioned the tobacco manufacturing and processing expansion at American Snuff as well as the $300 million of debt that we just paid down and we have some pension funding obligations that we'll need to chip in towards the later part of this year or early next year. But we will and are considering that.

Operator

Our next question comes from Thilo Wrede of Credit Suisse. Please go ahead.

Thilo Wrede - Credit Suisse

Susan, how much longer do you expect the MST industry shipments to be ahead of the consumer take away, wouldn’t one have to catch up to the other eventually?

Susan Ivey

Yes, really driven by new introduction pipeline and actually we saw less of that in the second quarter so the increase a little bit less, obviously there was a large Snus launch but I think as the pipeline introduction slowdown you’ll start to see that catch up and really this focused Grizzly’s performance on an off-take basis and continuing to capture more than its fare share of industry growth, is obviously demonstrates its momentum.

Thilo Wrede - Credit Suisse

Will you expect a slowdown of the pipeline to happen this year or is the something that we’ll only see in 2011?

Susan Ivey

Honestly Thilo, I can’t answer that. I think there is a lot of activity, it's highly competitive in that space but in the long run the consumer off-take drives the real growth of the category.

Thilo Wrede - Credit Suisse

Okay, and in smokeless where do you see price caps in your future. From groceries point of view, what would be the appropriate price cap?

Susan Ivey

I’m not going to give you a number; I think what demonstrates the strength of Grizzly is how much that gap has closed in the last 18 months and Grizzly continues to power forward based on its strong product offering, great value price and obviously we continue to invest in equity behind that brand and our new metal lids are performing well as our new line extension. So it has clearly withstood a distinct shortening of that gap and I believe it will continue to do so.

Thilo Wrede - Credit Suisse

So no comment whether that capital continue to fill itself?

Susan Ivey

Well I think everybody should be pleased with the die and the can across the category.

Operator

Our next question comes from Judy Hong of Goldman Sachs. Please go ahead.

Judy Hong - Goldman Sachs

Just a few questions. On the cigarette side, can you quantify the inventory impact on your shipments in the quarter and then Susan just your perspective on where the industry underline consumption is trending at this point?

Susan Ivey

Sure Judy. We had basically zero inventory impact first quarter coming into second. We had seen our running rate at wholesale inventory has been stable through the year. So we were not impacted by any changes there. In terms of industry consumption, the second quarter, the industry was down 2.2%. So that means for the half it's down 4.7%. We are continuing to believe it will come in at 4% to 5% and probably on the low end of that as we go through the year.

Judy Hong - Goldman Sachs

The 2.2% was what you saw in the second quarter from an industry consumption decline.

Susan Ivey

On adjusted shipment perspective. So we try to take account of other inventory movement.

Judy Hong - Goldman Sachs

So that would imply that's better than your 4 to 5% for the balance of the year or at least that’s better than sort of the underlined historical trends?

Susan Ivey

Well we’re still lapping the first quarter. Remember the first quarter had a significant decline, because we were lapping the tax increase. So year-to-date the industry is down 4.7% on an adjusted basis, that’s our calculation. And so we would expect as the year unfolds I believe the low end of that four to five we’ll have to see how that comes out.

Judy Hong - Goldman Sachs

And then just in terms of Pall Mall I know obviously a year ago you had more tactical promotions that you’ve implemented, beginning of this year you’ve moderated that. Is there any change in terms of how you’re thinking about Pall Mall promotional strategy? And just in terms of the broader brand performance as you kind of think about profit versus volume on that brand.

Susan Ivey

Well I think we need to be clear that we have moderated the promotional expense on Pall Mall. And while it is operating much more than everyday low price style of promotion, that’s very specific by state. The brand is up as you know 1.8 share points on year ago, and its up half a share point from the prior quarter. And we actually moderated promotional levels in this second quarter. So, I believe that the strength of the brand in the context of its true differentiation in the value segment continues to play well in this economy. And we continue to see as the trail continues about half the people who try the brand stay with it. So we are obviously growing margins on Pall Mall. Reynolds margin improvement year-over-year and quarter-over-quarter speaks to that. And so I think we have a good strategy to balance the profit and market share on Pall Mall.

Judy Hong - Goldman Sachs

Okay and then just one final question. On menthol you’ve talked about the Camel menthol gaining share. Can you just talk about where you think the share is coming from a sourcing perspective, whether its Camel non-menthol brand, your menthol brands like Kool, Salem or your other competitor’s brands within menthol and then as you think about the FDA looking at the menthol regulation, is the way you are approaching the menthol category, any different now than it was six months or year ago?

Susan Ivey

I would say on the last question, it's not any different except that I think that our casual technology in the menthol space for Camel is appealing to other premium menthol smokers and to see how the share point grows quarter-over-quarter as we introduce that product in the third or first quarter period with the new packaging is very encouraging for us. So I would say it is drawing probably from a broad base of consumers but primarily competitive menthol and we are very pleased with that performance.

Operator

Our next question comes from David Adelman of Morgan Stanley. Please go ahead.

David Adelman - Morgan Stanley

First on Engle, I wanted to ask you on the Loop Tax case. Was it the nature of the intermediate courts of appeals that paying them that prompted you to take a reserve for that case. In other words that created a very low probability of Florida Supreme Court for you.

Tom Adams

That’s it, I mean this was the case that was actually within Florida as you know and it was tried back in 2002. So it’s a bit different from these other Engle (inaudible).

David Adelman - Morgan Stanley

Okay and then more broadly Susan on the (inaudible) cases, I understand all the reasons why the cases are difficult to defend. But are you surprising in the magnitude of the average damage awards and the frequency with which punitive damages and have been awarded in those cases and do you think there is anything broader that that reflects other than the structure of the cases?

Susan Ivey

I don’t think so, David and I really don’t believe we are surprised, as I said in my remarks these early cases, the plans were to bringing their best cases, it is Florida and we continue to be confident in our appeals and that we will prevail and these things will just take time to unfold.

David Adelman - Morgan Stanley

Okay, and then on the Snuff business, in American Snuff, I know that they are not big numbers. But in the first quarter year-on-year operating income I think was flat, this quarter despite a month of pricing in snuff profits were down. Is there something else going on or its not big numbers and don’t make much of that.

Susan Ivey

I wouldn’t make much of it, I think what you have to remember is that we do have some of that business is in roll-you-own and some of these other non-core tobacco products or we are lapping tax increases in the 1000% range. So, we continue to believe moist snuff operating income will continue to improve, American Snuff will continue to improve as we get the full pricing and continue the momentum on moist. But we do have this little drag on the profits from these other categories.

David Adelman - Morgan Stanley

And for planning purposes, you are assuming that there is going to be a premium brand, Wintergreen product priced at parity with Grizzly for the foreseeable future?

Susan Ivey

I would say that’s the only planning assumption one can use.

David Adelman - Morgan Stanley

Right, okay. And then is there any update on a different topic on the disputed payment mediation process?

Susan Ivey

Well yes, you probably know the details of this but we had to pick three arbitrators and each side got to pick one and then each of those two had to pick the third which the two sides had to agree. So I am pleased to report we have a panel of three and therefore that panel of three has now started calling for information and starting to hold hearings or discussion about the arbitration process and what sort of discovery will take place. I mean that is momentum because it's movement and now there is supervision over the two parties. So, yes it is picking up pace. We still wouldn't expect anything towards the back end of next year, but it is underway.

Operator

Our next question comes from Adam Spielman of Citigroup. Please go ahead

Adam Spielman - Citigroup Investment Research

Good morning

Susan Ivey

Good morning Adam

Adam Spielman - Citigroup Investment Research

I have got a couple of questions about formations. First of all on your Camel menthol style, can you tell us the degree of formations you had, I'm trying to understand how you got so much market share gain. And I guess I'm particularly thinking of some of your competitors who have made their brands very heavily and get market share gains on how much they use?

Susan Ivey

I think on Camel menthol, we don't disclose the specific amount spent by on a style but I would have you think about it in the context of it truly offers innovative consumer relevant technology. The capsule, giving people the opportunity to add menthol to their smoke, during the smoke, whenever they want to, is very appealing to competitive premium menthol smokers. And so, I really believe there is nothing else in the industry with that capability to deliver fresh menthol when you want it. And so I believe the market share gain, and certainly there have been introductory promotions. But I would say the market share gain and sort of the top value of the differentiation of the style is really driving that growth, because as you’ve identified half a share point in a quarter is substantial.

And remember when we launched Camel Crush nationally, we saw about seven tenths of a share point move into that variant in the first couple of quarters and we do not see these new menthol styles cannibalizing Crush, so it is incremental. So we are pleased with the results so far.

Adam Spielman - Citigroup Investment Research

You are used to say that on Crush that you really weren’t promoting it, but it was 0.7 share points without any real extra promotion, is that still true, are you beginning to promote it little it?

Susan Ivey

Yes, I think when we, I doubt we ever said there was no promotion, because that wouldn’t have been true. What we described was, there is lower levels of promotion because the product point of difference sells itself. And that is the case with Crush and the case with Camel menthol. So you are doing some promotion to generate trial but you’re not needing to put ongoing price support to continue the momentum. So versus another line extension that was really just a me too in the sector where it has to be driven by price to generate trial, these products have a point of differentiation and don’t require the same level of spend.

Adam Spielman - Citigroup Investment Research

Turning to Pall Mall, did I hear you say you actually reduced promotions on the brand in the quarter and you still gained shares sequentially in the quarter on that brand?

Susan Ivey

Yes, you did.

Adam Spielman - Citigroup Investment Research

And then turning to the buybacks, just to follow up the question at the beginning, what sort of debt-to-EBIT ratio would you look to half before you basically would need to do buybacks? I guess that is one part of the question. And in other way of asking the same question is how much do you think you need to present your pension fund?

Tom Adams

Well in terms of debt-to-EBITDA, I think I mentioned that we were on a pure debt-to-EBITDA. We are at about 1.6 now and we try to operate between 1.5 and 2.5, just the investment grade. But with pension and the debt that sits there, it probably pushes it up to about 2.1. So we are mindful of that. We believe that they will probably have to put in $300 million or thereabouts in each of the next two or three years unless we can get either higher discount rates which frankly I don’t see based on what German Bernanke said yesterday, actually for the next year or so, or outperform, you know its had some significant earnings in the pension plan. So we just have to kind of watch it going forward Adam.

Operator

Our next question comes from Christine Farkas of Bank of America/Merrill Lynch. Please go ahead.

Christine Farkas - Bank of America/Merrill Lynch

Thank you very much. Good morning Susan and Tom.

Susan Ivey

Hi Christine.

Tom Adams

Hi Christine.

Christine Farkas - Bank of America/Merrill Lynch

A question on your snuff, back to the snuff margins, looking at the overall decline in profitability, I just want to confirm are RYO margins lower or higher than the moist smokers?

Tom Adams

I believe they are a bit lower.

Christine Farkas - Bank of America/Merrill Lynch

A bit lower, so truly the volume and the magnitude that offset the smokeless profits?

Tom Adams

We also had some FDA compliance as we changed our packaging and also signage in stores, POS, and so there were those implementation costs that were included in the quarter and they obviously weren't in the year-ago period.

Christine Farkas - Bank of America/Merrill Lynch

Okay, that’s helpful. And while I have you Tom, can you confirm your tax rate outlook for the year, has that changed?

Tom Adams

It hasn’t we are still at 37 to 37.5.

Christine Farkas - Bank of America/Merrill Lynch

Okay, great. And then broadly on Camel, Susan, the pricing for your cigarette division was strong high single digits net to Reynolds. I’m curious of the Camel pricing, it looks like that average or it was perhaps more moderate?

Susan Ivey

I described in the last call, we have been pretty deliberate about trying to raise Camel margins and closing some of the price gaps, trying to reduce some of those promotion level. So, Camel has to be competitive. We lost a little bit of that competitive pricing in the first quarter and that hurt Camel and Camel really has come back strong and it continued to strengthen in the quarter. June particularly was one of the highest months we have ever seen on Camel. So, we believe it has momentum with the new style and that it is competitively priced. We are taking some promotion off of Camel as we go into August, moderating it again. We just have to continue to play out this competitive environment. But Camel is strong, its demographics are good and it continues to build momentum.

Christine Farkas - Bank of America/Merrill Lynch

Okay, so it's certainly not a big move or change in pricing or promotion that return that share growth in the quarter, it was really the underlying fundamentals of the brand and appeal to the consumers?

Susan Ivey

Yes, Christine.

Christine Farkas - Bank of America/Merrill Lynch

Okay. And then just lastly on Snus, I believe you indicated that new rollout or line extensions or additional brand I should say in the Camel Snus are coming, did you say that the packaging itself has also changed from those tins, is that right?

Susan Ivey

We are still using that shaped tin, but obviously all of the packaging had to change in June for the snuff category with new warning notices and that included Snus and so all of the packaging on Snus including the two new styles has been upgraded a new style, but it's still the same tin basically.

Operator

(Operator Instructions) Our next question comes from Ann Gurkin of Davenport. Please go ahead.

Ann Gurkin - Davenport & Company

Good morning.

Susan Ivey

Hi Ann

Ann Gurkin - Davenport & Company

Just want to follow on, you touch a little bit on the change and packaging and point of sales materials, any comments from retail, I guess we have seen signage for the black and white logos and descriptions and I was just curious any kind of early read or feedback?

Susan Ivey

We really haven't Ann because basically the country changed over in a matter of week. I am sure when consumers have their first trip into the store they say, oh, that's different. But now it's not different any more. So it obviously with the huge amount of work to change out all of that point of sale and to ensure that we met that FDA requirement, but we did need it, and we have not had any negative responses from the trade or our trade marketing people.

Ann Gurkin - Davenport & Company

And then secondly, I am referring to American Snuff, I guess just a little more detail in terms of, if you look towards the second half, obviously the environment is very competitive, are you commenting at all whether you need to step up support for the brand promotions, anything in the second half, any change in strategy that you can comment on, particularly Grizzly?

Susan Ivey

I would say, you know Grizzly has maintained pretty low levels of promotional support. It really is at its everyday low price and it has continued to build momentum through the second quarter. And we've seen that trend improve month-over-month. It is still growing faster than the categories, and so we do not see any need to change the promotional strategy or otherwise.

Operator

Our next question comes from Karen Lamark. Please go ahead.

Karen Lamark - Federated Investors

I want to go back to the Snus. I think you said the share was steady. Would you attribute that to the simplified pricing that you referred to, or less promotional pricing, is sort of my read, and if so, was this the first quarter in which you implemented that? Thanks.

Susan Ivey

We saw a couple of things Karen interestingly. You may have seen the 60 minutes program where there was some more consumer awareness about Snus. That drove an increase in shipment. We also have had a competitive national launch in the Snus category with heavy promotion in the Snus category. And what we start to see though is that Camel Snus is continuing to perform very well. The awareness of the category is growing and I believe Camel Snus will continue to grow. The simplified pricing makes it clearer for the consumer to understand the price and the price they should pay and it enables our trade marketing people to spend time talking to consumers and to retailers about Snus and how to use it, and the various styles in the category.

So, we now have two major players in the Snus category in the United States. I believe the whole category will continue to grow and I believe that Camel’s growth will outpace the category, because we believe we have a stronger product offering in the category.

Operator

And I’d now like to hand the call back over to Morris Moore for any closing remarks.

Morris Moore

Thank you again for joining us for the call today.

Operator

Ladies and gentlemen that does conclude today’s conference. You may now disconnect and have a wonderful day.

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Source: Reynolds American, Inc. Q2 2010 Earnings Call Transcript
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