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Lorillard (NYSE:LO)

Q1 2014 Earnings Call

April 24, 2014 1:00 pm ET

Executives

Robert Bannon - Director of Investor Relations

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

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

Analysts

Nik Modi - RBC Capital Markets, LLC, Research Division

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

David J. Adelman - Morgan Stanley, Research Division

Michael Scott Lavery - CLSA Limited, Research Division

Owen Bennett - Nomura Securities Co. Ltd., Research Division

Operator

Good morning, ladies and gentlemen, and welcome to the Lorillard, Inc. First Quarter 2014 Earnings Conference Call. My name is Ryan, and I will be your operator for today's call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

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

Robert Bannon

Thank you, Ryan, and good afternoon, everyone. I am Bob Bannon, Lorillard's Director of Investor Relations. And joining me on today's call are Murray Kessler, Lorillard's Chairman, President and Chief Executive Officer; and David Taylor, its Chief Financial Officer.

By now, you should have received a copy of our first quarter 2014 earnings release. It can be found on the company's website, lorillard.com, under news releases.

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

Also, certain financial information, such as adjusted net income and adjusted earnings per share, that will be discussed on today's conference call, is presented on a non-GAAP basis. The description, most directly comparable GAAP measure and reconciliation between the non-GAAP and GAAP measures are provided in the company's earnings release, which is also available on our website.

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

Murray S. Kessler

Thank you, Bob, and good afternoon, everyone. There were 2 very different dynamics at play during Lorillard's first quarter. First, our core cigarette industry-leading fundamentals remained unchanged, with strong market share gains, robust pricing realization, improved operating margins and 5% operating profit growth, despite a number of unique headwinds in the first quarter that cost us some volume.

And second, we continued to invest in our e-cig business that grew significantly year-over-year at retail but, just like the total e-cigarette category, flattened sequentially. In light of what appears to be a constructive regulatory framework that was announced today, new major manufacturers rolling e-cigs nationally in the U.S., our launch of blu into the U.K. and the rapid growth of vapor shops, this investment is critical for Lorillard to protect its leadership position and reignite growth in this emerging new industry. However, for the quarter, it had a $0.02 drag on the adjusted EPS growth comparison.

Without the one-off headwinds in cigarettes, which I'll explain in a minute, the company could have easily covered the $0.02 drag and increased total adjusted EPS growth well above the 4.5% we reported in the quarter. The good news is, we don't expect the one-off cigarette issues we faced in the first quarter to repeat themselves any time soon, which is important, as we expect the e-cig investment to remain high, especially over the next 6 months. Let me backup for a few minutes and give you some more details on our performance by segment.

Starting with cigarettes. Total Lorillard wholesale cigarette shipment volume was down 2.9% for the quarter versus a year ago, or 267 million units. Lorillard domestic cigarette volume decreased 2.3%, and total domestic industry shipments were down 2.7%. Changes in wholesale inventory patterns during the quarter had a negative impact on first quarter wholesale shipments for Lorillard in contrast to a positive impact for the balance of the industry.

Adjusting for the impact of changes in inventory, Lorillard domestic wholesale shipments declined approximately 1.8%, significantly outperforming adjusted total industry shipments, which decreased approximately 4%.

Newport domestic wholesale shipments were down 1.5% versus a year ago for the quarter and down 0.9% after adjusting for inventory. The adjusted volume results are aligned with what we observed at retail via our proprietary retail database.

As Lorillard retail volumes outpaced the industry declines, the company once again gained share. Specifically, total Lorillard retail market share increased 30 basis points versus a year ago, to 15.2%, its highest level ever and first full quarter over 15%.

Newport's retail market share reached 13%, an increase of 40 basis points compared to the first quarter of 2013. Share gains were driven by core full flavor Newport Menthol, as well as new initiatives, including Newport Non-Menthol, both Red and Gold; Smooth Select; and growth in geographic expansion markets. Our share of menthol was flat versus a year ago at 40.7%, but up 80 basis points sequentially.

Obviously, I feel good that Lorillard continued to outperform the industry at retail. So let me spend a few minutes on the issues I characterized as one-off that affected our first quarter wholesale shipments.

First, Puerto Rico and U.S. Possessions accounted for 60 million units, or about 23% of the decline. There was a $1 per pack tax increase in Puerto Rico July 1, 2013, which has been affecting our volume. We will lap that increase at the end of the second quarter.

Second, factory pack promotions were purposefully and significantly reduced in the first quarter. Remember, in the first quarter last year, we increased factory pack promotions in the face of increased menthol competition. We're not big fans of price promotions, so we have been reducing them and using them more tactically as needed on a state-by-state basis. Our use of factory packs was already dramatically lower than our menthol competitors. This reduction in wholesale factory packs shipped of over 200 million units for the quarter takes that even a step further. The reduction, however, had an impact on both inventory and to a much lesser extent, retail, as we believe incrementality is low for those types of promotion.

We believe this accounts for about another 25% of the decrease versus a year ago. But of note, this reduction in factory packs was a key driver to the robust pricing realization and gross margin expansion in the quarter. There are no further reductions of factory packs planned for the rest of the year.

Third was holiday timing. Retailers traditionally bring in extra volume prior to Easter, as the number of our distribution centers are closed on Good Friday. In 2013, Good Friday was on March 29. This year, Good Friday was in the second quarter, April 18. We estimate the difference due to holiday timing accounts for about another 25% of the decrease versus year-ago.

And fourth, weather. The final factor affecting Q1, which is difficult to quantify, is the severe weather that affected the country during February and early March. Newport does north of 70% of its volume in the states that were most affected by bad weather, disproportionately more than our competitors. And while I'm not one to blame weather, it clearly had some effect, as we had multiple distribution centers closed 5 different days during the quarter. Wholesaler deliveries to retail were also interrupted in multiple markets. That is highly unusual. And I'm pretty sure we're past this factor as well.

So to repeat myself on cigarettes. The business fundamentals remained strong. Adjusted Newport domestic wholesale shipment volume, down 0.9%, is well within our normal range, especially in the context of the factors I just described. It is also clearly well above the industry 4% decline. And hence, we continue to reach record-level market shares. That, plus tight cost controls, highlighted by a reduction in factory pack promotions, resulted in a 100-basis-point increase in gross margins and a 5% adjusted operating profit growth. For cigarettes, the quarter was solid.

Turning to eCigs. Net sales were $51 million, a decline of $6 million versus a year ago. There was a $5 million operating profit loss for the segment, compared to a $7 million gain in the year-ago period. That's the $0.02 drag on adjusted EPS, I was referring to. I believe that performance was better than first appears, with one exception. Remember, in the first quarter of 2013, we were in the early stages of our national expansion of blu to retail. The year-ago quarter contained significant pipeline inventory.

Also, remember that we lowered the price on rechargeable kits mid last year, so there is a dramatic difference in the wholesale price affecting the year-over-year sales comparisons. And that impact is approximately $7 million.

That is last year's first quarter net sales adjusted for the price reduction would have been about $7 million less and accounting for pipeline, would reduce the year ago number further.

So to give you a clearer picture of underlying sales in the business trajectory. We have decided to switch to Nielsen all-outlet dollar sales moving forward. That data has been provided in the release. As Nielsen is based on consumer purchases, there is no impact associated with retail pipeline builds, although the price reduction on rechargeables is reflected.

According to Nielsen, blu achieved a 45% all-outlet dollar share of the U.S. e-cig market, a 10 share point increased versus year-ago, based on a 63% increase in total dollar retail sale. Kit sales increased 5% versus a year ago, despite the price reduction, as unit volume for kits was up 79%. Cartomizer dollar sales were up 55%, and disposable dollar sales were up 96%, all strong.

And the dramatic increase for blu and the category has to have been a factor contributing to the 4% cigarette industry accelerated decline we have seen in the last year and the first quarter of this year.

Of concern, sequentially, cig sales growth has flattened in recent quarters. First quarter retail sales increased by only 10% versus the fourth quarter of 2013, below our estimate. In our opinion, the sequential slowdown in e-cig sales is directly related to the rapid rise of vaporizer sales in vape shops. It's difficult to quantify the size of this segment, but it is clearly large and growing.

So in combination, we believe the trend towards vapor products is continuing to rapidly expand, we just can't fully measure it. We also believe these vaporizer-type products are growing faster than e-cigs right now because they deliver a superior consumer experience to the better value. That is bigger batteries, more vapor, more satisfaction, lower cost to refill, albeit, they come with their own set of significant regulatory challenges.

As I said in my NATO presentation a few weeks ago, the challenge for e-cigs, which we believe is the preferred consumer format, is to put -- close the performance gap relative to vaporizers and do that in months, not years.

Blu will be making a series of technical advances in the next 6 months that improve battery strength, vapor production, consumer value and satisfaction. We believe these types of changes will accelerate the acceptance and/or minimize the defection from traditional e-cigs, but we will be watching the vaporizer category carefully.

We also believe that industry sales will accelerate significantly, as our tobacco peers each role nationally with their products. We are encouraged by what we saw in their test markets. In general, blu sales were only modestly affected, yet the category grew anywhere from plus-70% to plus-250% depending on the test market you look at. Albeit, these are relatively small markets.

Still, we think at this early stage, increased competition will increase visibility and awareness for the entire category and is, therefore, a good thing. But of course, it'll require us to spend appropriately and innovate rapidly to retain our leadership position and, as I said, close the performance gap versus vaporizers.

Notably, we have just received the proposed rule on e-cigs by the FDA. On the surface, it appears that the FDA is taking a science-based approach and that the rule itself defines a constructive process that recognizes that e-cigs are different than combustible cigarettes.

Despite what I'm sure will be a robust give-and-take process over the next year, there is nothing I've seen so far that changes our belief that e-cigs represent a major opportunity to align the interest of business and public health, and therefore, supports our decision to invest in e-cigs.

In the U.K., we had nominal sales in the first quarter, as we were depleting retail inventories of SKYCIG in preparation for our conversion to blu, which has just begun. We expect to build distribution across the U.K. in the second quarter, with a full line of blu products. The product line will be supported with significant brand-building activities similar to the U.S. And just like the U.S., now is the time to establish the strong brand position in what is the second-largest, yet highly fragmented, e-cig markets in the world.

So in conclusion, I am pleased with the company's strong underlying fundamental performance and record-high share results on cigarettes, despite some less favorable events that occurred in the quarter. And I believe as much as ever in the e-cig opportunity, although it will require continued investment and a much more rapid pace of innovation.

The fact that we could grow profits and market share in a quarter with the challenges I discussed, is yet another demonstration of why we remained confident in our ability to deliver a double-digit total shareholder return, as measured by EPS growth and the dividend yield, consistently over the long term.

And with that, I'll turn the call over to David Taylor, our Chief Financial Officer.

David H. Taylor

Thanks, Murray, and good afternoon, everyone. After a few comments, we'll open the line for questions. Consolidated net sales for the first quarter increased 1% over last year, to approximately $1.6 billion. Our reported results include some items both in this year and last that make comparisons of reported results less meaningful than comparing our adjusted results, which exclude the impact of those items.

The first quarter of both this year and last year included the benefits of some special MSA-related matters, which have been excluded from the adjusted numbers. In addition, last year's charges for compliance with the DOJ case and this year's accelerated write-off of the SKYCIG brand have also been excluded. The details of these adjustments are included in the press release in the section entitled reconciliation of reported GAAP to adjusted non-GAAP results. My comments will therefore address adjusted results.

Adjusted operating income for the first quarter increased 2.1% from last year to $447 million in the first quarter, and adjusted EPS increased 4.5% to $0.69 per share.

Looking at the results for traditional cigarettes. Net sales increased 1.4% from last year's first quarter as a result of higher average net selling prices, which more than offset a 2.9% decline in wholesale shipment volume. As you've already heard from Murray, a number of factors created some headwinds for our cigarette shipment volumes. Wholesale inventory patterns had an impact. Levels of inventory at our wholesale customers declined during the first quarter of 2014, more than they did during the first quarter of last year, even though we entered this year with a lower absolute number of sticks at wholesale. Adjusting for those differences in wholesale inventory patterns, we estimate that domestic wholesale shipments declined approximately 1.8%, as compared to the actual decline of 2.3%.

Timing of the 2013 holiday calendar, differences in our 2014 promotional calendar and some unusually harsh weather in our core markets, perhaps to a lesser degree, also had a negative influence.

Strong comparison -- strong comparative pricing levels more than offset the volume decline. Net sales for cigarette, calculated before excise taxes on a simple consolidated basis, increased 6% from last year, reflecting the various pricing actions we've taken and lower levels of promotional spending in the current year. These higher net selling prices drove the improvements in adjusted gross profit and adjusted margins in the quarter.

Adjusted gross profit for cigarettes in the first quarter rose 4.2% to $572 million, and adjusted gross margins improved to 37.1% of sales from 36.1% last year, driven primarily by the higher net pricing partially offset by increases in settlement costs and other raw material costs.

Settlement cost per unit, based on what we know today, will likely be between $36 and $36.50 per thousand units for the remainder of the year. Adjusted selling, general and administrative costs for cigarettes in the first quarter were roughly flat, increasing only $2 million.

The strong net price realization, combined with good cost containment, resulted in an increase in first quarter adjusted operating income of $21 million, or 4.9%, from last year's first quarter.

Now, as we turn to first quarter results in electronic cigarettes. We continue to spend aggressively behind the category and our blu brand. This includes the efforts aimed at rebranding the product offering in the U.K. to blu, as well as continued advertising and marketing of blu in the U.S.

Net sales for the electronic cigarette segment totaled $51 million, which is $49 million of sales of blu eCigs in the U.S. and $2 million of SKYCIG, compared to a total of $57 million in last year's first quarter.

The segment generated an adjusted operating loss of $5 million, reflecting the impact of the rebranding efforts in the U.K. and continued advertising costs in the U.S. We had indicated that we expected blu eCigs to operate at a near-breakeven level in the short term, and that's still what we expect to see in our U.S. operations. However, the decision to rebrand the product offering as blu in the U.K. and the associated marketing and launch costs will likely require further investment spending in 2014.

Unlike the experience at blu U.S., in which Lorillard already had relationships with the retail universe, expansion into retail in the U.K. will require more time and larger incremental expenditures, combined with an aggressive advertising and marketing push behind the brand.

The net operating income impact of those actions and investments in the U.K. could total $10 million to $20 million, which will likely be incurred over the next 6 to 9 months. We believe that now is the time to make these investments to establish the blu brand and that they will result in significant volume and share growth in the U.K. and create a meaningful profit opportunity for blu.

Some other things. The adjusted effective tax rate for the quarter was 37.5%, an increase from last year's first quarter rate. A combination of changes in state tax rates, changes in the allocation of taxable income amongst tax jurisdictions and discrete items benefiting last year accounted for the difference. We expect the full year tax rate to be approximately 37% to 37.5%.

We continued our share repurchase program during the quarter, repurchasing approximately 3.2 million shares at a cost of $158 million. That leaves approximately $156 million to be utilized under the current $1 billion authorization.

So in summary, we had a good start on 2014, fueled by our cigarette segment, which could have been stronger absent some of the pressures that we've described. The cigarettes business has been and will continue to be the core of the Lorillard story. And in addition, our commitment to build a strong and profitable business in the electronic cigarettes space remains. We'll continue to make investments in markets and in product development as we seek to build on the blu brand.

We're confident that we can continue our track record of rewarding our shareholders by creating significant value on their behalf.

Operator, we can now take questions from call participants.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Nik Modi from RBC Capital Markets.

Nik Modi - RBC Capital Markets, LLC, Research Division

So, Murray, just -- I know it's pretty early because the regs just came out, but I was curious if you can give us your -- any thoughts on the substantial equivalency clauses that were kind of in the regs? It's a bit confusing if it's a good thing or bad thing. And then the second question is really around blu. And how long will it take to clear out kind of the current generation of products out of the channel before you could actually get the next generation of products into the marketplace?

Murray S. Kessler

Okay. Let me just make sure I don't lose that thought here. Okay, so first part. The deeming regulations. Let me make it a general comment. I didn't know what this might look at, how far they would go with, but I was pleased, and I put out a press release on that, that they're taking a science-based approach to it. I don't agree with everything that that's in there. But where -- on each part of it, they said they were going to study the science, do additional research, which is necessary, open up to comment, and there weren't sort of the knee-jerk reactions. So I think in general, that's a positive. As I read the preamble, there is clearly maybe the most articulated ever so far from the FDA, that there is a recognition of a continuum of risk. And that needs to -- there's all kinds of disclaimers around looking at that from a total population impact. And I understand all that, but there is a recognition that, that potential exists. And that's a good thing. When you read the regulations as they stand right now, the only gray area I thought was -- well, there's a few gray areas, but the biggest gray area is the one you're asking about, which is substantial equivalence. It clearly spells out in the document that especially for e-cigs, the sort of the weighed substantial equivalence, that process was designed in the original reg with the February 2007 date for a predicate product, that, that pathways probably not possible for the e-cigarette category. It didn't exclude it entirely, but it recognized that it's probably not possible and asked for comments on what might be a different mechanism. The fact that they've asked and open it up for a different mechanism is extremely encouraging. So 1 of 2 things would've had to happen. If you went down the SE, you would have to change the date. But frankly, I'm encouraged by the opportunity to go down it and develop a different mechanism. And that will be the direction our comments go because it doesn't make sense with a product that's as rapidly changing as this. So as long as that mechanism is more flexible, given this type of product, I think, in general, this bodes well for the industry. Now on your second question. The good news is, from a relative standpoint, a lot of the changes that I'm talking about are incremental changes. So it's not take something completely off the market. There are numerous changes that'll change as they become available. So there will be changes in cartomizers that you work through. There will be a new product, which I'm not ready to speak about now, but that's not necessarily taking something off the market. Think in terms of razors and blades, Nik, where there's Mach 3s and Mach 4s and different scenarios like that. And then from a battery performance standpoint, some of those changes have been made, but there's significant improvements coming. And then on satisfaction, there's changes to technology that those are being folded in and as we speak, and will start hitting the market. The net result of those is, if you're looking for a day where it's like all of a sudden, it's -- I'm announcing something new, that's not the way it's going to happen. Things will just get better and better. And consumers, as I've already witnessed, these are very meaningful changes to them. So it'll be one right after another, starting probably towards the end of the second quarter, beginning of the third quarter.

Operator

Your next question comes from the line of Judy Hong from Goldman Sachs.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

So, Murray, just following up on deeming. And I guess I am just curious in terms of how you think about, now that we have some clarity in the proposed regulation and, obviously, it's going to take some time before it becomes final and gets implemented in the marketplace. But just in terms of the practical impact that that's proposed regulation may have on your business and your strategies. So thinking about manufacturing processes, thinking about some of the tanks and vaporizer products that, as there is more clarity on some of the regulations. So how is this impacting how you're thinking about sort of the practical impact in the near term? And then competitively, do you think that you will see more barriers to entry? Or for the next couple of years, this is still kind of the Wild Wild West were you still have to deal with a lot of new entrants in the marketplace, just continues to be pretty competitive?

Murray S. Kessler

It's a pretty broad question. Let me try to cut it into some pieces. Practical implications. We have spent millions in putting in quality controls and clean rooms and consultants that are supervising [indiscernible]. And so I think we are ahead of the industry, certainly the bulk of the industry, in preparation for what we'll always would be expecting to have CGMPs on, on these product. So I think from a practical standpoint there, it's -- I find that to be good news because we're prepared. And that should give us competitive advantage. Having said that, I think that'll take years to implement because you've got to finalize the rule, then you got to have the transition period and then they've got to write GMPs and we still don't have GMPs yet on cigarettes and it's 5 years later. So I think there'll be time for others to get there. But we've made that investment. From a practical standpoint and in the short term, it's not disrupting our product mix or our marketing methodologies in the short term. And the only one that was a question was sampling, which has been banned. And again, that would be a few years from now. And we have a chance to comment on that and explain why we think smokeless is still allowed to be sampled in adult-only facilities and why we think that it still makes sense for here. But it may or may not survive. We'll see, but that would be an effect. But I don't think, relative to all the marketing tools available to us, we'll work around that. We -- that's our jobs. Other practical implications? Vaporizers. I have been in a wait-and-see mode with liquids. And I told you my strategy on it, which is to improve performance. But I've also said I'm going to watch that carefully. If these regulations would have just shut that segment down, that would have not been an area I might have been open to exploring. Now, based on what I've seen here, I'll keep it in my consideration set. It's not my preferred method, because I think the smaller, closer to resembling cigarettes technology is still going to be consumer preferred if I can get the performance there, but we'll be open-minded to it. I mean, those are some examples. But the net-net is we made a bet, we're making some investments. And based on what I heard today, we'll continue to make those investments.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. And then maybe just on that note, the e-cigarettes investment side. So I'm just hoping to get a little bit more color just as it relates to maybe how you're thinking about investment in the U.S. market. So, obviously, you've had your competitors do test marketing in a few markets going national in the middle of the year with pretty big investments. So how much do you think that you need to spend also to compete against those players in the U.S. market? And then in thinking about the U.K. market, David, just -- the $10 million to $20 million incremental investments, this is, I would assume, beyond kind of the U.S. investment that you had contemplated perhaps a couple or 3 quarters ago. So should we really expect a much bigger loss in this business in the next few quarters? Or could the profitability on the U.S. side of the business improve so that the overall impact from the higher investments is not as high?

Murray S. Kessler

I thought -- I'll turn it over to David for the U.K. But what he said in his comments was that he thought that the U.S. was relatively breakeven in the $10 million to $20 million operating profit impact associated with the investment over the next 6 to 9 months in the U.K.

David H. Taylor

That is exactly what I said. And could the U.S. profitability improve to offset some of that drag in the U.K.? It could. But we're not trying to manage it in that way. And we also believe that those investments in the U.K. market, now is the time to make them, and we can't just dibble-dabble around in trying to make them. And we believe that they will result in profitable share growth. So I would not expect to see that level of drag in the U.K. market continue beyond the 6- to 9-month period that we're talking about.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay. So the flat comment in the U.S. is just year-over-year impact. So you're not looking to break even? Or is that a breakeven on an absolute sense?

Murray S. Kessler

We're saying breakeven. We're not giving a specific number. We're just saying roughly breakeven in the U.S. And we made a little bit of money last year. But you pointed out yourself, you've got 2 national competitors rolling out as we speak, so there's some level of investment associated with that just defensively. We didn't really spend that much money to defend in those -- in their test markets. They were -- a couple of them were -- first off, they're out West, smaller Lorillard markets and smaller blu markets and smaller e-cigarette markets in general. They are relatively tiny. And you saw the kind of investments that were made out there. We weren't going to play that game. But as it rolls national, we have -- we will continue at that investment level, with national advertising and support for the brands and lots of new product activity, technology and, in our opinion, stay ahead from a technology standpoint. So that all requires some investments. The investments that David is talking about, of $10 million to $20 million, is meaningful. But relative to us, we make a couple of billion dollars a year, and a $20 million bet for something that we expect to make money and pay back in the next 24 months is not a huge bet relative to the size of our company, and the world has been chasing us on this a little bit. But I don't want you to think of that this is -- we're just going to invest year after year after year. We expect this to be a profitable business for us, but we've got to weather the storm of this national rollout.

Judy E. Hong - Goldman Sachs Group Inc., Research Division

Okay, that's helpful. And then just my last question on the cigarette side. So the net pricing realization, can you help us sort of strip out the Puerto Rico tax impact? Presumably, you've taken pricing in that market, too, to offset the tax increase. So just wondering if that actually had a relatively sizable benefit, or is this really just the lapping of the factory pack promotions and just favorable pricing you've seen on the U.S. side?

David H. Taylor

Judy, it's primarily the latter. It's the list price increases we've taken over the last 12 months, as well as the lower promotional spending in the first quarter of '14. Those are the factors that really drove that healthy pricing.

Operator

Your next question comes from the line of Bonnie Herzog from Wells Fargo.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I just -- my first question is on the deeming regs. And given they did not ban flavors right now, I'm curious how you might be interpreting this as it might relate to the FDA's outstanding review of menthol.

Murray S. Kessler

Well, I actually think it's a -- maybe not that specific issue. But the entire deeming regulation, in my opinion, is a positive read through on menthol. Because what they've said is that they're going to make science-based decisions. In the past, they've talked about that. But this is walking the talk. This is -- they didn't make any knee-jerk reactions. They pointed out the concerns on flavors in e-cigarettes, right? But they said, you can't just say it's a problem. You've got to provide support and facts and data, and they didn't have the regulatory authority to do their research before because it wasn't under their jurisdiction, and now they have it. And given where we believe the science is on menthol, if they have made a commitment, which they appear to have done, which they've said from the beginning, to be fair, that they are going to be science-based decision, then I think this feels pretty good for menthol. And then the other part on menthol is they've -- the areas of concern, they've taken action on. I mean, they've done, they put out additional research where they said they would, and they're running off a lot of advertising on the youth side on that new campaign of theirs.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Right. Good point. In terms of Gold, I might have missed it, but did you say what share Newport Gold has now in the quarter?

Murray S. Kessler

No. Newport Gold, I told you at the last quarter that it -- we had trouble with trials. It's actually -- the weekly volumes have been building a little bit on Newport Non-Menthol Gold. But we've got a number of adjustments that I talked about we'd be making to address the trial issues. And I'm not prepared to talk about those specifically for competitive reasons. But we will as the year progresses. But it's built a little bit from the fourth quarter.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

So you would say that it's been incremental, and do you feel comfortable saying that the trial has picked up, you've seen some improvements?

Murray S. Kessler

Modest improvement, modest.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Okay. So you're still working on it. Okay.

Murray S. Kessler

We're definitely working on it. And we have -- but there are some other changes that we wanted to make, and they'll be coming soon.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Okay. In terms of distribution channels, you talked a little bit about the vape shops that are certainly springing up all over the country. But are there other distribution channels you might be considering for your e-cig business that you aren't currently in today? Any other opportunities is, I guess, what I'm thinking about for your business.

Murray S. Kessler

Well, we're already going after some of those. I mean...

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I'm thinking of kiosks. I mean, there's some other things, other ways people are getting these products.

Murray S. Kessler

Not kiosks. But we've been asked to present in casinos, as an example, that we don't traditionally go in with our normal wholesalers. And we are selling with blu eCigs because they solve the problem for casinos, as an example for that.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Right. Okay. Then, Murray, my final question would just be now that MarkTen and Vuse are rolling out nationally, are you seeing any changes in terms of your merchandising of blu or movement behind the counter, things like that, losing space or what are your thoughts there as this continues to play out the rest of the year?

Murray S. Kessler

Well, I don't want to speak for my competitors. But what it looks like their scenario is they're placing their products within the cigarettes section. We have invested in beautiful merchandising units and have great visibility as a standalone section. And right now, that's where I intend to leave it. I don't want to take blu, which has very good visibility in an e-cigarette, standalone e-cigarette section right now and sort of diminish the space and visibility for it, forcing it into our '14 share of -- our '14 or '15 share of cigarette. So I'm very pleased with the space. We have contracts for that retail placement. We've put shelving units. And that's been a big part of our investment to make sure we have that primary space. And our competitors are going to be in any different area, and that's fine by me.

Operator

Your next question comes from the line of David Adelman for Morgan Stanley.

David J. Adelman - Morgan Stanley, Research Division

Two things, Murray, that I wanted to ask you. One was on Newport's share of the menthol category. And you -- I was going to bring it up, but you highlighted in the prepared remarks that it was essentially flat and, therefore, Lorillard's overall share of menthol has been essentially flat over the last year. And I'm curious, what -- why do you think that's the case? Because the brand has a long, distinguished history of not just gaining share, but gaining share of the category. Do you think perhaps Newport Red and Gold have taken some of the Newport Menthol's consumption? Could it be a function of where the menthol category may be growing versus your own strength, or your promotional practices?

Murray S. Kessler

So our -- I would say that it's a combination of primarily promotional practices, especially for this first quarter. Because the 200 million units that I cut were all in the first quarter of last year. And you had the Smooth Select launch, which had pipeline inventory, and that's the downside of our method of measuring, right, both in the first quarter. So you had some pipeline build and you had 500 million, 600 million units' worth of factory pack promotions last year, and we cut that back significantly. So those 2 factors, more from what's being forced out to stores, I think, affected the year-over-year comparison.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then, secondly, I wanted to ask and get a sense about the magnitude of improvement we should expect in the performance, taste, nicotine delivery of blu today versus where it could be, whether it's 6 months from now or a year from now? I mean, if the ultimate goal is to get something that is -- where a smoker is almost indifferent between a cigarette and blu, relative to where we are today, how much can you advance that on what you see in the internal development pipeline?

Murray S. Kessler

Well, you just changed the frame of reference on me. Because what I was referring to is sort of what is an incremental performance in vaporizers and why I think it's been growing so much. So I think you'll see dramatic where our rechargeable pack that we reduced the price on, I think one of the downside sides of that coming out of the chute is that it sounds like a cigarette, et cetera, but the battery would last an hour or so. And then you'd have the second one you were carrying around and recharging. And if you were a hard-core vaper and you went through that battery faster, you might not have the second battery recharged in time, where the kind of improvements I'm talking about, you'll see right away for that. That will never occur again. Once you get those upgrades into place, they'll last most of the day and you'll always have a fully recharged battery with you. And then with that extra power comes more vapor. Yet a more significant change, when you get the cartomizer change, which I'm not prepared to explain to you today, I will when it gets closer, but that improves both vapor production and value. So again, you're closing that performance gap. Other changes in the design of the way the heating element -- the satisfaction will improve over time and you feel that and e-cigarette consumers will describe that. And a lot of times, they describe that in throat hit in the way the product actually feels. So when we started this process, I said, boy, we're 20% of the way there when we bought the company and I'm not sure we're that much further along today. I think we'll double that in the next 6 months to 1 year. But we're not -- we still have work to do. And there are next generations of technology I am -- already had presented to me that will continue to gain ground on cigarettes. But we're few years, at least a few years, from getting all the way to a cigarette.

David J. Adelman - Morgan Stanley, Research Division

Do you think there are some realistic risks, Murray -- as a follow-up -- that if you don't -- not just you, but if the industry in totality doesn't advance the product far enough, that you'll have had enough trial by consumers that even at some distant point, if the product is significantly advanced, it will be harder then to get trial and adoption. Is that a consideration at some point or not really?

Murray S. Kessler

I thought I showed a chart in one of the investor presentations that I can certainly dig out again. But that's been -- that hasn't been a problem so far because people sort of see it's like sort of those cellphone bag cellphones versus it keeps getting better again, and people might have had negative experience. But I can get you the data, if you don't remember it, where we had done a survey when we bought blu, when we were first investigating blu, that said what percentage of people said they would definitely buy it again based on they has tried it 5 years ago versus -- or 3 years ago versus 2 years ago versus 1 year. And you saw the repeat numbers coming up very high in awareness. So you do get people coming back to try it again. But I completely understand the question. When you have 60% or so of the cigarette smokers have tried this product and a much smaller percentage who have converted that, you got to go back and get them a second time, but that's our challenge. And -- but I think as technology improves, more and more people are aware of the e-cigarettes. It's still gaining a lot of momentum.

Operator

Your next question comes from line of Michael Lavery from CLSA.

Michael Scott Lavery - CLSA Limited, Research Division

Could you just talk a little bit on the trade movements in the quarter and just help us understand a little bit of what to expect for 2Q or the rest of the year? Certainly, we hope in the Northeast it doesn't snow as much as it has, although I don't rule out anything, I guess. But if -- assuming the weather is better and -- how does that Easter shift work? Does that actually -- that hurt 1Q, but helps 2Q? Can you just explain to us some of those moving parts?

Murray S. Kessler

It really doesn't help 2Q. Last year, what happened is the weekend of Easter was the last weekend of the year. So they're closed. A lot of distribution centers are closed, so they got to bring it in prior to the weekend, and then the quarter end. This year, it's in the middle of April. So they bring it in on the weekend and they're back to normal again on Tuesday. It's just -- because it's not at the end of a quarter. Having said that, look, I got to be honest. When I was on the conference call a quarter ago, I thought inventory was going to benefit us a little bit this quarter, not hurt us a little bit this quarter because we came in cleaner than we did the year-ago. Having said that, for us, inventories were reduced during the quarter. And I explained some of the reasons for that. Part of that was Easter, which probably would have affected the entire industry or most of the entire industry. And the second was the factory pack promotion reductions also had an impact on inventory, which I didn't anticipate. I just sort of looked at what we did last year in shipping them. But the reality is that some of those were -- a fair number of those, more than half of the inventory changed year-over-year, was factory packs that were still in inventory at the end of the first quarter that ended up shipping in the first week of the second quarter. That should have a positive impact on -- that part should have a positive impact on the second quarter. Net-net, we are at as low a level on inventory as we've ever been right now going into the second quarter coming into higher seasonality. There was a slight increase in inventory. Last year, I don't expect it to be much different, but I -- I'm not good at predicting these. So I don't think inventory should be a huge factor in the second quarter, but I've been surprised before.

Michael Scott Lavery - CLSA Limited, Research Division

And just to clarify, I think I understand what you're saying. But certainly you're saying it doesn't look like it should be a negative hit again. But is it reasonable to think that inventories, historically in the trade have just been trending down, so at the lowest level now, is potentially sustainable, it won't necessarily give a lift back?

David H. Taylor

Remember, the action that we took, with respect to trying to manage those intentional loading by some of our wholesale customers. We took that action late last year. Now flash forward to the second quarter last year, that was just -- that ended June 30, just after a June price increase. We're going to continue this practice of trying to hold our wholesale inventories down, so that fluctuations don't happen and our wholesalers don't load as much. So in theory, we should [indiscernible] from that level of wholesale inventories from -- in the current year below that, which was there last year. That's theoretical. We've -- and we expect that to happen. But the exact impact on the volume comp is, as Murray said, difficult to forecast.

Murray S. Kessler

But just to clarify, Michael, the inventory we ended the second quarter with is not like -- it's sort of as low as it's ever been, but it's not wildly out of line. It's just about 100 million units less than it was at the end of the first quarter last year. And I assume that we came in clean. We end clean. It shouldn't have changed much. But reality, about 3/4 of that was the factory pack promotions that aren't there this year because we just cut that -- we cut that practice back. And there are some other little minor things that changed it. Second quarter, it should come up a little bit for seasonality. And that's what happened last year, too. So it's not just the absolute inventory. It's what happens at the beginning of the quarter to end of this quarter this year versus the beginning of the quarter to the end of the quarter last year. And that's how you do your adjustment. And I don't think there should be a radical shift in the second quarter, but I can't always predict.

Michael Scott Lavery - CLSA Limited, Research Division

No, okay, that's very helpful. And then on e-cigarettes, you said you had the big lift a year ago from pipeline sales for new distribution. I think you had gone from 60,000 to 80,000 retail outlets then. But you had gone from 136 to 149. And so you'd added another 13,000 this quarter as well. Are those a different quality or size outlet that they wouldn't have had as much impact? Or is it just that there's not quite as many that you cite the comparison of the pipeline fill for that?

Murray S. Kessler

Yes, we report sort of the stores selling, et cetera, but we had just rolled national. That's why you'd see retail up 68%, et cetera. We had those old kits. They sold for twice the wholesale price. We had started with disposables in many stores. And we made a big push for those rechargeable kits at a higher price in the first quarter of last year, and it was like $7.5 million different in comparing the 2 years just on the price associated with those kits, let alone the pipeline of putting 24 disposables. I understand your math. What you're saying is you gained some distribution this year, but you did it at much lower prices and a lot of that is just broadening the line.

Michael Scott Lavery - CLSA Limited, Research Division

Okay. And then the fact that there's not restrictions on -- the deeming regulations don't force things behind the counter, or they seem to allow secondary displays to continue. I know you've just said how that's been a part of your strategy. But is there any of that, that you might increase or you've been again waiting to see sort of what the rules are and now you might consider extra secondary placements or displays?

Murray S. Kessler

Repeat the question one more time.

Michael Scott Lavery - CLSA Limited, Research Division

Well, I guess, I'm just saying, you've got -- you're not using your cigarettes space behind the counter for blu. Regardless of where it is, are there incremental placements you might consider now, now that you know that the regulations aren't going to force you behind the counter?

Murray S. Kessler

Yes, we're not behind the counter, but we're not self-service either. I mean, that -- we don't allow self-service. I mean, it's not about secondary units. Our method is to get in a beautiful merchandising unit for blu with great point of sale, primary point of sale visibility on it, in the different sized formats that we get it in, get a great presence, get point-of-sale in the front of the store to capture people's attention and I think our sales force has done a phenomenal job doing that. I don't think there's an issue on blu getting visibility at retail.

Michael Scott Lavery - CLSA Limited, Research Division

Okay, that's helpful. And then just last question on the U.K. Obviously, it's a fragmented market. How big is the biggest player? How fragmented is it? Is that a -- or are you still ahead of the game in terms of being able to put yourself pretty quickly in that position like you did here? Or is there anybody else getting a leg up already? What's the competitive situation look like?

David H. Taylor

Well, the competitive situation and the way we'll execute in the U.K. is entirely different than what we did in the U.S. We had a sales force here in the U.S. that already covered the retail universe. We did not have that when. We did not have that when we acquired SKYCIG. We're In the process of doing that. There's different ways of getting your product in these major retailers, with listing fees and the like that we didn't have that experience here in the U.K. (sic) [U.S.]. And we will be competing against the likes of BAT that is -- that has those advantages and they're rolling their own e-cigarette product. It's one of the reasons that we can't just sort of go slow. We need to go quickly and establish blu as the real brand and pull it through with a branding effort rather than just distribution effort.

Murray S. Kessler

But to be real specific to his question, though, is anybody bigger than like a 5 or 6 share at this point? I mean, it's all very fragmented.

David H. Taylor

It's very fragmented.

Murray S. Kessler

And I would say, part of our sense of urgency, Michael, there is no 25-, 30-share brand in the U.K. today like us and perhaps Enjoy a year ago. What you have there is a bunch of little players and BAT rolling to go national and try to do the same thing we're doing. So you're going to have a concurrent launch, as far as I can tell, between the Vype product and blu. Vype is BAT.

Operator

Your next question comes from the line of Owen Bennett from Nomura.

Owen Bennett - Nomura Securities Co. Ltd., Research Division

And just one question, if I may. Just going back to the pricing. So if I heard you right, you said there will be no more reduction in factory packs into the rest of year. I was just curious as to how this will impact pricing realization going forward. And therefore, is the more realistic expectation with pricing for the rest of the year more like between 4% to 5%? Some help in trying to quantify the impact myself. Could you give an indication how much lower the factory pack promotions were priced compared to the regular pricing?

Murray S. Kessler

The fact is that the robust pricing was aided not only by the list price increases, but the lower promotional spending. So you won't get that lower promotional spending in Qs 2, 3 and 4 as compared to Qs 2, 3 and 4 last year. I'm not prepared to quantify exactly how much that lower promotional spending impacted the price realization. And I'm loathe to give you a forecast for what our pricing will be going forward. But you could -- all other things being equal, and if we take the same level of list price increases that we took in the prior year, that the level of price realization, absent other mix factors -- a lot of things go into this calculation -- it will be lower than 6%. Part of the positive factor was those lower factory packs. Everything else being equal, it will be lower, but I'm not going to be able to give you an exact number.

Operator

We have no further questions on the line. I would now like to turn our call back to Mr. Kessler for closing remarks.

Murray S. Kessler

Thank you for your continued interest in Lorillard. We're excited about the opportunity and our investment in e-cigs, although it will take a little bit more investment. And more importantly, very pleased to see the continued strength in our cigarette business, which pays the bills around here and allows us to generate the cash that we return to shareholders year-after-year and deliver those double-digit returns. So thank you once again.

Operator

This concludes the Lorillard Inc. First Quarter 2014 Earnings Conference Call. For a replay of this conference, please dial (800) 585-9367 and enter the conference ID 28927750 to listen to the call. You may now disconnect.

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