Lorillard Inc. (NYSE:LO)
Q2 2010 Earnings Call
July 26, 2010 10:00 a.m. ET
Bob Bannon – Director, IR
Martin Orlowsky – Chairman, President and CEO
David Taylor – EVP, Finance & Planning and CFO
Judy Hong – Goldman Sachs
David Adelman – Morgan Stanley
Nik Modi – UBS
Andrew Kieley – Deutsche Bank
Christine Farkas – Banc of America Merrill Lynch
Thilo Wrede – Credit Suisse
Anna Shtromberg - National Australia Bank
Good day ladies and gentlemen and welcome to the second quarter 2010 Lorillard Inc. earnings conference call. (Operator instructions.) I would now like to turn the conference over to your host for today, Mr. Bob Bannon. Please proceed.
Thank you Madge and good morning everyone. I’m Bob Bannon Lorillard’s director of Investor Relations and joining me on today’s call is Marty Orlowsky, 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 second quarter 2010 earnings release. It can be found on the company’s website, Lorillard.com, under News Releases. But, before we begin I would 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.
I would now like to turn the call over to Marty Orlowsky.
Thanks Bob. Good morning everyone. We’re pleased with the company’s performance for both the second quarter and the first six months of 2010. Lorillard and the Newport brand achieved record wholesale and retail shipment market share, and the company’s domestic wholesale unit volume performance outperformed the industry when comparing 2010 with 2009 for the second quarter and the first 6 months of the year.
As most of you are aware, comparing performance trends for the second quarter of 2010 and 2009 is difficult on face value and can be misleading due to distortions in wholesale and retail trade inventory purchase behavior, which resulted from the effect of the federal excise tax increase that occurred on April 1 last year. As such, a clearer picture of market performance is reflected in the first six month comparison each year, which will tend to wash out the anomalies that occurred in 2009.
Total Lorillard domestic wholesale shipment unit volume increased 5.3% in the first half of 2010 versus 2009, compared with an industry decline of 4.9% for the same period. Newport was up 2.5% for the same six months of comparison. Wholesale shipment domestic market share for Lorillard increased by 1.10 points for the first six months of 2010, resulting in a total share of 12.16% and Newport shipment share of the domestic market for the first half of 2010 was 10.44%, an increase of 0.75 points over the first half of 2009.
At the retail level, based on our data, Newport achieved a 10.93% share in the first six months of this year, an increase of 0.66 points over the same period in 2009. (Inaudible) grew 0.44 points for the same period with comparison, achieving a 1.44 retail share of market.
Lorillard’s performance for the first six months of 2010 reflects a continuation of the success of our core business strategy of balancing Newport’s market share performance and profitability.
And now I’d like to turn it over to David Taylor for a recap of our financial performance.
Thanks Marty, and good morning everyone. I’ll briefly review the results and then we’ll open the line for questions.
Net sales for the second quarter of 2010 were $1.52 billion, compared to $1.519 billion in the second quarter of 2009. Roughly flat with last year’s second quarter.
In last quarter’s call, we pointed out that the disruptions in shipment patterns caused by last year’s federal excise tax increase make quarter to quarter comparisons for 2009 tricky, and cautioned that a better comparison would be the first six months of 2010. When we look at the first six months, our net sales, excluding excise taxes, increased 8.8% to $1.96 billion from $1.8 billion last year.
Total wholesale shipments declined by just under 1% for the second quarter, but increased 4.9% for the six month period. Higher net average selling prices for the second quarter essentially offset the effects of the lower volume mix and higher sales promotion costs accounted for as a reduction of sales. When these higher average selling prices are compounded by an increase in volume, such as we saw for the six-month period, the result is the almost 9% increase in net sales before excise taxes.
Gross profit in the second quarter of 2010 declined by $10 million to $542 million, or 52.2% of sales excluding excise taxes, from $552 million or 53.4% of sales excluding excise taxes in the second quarter of 2009.
Cost of sales in the second quarter of 2010 reflect increases for certain raw materials costs such as tobacco and wrapping costs and the new FDA fees when compared to last year’s second quarter, the same sorts of dynamics we saw in the first quarter. Amounts due under the state settlement agreements increased $4 million compared to last year’s second quarter as a result of the inflation factors in those agreements, which was partially offset by volume and market share adjustments.
Selling, general, and administrative costs remained roughly flat, increasing $1 million to $97 million in the second quarter of 2010 from last year’s $96 million.
Second quarter operating income decreased roughly 2.4% to $445 million, or 2.9% of sales excluding excise taxes, from $456 million, or 44.1% of net sales excluding excise taxes in last year’s second quarter.
When the first six months of 2010 are compared to the same period last year, you see an increase in operating income of over 10% to $827 million from $751 million last year. Operating income per unit shipped for the six-month period increased approximately 5% compared to the first half of last year.
Interest expense totaled $28 million in the second quarter of 2010 and reflects interest expense on our senior notes net of the effect of the interest rate swap which lowered our interest expense by $6 million in the second quarter.
Our effective income tax rate in the second quarter was 37.1%, the same as last year’s quarter, and we currently estimate that the effective tax rate for the full year will approximate 37.2%.
Net income for the second quarter of 2010 was $263 million or $1.73 per share compared to $286 million or $1.71 per share in the second quarter of 2009.
Earnings per share for the first six months of 2010 was $3.22 per diluted share compared to $2.80 per diluted share for the first six months of last year. The $0.42 improvement in EPS in 2010 includes the positive impact of the lower average share count, which amounted to about $0.28 per share.
As we have said, comparisons of volumes in the first two quarters of 2010 to last year can be confusing. So we think investors and others should look at the first half of 2010 and compare it to last year. When those comparisons are made, with most of the noise surrounding last year’s excise tax increase equalized, the picture is impressive: a unit volume increase of almost 5%, a sales increase of almost 9%, an operating income increase of 10%, and an EPS increase of 15%. A successful first half by almost any measure.
In February, we announced a $250 million share repurchase program, which was completed during the quarter after having purchased 3.3 million shares at an average price of $76.29 under that program.
I know that many of you will want to know whether we intend to use the proceeds of our recently completed bond offering to further increase our share repurchase activity, but as of this date I cannot comment on what, when, or how much the board may authorize the company to repurchase in the future.
With that, I’d like to open the line for questions. Madge, could you do that for us?
Yes sir. (Operator instructions.) And your first question comes from the line of Judy Hong from Goldman Sachs. Please proceed.
Judy Hong – Goldman Sachs
Dave, just on the share buyback comment, obviously you don’t have any news today, but philosophically is the board thinking on the use of cash, whether buyback or dividend increases, is that any different today than it was, say, a year ago, especially in light of what’s going on with the FDA reviewing the menthol regulations?
I don’t really think that the thinking of the board is dramatically different today in light of the FDA’s considerations. I don’t think that has fundamentally changed the way the board is going to think about capital resource allocation.
Okay. And then just in terms of the second quarter, I know you talked about looking at the six months trend, but can you just quantify how much the destocking impacted Newport’s volume in the second quarter?
The inventory movement
It was about a $2 million unit carryover from the first quarter into the second quarter and that pretty much got washed out through the second quarter. And then again there was a slight uptick in inventory build by some wholesalers in anticipation, and maybe even the retailers, in anticipation of the New York State excise tax increase that took effect July 1. But I don’t think that was a material number to deal with, so I’m going to say for all practical purposes all of that stuff has been basically washed through the system.
Just to clarify, Marty, in the third quarter of last year, though, you had another pretty significant destocking on the Newport volume, so when we think about the third quarter shipment trends, doesn’t that really give you a very favorable comparison, just in terms of year-over-year inventory movement comparisons?
Well, it could. I think that depending on what may or may not occur during the third quarter of this year, can affect that one way or another obviously. But at this point, I really can’t say how the comparison is going to net out at the end of the quarter itself, so we’ll just have to wait and see.
And then just broadly Marty, as you think about Newport’s share performance in the first half of the year, just in light of continued intense competitive activity, whether it’s from Marlboro menthol or Camel (inaudible), how would you assess the Newport’s performance and really just kind of looking at the share and profitability balance that you’ve been able to achieve?
Well frankly, we haven’t really witnessed any significant shifts in terms of the competitive framework so far through the year. I would not necessarily, I can’t anticipate at this stage of the game whether there’s going to be any radical or significant change occurring. So assuming all things remain as they’ve pretty much been, the Newport brand should continue to perform competitively, as it has.
And your next question comes from the line of David Adelman of Morgan Stanley. Please proceed.
David Adelman – Morgan Stanley
Marty, is there any update you can provide with respect to the status of the CEO search process?
Okay, is there a point in time you would think if there hasn’t been news that it would be appropriate, or are you willing if there’s not a clear candidate, to extend your employment agreement?
Well, if there isn’t a candidate, we’ll see how it evolves, is my best answer to that.
And then a question, Marty, on the Engle progeny cases. Can you approximate what fraction of the progeny plaintiffs have a material history of smoking Lorillard products? Can I ask that out of curiosity because I don’t think that you’ve been a defendant in any of the first 20-21 cases that have gone to trial.
That’s correct. We have not been. We are not, obviously, involved in the vast majority of the cases. I think the count was . . . We’re obviously not represented in the majority of the cases, and to date, as you’ve said, we have not been involved in a trial. Obviously that can happen at any point in time going into the future, but in the overall mix of it, we’re a much lesser factor with respect to the totality of the cases that are involved in this whole business.
Okay, and then one last thing, Marty, on the FDA. Am I correct that the FDA is not under . . . once the scientific advisory panel comes up with a recommendation, whatever that recommendation is, the FDA is not under any mandated timeframe to take action if any in response to that recommendation. Is that correct?
That is correct. The only one under the time clock is the committee itself, but the FDA certainly is not, just as the FDA is not obliged necessarily to follow the recommendation itself. They have the option as you well know to consider the input from the committee and consider other aspects of the issue, so in either case the FDA is not under the clock.
And actually just to revisit Judy’s question for one second with respect to the buyback, there’s no broad philosophical change whatsoever in you or the board’s attitudes towards share repurchases.
No there is not.
And your next question on the line comes from Nik Modi of UBS. Please proceed.
Nik Modi - UBS
Quick question on cost of goods, just noticing you had a downtick in cost of goods per package. That line item, all those moves around so much, just curious on your perspective on what’s really driving the changes there so we can just think about that more effectively going forward.
I’m not sure that it’s, Nik, it hasn’t changed dramatically but there are a large number of elements in cost of sales that aren’t directly variable with the number of cigarettes we sell.
Okay, so it’s more fixed cost in nature.
Distribution, FDA or other period costs are not necessarily variable with the number of units that we sell, so we sold a significantly greater number of units in Q2 than we did in Q1, so when you’re doing the arithmetic some of those costs are fixed and some of them are variable.
Okay, and then just one question, David, on the negative mix from Maverick. Is there any perspective you can provide on what the impact of that was on your margin, or the net pricing, just to get a sense on how big of an impact that could have been?
I don’t think we’ve actually tried to quantify the impact of mix-shifts on net sales. But you could imagine that our net pricing was essentially offset by the ramifications of both volume and mix as we said before. We haven’t really tried to quantify the net change with pricing and mix impact.
And your next question comes from the line of Andrew Kieley of Deutsche Bank. Please proceed.
Andrew Kieley – Deutsche Bank
Marty, I know you said the impact on second-quarter shipments due to the New York State tax increase wasn’t material. Is there a round number you could put on that, and then does that create a challenge for your third quarter shipments, and are you seeing any early impact on the consumer takeaway in New York as a result?
No, I can’t quantify it. I don’t really know what it is. As I said, it wasn’t very significant, and I don’t think that the early buying in the second quarter for the third quarter is going to have any sort of real material impact on third-quarter numbers.
And we have not seen, yet, any effects of consumer takeaway based on the pricing that’s now in effect in New York City and New York State. So, right now we perform pretty well in the past following excise tax increases in New York State, some of which have been rather substantial in nature.
Again, that’s not a guarantee that the future will perform the same way, but clearly, and it’s not an encouraging situation to be in with the kinds of increases that took place in New York, but nonetheless, we have to view it as we do excise tax increases in any state. There tends to be an adjustment on the part of consumers over time.
We may, may, and I emphasize that, see some negative impact in the short term at some point following this excise tax increase, but we’re reasonably confident that over time we will perform reasonably well. Our market share in New York State has actually been growing rather substantially over the past couple of years, even in light of what took place following all of those tax increases.
So we’re very cautious about what the situation is there and feel reasonably confident that it will not have a major, major impact on us.
Have you taken any incremental pricing since July 1 on top of that?
And then, second thing, just to follow up on FDA, now that we have two panel meetings under the belt, has anything changed in your expectation in the outcome there, either from the data they requested or the line of questioning from the committee? And secondly, when do you think the contraband issue might play more of a role, because we’ve heard virtually nothing about that so far in this process.
That’s a really good question, the contraband. We’re wondering about ourselves when they’re going to look at it since it’s written into the law and it’s a critical component for consideration and evaluation of the effects of any decision made regarding menthol. We’ve been encouraging the FDA to keep this as a major agenda item. We don’t know yet when they will get to it or how they will view it. So that’s a big unknown at this point although at some point in time it must be taken into account. So while it has not been done in the first two meetings, we fully expect at some point it will be an item for discussion and an item that must be taken seriously in their deliberations on the issue.
You asked about expectations, we don’t have any expectation necessarily of outcomes here. The only thing I can say about the first two sessions that occurred, or the first two meetings that occurred by the panel is that there were really no surprises. I think I said that following the initial meeting of the FDA group earlier this year. The script for many of the cast of scientists that are on the panel is fairly consistent with most of their past expressions and articulations of their views.
To be honest with you I think it’s a little disappointing that some members of the panel are not necessarily pursuing the issue on the basis of discovering facts and validating facts. It seems that some tend to just regurgitate things that they’ve said in the past without really looking at the science necessarily. And this is not a surprise. I think we need to wait and as this process unfolds, and see where it goes. So we don’t have any expectations at this point.
And your next question comes from the line of Christine Farkas of Banc of America Merrill Lynch. Please proceed.
Christine Farkas - Banc of America Merrill Lynch
A follow up on the New York, and you’ve been clear. I just want to understand if the changes you’ve seen with respect to the buy-ahead is similar to what you’ve seen in the past ahead of price increases, or does it look different this time?
No, it’s essentially the same.
And then prior, in the prior quarter David, I believe you touched on legal fees being higher than the prior year due to Engle or other factors. What did you see this quarter with respect to the legal fees?
Legal fees were about flat with last year’s second quarter and although we may have expected them to increase in the second quarter based on the trial calendar for Engle, a lot of those cases actually were deferred out of the second quarter and into periods in the future.
Okay, so some of those expected costs might be pushed out rather than any other timing factors.
Yeah, and that calendar is a bit unpredictable. Even though a trial gets placed on the calendar, it doesn’t mean that they always happen on that schedule.
And your next question comes from the line of Thilo Wrede. Please proceed.
Thilo Wrede – Credit Suisse
Could you provide us with an update on where the MST development stands?
We’re still continuing on a path of having, of being in a position to compete in that category. I don’t have anything specific to add at this point, but we still continue to have the interest.
And any timeline when you want to have a product on the market?
In a reasonable time in the near future.
And then one question regarding the FDA from me as well. How would you assess your success rate so far to convince the advisory committee that the science is inconclusive when it comes to menthol?
Well we didn’t go into the process with a series of milestones for success or failure for that matter. We’re dealing with it as it comes along. We think we’ve made some very effective presentations of the information as requested by the FDA, particularly this last round, both in the science and the marketing areas. So we feel very comfortable and confident that our ability to present the information was done so and it was done in an effective manner.
And so it’s not a matter of measuring or accepting degrees of success or degrees of anything. As I’m sure you, I don’t know whether you were there, Thilo, or not, but if you weren’t you could certainly see it on the Internet, the questions asked by the panel clearly range across the full spectrum of both science and non-science and so it’s kind of difficult to sit there and sort of measure or determine based on what questions come up and attempt to read the tea leaves with respect to the implications of those questions. I think it’s just, right now it seems to me to be a process of, from the panel’s perspective, of attempting to touch on any number of areas that may or may not be ultimately a part of the mix for the consideration of their decision.
Would you say that the panel members were receptive to your line of argument, to your view of menthol?
I really can’t comment on that. You know, whether they were or weren’t. Certainly unless we attach electrodes to their brains, not to be facetious, I have no idea.
And your next question comes from the line of Anna Shtromberg from National Australia Bank. Please proceed
Anna Shtromberg - National Australia Bank
Hi, just to prolong this FDA panel questioning, when do you think will be the next time we will hear any kind of news out of the committee or FDA in terms of maybe . . . the decision needs to come out by March 2011, but between now and then do you expect any kind of news coming out?
Well when you say news there’s still going to be a number of sessions convened by the committee to explore a number of issues and in fact not just exclusively dealing with the menthol, as the one before this last one. So when you say news I think there’s going to be, there still will be a number of meetings held by the committee. They will cover a number of topic areas, some of which we don’t even know yet what they will consist of. They will inform us. I think that I don’t know if there will be any news specifically that’s going to evolve until it gets toward the end of the process itself.
Understood. Thank you.
There are no more questions at this time and I would now like to turn the call over to Mr. Orlowsky for closing remarks.
Thank you. We have no further comments to make. Thank you all for participating on the call and have a good day.
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