Reynolds American Acquires Lorillard Conference Call (Transcript)

Jul.15.14 | About: Reynolds American, (RAI)

Reynolds American Inc. (NYSE:RAI)

Reynolds American to Acquire Lorillard

July 15, 2014 08:00 AM ET

Executives

Morris Moore - VP Investor Relations, Reynolds American

Susan Cameron - President and CEO, Reynolds American

Murray Kessler - Chairman and CEO, Lorillard

Tom Adams - CFO, Reynolds American

Analysts

Vivien Azer - Cowen & Company

David Adelman - Morgan Stanley

Bonnie Herzog - Wells Fargo

Michael Lavery - CLSA

Judy Hong - Goldman Sachs

Nik Modi - RBC Capital Markets

Adam Spielman - Citi

David Dellman - Morgan Stanley

Todd Duvick - Wells Fargo

Lisa Lewandowski - Bank of America

Priya Ohri-Gupta - Barclays

Filippe Goossens - Mitsubishi Securities

Temple Houston - Prudential

Morris Moore

Good morning and welcome everyone. I’m Morris Moore, Vice President of Investor Relations at Reynolds American.

Before we begin the discussion on today’s announcement, I’ll give you a moment to read our precautionary statement on forward-looking information. We will be discussing some forward-looking information and actual results could be different from our forecast. These risks are listed in our press release this morning as well as in our SEC filings. We will include some adjusted results in our presentation. A reconciliation of adjusted to GAAP results is at the end of the presentation, which will be available later today on our new transaction Web site at www.reynoldsamericaninfo.com.

With us today are Susan Cameron, Reynolds American’s President and Chief Executive Officer; Tom Adams, our Chief Financial Officer; and Murray Kessler, Lorillard’s Chairman, President and Chief Executive Officer. He will provide comments on the agreement reach for Reynolds American to acquire Lorillard. Then we’ll cover the highlights of the transaction, Reynolds American’s transformation journey, the Newport success story, and the reasons why this transaction is so compelling and the financial highlights. After that, we will be happy to take your questions.

Now, I’ll turn the call over to Susan.

Susan Cameron

Thank you, Morris, and good morning. My thanks to each of you for joining us. We are very excited to announce that we have reached an agreement under which Reynolds American will acquire Lorillard in cash and share transaction valued at $68.88 per share, which values Lorillard at $27.4 billion. As part of this transaction, Imperial Tobacco will be purchasing the KOOL, Salem, Winston, Maverick and blu assets of R.J. Reynolds and Lorrilard. And British American Tobacco will be investing $4.7 billion to maintain their 42% ownership in Reynolds American. Additionally, Reynolds American and British American Tobacco have in principle agreed to pursue an ongoing technology sharing initiative for the development of next-generation tobacco products, including heat-not-burn cigarettes and vapor products.

What we’re announcing is compelling, strategic and surge to create further value. Reynolds American’s acquisition of Lorillard will increase scale, generate considerable cost synergies and efficiency and enhance geographic diversification, all of which will result in new revenue opportunities and it benefits adult tobacco consumers. The transaction supports Reynolds American’s ongoing efforts to lead the transformation of the tobacco industry, while also making Imperial a more competitive U.S. player.

Imperial is the fourth-largest tobacco company in the world by market share. And their brands are sold in more than 150 countries, including here in the United States through their Commonwealth-Altadis operating company. Today their U.S. cigarette brands include USA Gold and Sonoma. The addition of KOOL, Salem, Winston, and Maverick to their portfolio is expected to more than triple their U.S. market share and they are also purchasing the current e-cigarette category leader blu. Our transaction is expected to close in the first half of 2015 and will be subject to regulatory and shareholder approval.

From a strategic standpoint this combination is absolutely compelling. It will give us a unique portfolio of iconic brand as well as adding a geographic benefit from R.J. Reynolds strength in the Western U.S. and Lorillard’s complementary strong presence in the Eastern U.S. Synergies and revenues generated by this combination will better position Reynolds American’s operating company to fuel continued investment in brand building, R&D and innovation for the long-term future of the Company.

As you see from this snapshot or combined brand portfolio represents an enhanced growth profile with strength across categories and price points.

Throughout our conversations, I have been very impressed by the Lorillard team; the company that they have built and their terrific product portfolio. I’m confident that together we can build on our combined strength to grow further and continue the transformation of the tobacco industry. We started this transformation journey in 2004 with the merger of R.J. Reynolds and Brown & Williamson. In the decade since the B&W merger, these are some of the things that we have accomplished. The next move for us represents that change. We will continue to transform our industry by driving innovation throughout our businesses, redefining enjoyment to adult tobacco consumers and reducing the harm caused by smoking.

We have always focused our investments in the long-term growth of our key brands, particularly in the smoke free space. The acquisition of Lorillard will allow us to continue this journey as well as to create and cultivate new and meaningful revenue stream while proactively shaping the intra-external environment. We’re confident in the FDA’s commitment to science-based regulation coupled with a transparent rulemaking process, which will allow us to manage menthol regulation over time.

Our strong portfolio of key brands has been diversified across key categories, allowing us to best position ourselves for the continued transformation of the tobacco industry.

Since Reynolds American’s formation in 2004 we have also focused on key products to position ourselves to take advantage of the growth space. This chart illustrates just how dramatic that shift has been at RJ Reynolds and the Company is much stronger for it. This growth brand strategy has clearly delivered results and our adjusted operating margin has more than doubled since 2004. As you can see we generated exceptional total shareholder return significantly outpacing the S&P 500 and we intend to continue that trend.

Before inviting Murray to discuss the transaction from Lorillard’s perspective. I’d like to highlight VUSE a product which we believe will be a game changer in the e-cigarette space. Since its expansion into Colorado in 2013, its first major market, VUSE has delivered outstanding results and quickly became the category leader. Sitting here today we can proudly say that we are well underway with our national expansion. We have just expanded to 15,000 additional outlets and we are on our way to full national distribution, all of which illustrates that VUSE has a bright future ahead of it.

We will continue to compete with blu as we have with VUSE already. And it’s important to know that VUSE has also helped to transform the e-cigarette market in Colorado by tripling the size of the total category. A closer look at the e-cigarette market in Colorado shows that VUSE has almost 70% share. As I’ve already said VUSE began the first phase of its national distribution in June and that’s going very well, and we’re now pursuing a technology sharing agreement with British American Tobacco which holds great potential for new avenues of growth for VUSE globally down the road. It is these types of innovative product investments that we look forward to continuing to make to position ourselves for future growth.

And now without further ado, I’m delighted to turn to over to Murray.

Murray Kessler

Thanks Susan. This is truly a big day for all our companies; we believe these transactions are a win not only for our shareholders but also will win for our employees, customers and consumers. At the core of this belief and what has made all of this possible is the incredible Newport brand. Newport is a remarkable success story and has been a marquee brand not only for Lorillard but as part of the tobacco landscape. As most of you already know Newport is the number two cigarette brand in the United States with a 13% share of the total industry. The brand has two of the top five fastest moving SKUs in the entire industry and of course Newport is the number one menthol brand in the US with a 37.4% share and has a unique and attractive demographic profile.

Retail sales for Newport exceed over 10 billion annually making it one of the biggest brands in the United States. And as you can see this success is the result of consistent growth over the last 30 years including the last 11 consecutive years and the first and second quarters of this year. It’s hard to find another consumer brand that can tell that kind of consistent success story.

We attribute that success to incredibly strong brand equity. Our expertise in full flavor and menthol which results in a superior product and favorable demographics all of which bode well for continued success going forward. This long term success story and the complementary nature of Newport to Reynolds core brands was not lost on Reynolds board and management team which is why we’re here today. They were able to come forth with a transaction that is able to deliver significant and immediate value to Lorillard’s shareholders through a tax premium as well as the potential to participate in the upside potential of this amazing new Company. And at the same time and I give them tremendous credit for this, provide greater certainty to the transaction’s completion through a well thought out pre-arranged divestiture package with Imperial and the support they were able to garner from their major shareholder British American Tobacco.

In this transaction Lorillard’s shareholders will receive for each Lorillard share $50.50 in cash and 0.2909 of shares in Reynolds stock at closing. The 68.88 per share value based on Monday’s closing price for Reynolds stock represents a premium of 40% to Lorillard’s closing stock price on February 28, 2014 prior to the media speculation about a potential transaction. That’s 27.4 billion in enterprise value and a 13 times enterprise value to EBITDA multiple placing this transaction near the very top of precedent transactions.

Lorillard’s shareholders will own approximately 15% of the combined company. This valuation recognizes all the hard work and effort that has gone into making Lorillard the company that it is today.

We are also pleased with the transaction with Imperial which is going to leverage Lorillard’s existing infrastructure and operations. Following the transaction Imperial will continue to drive growth in blu, the leading e-cigarette brand and is expected to make significant investments to revitalizing growth of KOOL, Salem, Winston and Maverick brands. Imperial is also acquiring Lorillard’s headquarters as well as our manufacturing and R&D facilities in Greensboro, North Carolina and Danville, Virginia and almost all of our sales force.

We are pleased that Imperial recognizes the importance of our employees and the success they bring to our operations, as well as the quality of Lorillard’s facilities and the strength of our customer network. I am convinced that they have strong plans to make them a strong number three player in the U.S. tobacco industry, but I will leave that for their conference call.

Again I am very proud of what the Lorillard team has accomplished. And I’d like to take a moment to express my appreciation for the hard work of our dedicated employees. We look forward to working with the Reynolds and Imperial teams to complete these transactions and to achieve a seamless integration.

And with that I will turn the call back over to Susan to illustrate just how compelling the post merger transaction economics are for shareholders of both companies. Susan.

Susan Cameron

Thank you, Murray. Clearly this transaction will give us an even stronger portfolio of iconic key brands. Newport, Camel and Pall Mall are the number two, number three and number four cigarette brands in the U.S. And Newport is the top menthol brand. We also have Natural American Spirit, now a top ten brand and the fastest growing brand in the U.S. Grizzly is the number one brand in the moist-snuff industry while the superior VUSE digital vapor cigarette is showing very positive early results.

The transaction also provides an enhanced growth profile. As you can see if the deal had taken place last year, growth brands would have accounted for 90% of R.J. Reynolds total cigarette market share. By comparison Camel and Pall Mall represented only 25% of the Company’s total market share in 2004.

As I mentioned earlier, the complementary regional strength of each company and the Camel and Newport brand will be a factoring future revenue growth. The Company and specifically these brands do not significantly overlap in many of these markets. For example, in the West R.J. Reynolds cigarette brand have a 33% share of the market, while Lorillard cigarette brands are underrepresented. This offers a big opportunity to increase Newport share in that market.

All in all, Reynolds American and Imperial’s competitive position will be greatly enhanced making Reynolds American a stronger number two in the industry and making Imperial a strong number three. And of course the deal will give us increased scale in cigarette volume and share and that combines with the synergies, will result in higher adjusted operating income.

In addition, Reynolds American and its operating companies have a proven record of successful execution not just in integration experience but also in cost management. Their intense focus on efficiency and productivity improvement is embedded across all areas of the Company, and that’s clearly reflected in Reynolds American’s strong operating margin improvement over the years.

So we’re confident that this transition will a smooth and successful one, setting the stage for our next phase of growth. And now I’ll turn the call over to Tom for more financial details.

Tom Adams

Thank you, Susan. To began I’ll provide a high level summary of the transaction terms and structure, after which I’ll walk through some other key financial details. As Susan mentioned Reynolds American will acquire Lorillard in a tax and share transaction valued at $68.88 per share, which values Lorillard at $27.4 billion. As part of this transaction, Imperial will be purchasing the KOOL, Salem, Winston, Maverick and blu assets of R.J. Reynolds and Lorillard and British American Tobacco will be investing $4.7 billion to maintain their 42% ownership. The offer represents 40.4% premium to the stock price prior to initial media speculation.

In addition to this strategic attributes both Susan and Murray outline for us, there is a very compelling financial reason as well. The enhanced financial profile of the combined company will lead to further top line growth and enhancement of margins and is accretive in the first full year. We will also have strong double-digit accretion in the second year and beyond.

We will maintain our current dividend policy until close and target 75% dividend payout policy thereafter. The combination strengthens our result to continue our commitment to have strong dividend payout. Our pro forma balance sheet highlights our strength and leads us to expect the confirmation of an investment grade rating. Our financial strategy once we closed is simple; we will focus on deleveraging in the near-term and will pursue strategy which will give us flexibility for returning capital to our shareholders over the long term. We also have a bridge financing facility in place which will be replaced by permanent financing.

We expect to achieve cost savings of approximately $800 million on a run rate basis, primarily stemming from a reduction in corporate expenses and the assumption by Imperial of certain Lorillard operations along with the divested brands. From a revenue standpoint our complementary geographic strengths will provide us with increased opportunities. In addition we will leverage R.J. Reynolds sales force to expand Newport’s presence.

Imperial will purchase Lorillard’s operations including the manufacturing facilities, the sales force and the headquarters for a purchase price of $7.1 billion. During the transition period, each company will contract manufactures of their respective brands. For your reference here is more detail on the sources and uses. And here we have an illustrative operating income bridge using 2014 as an example. So you see run rate synergies of $800 million plus coming in and the contribution from the divestitures going out.

Now I’ll turn it back over to Susan who will conclude our prepared remarks.

Susan Cameron

Thanks Tom. Before we begin the Q&A portion of the call, I would just remind you that we expect to close this transaction in the first half of next year, once we obtain the necessary shareholder approval and clearance from regulators. We’re hugely excited about the road ahead. As we noted earlier as a result of this acquisition, R.J. Reynolds will have a significantly strengthened and diversified portfolio of great brands across all key categories, the most balanced portfolio in the industry. We will also increase sale, enhance our growth profile, generate considerable cost synergies and efficiencies, and broaden geographic diversification, all of which will result in new revenue opportunities and best position us to capitalize on additional growth prospects. We look forward to integrating Newport with the rest of our Company’s powerful brands; Camel, Pall Mall, Natural American Spirit, Grizzly and VUSE.

And with that we will now take questions. Operator, the first question please.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Our first question comes from Vivien Azer of Cowen & Company. Your line is now open.

Vivien Azer - Cowen & Company

So, my first question has to do with kind of the extended timing of the close with an anticipation in the first half of ‘15, that’s an awfully big window. So can you talk a little bit about the regulatory review? What interactions you’ve had with regulators and where you see any potential pitfalls?

Susan Cameron

Sure Vivien. Thanks for the question. We look forward to working with regulators and our experience with these processes is that it will take between six and 12 months to complete this review. We also need to get the shareholder approval from the Reynolds shareholders, the Lorillard shareholders and the Imperial shareholders. And we are confident that we will be able to close this transaction. We will start the integration planning process in the next 30 days and we will be ready to move with integration as soon as we get those approvals.

Murray Kessler

Yes and from my perspective Vivien, we were very well advised and this is a very thoughtful well prepared disposition package that creates a tremendous competitor. And don’t underestimate that Imperial is now tripling in size in the U.S. and has a great sales force and management team that they’re on the top and plus they’re great people as well. I don’t mean to say it’s just ours. But that gives us great confidence in this going through and that too is going to be an education process and we’re very confident ultimately that the deal gets done.

Vivien Azer - Cowen & Company

And I perfectly understand that I am sure you know quite a lot of diligence went into this and very thoughtful consideration in terms of anti-trust issues. But one of the things that strikes me is that this deal does very fairly significantly relative to the brand and deal Susan that you separated in and in particular as it relates to as ASU 30 market shares which the FTC has pointed out. So can you just help us get more comfortable with potential ASU 30 HHI issues?

Susan Cameron

Vivien I think we’ll see how that unfolds as we go through this regulatory process. But I am very confident that this portfolio of strong iconic brand lives together very well and I am very confident in Imperial’s ability to compete with the package that they are acquiring. And as I said we look forward to working with regulators through this process and we’re excited about our future growth prospects.

Murray Kessler

Yes, bottom line that this deal across the board is pro-competitive.

Operator

Thank you. Our next question comes from David Adelman of Morgan Stanley. Your line is now open.

David Adelman - Morgan Stanley

A couple of quick things. First on a follow up to the anti-trust question, under the merger agreement Susan are you committed to making or would you need to make divestitures above and beyond what you’ve committed to the Imperial to satisfy the regional best efforts?

Susan Cameron

David, we’re very confident in this package all of those details to be released in the agreement. But quite frankly we are so confident in this divestiture package and the creation of a strong third competitor that we don’t believe any of that will be necessary.

David Adelman - Morgan Stanley

Secondly, can you frame a little bit that 800 million in cost savings, just in the context that I think Lorillard’s total existing controllable costs are only about 1.3 billion and obviously some element of that’s being divested and you can’t realize cost savings on Maverick?

Tom Adams

David this is Tom. That’s true. I mean there is about a little over $0.5 billion of transferred cost to Imperial in connection with the fixed manufacturing and the sales force and the Lorrilard headquarters in Greensboro. And then there is also going to be some G&A savings in terms of legal synergies that we would see. And so those are the big buckets of cost savings that we see.

David Adelman - Morgan Stanley

But just to be clear Tom, does the $800 million exclude or include the $500 million in cost which are going to Imperial. I’m trying to understand what you might realize?

Tom Adams

It includes.

Murray Kessler

So the chart that Tom showed when he walked through and sort of showed that those were gross numbers and then the numbers going out were at contribution level David.

David Adelman - Morgan Stanley

Two other things; Susan, Lorillard essentially has a Newport sales force as a practical matter. And that has certain implications about where they call on accounts, which accounts they’re calling on, which stores they are going into? And that is considerably different in certain instances than the Reynolds sales force or at least its strength. What's your confidence both through the transition and then more importantly subsequent to having the Newport brand that the Reynolds sales force is going to be able to execute effectively. Where Newport currently has its strength?

Susan Cameron

Good question, David. I think it’s important to understand that as we go through the integration and planning process, we have every intention of taking on portions of the Newport sales force and we’ve agreed with Imperial that we’ll math that out in the integration process. We understand the difference in store profile and it will be important to continue to call on those stores for the continued success of Newport. I think the big advantage here is in the combination that the complimentary geographic strength of the two companies will give us future growth prospects.

Murray Kessler

So David, I said most, the Imperial was taking most of the Lorrilard sales force in. You’re exactly right and that has not been lost in those areas that are particular to Newport that will be dealt with in as the sales force is divided up.

David Adelman - Morgan Stanley

Then two other quick things; Susan as part of the totality of this transaction, are you extending or altering the 10 year standstill with BAT that's going to expire shortly?

Susan Cameron

We are not, David. We are very pleased that British American Tobacco has emphasized their confidence in this transaction by buying up $4.7 billion to retain their 42% ownership in the Company. And we’re very excited about the prospects for this joint R&D and innovation next generation product combination. So we see great global prospects for our technology, look forward to sharing our technology with them and the specifics of that will be forthcoming. But we have not; we will not be extending the standstill. Thanks.

David Adelman - Morgan Stanley

And then last question, I take your comfort, your respective comfort on the outlook for menthol regulation. But what is the language in the agreement with any event that there were a material adverse change with respect to the FDA’s regulatory intent with regard to menthol cigarettes while the deal was prior to closing. Is that carved out and it’s not considered a material adverse change or is it?

Murray Kessler

It is not a material adverse change and our Lorrilard shareholders are adequately protected, but don’t lose sight of the big picture and I know you started that way. We do not believe the science reports and we believe that the way this has gone and the responses that you have seen from all of the companies around the world on this demonstrates that while cigarettes are dangerous there is not a significant difference between a menthol cigarette and a non-menthol cigarette and ultimately the science will prevail and there is a transparent process and we’re confident in the result.

Operator

Thank you. Our next question comes from Bonnie Herzog of Wells Fargo. Your line is now open.

Bonnie Herzog - Wells Fargo

My first question and I’m curious how and why you decided to go or keep VUSE and not keep blu, why not keep both of them? Did you feel you might be required to divest one, just kind of want to understand the rationale behind that decision?

Susan Cameron

Sure Bonnie. I mean divesting blu was a business decision and it was important to Imperial as part of this divestiture package and ensuring that they were a strong number three player. I think in context we have such confidence in VUSE superior technology that it is of a game changing product. Its early market results demonstrate that and we believe that VUSE will be very successful and is showing great signs as we have embarked on our national roll out. So we are very confident that VUSE can continue to compete with blu and we look forward to that continuing.

Murray Kessler

And from our perspective we think blu will be successful as well and that's a good thing. Again this deal is pro-competitive.

Bonnie Herzog - Wells Fargo

And just to follow on, do you expect ultimately to have a portfolio of brands, maybe just drill down a little bit more about some of the details with BAT’s partnership with your company in terms of next generation products and potential timing and then the eventual impact on the P&L. How positive could that be ultimately?

Susan Cameron

Bonnie really today we wanted to talk; we wanted to announce we were in discussions to initiate that partnership. And we will come back with more details on that. Really today we want to talk about this transaction which is complicated enough in its own right with the four players, and focused on the strategic and financial merits of this compelling transaction. But having said that I have a lot of confidence in the future next-generation product combination and we’ll come back to it at a later date.

Operator

Thank you. Our next question comes from Michael Lavery of CLSA. Your line is now open.

Michael Lavery - CLSA

Susan I just wanted to get some sense to, I believe you have it’s a two-year contract I think there is. Does this deal change any expectation of what your tenure might look like or how you see some of their trajectory for your time with Reynolds?

Susan Cameron

Michael, I appreciate the question, but really today I am focused on this compelling transaction. I am absolutely committed in terms of contract for two years. We will see where that goes. I’m absolutely confident we will close this transaction in the first half. I’ll be seeing all of that through, and if that results in any extension of my tenure we’ll keep you posted.

Michael Lavery - CLSA

And then just a clarification on the standstill agreement. Certainly you just addressed at the timing events, looking in different way. Doesn’t that only really apply if there were any hostile attempt by BAT to take over the rest of Reynolds which I think both of you have indicated is not really under consideration?

Susan Cameron

Well, I think the standstill does expire in 10 days time or something like that and we feel very good about our partnership with BAT. As a 42% shareholder, they have expressed their confidence and put their money in, 4.7 billion. And the government’s agreement for Reynolds American precludes BAT from having any control over our business until they would earn 100% of the stock. And so the standstill really expiring has no change in the way we operate this business and we look forward to our continued partnership with British American Tobacco.

Michael Lavery - CLSA

And then, just to clarify, you showed the chart with key gross brands totaling 90% of the pro forma company. So I guess it spins like Doral or Capri or Misty that are left in that 10%, is that right?

Susan Cameron

Yes, and also True and Old Gold and Kent. So we have those brands, in addition to the ones you mentioned Misty, Capri and Doral. That makes up the remaining10%.

Michael Lavery - CLSA

I know in my current portfolio, at least the brands that belong to Reynolds now, that’s been a source of funding for Pall Mall and Camel just because the support spending there and so those margins are good. Is the thinking that you are going to keep some of that approach intact with that 10%, that will be left of I guess six or seven brands combined?

Susan Cameron

Yes without doubt and of course there is significant revenue enhancement with Newport, the Newport brand joining the portfolio and that will certainly enable us to continue to invest behind the equity in our drive brand as well as R&D and innovation for the future of the Company.

Murray Kessler

Strategically it is a home-run relative to making 90% of value of this company coming from core brands. You would much rather have core brands driving away without that tail. That’s a huge transformation for this Company.

Michael Lavery - CLSA

I guess there must be some degree of balance between the two, or why wouldn’t you have divested more to Imperial? I mean they work together, right?

Susan Cameron

Yes. I mean we feel very good about the divestiture package and we feel good about what we are retaining. I think the balance of all of that will further enhance our strategy and make Imperial a strong third competitor.

Murray Kessler

Michael, you’re not divesting at the same multiple year combined. I mean there is economics involved here.

Michael Lavery - CLSA

And then just lastly on the e-cigarettes, obviously getting blu as part of the divested brands to Imperial takes you away from competing in Europe, where that has been ramping up some international expansion for Lorillard. Would you expect to re-enter that market with the VUSE brand or is there just a focus on the U.S. at the moment? How do you think about that?

Susan Cameron

I think about that in our announcement today to pursue this joint sharing arrangement with British American Tobacco, most specifically in heat-not-burn and e-cigarette products. So I believe that we have a great future working together in terms of using VUSE technology, the VUSE brand, however that manifests itself in global expansion and we will come back with details as we work through that arrangement, but I’m very bullish about the combination of the R&D resources of both entity and the geographic and revenue generating opportunities of that initiative.

Michael Lavery - CLSA

Is capacity still an issue for VUSE that would affect how the timing that would look like?

Susan Cameron

Yes, we continue to ramp up capacity, roll out in the 15,000 stores; we will do another roll out in early September. Things are coming on stream and fortunately we are selling it very quickly.

Operator

Thank you. Our next question comes from Judy Hong of Goldman Sachs

Judy Hong - Goldman Sachs

So Susan, I guess when you came to our conference in May, you commented that you are happy with your organic growth strategy for RAI. So just curious sort of pros and cons of staying standalone on RAI versus the acquisition you are making, clearly their benefits two acquisition, but just from your perspective, why now?

Susan Cameron

Judy, I think the other thing I’ve said to many of you on the phone is would it be a strategic dream to have Newport in the Reynolds American portfolio and I have always said, yes, absolutely. And it would have financial merit. And I think the transaction that we have worked to construct here, delivers that brand into our portfolio which drives obviously in the financial merit in terms of significant synergies, accretive year one, double-digit accretion in the out years. The opportunity for us to continue to invest in brand building, I think this is a win-win believe it or not for all four parties. And I couldn’t be more proud of all the way we’ve all worked together to construct it. And I am absolutely confident that our journey to transform the tobacco industry is enhanced by this transaction.

And we’ve laid the numbers out in front of you. I think it speaks for itself.

Judy Hong - Goldman Sachs

And then Murray just from your perspective, I think the multiple that Lorillard’s getting acquired certainly is higher than what you’ve seen in the last four-five years, but you’ve also seen Lorillard’s stocks getting discounted because of the menthol lift. You could argue that on a fundamental basis, Newport really a strong growing brand and you’ve banished it beautifully. So just in terms of how you thought about the multiples and in the context of the historical transaction multiples in tobacco space?

Murray Kessler

I think it’s near, and for the size it’s at the very top of precedent transactions. But there is a very thoughtful process with great advisors that go through, that compare our standalone plans and everything’s involved with evaluating the business against what was presented here. And we came to the conclusion that, that’s a combination of immediate value that’s created and the ability to participate in the upside is more attractive than our standalone plan. I mean it’s that simple with some of the best advisors and our own teams analyzing that.

So look we create a lot of values. Simply say when we put our strategic plan in place three and half years ago, our enterprise value was $12 billion and three years later this transaction is being done at $27.4 billion. I don’t have a problem looking anybody in the eye and saying creating $15.4 billion of value in three years is a pretty nice reward for those who invested with us.

Judy Hong - Goldman Sachs

And then Tom just in terms of the mix of equity and that here I guess one could have argued maybe you could have pushed to get leverage a little bit higher even. So just curious how the equity and that mix on the deal that you thought was appropriate? And then, post the deal, it sounds like you are going to go to 75% dividend payout policy as opposed to 85%. So just in terms of what the difference going forward would look like? And have you had any conversation with the rating agency that on a combined basis, you could actually get even a little bit more favorable rating considerations?

Tom Adams

Judy, one correction, our dividend payout policy today is 80%, it’s not 85%. But, yes. I mean we did go talk to the rating agencies the debt-to-EBITDA ratio coming out of this transaction, is going to be about 3.6 times, and that’s significantly higher than where we are today. And we think the mix between cash and equity is appropriate in circumstances and we are going to be focused in the first two years to get down to within below three on the leverage ratio. So that’s going to be our focus to deleveraging strategy for the first couple of years.

Judy Hong - Goldman Sachs

You haven’t said about the dividend will….

Murray Kessler

Yeah, and the dividend will actually be higher because of the combined higher earnings of the company even with the payout policy at 75%.

Judy Hong - Goldman Sachs

But just in terms of going to the 75% payout policy would be at the close of the transaction or do you still…

Murray Kessler

Yes.

Susan Cameron

Yes, at close.

Murray Kessler

We’ll maintain our current payout until the close of the transaction.

Operator

Thank you. Our next question comes from Nik Modi of RBC Capital Markets. Your line is now open.

Nik Modi - RBC Capital Markets

So just a couple of questions. Tom, just want to confirm the cost or the synergies are all cost related. And then I guess the second question is for Murray, when you think about the Newport and obviously second largest brand in the industry, one of the best performing brands in the industry. But it has been hindered by not having the kind of contracts with Reynolds and Altria have. So just wanted to get your perspective, Murray on how you think that could change Newport’s growth profile? And then just I’ll hang on to that is, in terms of Newport Gold and Red, I mean it makes sense now to push those brands for or what Camel now suffice as being kind of the non-menthol comparing.

Murray Kessler

Well you just asked a lot of questions, the first part do I think that there is significant opportunity to grow the Newport in what I’d already have illustrated as geographic expansion as one of our core strategies and strategic pillars. Absolutely. I mean today when you go into markets that have historically been a big market for us, you might have a state where we have one or two sales people, where you’re going to have 20 now or 25. And you’re going to go into customers with, where we had 4% share in a low market state and trying to get visibility on states and going into, that’s one of the reasons I say this is pro customer as well, because you are going to go in with such bigger packages for them and of course it’s going to result in bigger states and I think that’s an upside. I think by the way that works for Imperial as well.

The second question on Newport non-menthol Gold et cetera, look this is, we will precede business as usual, we have to by law and we will continue to grow those brands. And I’m sure after the transaction we’ll strategically or I won’t but the management team will look strategically look at growing all of their brands, and there is tremendous opportunities there in terms of substantial equivalent and having more predicate products and technology. I haven’t been bashful saying that our core strength is full flavor menthol and we haven’t traditionally been good at non-menthol.

So getting to the sharing of the R&D expertise in those types of areas having credited products to use to help get substantial equivalent will help grow the brand, that’s not my call in the future that Susan’s et cetera. But do I see opportunity there as well? Yes, I would personally and again this isn’t my call. I would continue to try to grow every brand in every opportunity there is, because they’re, remembered they’re not the same for the most parts; they’re not the same consumers. So you know they’re very different demographics et cetera and our consumer profile also a lot large percentage of them like non-menthol cigarettes as well, that’s why we’ve done well with Newport Red. So there’s a lot of growth opportunities, I mean could go on and on, it’s not even being mentioned today and it could be many years from now but Kent’s a very big brand around the world as well and BAT has tremendous expertise on that, and who knows where that might be one day. I mean the opportunities are just fantastic.

Susan Cameron

First question for Tom, which I sort of forgot.

Tom Adams

The 800 cost savings are cost savings, there’s not revenue synergies in there, Nik.

Nik Modi - RBC Capital Markets

Excellent and Tom how, that could really give a timeframe on when you expect that 800 to be realized, is this kind of a two year thing, three year thing?

Tom Adams

It’s probably over about a two year period, because we’ll be doing contract manufacturing for each other and so it’s probably by the end of that two year period we’ll realize all of this.

Murray Kessler

But you know Tom I don’t want to cross any lines, but the nature of Imperial taking a lot of our operations will make some of those happen faster than, that’s true.

Tom Adams

That’s true.

Operator

Thank you. Our next question comes from Adam Spielman of Citi. Your line is now open.

Adam Spielman - Citi

Two questions please. First, speculation about this transaction has been ongoing for some time; to what degree during this period have you been able to speak to the FTC about the divestiture package? And have they given any comfort on what being proposed being adequate? And second, to what extent did you expect the competitive dynamic to change. Winston, KOOL and Salem haven’t had much investment in recent years. Imperial is committed to reinvesting the cost synergies that they’re anticipating from the transaction. So how do you expect the competitive dynamic might change?

Susan Cameron

Well Adam I think it’s important to understand that you don’t pre talk to the FTC, we put together this package, we’re very confident in getting this transaction done with that package and that it will create a strong number three player for Imperial. Winston, KOOL and Salem have not been supported in recent years, but all of them have been big brands in the past. And how they pursue that will be interesting and it will continue the competitive dynamics of this industry which have always been strong. And I think we’ll see that unfold, but we are very confident that making Reynolds American a much stronger number two player with a very big industry leader in this sector. And Imperial becoming a 10% market share company with a good portfolio of brands and an e-cigarette contender will ensure the competitive landscape stays as fierce as it always has been.

Operator

Thank you. Our next question comes from David Dellman of Morgan Stanley. Your line is opened.

David Dellman - Morgan Stanley

Well I had two quick follow up questions, thank you for taking them. First on the divestitures to Imperial, the gap between the pre tax and after tax proceeds is large 7.1 billion to 4.4 billion. Is that because it’s been taxed as ordinary income rather than a capital gain?

Tom Adams

Yes. That’s why, that’s the case.

David Dellman - Morgan Stanley

And then Tom, can you just clarify, I didn’t have the slides and I have gotten a lot of email questions from investors while this call has been going on about the cost savings or the cost synergies. Let me talk or articulate something and let me if this is right? Is it correct that if we take the existing two independent businesses completely combine them, then remove the businesses that are being sold to Imperial and what’s being retained versus a historical cost base, you expect to realize annual cost synergies is $300 million, is that correct?

Tom Adams

Actually, I didn’t follow your math David, I am sorry.

David Dellman - Morgan Stanley

No. That’s okay. Let me say it again. If you take the two independent companies, you bring them together and then you remove the businesses that are being sold to Imperial and what’s being retained?

Tom Adams

Let me stop you. The things sold to Imperial is our three brands Winston, Salem and KOOL, Maverick from Lorillard and then the blu brand, and the blu brand is really be only business.

David Dellman - Morgan Stanley

Sorry. On what’s been sold? What I am trying to understand though is on an apples-to-apples basis on what the new R.J.R will be relative to the constituent parts will be a net $300 million in cost savings?

Tom Adams

Yes. I think the best way to look at it David, is on page 37 this Bridge where we’re getting the Reynolds operating income for 2014 is about 3.1 billion we’re going to get the Lorillard income about $2.1 billion. We’re going to divest $1.1 billion of that in terms of that, and that’s brand contribution, that money out. And then we’re going to add in $800 million of run rate synergies at 4.8 billion.

Operator

Thank you. Our next question comes from Todd Duvick of Wells Fargo. Your line is now opened.

Todd Duvick - Wells Fargo

I wanted to ask a quick question on the balance sheet, you’ve obviously talked about the leverage; you’ve talked about wedding the transaction with rating agencies which both are very positive. In terms of the incremental debt we estimate about $8 billion of incremental debt. Can you confirm that we’re in the right ballpark and in terms of terming out of portion of that debt; can we assume that it’s going to be after regulatory approval, so probably closer to the close of the transaction?

Tom Adams

Yes, Todd. It’s actually about $9 billion worth of new debt, we’ll be keeping this, and this is on page 36 of the slides that we’ve put out. We’ll be assuming, we have about five but Reynolds has about $5 billion of the debt, Lorillard about 3 and we’ll be assuming the Lorillard debt and going after the market for approximately 9 billion at closing.

And yes we will be, it will be looking, it’s probably going to be closer to closing then sooner to that and we’ve also established bridge facilities with JP Morgan and Citi, that they can bridge us to the transaction until we can get our permanent financing in place.

Todd Duvick - Wells Fargo

And is it safe to assume that the majority of the $9 billion will termed out in the debt capital markets with just a small portion kept for the pay down?

Tom Adams

We’ll actually put some, when we term this out and yes we’ll term it out with bonds into the out years. We’ll first of all bring enough closer and to basically de-lever the Company as we said they get lower from 3.6 down to below three in two years. So there is low rate across a wide spectrum of time.

Operator

Thank you. Our next question comes from Lisa Lewandowski of Bank of America. Your line is now open.

Lisa Lewandowski - Bank of America

Tom for the tax rate, I mean you guys currently have very similar tax rate of about 37%. Would that change at all?

Tom Adams

I would suspect not, but we’ll have to put a final point on that, but I don’t think it would change very much sitting here with thinking about it right now.

Operator

Thank you. Our next question comes from Priya Ohri-Gupta of Barclays. Your line is now open.

Priya Ohri-Gupta - Barclays

I appreciate all the details around. But coming to financing you expect to put in place. But we’re just hoping that as we think about sort of the medium term. How should we think about your ratings objective? Are we thinking, are you guys looking to sort of improve over time to mid triple view with the agencies or should we see you continue to be split rated. And then just secondly do you have any expectation to put a fixed rating in place? Thank you.

Tom Adams

We like being investment grade regardless of where it is the split rating doesn’t bother us that much. We have had discussions with the rating agencies S&P and Moody’s and are confident that we’ll maintain our investment grade ratings, which is very important to Reynolds today and will be in the future as well. And at this point, we don’t have, we haven’t had any conservations with Fitch about reinitiating coverage by them.

Operator

Thank you. Our next question comes from Filippe Goossens of Mitsubishi Securities. Your line is now opened.

Filippe Goossens - Mitsubishi Securities

Few questions on my side is what as I may. Maybe just as a follow up on Priya’s earlier question. Medium to longer term do you a specific leverage targets that you would feel comfortable with Tom?

Tom Adams

Historically we’ve operated between 1.5 and 2.5 times and we’re really going out above that and we’ve as I said earlier we promised the rating agencies we get to low three at within two years. And after that we’ll take a long hard look about how we can enhance our shareholder value through some mix of including the pay down debt but potentially instituting a share repurchase program that naturally would be the decision of the Board.

Filippe Goossens - Mitsubishi Securities

Then given that the deal is going to close in the first half of 2016, have you entered into any interest rates hedges given the prospect of potentially rising interest rates by that time?

Tom Adams

At this point we haven’t done anything except get the deal done.

Susan Cameron

Which, I can tell you.

Filippe Goossens - Mitsubishi Securities

The 5 billion in operating income that you listed in the press release, is that inclusive of the 800 million in synergies or that will be on top of the 5 billion?

Tom Adams

It’s inclusive, and it will build over time, I think we start a little bit I guess at 4.8 initially and then building the 5 and then stepping up over time. So it’s quite an impressive new organization.

Filippe Goossens - Mitsubishi Securities

And then the final question. Susan, when you worked with the Board on this transaction, have you kind of anticipated what the potential competitive reaction maybe of that other player that’s still out there in U.S. market?

Susan Cameron

Filippe, this is a very competitive industry. And of course one is always talking about what the competitor may or may not do. But I feel very confident that this iconic brand portfolio will compete very well with the industry leader and that Imperial will compete in this marketplace. And we have some time to run; we will close this in the first half of ‘15. But I think everybody will be competing for market share. We have a great brand portfolio here, great demographics and we are committed to transforming this industry as we’ve been committed for the last 10. So I look forward to the future and the competition will continue.

Operator

Thank you. And our final question comes from Temple Houston of Prudential. Your line is now opened.

Temple Houston - Prudential

One last debt question, you mentioned earlier the Lorillard bonds would be assumed. Can we assume that that means they’ll be pari passu with existing Reynolds debt and any new Reynolds debt that you might have to issue?

Tom Adams

I mean if you’re talking about the guarantees, we’re looking at that right now. And we’ll come back to you folks later on that particular aspect.

Operator

Thank you. At this time, I would like to turn the call back to management for any closing comments.

Susan Cameron

Thanks all of you for your questions and your interest in our Company. Before closing, I would like to reiterate that what we have announced today is not only compelling and strategic, but also serves to create further value. We look forward to continuing to lead the transformation of the tobacco industry, meeting society’s expectations for how a tobacco company should operate, while also growing our businesses responsibly and sustainably. As Morris said at the beginning of the call, today’s presentation will be posted to our transaction Web site at reynoldsamericaninfo.com. We plan to post regular updates on this Web site throughout the transaction process. Again, thank you for your time today, all the best.

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