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Executives

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

Robert Bannon - Director of Investor Relations

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

Analysts

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

David J. Adelman - Morgan Stanley, Research Division

Andrew Kieley - Deutsche Bank AG, Research Division

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

Vivien Azer - Citigroup Inc, Research Division

Nik Modi - UBS Investment Bank, Research Division

Karen Lamark - Federated Investors

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Lorillard (LO) Q3 2011 Earnings Call October 24, 2011 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Lorillard Inc. Third Quarter 2011 Earnings Conference Call. My name is Sarah, 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 over to your host for today's call, Mr. Bob Bannon. You may begin, sir.

Robert Bannon

Thank you, Sarah, and good morning, everyone. I'm Bob Bannon, Lorillard's Director of Investor Relations. And joining me on today's call is 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 third quarter 2011 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.

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

Murray S. Kessler

Thank you, Bob, and good morning, everyone. Lorillard's third quarter played out just as we expected and just as we said it would during our last conference call. I'm pleased to report that very strong fundamentals continue. We acknowledged that strong fundamentals were masked by a significant comparative reduction in wholesale inventory, adversely affecting our reported volume growth by just over 400 basis points. But we can't emphasize enough that absent the inventory comparison, which was simply a timing issue, our business, as measured by retail shipments, was as strong as we've seen all year. This is especially encouraging as we reduced promotional spending versus year ago on our flagship Newport Menthol brand, and our recent round of price increases are all sticking. We also observed no unusual competitive promotional activity during the quarter.

So let's take a closer look at third quarter highlights. First, total Lorillard domestic volume increased 2.8% versus year ago in quarter 3. Adjusting for inventory fluctuations, total Lorillard domestic volume was up an estimated 7%. This is about the same level of the growth adjusted for inventory changes we saw in the first and second quarters. The point is further illustrated by a look at shipments from wholesale to retail, as measured by our proprietary Excel database, which is unaffected by changes in wholesale inventory.

Total Lorillard retail shipments were up over 8% versus year ago in the quarter. Of note, Lorillard discount brand shipments to retail, while still up double digits at about 12%, actually slowed a little from prior quarters. So the acceleration of our retail shipment and market share growth was driven by our premium brand Newport, which grew 8% in total versus year ago during the quarter, following 5.5% growth in the second quarter and 6.3% in the first quarter. Again, I'm referring to retail shipments, which are more indicative of consumer purchasing and eliminate the noise from quarter-to-quarter due to inventory swings. Given the difficult macro-economic environment that continued during the third quarter, we were happy to see such a strong performance on our premium brand.

Our premium strength traced to the incremental volume this year associated with the Newport Non-Menthol launch and a very strong quarter and improvement in trend on our flagship Newport Menthol business. Newport Menthol benefited from our geographic expansion plan, which we highlighted during our Investor Day. Both of these initiatives are performing extremely well. Newport Non-Menthol continues to hold just under a 1% share despite our recent 20% price increase which has significantly enhanced profitability on this new brand, and Newport Menthol, in expansion markets, continues to grow double digits.

It's worth mentioning, as a number of investors are concerned about heightened promotional spending hurting industry pricing power, that even with our investment in these expansion markets, total Newport Menthol promotional spending was down versus year ago for the quarter, and it is down for the year. This also includes the increased spending effect of volume previously sold non-promotive on Native American reservations in New York, switching to promoted volumes in other locations.

So let me repeat myself. While I can't speak for the rest of the industry, Lorillard has reduced by down-spending this year and this quarter. We recognize that between mix, and more importantly this quarter, the negative inventory comparison, it is hard to see the impact of pricing. David will try and make this as transparent as possible during his comments. Let me reassure you, however, that the price increases we took in July are being fully realized to the income statement.

Turning to the broader industry. We estimate total industry domestic shipments declined 6.4%. Similar to Lorillard, the total industry was negatively affected by inventory fluctuations. We estimate that impact to be about 3 percentage points.

As our retail volume grew briskly in a declining industry, Lorillard, once again, gained share across all market categories. Total Lorillard share was 14.2%, up 1.3 points versus year ago. Total Newport gained 1.1 share points, and our discount brands gained 0.3 share point. Total Lorillard share of Menthol was 39.2%, up 0.9 share points versus year ago, our strongest gain all year. Newport share of Menthol was 36.1%, up 0.3 share points versus year ago, also our strongest gain all year.

Operating profit for the quarter was down 2.2%. EPS at $1.94 per share was up 7.2%. Operating profit in EPS were, obviously, negatively affected by the inventory comparison. Keep in mind, $400 million non-promoted units, primarily of Newport Menthol, is worth about $35 million in operating profit or $0.16 per share. There were no other extraordinary variances in the quarter.

So while we don't give earnings guidance, this is exactly what we expected. And had we given guidance for the year, we would not, and I repeat myself, would not be changing it right now. Notably, we believe the continued strength in our brand fundamentals combined with wholesale inventories now at more normal levels, bode well for a very good fourth quarter. And for these same reasons, we are bullish on 2012 despite the outlook for a challenging 2012 macroeconomic environment.

Finally, a brief word on the FDA's review of Menthol. We are currently awaiting the peer review of the FDA's preliminary assessment of the science, which is due out shortly. We have no reason to believe this is anything more than just that, a preliminary review. When it comes out, we will respond appropriately during the comment period. Again, we believe this is just one more step than what we believe will be a very long review process.

You know our position. The best available scientific evidence does not support an assertion that menthol and cigarettes negatively or disproportionately impacts the public health. Smoking has serious risks, but menthol does not contribute to those risks. A menthol cigarette is just another cigarette and should be regulated no differently in totality or for any demographic group. Furthermore, any. draconian regulation would have real, unintended consequences, including the expansion of a contraband market, a loss of tax revenues and a significant loss of jobs.

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

David H. Taylor

Thanks, Murray, and good morning, everyone. I'll briefly discuss the numbers, and then we'll open the line for question. Net sales in the third quarter of 2011 increased 3.5% to $1.622 billion as compared to the third quarter of 2010, driven by the 2.8% increase in wholesale shipment volume.

Like last quarter, our average wholesale selling prices in the quarter were higher across the board but were partially offset by other factors. We spent considerable time on these calls over the last several quarters, reviewing the impact of the shift in the mix of our product, as the relatively lower-priced Maverick and Newport Non-Menthol have grown at a more rapid pace than our premium-priced Newport Menthol product. That dynamic impacts the current year's third quarter as well. Newport Non-Menthol and Maverick wholesale volumes, in this year's third quarter, were greater than the prior year quarter, while the rest of our portfolio showed decline.

Also, as we explained in last quarter's call, the impact of fluctuations in wholesale trade inventory levels can be seen in the third quarter's results. To be more specific, even at the risk of being repetitive, we saw strong volumes in last year's third quarter, some of which was aided by a build in wholesale trade inventory in that quarter. In this year's third quarter, we saw the opposite, with wholesale trade inventories declining after building in the second quarter. This was to be expected, and the impact on volume comparisons and average net pricing should not surprise anyone. After adjusting for the effect of the increase in wholesale trade inventories last year and the decline this year, we estimate that our wholesale domestic shipments would have increased 7% for the quarter, rather than the 2.8% as reported.

In addition, and as you know, the pattern of consumer promotion buydown programs follows movement at retail, not at wholesale. The costs of these programs are accounted for as a reduction in sales. So in a quarter like this one, they disproportionately impact the consolidated net price comparison to last year. The cost of consumer buydowns in the third quarter was about flat to the second quarter and down from last year's third quarter. We would estimate that the impact of this wholesale trade inventory pattern on the net pricing comparison to last year, calculated on a simple consolidated basis, reduced the net price comparison by about 1% in 2011 from 2010. Likewise, the mix effect that I discussed a moment ago amounted to about a 3% reduction in the net price comparison.

So to summarize, a simple calculation of net price per unit in the third quarter, when done on a consolidated basis before excise tax, results in a about a 1% per unit increase from last year. That, actually, is made up of higher realized prices of about 5% across our entire portfolio. However, that 5% was masked by the 3% product mix impact and the 1% impact of the wholesale inventory movement.

The 4 percentage point difference in the third quarter unit volume comparisons to last year that arises from that wholesale inventory trade fluctuations would equate to about $75 million in sales and about $35 million in operating income, which more than accounts for the $10 million decline in operating income in the quarter.

As we enter the fourth quarter, we estimate that wholesale trade inventories are closer to one would call normal. Gross profit in the third quarter of 2011 was roughly flat when compared to last year's third quarter. Cost of goods sold in the third quarter reflects increases over last year in certain costs, including increased FDA user fees. Amounts due under the State Settlement Agreements and the tobacco growers assessment increased $20 million compared to last year's third quarter.

Selling, general and administrative costs increased $7 million from last year's third quarter, primarily due to higher salaries and benefits, legal fees and expenses associated with increased litigation activity during the quarter and marketing and other costs associated with our strategic initiatives, including the continuing brand-building costs in support of Newport Non-Menthol.

Third quarter operating income declined 2.2% to $455 million from $465 million in last year's third quarter. Year-to-date, operating income is up 5.5% compared to last year. Fully diluted earnings per share for the third quarter increased 7.2% from last year's third quarter to $1.94 per share. Year-to-date EPS is up 13% compared to last year. The lower share count as compared to the year-ago quarter added $0.18 per share to EPS in this year's third quarter, accounting for the increase.

We accessed the debt market in August, issuing $750 million in senior notes, $500 million in 5-year notes at 3 1/2% and $250 million in 30-year notes at 7%. With this issue, we are close to our stated target of 1.5x EBITDA. We would expect that as our earnings grow, we would access the market again in the future in order to stay close to that ratio. The board authorized a $750 million share repurchase shortly after we closed the debt transaction. That program is ongoing.

During the quarter, through September 30, we repurchased approximately 4 million shares at a cost of $438 million under 2 separate share repurchase authorizations. As of September 30, we had $553 million remaining on the new $750 million program. These actions clearly demonstrate our intent to return cash to shareholders in the form of both dividends and share repurchases.

We're pleased with the company's performance this quarter and for 2011 so far. As Murray indicated, the fundamentals of our business remain strong and vibrant, and we remain confident that we can outperform the industry and deliver superior value to our shareholders.

When we spoke on this call 3 months ago, we were bullish on our future, and we remain so. Nothing in the third quarter has changed our view or our expectations for 2011 volume and earnings, nor our outlook beyond that, and we expect to continue the positive momentum that we've experienced thus far in 2011.

And with that, we'd like to open the line for questions. Sarah?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Nik Modi with UBS.

Nik Modi - UBS Investment Bank, Research Division

Murray or David, can you just provide any perspective on October? I mean, if the inventories have weaned out in the fourth quarter, are you seeing the volumes track in line with what you've been seeing with the retail trends lately?

Murray S. Kessler

Well, we don't give forward-looking estimates, but I try to sort of say that as well as I could in my comments to say that inventories are normal. So what I'll just reemphasize, and then you can take from it what you want, is that the trends have been extremely predictable, extremely consistent all year long, and the only thing that changes underneath it was the inventory. And I said I was bullish about the fourth quarter and next year, so there was nothing that I said that would suggest a change in fundamental.

Nik Modi - UBS Investment Bank, Research Division

Great. And then David, one real quick housekeeping item. On the dividends, I mean, clearly, your payout ratio is below where the target payout as you've indicated should be. Any thoughts on that? And your philosophy there, has it changed? Or do you anticipate keeping in line with the historic number?

David H. Taylor

Clearly, our target has not changed, and our philosophy hasn't changed. And yes, clearly, we've-- we're paying out dividends at a rate lower than that stated target, so one could expect a dividend increase at some point in the future.

Operator

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

David J. Adelman - Morgan Stanley, Research Division

Can we speak for a moment more, Murray, about pricing in the quarter, or price mix up to 0.7. I just want to understand, like if you go back say, to the first quarter, net pricing per pack is down versus that point. You didn't have the -- I don't think there was significant inventory movement that quarter. Maverick is less of the total volume this period. You've taken pricing across the board since then, and you had a substantial price increase on Newport Non-Menthol coming into the third quarter. So is there something else at play? I know you went through a lot of details. But just stepping back, I would have thought, given those dynamics, you would have seen more of an increase in your sequential and year-on-year pricing?

Murray S. Kessler

I really think you've got 2 things at play in the quarter. With the way we look at them. I've been telling you that we've been reducing buydown spending all year long. And it was down again this quarter, but it wasn't down as much this quarter. It was down prior quarters. And I think your note sort of nailed it. You had roughly 4% to 5% of your volume going through Native American reservations completely non-promoted in New York. And we didn't know how that was going to exactly play out, but you see our total volume trends out. So therefore, consumers kept buying the products, and they had to move from a non-promoted location to a promoted location. So you had a -- it's not a permanent. We'll lap it. But you had this effect of non-promoted volume becoming promoted volume in the quarter. And then the second one that I still think it's hard for all the analysts out there to model that we can, which is based on our go-to-market design, our buydowns are a relatively larger percentage. We have a higher list price and a higher buydown. So when you get a quarter like this, where inventory is reduced, the buydowns still fully occur. And when you take out that volume -- if you don't take out at sort of a deep enough buydown level, you also get a distortion, and that's completely timing, and it's not real at all. It's just in the modeling. So those 2 numbers alone, in my estimation, account for 2/3 of the variance in a model like yours. And then we had a couple of small cost things with the recall and signing a new union contract to get it. So it's not complicated. We took the price increases, and those all passed through. We didn't spend back $0.01 more on it. We just had a couple variables, mostly timings that'll work their way through.

David J. Adelman - Morgan Stanley, Research Division

And Murray, have you considered altering your buydown rates towards where the volume has migrated? Do you think that, that would be an overreaction?

Murray S. Kessler

We've...

David J. Adelman - Morgan Stanley, Research Division

In other words, reducing buydown levels where some of the Native American volume has moved towards?

Murray S. Kessler

Well, it's almost impossible to answer that question, to try to understand exactly where it went, how much -- New York's up, neighboring states are up. We modify buydown rates all of the time. So I think I know where you're going with the question. And the answer is probably we do that kind of stuff all the time as a matter of routine.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then as it relates to the FDA. Murray, do you have any greater insight into then what the FDA itself has publicly said, with respect to when its view of the Menthol science would be publicized?

Murray S. Kessler

I continue to rely on Neil Wilcox, who we hired who's been terrific for us, because he comes with that FDA perspective. And if you remember, we had sort of the -- there was a bunch of rumors flying around in speculation a few months back about a modification to the menthol report. And he continues to remind me that -- generally speaking, what they say, they do. And what they said this time was a preliminary review of the science out at the end of the year, November -- early November, early December somewhere in there. So I believe we're going to see a peer review of the preliminary assessment of the science that'll be open for comment, nothing more. And I take it at face value.

David J. Adelman - Morgan Stanley, Research Division

You don't know now and probably won't know after its published who the peer reviewers that were selected are, is that correct?

Murray S. Kessler

I don't know if that's true or not whether they'll share the peer reviewers at that point. Sometimes, they do, sometimes they don't.

Operator

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

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

Murray, just in terms of the industry outlook for 2012, you said you're pretty bullish on your outlook and just the ability for the industry to maintain relatively rational pricing. I guess, I'm just wondering, just with respect to your outperformance on the volume side, industry is down 3.5% underlying, and you're up 8% or so. The risk that, that dynamic sort of forces your competitors to step up spending, just given that share shift that you've seen, and how would you sort of think about your pricing or promotional strategy in the context of that risk?

Murray S. Kessler

Okay. It's hard for me to speak to my competitors. But remember, we're going to lap the introduction of Newport Non-Menthol here another couple of months of so they -- from an industry standpoint, it's kind of weathered the storm of a new brand being launched. It's big for us, it's little for the industry. One share for us is -- and then take fair share of that for the competitors. It works its way to a few tenths for everybody else. I doubt they would do something sort of draconian or crazy over a few tenths of a share point. For us, we have a very clear strategy. We intend to bring Newport pleasure to all adult smokers -- responsibly bring Newport pleasure to all adult smokers. And our intent to do that is through the pillars that we talked about which is right now building our Newport Non-Menthol business profitably, and we took a big price increase this time, and getting those geographic expansion markets back in line competitively, so they have a normalized level of promotion instead of being milked the way they were. We're in about 8 markets. That's the bulk of the volume, so don't expect another big increase in spending coming there. Either, they're growing double digits. We've already lapped 2 of those markets. And as we go out -- exit this year, we'll lap another 2 of those markets, and that effect will basically go away sometime next year. So for us, it's blocking and tackling and doing what we've always done and -- but it starts with superior advertising and working that strategic plan we showed you at Investor Day.

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

Okay. And then just in terms of Newport's performance, both on the Non-Menthol side and on the Menthol side, I think in Q2, you ended the quarter with Red up about a -- just over a share point, and it sounds like that sort have been the share level the last 3 months or so. Are you comfortable saying that's kind of where we should see the Newport Red settling? Is there more opportunity to see that brand get much bigger? And then on the Newport Menthol performance, you talked about the acceleration in 3Q. Just maybe talk a little bit about was that mostly geographic expansion? What's been helping the Menthol performance on the Newport side?

Murray S. Kessler

So the first one, Newport Non-Menthol, I think right now with that big price increase, the volume has held very steady on that, but the growth has slowed. And I think for now, that's probably a good place to stay. But we will, like every other brand, and just like we did with Maverick and others, there will be initiatives overtime to grow that business. So our expectation will -- to be to grow it from here. But the sort of -- it found its level at that price. So I think you're accurate in that statement. I mean, the price increase has a dramatic effect on the profitability of those billions of units that were incrementally selling. On Newport Menthol, I was real pleased in the third quarter, and it was -- a large part of that was driven by geographic expansion markets.

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

Okay. And then just finally, the clarification on Q4 volume, because, I guess, you're lapping the Newport launch and I remember having one less shipping day as well. Is that correct? Or was the shipping day comparison comparable?

Murray S. Kessler

No, you're correct.

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

Okay. So we just have to take it to -- with the inventory now being pretty normal, we have to take into consideration that shipping day comparison, and then -- and that's really the only thing to really think about from a year-over-year comparison perspective?

Murray S. Kessler

Yes, I think you're thinking about it the right way. You have one less shipping day. You do have the inventory pipeline load from the new product on Newport Non-Menthol, but on the other hand, you have 13 weeks. You have the full quarter of shipping it, so those are countervailing effects. But yes, you should have a -- you should rebuild the volume modeling based on those factors that you just said and that would be accurate, with the fundamentals that we have been talking about.

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

Right. And then on the positive side, the price mix impact should be much better than what you saw in -- since 3Q, just because you don't have the inventory situation. And then the mix impact from Red would be also muted?

Murray S. Kessler

Right. And the only thing you will have continuing for a couple of quarters is that Native American effect I talked about.

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

And how much was that, just in terms of the Native American impact? You said it was 2 points or 3 points on the...

David H. Taylor

It's really hard to quantify exactly how much the Native American effect impacted net pricing, Judy, because we really don't know -- it's hard to track exactly where that volume went. What Murray said was that we had roughly 5% of our volume going through those Native American reservations previously that was non-promoted. And you can see what happened to our volume comparisons. And so if that moved, theoretically, if all that volume moved to promoted locations, that would have increased our buydown spending, but exactly how much is very, very difficult. And did they go to non-promoted store, promoted stores, which -- but it wouldn't be as big an impact as you just said though.

Operator

Your next question comes from the line of Chris Growe with Stifel, Nicolaus.

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

I just have a couple of questions for you. The first is, you still have 8 expansion markets, is that correct? That has not changed in the quarter?

Murray S. Kessler

Correct.

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And then, I guess, in related to that, the level of promotion that you're signing deals to those new markets, just -- you still have Newport promotion down starting the quarter. And as a result, that incorporates all that incremental promotion especially with those expansion markets, correct?

Murray S. Kessler

Correct.

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

Okay. And I just want to ask about the Maverick growth slowing. Do you read much into that or -- because I think, the price goes from pretty steady if you look it that way between some of the premium brands. Is anything related to that, that you believe led to Maverick slowing a little bit in the quarter?

Murray S. Kessler

Yes, we took a healthy price increase for the first time in a year that could have affected a little bit. I mean, our reaction is it's gotten -- it's over 5 billion units now, so it's gotten to be quite a big brand. And to be able to take a $0.10 price increase plus continue growing at 12% on a 5 billion unit brand, I'll take that all day long. But one year and 1.5 years ago, it started growing 30-something percent. So as it's gotten scale and gotten bigger and bigger and bigger, it's harder to slow down. But I would say that it's fair to say that the pricing had a little bit of effect on it as well, but again, it's a very profitable mode for us.

Christopher Growe - Stifel, Nicolaus & Co., Inc., Research Division

Sure. I had assume that was the case and that's the way I modeled it. I just want to make sure it was clear there's nothing else going on there, sure. And the last question I just have was on your timing for share purchase. And honestly, you're holding a lot of cash from the balance sheet. We went through this a couple years ago as well, and you took on a lot of debt. Is there any motivation to move more quickly on buying back stock now? Or was it just opportunistic around the stock price?

David H. Taylor

I don't know if there's any motivation to accelerate or decelerate those purchases where we have been in the market since the board authorized us to go there, and we will continue to repurchase shares. It's not really opportunistic, but it's really more a term of changing our capital structure to reduce the weight of average cost of capital, and we will continue to buyback shares. But I can't really comment on whether that's going to accelerate or decelerate, Chris, I'm sorry.

Murray S. Kessler

Yes. I mean, Chris, I will just add to it to. I mean, look, there's no magic in our model. We believe our job is to generate a lot of cash and give it back to shareholders. And we've been aggressively buying back shares, and we intend to stay at the 70% to 75% dividend payout ratio. So it's -- that's what we do, and the timing of which a little bit we're trying to execute it the most efficient way possible.

Operator

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

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I just had a question kind of circling back on pricing. You mentioned, of course, your net pricing was pretty strong after you make all of the adjustments. But I was kind of wondering if you could get a little more detail and sort of what you're seeing regarding the health of the consumer and the acceptance of pricing, in general, across the overall industry? And then also could you talk a little bit about the price gap between premium brands and the discount brands overall?

Murray S. Kessler

I'll try to answer those questions. Let me just break them up in pieces. It's harder for me to talk to the industry. For Newport Menthol, we took a price increase, our buydowns in total were down versus the year ago and our volume accelerated in the third quarter, so this was one of our strongest if not the strongest all-year performances on our premium Newport Menthol brand. It accelerated by a few hundred basis points from the second quarter to the third quarter. So I'm delighted to see that, right? Going into what, sort of a tough economy and everything that's out there, our premium brands -- it was Maverick that slowed down a little bit. So that's what drove the overall 8% retail consumer takeaway which is our measure -- which is wholesale to retail shipments through Excel. But we're -- look, we were up about 8% in the first quarter. We're up about 8% in the second quarter. We're up about 8% in the third quarter retail. The difference is Maverick slowed a little bit, so our retail -- and you already know that Newport Non-Menthol stayed still and the kind of flattish during the quarter versus the previous quarter. So what made the difference up? It was our premium brand. So from a consumer standpoint, we feel very bullish, and that all the things that we've done continue and the fundamentals of our brand. I feel great about the quarter. I wish the inventory didn't happen. But I feel great about the quarter, in terms of what consumers are purchasing. Our price gap strategy is unchanged. We don't like to compete on price. We like to compete with a superior product, right advertising and fundamental marketing, and when appropriate, carefully launching a new product. So we remain the most expensive cigarette on the market of the sort of traditional premium brands. There's a couple smaller ones. And we try to keep that gap close, but not be the cheapest. For the discount -- the deep discount, I didn't see anything dramatic, I think it was about even in the quarter.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Okay. That's helpful. And just maybe a final quick question on Newport Red. I think you mentioned in your press release that the market research cost went up behind this brand in the third quarter. So are these costs expected to continue as you monitor and then possibly tweak your strategy behind this new brand?

David H. Taylor

Bonnie, it went up compared to the third quarter of the prior year, which would contribute to that difference in SG&A. But I -- we didn't see any acceleration in any of those brand-building costs in the third quarter from the first half of the year.

Murray S. Kessler

And I think you said research but you -- I think David said on the call brand building. We're advertising the brand, and we advertised it consistently throughout the year, as he said, but there was no increase or dramatic increase in advertising from prior quarters.

Operator

Your next question comes from the line of Ann Gurkin with Davenport.

Ann H. Gurkin - Davenport & Company, LLC, Research Division

Just wanted to follow-up a little bit on the expansion markets. Are you pleased with the return you're getting from the incremental brand support in those markets, or do you need to tweak that?

Murray S. Kessler

No, we're-- it's exceeding our expectations. We wanted to make it competitive, even if we took a little bit of a hit. Because remember, I keep saying it over and over again, we're not promoting below the price of competition, we were just eliminating our disadvantage. And those markets have responded beautifully. We have now fully lapped, and we're about 14, 15 months into the first 2 markets where we started, and those have fully paid out. So now we have gone in those original 2 markets from brands that were declining to brands that are more profitable than they were before and growing double digits in those markets. The same pattern is repeating itself with the second wave of markets which we will lap probably this quarter, and then -- and we're off to a great start on the remaining 4 which is somewhere around mid-2012 that we lap them. So the long and short of it is as we went from a -- we probably have a 17 to 20 point -- I'm not sure of the exact number, but they were in declines and now they're growing at somewhere between -- maybe even aside 20- to 30-point turnaround in those markets.

Operator

Your next question comes from the line of Andrew Kieley with Deutsche Bank.

Andrew Kieley - Deutsche Bank AG, Research Division

Murray, in terms of the Newport Menthol expansion, the 8 markets, it sounds like the -- any expansion beyond those 8 markets? Is that capped or stable for a while here?

Murray S. Kessler

We -- in essence, the amount of Newport -- or excuse me, in essence, the amount of Full Flavor menthol that in expansion markets available for us to become more priced, more competitively with, we've captured 80%, 90% of that at this point. So could we tweak another market? It's just not going to add up too much money. So if you're trying to model in your P&L, the amount of money we're going to spend, we're spending for the most part, right? And we'll lap those over time and hopefully continue to have growing markets like we've seen in our original markets. As we grow in the west and other areas, that's going to have to be beyond that, beyond Newport Full Flavor Menthol. It's going to have -- we're going to have to work Newport Non-Menthol et cetera in markets where those opportunities exist. So we have plans to grow, but the spending effect is, for the most part, in the P&L at this point.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And then the decision to take up the pricing on Newport Red, I guess, I expect a little bit longer runway on those promotions, since the brand is ramping up so nicely. Is it just that you wanted to reallocate some of the promotional dollars to other things? And how quickly do you think Newport Red would ultimately get towards your objective of a standard Newport price point, I guess?

Murray S. Kessler

Well, we said it would take years to get it up there. And no, we didn't do anything to reallocate it. We thought that getting to a point -- remember, we, Newport starts at around 11-plus shares, so getting a full share point in there. We're not trying to sell volume just for volume's take. When you sell a lot of volume, you got to put in machinery, you got to -- all kinds of things are affected. You've got to run the plants. You have got MSA cost and all that. It's got to make money for us. We're in the business to make money, and this price increase has a significant effect. So I mean, our levels of profitability and volume at the end of our first year of launch are dramatically higher than anything we originally modeled.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And then one for David, I guess. As you get closer on the share repurchase, I understand you're not going to give us timing our future amount, but as you get closer to the leverage target here, can you say what levels of cash the company's comfortable holding? Or how we should think about that?

David H. Taylor

As we look at the cash on the balance sheet, we do have -- we have a revolving credit facility of roughly $185 million that counts as a part of our liquidity. We typically would not want to get the cash on the left side of the balance sheet much greater than $100 million to $200 million. That's about right. Now that is net of any MSA accruals. So what I like to -- the way I like think to think about that is I want to have cash equal to the MSA accrual plus some excess liquidity.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And just finally, Murray, I was wondering on the legal side, if you could just give us an update on where the TPSAC lawsuit stands? And maybe on the Evans case, how you look at the appeals there? And is it -- I've read something that the court was requiring you to hold the full amount of the verdict in cash? Is that the case, or is that not the case?

Murray S. Kessler

Well, no, on the cash they're not requiring them. They had filed that the original judge we went to, we appealed that, and a judge reversed that. And so no, we are not required to hold the cash, so that's incorrect. On the Evans case itself, we believe we have meritorious defenses, and we're appealing that. The judge did reduce the original compensatory damages, not the punitive damages, so the number's a lower number but then you add interest on it. So long and short of it, we think they got it wrong. And we will appeal that case, and hopefully, get ourselves into a more favorable court. On TPSAC, we continue to make those challenges, and we believe that is a case that has been worth doing. The government, as far as I understand, and my lawyers can clarify this and follow-up calls. But as far as I understand, the defense of the government is not one of whether we're right or not, there's is more on standing and whether or not we've been damaged at this point. And in the meantime, there has been progress made in TPSAC and some people have moved off, some others haven't. And even some of the things we're seeing, we think that standing up for ourselves is having an effect on the whole process. And that alone is -- it has been worthwhile to the company and to the industry, and hopefully, we'll win the case as well.

Operator

Your next question comes from the line of Vivien Azer.

Vivien Azer - Citigroup Inc, Research Division

As we think about the margins this quarter, you spoke to, obviously, some of the mix impact and the inventory volume shifts, and you quickly mentioned in Q&A the Newport recall. I'm curious, if you could frame for us kind of order of magnitude how big of a deal that was? And also some of the manufacturing overtime issues that you highlighted maybe 6 weeks ago, whether that was impact as well?

Murray S. Kessler

Okay. Vivien, there were a few things that impacted the cost structure in the quarter, none of which individually were material. We did have a cost of the recall. As Murray said, that was just a couple of million dollars. We signed a new 4-year contract with our labor union during the quarter, which gives us some certainty going forward. And that had a signing bonus attached to it which was about $3 million in total. There was some other cost pressures during the quarter of input costs. We see sort of mid-single digit price increases on things like tobacco and some other ingredients cost, but none of the -- nothing individually added up to anything material. But the other things like the recall and the new union contract, you would say those are -- those wouldn't repeat themselves going forward.

Vivien Azer - Citigroup Inc, Research Division

Understood. My other question has to do with the lawsuit around graphic warnings. Can you give us an update on that?

Murray S. Kessler

Well, you'd see the case was argued -- not the case was argued, just the injunction. Preliminary injunction was argued. The actual case itself would be probably a few months from now or into the spring. The judge had indicated that he would evaluate the preliminary injunction. We think that our lawyer Floyd Abrams did a great job arguing why we believe this is a violation of both the First Amendment and the Administrative Procedures Act. We believe the government has crossed -- has violated both. And we are optimistic on winning the case itself, and we're hopeful that since we're optimistic on the case itself that we'll be granted an injunction. That he said he was hopeful to have an opinion on that by the end of October. And I believe there was a commitment for November. So anytime.

Operator

Your next question comes from the line of Karen Lamark with Federated Investors.

Karen Lamark - Federated Investors

I have a question on SG&A. I believe you said there'd be no dramatic increase, or there was no dramatic increase in the advertising cost. And I understand there's always one-offs. But SG&A to sales is up in the quarter and year-to-date. And I'm just wondering, should we expect a higher run rate going forward?

David H. Taylor

Karen, I think the run rate for SG&A could be variable quarter-to-quarter and is mostly going to vary as a result of litigation activity. The legal defense costs vary, obviously, with the number of cases in trial, number of cases at various positions through there. The increase in advertising or brand-building costs on an annualized basis is probably basically level now. I don't expect to see that material or dramatically increase over time, but we're going to see upward pressures on SG&A, just from things like salary and benefit cost increases and other cost increases. But most of the change quarter-to-quarter revolves around legal defense costs. And as you do the comparison to revenues in the current quarter, you have to continue to take into account that inventory movement that we continue to talk about. And I'm also reminded that sequentially, SG&A is not really up in the third quarter by any measure.

Operator

If there are no further questions, I would like to turn the call back over to Mr. Kessler for any concluding remarks.

Murray S. Kessler

Thank you for your continued interest in Lorillard. We're -- as I said, fundamentals remain strong. We're optimistic about the fourth quarter and 2012. Thank you for your interest.

Operator

This concludes the Lorillard, Inc. Third Quarter 2011 Earnings Conference Call. For a replay of this call, please dial (888) 859-2056 or for international participants, please dial (404) 537-3406. The conference ID number for the replay is 17389350. You may now disconnect.

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