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Reynolds American (NYSE:RAI)

Q3 2011 Earnings Call

October 25, 2011 9:00 am ET

Executives

Thomas R. Adams - Chief Financial Officer and Executive Vice President

Morris Moore - Vice President of Investor Relations

Daniel M. Delen - Chief Executive Officer, President, Director, Chairman of R J Reynolds Tobacco, Chief Executive Officer of RJR Tobacco and President of RJR Tobacco

Analysts

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

David J. Adelman - Morgan Stanley, Research Division

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

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

Vivien Azer - Citigroup Inc, Research Division

Nik Modi - UBS Investment Bank, Research Division

Anton Kawalsky - Canyon Capital

Karen Lamark - Federated Investors

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Reynolds American Third Quarter Earnings Conference Call. [Operator Instructions] As a reminder, today's conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Morris Moore, Vice President, Investor Relations. Sir, you may begin.

Morris Moore

Good morning, and thank you for joining us. Today, we'll discuss Reynolds American's results for the third quarter and 9 months, as well as our revised outlook for the full year. We'll focus our discussion on adjusted results as management believes this better reflects the underlying business performance. A reconciliation of reported to adjusted earnings is in our press release, which is on our website at reynoldsamerican.com. Joining me this morning are RAI's President and CEO, Dan Delen; and Tom Adams, our CFO.

The information we're about to discuss includes forward-looking statements. When we talk about future results or events, a number of factors could generate results materially different from our projections today. These factors include, but are not limited to, items detailed in our press release and SEC filings. Except as provided by Federal Securities laws, we are not required to publicly update or revise any forward-looking statements.

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

Daniel M. Delen

Good morning, everyone. Let me begin our discussions with several very positive developments. Earlier today, Reynolds American announced that its Board of Directors had approved a 5.7% increase in its dividend. Tom will provide more details in just a moment, but I'm very pleased with the Board's vote of confidence and continued support, not only for our near-term direction but also for our long-term strategy. We also like to report that for the fourth consecutive year, RAI has received independent recognition for its ongoing sustainability and responsibility initiatives. The company was again awarded membership in the Dow Jones Sustainability North America Index, and is the only U.S. tobacco company in the index. And we are certainly proud of that recognition. So some very good news to start off our call today.

Turning to RAI's outlook. Based on our results through the third quarter, we are tightening our earnings outlook for the full year. We now expect adjusted EPS of $2.63 to $2.68. I would note that our guidance excludes the impact of the individual Engle progeny cases and the Scott lawsuit, as well as implementation and integration costs and tax items, which Tom will discuss in more detail.

Now I'll give you my perspective on the company's results in the third quarter and year-to-date. Overall, I'm very pleased with RAI's solid third quarter performance. I believe our performance reflects both the fundamental strength and positive momentum of our business strategy. These results are particularly noteworthy because they come in the face of a challenging economic and competitive environment. Our third quarter results underscore our ability to manage near-term challenges while continuing to transform our business for the long term in an evolving industry.

So let's look at how our operating companies did in more detail. R.J. Reynolds performed very well this quarter despite a difficult operating environment. The company delivered higher adjusted operating income and excellent improvement in their adjusted operating margin in both the third quarter and the first 9 months of this year. Driving these results were gains on the company's 2 growth brands, Camel and Pall Mall, along with continued pricing and productivity improvements. Before I get into more detail on our performance, let's step back and look at industry cigarette volumes.

Total cigarette industry shipment volume declined 6.4% in the third quarter, and R.J. Reynolds' volume, excluding the company's de-emphasized private label brands, was in line with the industry. As many of you know, industry shipment volumes have fluctuated significantly across the quarters this year due to large swings in the wholesale inventory levels.

When we look at the category on a year-to-date basis, we get a much better view of the actual underlying performance. For the first 9 months of this year, industry shipment volume declined 3.7%, while R.J. Reynolds' cigarette volume, excluding private label brands, was down 4.4%. R.J. Reynolds' volume decline was driven by losses on support and nonsupport brands. These brands have been hit hard by a significant increase in competitive promotional activity this year. As you know, R.J. Reynolds manages these brands to optimize the mix between market share performance and profitability. And in order to accomplish that, the company has not significantly increased the discounting levels on these brands this year.

Now looking at market share. R.J. Reynolds' total cigarette market share, excluding private label, was down 0.8% for the quarter. But, again, for the 9 months, it was in line with the prior-year period at 27.4%. R.J. Reynolds' growth brand, Camel and Pall Mall, once again delivered good performance in the third quarter. These 2 brands continue to play an increasingly important role in R.J. Reynolds' results and now account for 60% of the company's total cigarette volume.

Camel, R.J. Reynolds' premium growth brand, continues to deliver solid performance despite a really challenging marketing environment. This environment is putting pressure on all premium priced products, and Camel is no exception. Although the brand's market share was down slightly compared to the prior-year quarter, Camel has delivered steady, sequential market share growth this year. Camel is benefiting from the outstanding performance of its menthol styles, which increased our market share by 1/2 a share point from the prior-year quarter and now stands at 2.4%. And Camel menthol has accounted for the majority of growth from the premium menthol category this year.

Camel's menthol styles, which include Camel Crush and Camel Crush Bold, utilize R.J. Reynolds' innovative capsule technology, which offers adult smokers the choice of how they enjoy their smoking experience. This option has proven to be quite appealing and is driving positive brand demographics. Camel Crush Bold, which was expanded nationally in late July, is only the second style for Camel Crush and is R.J. Reynolds' only cigarette line extension in more than 3 years. This style offers a richer, more full-bodied taste, and the company expects it to further broaden the appeal of the Camel brand and drive additional growth.

But our commitment to innovation doesn't stop there. We also see tremendous growth potential for Camel SNUS. I'm pleased to say that Camel SNUS enjoys a 70% share market in the category, and shipments are up more than 20% this year. While the category itself is still small, awareness and trial remains high. And we continue to believe that the same consumer convenience attributes that are driving growth in other smokeless tobacco product categories should benefit the SNUS category as well.

Now turning to Pall Mall, R. J. Reynolds' value growth brand. Pall Mall continued to deliver strong market share and volume gains in both the third quarter and year-to-date periods. This growth came in the face of significant competitive activity with many brand choices at or below Pall Mall's price point. Pall Mall's third quarter market share increased by 7/10 of a percentage point and stands at 8.6%. The brand's strong performance is underpinned by its positioning as a high-quality, longer-lasting cigarette that offers exceptional value. In today's economic environment, Pall Mall is a terrific asset in R.J. Reynolds' brand portfolio.

So all in all, R.J. Reynolds has performed well through the third quarter. The company's results show the strength and resilience of its business model. The company's growth brands continue to drive improved performance by bringing innovation, coupled with a rich heritage, to the market.

Now onto American Snuff. The company once again delivered strong marketplace performance in the quarter despite the intense promotional environment in the moist-snuff category. American Snuff achieved outstanding growth in both volume and market share in the quarter. The company's market share increased 1.1 percentage points from the prior-year quarter and now stands at 31.6%. American Snuff's flagship brand, Grizzly, drove the company's performance, delivered excellent volume growth of more than 9% in the quarter and almost 10% for the year-to-date period.

Not many brands are delivering 10% growth in this economy. On top of that, Grizzly's third quarter market share increased by 1.6 percentage points from the prior-year period, with a total market share of 27.8%. Grizzly is really benefiting from the new retail contracts that American Snuff rolled out in the second quarter of this year. This investment is providing the brand with its fair share of retail space, as well as better brand and pricing communication. Grizzly is also benefiting from the strength and scale of R.J. Reynolds' field trade marketing organization, which now also serves American Snuff. I would also note that Grizzly celebrated its 10th anniversary in September. The brand is a true success story, becoming the market leader in a rapidly growing and highly profitable category in just 10 years.

So those are the highlights for American Snuff. I believe that the company's solid underlying performance and the investments they are making puts them in position to deliver sustainable growth well into the future.

Before I turn the call over to Tom, I would briefly like to point out that RAI's Santa Fe subsidiary continued to deliver excellent results in the third quarter, as its Natural American Spirit brand again drove gains in earnings, volume and market share. So good news on that front as well.

That's a look at some of Reynolds American's achievements in the third quarter. Now Tom will provide additional details. Tom?

Thomas R. Adams

Thank you, Dan, and good morning, everyone. As you've just heard, RAI and its operating companies continued to deliver good results last quarter. As I discuss that performance, I'll focus on adjusted results to provide perspective on our underlying business. So let's start with RAI's results.

On a reported basis, third quarter EPS was $0.63 per share, down 3.1% from the prior-year quarter, driven by an accrual for the 4 Engle progeny lawsuits, specifically the Martin, Hall, Gray and Campbell cases. $63 million was accrued in the third quarter, which included $53 million for compensatory and punitive damages and $10 million for attorney's fees and statutory interest. These 4 cases have proceeded through the appellate process in the state of Florida, and R.J. Reynolds will ask the U.S. Supreme Court to review these 4 cases.

R.J. Reynolds' policy is to record any litigation loss when an unfavorable outcome in any individual case becomes probable and the amount can be reasonably estimated in accordance with Generally Accepted Accounting Principles. The company believes it has strong legal positions and defenses for its Engle progeny cases. But the nature, evolution and progression of the Engle progeny cases through the federal and state court systems in Florida do not allow management a sufficient level of predictability of the timing and outcomes on a case-by-case basis. So for the foreseeable future, we will provide adjusted EPS guidance, excluding any impacts of Engle progeny cases, in order to provide a consistent basis for evaluating ongoing business performance.

Excluding that charge of $0.06 per share and implementation and integration costs of $0.01 per share, RAI's third quarter adjusted earnings were $0.70 per share, up 2.9%. Adjusted EPS for the first 9 months of 2011 was $1.96 per share, up 3.7%. These adjusted earnings exclude the items I just described, as well as the Scott lawsuit and tax items. Reynolds American's adjusted operating margin for the third quarter increased 1.5 percentage points to 32.1%, driven by higher pricing and productivity at our operating companies.

Turning to R.J. Reynolds' performance. R.J. Reynolds' third quarter adjusted operating income, which excluded the accrual for the 4 Engle lawsuits, increased 2.6% from the prior-year quarter to $587 million, as higher cigarette pricing and productivity gains more than offset cigarette volume declines. R.J. Reynolds delivered significant improvement in their adjusted operating margin, which increased 1.4 percentage points from the prior-year period to 31.2%.

Now let's look at American Snuff. Third quarter adjusted operating income was $90 million, down 12.1% from the prior-year quarter. That decrease was driven by the impact of the sale of Lane early this year. Lane contributed about $10 million to American Snuff's operating income in the prior-year period. For the 9-month period, adjusted operating income was $258 million, down 5.1% from the prior-year period. This comparison was also negatively affected by the Lane sale. The company's third quarter adjusted operating margin was 54.9%, down slightly from the prior-year quarter, while operating margin for the first 9 months rose 1.9 percentage points to 53.2%.

Turning to moist-snuff volume, American Snuff's total moist-snuff shipment volume again saw strong growth to 7% in the third quarter and was up 7.7% for the 9 months. American Snuff's growth was driven by Grizzly, with third quarter shipment volume growth of 9.1%. And Grizzly's volume increased 9.9% for the first 9 months. So American Snuff is doing very well and is positioned to deliver additional gains this year.

Now I'd like to give some additional details on the dividend increase we announced this morning. As Dan mentioned, the Board approved a 5.7% increase in RAI's dividend, which further demonstrates the company's commitment to returning value to our shareholders. When combined with the increase that was announced in February, our total dividend growth is 14.3% this year or $0.28 per share on an annualized basis. We continue to view our dividend as the key tool for returning value to our shareholders, but we are also evaluating other opportunities to effectively use our cash and return additional value.

With respect to our balance sheet, Reynolds American ended the quarter with cash balances of $2 billion, and we have significant financial flexibility with a leverage ratio of 1.3x debt to EBITDA, which is slightly below our target range of 1.5 to 2.5x. We have also taken some significant steps to strengthen our pension plans. The company contributed $75 million to the pension plans in the third quarter. In addition, a contribution of $125 million was made in early October, bringing our total contribution to $200 million this year.

Now turning to guidance. Based on our solid performance through the first 9 months of this year, Reynolds American has tightened its full-year forecast to an adjusted EPS range of $2.63 to $2.68. That's an earnings increase of 5.6% to 7.6% from the 2010 adjusted results. As I explained earlier, this guidance excludes charges for individual Engle progeny lawsuits, the Scott lawsuit, implementation and integration costs and tax items, as well as any potential impact of goodwill and trademark impairments.

So in closing, we feel good about our performance and the value we are returning to our shareholders. We've delivered sustainable growth in our businesses, which has allowed us to reward our shareholders with the higher dividends. Our total shareholder return for the first 9 months this year of 20% would be considered good in any market, but when compared to the S&P 500, which has declined by more than 8.5%, it's been a very impressive performance.

On that positive note, we'll turn to the Q&A portion of the call. Gavin, would you remind our callers how to get in the queue?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Bonnie Herzog of Wells Fargo.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I guess my first question, I just wanted to touch on a little bit with the weakness or the pressure you're seeing on your premium brands. Can you talk a little bit more in detail about any initiatives you might be putting into place to try and stem some of the downtrading pressure they're facing?

Daniel M. Delen

Yes, I think first of all, I would characterize Camel's performance as being quite robust in the quarter. I think we look at it sequentially. We see that we actually grew 1/10 of a market share point, and this is in an environment, in a market environment, where there is significant downtrading going on. When I think about downtrading, I really think we need to look at the downtrading in 2 forms. There's obviously downtrading within the cigarette category, and more recently, we've also been picking up some of the growth of other smoking categories that are lower-priced smoking options. And by that, what I really mean is the little cigar category, which is tax advantage in this country today, which is growing. And also the -- it looks like traditional roll-your-own, but it's being classified as pipe tobacco, but it's actually being smoked as roll-your-own. So we have a little nickname internally for that, we're calling it the pipe-your-own category. But that's the downtrading sort of that's going on in the market place. And in the light of that, to have Camel hold up its performance like it did, I think it's very, very positive.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Okay. That helps. And then switching gears over to the margins that you've seen expand during the quarter. Can you touch on some of your productivity or cost-saving initiatives and how big of a role those programs played to help you expand your margins?

Daniel M. Delen

I think if I look back at the third quarter, I don't think there's anything huge of note within the numbers, but it's ongoing efforts within the company and really has become a way of life for us. So there is, at any point in time, 10s and 100s of little projects that actually go in that all contribute little amounts of money that all add up at the end of the quarter. So quite pleased with our increase that we've been able to post in the adjusted operating margin. Sequentially, that's up 2 percentage points, and year-on-year, that's up 1.5 percentage points. So I think that's very, very positive. And, of course, we also have the pricing gains quarter-on-quarter. And I think the headline sort of net price realization numbers are maybe a little bit overstated just because of some of the contract manufacturers that's within it. Even when we net that out, I would say that we have quite a positive net pricing realization number of around 3% on the ongoing domestic business.

Operator

Our next question comes from Judy Hong of Goldman Sachs.

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

Dan, just in terms of the competitive environment, maybe you can talk a little bit more about just what you saw in the third quarter as it relates to whether you did see more of a change in the intensity of the promotional spending or any sort of competitive activity and whether that came more from some of the smaller players. Because it does seem like Pall Mall's growth, while you did see some growth, growth has slowed a bit on that brand.

Daniel M. Delen

Let me just take those questions in turn. First, in terms of Pall Mall, year-on-year, we're actually up 7/10 of a market share point, which I think is quite positive. Of course, we're lapping some extraordinary gains during the same quarter last year on Pall Mall. But 7/10 is nothing to be ashamed of. In fact, I'm quite proud of that number, and what the organization has achieved. In terms of competitive pressure, I would characterize the third quarter as being sort of a fairly typical quarter from competitive pressure point of view, after characterizing the second quarter as being sort of a through the regular cycles but a pretty heavy kind of spend quarter. In fact, just looking at where we sit so far in the fourth, so, really, this quarter to date, I would say that it looks like there's a small ramp-up in competitive spend during this fourth quarter, but all within kind of a normal to-ing and fro-ing in the marketplace and the normal kind of cyclical activity that happens in the category.

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

And would you think that, that would be the case for 2012? You've talked about the consumers being under pressure. You've talked about the downtrading to not within cigarettes, but to some of the other tobacco products as well. Do you think that there's risk that the competitive landscape actually becomes more intense in 2012?

Daniel M. Delen

I mean, the answer to that question, Judy, really just kind of need to make an underlying assumption, and you can do that as well as I can in terms of where the economy is actually going from a macro category point of view. But I really look at our prospects next year and our ability to keep delivering shareholder expectations, and I'm quite bullish on that. I think we have the right organization. The right portfolio are present in the right categories in the marketplace. And I believe we can keep delivering, irrespective of the economic environment.

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

Okay. And then in American Snuff, just in terms of the profitability, even if you exclude the $10 million contribution from Lane, it looked like profit would have been maybe flat to down a little bit, even though volume was up 7% or so. So can you talk a little bit about the pricing and profitability on the Snuff business.

Daniel M. Delen

Yes, I don't think so much it's a pricing issue because, of course, we've had good pricing and we've had taken regular price increases over time on our moist-snuff business at American Snuff. Really, in the back-end of the first quarter of this year, we started spending or really investing into the marketplace a bit more. And that has to do with actually getting our fair share of presence at retail, getting our pricing communicated and through to the consumer and really just getting our fair share of things at retail. And so that requires some investment from a company point of view. And that investment, happy to report that it's actually paying off dividends, and we're actually seeing a good return on that investment as evidenced by the superior performance of Grizzly in the marketplace. It's up year-on-year, 1.6 market share points, sequentially up 4/10 and really quite proud of that performance despite the loss of the competitive pricing pressure in the marketplace.

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

Okay. And then, Tom, finally, just in terms of your full-year guidance, if I take the mid-point of your updated guidance, it still implies a pretty strong growth since fourth quarter versus sort of mid to high -- I guess low to mid single-digit growth that you've seen year-to-date. So was there anything just in terms of last year in the fourth quarter that sort of depressed the year-ago numbers? Or you're looking for pretty good pickup in fourth quarter? I'm just trying to figure out why you would anticipate a pretty strong growth in Q4.

Thomas R. Adams

Yes, there was nothing in last year's fourth quarter. I think this is just our confidence in each of these operating companies to deliver volume and share growth through the balance of the year, Judy.

Operator

Our next question comes from Chris Growe of Stifel Nicolaus.

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

Just had a couple of questions for you. I want to know, has there been -- was there in the quarter any inventory shift for you of note that we should basically get a better sense of maybe your underlying volume shook out in the quarter?

Daniel M. Delen

Yes, I think you're probably well aware that the industry ended with fairly high levels of inventory at wholesale end of the second quarter that way. I think we would characterize wholesale inventories today as being at normalized levels. And the sort of characterization I put around those inventories is that we had some, but we had disproportionately little at retail. In fact, I believe our number was right around the $500 million-stick level. But if you look at our share of that inventory that was sitting at wholesale, we were well underrepresented.

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

Okay. And then I noticed where you gave your shipment figures and then you had your retail share figures, one that stood out, in my opinion, was Camel, where you had shipments flat. But your market share for Camel was down a little bit at retail. I'm just curious in relation to that because I guess Pall Mall showed relatively similar shipment pattern, but we had a much stronger retail share pattern. Can you talk about those 2, maybe what was kind of going on? Was that really just the distortions in shipments because of inventory?

Daniel M. Delen

Yes, I don't have a specific answer for you on that, but generally speaking, when we do the actual market share, it's actually done by an outside company. So it's a retail audit. So they actually audit a certain number of stores. There may be small fluctuations within that. When we look at Camel share year-over-year, it's down 1/10, but sequentially, it's up 1/10. Now, of course, those are fairly small movements within that. So I honestly -- my own mind don't read too much into that.

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

Okay. And then just another question, just a quick follow-up on the Engle accruals. You've not had any other Engle accruals that you've taken to this point, right?

Thomas R. Adams

That's correct.

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

Okay. And then would you normally include attorney's fees within those accruals when you take those historically? For other cases, have you done that?

Thomas R. Adams

In the past, when we had paid, yes, we have.

Operator

Our next question comes from Nik Modi of UBS.

Nik Modi - UBS Investment Bank, Research Division

Just a quick question, Dan. When you think about the total tobacco strategy Reynolds has been pursuing for the last few years, is there anything missing in your portfolio? I mean, when you think about -- you talked about little cigars as being a growth category, roll-your-own. I mean, anything that you think would be interesting to fill in, in terms of the portfolio?

Daniel M. Delen

I think the way I would characterize it, Nik, is, obviously, the bulk of our business today, as we sit here, is still cigarettes, and it will be for the foreseeable future. But, of course, we're present and growing in the growing category of moist-snuff. We've organically launched into the SNUS category, very happy with that performance as well. We are, far and away, the leader in that small but growing category and, in fact, have seen 20% volume growth year-on-year. Then, of course, I think the consumer continues to look for new opportunities out there to enjoy the tobacco experience. And as you know, we are testing dissolvables as we speak. And, certainly, I think the concept there is very relevant, and I believe that consumers will keep looking, potentially even beyond that for new ways to enjoy the tobacco experience. So I think we're quite happy with our footprint sort of across the different categories as we see it having evolved to date but continue to look and continue to think about where this might be going in the future and what new opportunities may present themselves.

Nik Modi - UBS Investment Bank, Research Division

Great. And then the other question, just any thoughts on the FDA's white paper review in menthol, any thoughts, any updated thoughts from your side?

Daniel M. Delen

No, I think really where the FDA is on that, I think, has been well-reported in terms of what they're doing, the peer review currently. We're obviously engaging with the FDA on a tangential but maybe related issue, which is on the dissolvable side. Quite looking forward to a lot of that interaction because I think we have a great story to actually get out on that front. But I really don't think there's any new news currently on the FDA front.

Operator

Our next question comes from David Adelman of Morgan Stanley.

David J. Adelman - Morgan Stanley, Research Division

Dan, given the performance of the support brands recently, do you think, realistically, R.J. Reynolds is now in a period of renewed overall market share erosion?

Daniel M. Delen

David, I don't. I think when we take a look at our support brands, and just to remind the rest of the people on the call, these are bands like Winston, Kool, Salem and Doral. They tend to have a older consumer demographic profile, and they tend to have more price sensitive consumers within the franchise. So, of course, when there is a lot of pricing activity in the marketplace, they tend to be overrepresented in some of the downtrading that actually happens in that kind of an environment. We watch these brands very closely just to make sure that we are optimizing the quarter-to-quarter and year-to-year kind of results from -- and really trying to balance out the profitability on these brands with the market share performance. I think we do spend a little bit of money on these brands, but obviously, disproportionately, they get significantly less resources than our growth brands, those being Camel and Pall Mall. So I think we have the right strategy in place for these brands, but, of course, they will fluctuate quarter-to-quarter and year-to-year based on what's going on in the marketplace and the competitive pressures.

David J. Adelman - Morgan Stanley, Research Division

And, Dan, what's your confidence that R.J. Reynolds, over time, can grow its operating income? I think through the 9 months, it's up about 1%. If you look out over the next couple of years, what's your assessment on that metric?

Daniel M. Delen

Well, obviously, giving forward guidance is problematic, but I would say that I am very confident that R.J. Reynolds is on the right strategy, has the right portfolio in place and can meet its operating expectations into the future.

David J. Adelman - Morgan Stanley, Research Division

Okay. And I have a question on Engle and, potentially, pricing. If -- I know it's not your base case assumption, but assume that these losses are not reversed on appeal, the trial activity persists and it becomes sort of an ongoing irritant, not just for your company but for your competitors, do you think ultimately in that environment that the industry would essentially price for these kinds of cases as it has with FDA user fees and MSA accruals, in other words it would just become a cost of doing business?

Daniel M. Delen

I mean, David, you're asking me to speculate. I'm working on the assumption, and I have the belief that these cases will be overturned on appeal. And that's really the scenario that we are focused upon. If we look at the sort of 2 DCAs in Florida and the federal court that's actually looked at the cases, they've all come to different opinions on these kinds of cases. So we're quite confident that our appellate strategy will prevail. And, of course, there are issues of timing that come into play as to when eventual review will be won by ourselves. But that's really where our focus is as an organization, and we're quite confident that we can see our way through this challenge on the legal front.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then lastly, the increase in the dividend, is there sort of a subtle indication with respect to that as it relates to the Board's interest or enthusiasm of ultimately initiating a share repurchase program?

Thomas R. Adams

No.

Daniel M. Delen

I think, clearly, it's just a fantastic vote of confidence as we sit here today. And, obviously, we have a target payout policy of 80%. This is roughly in line with that, and we're happy to be able to actually reward our shareholders along the way. We obviously prefer to do that through dividends but are actively considering other alternatives as well.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then one last thing, do you think that the U.S. cigarette industry consumption decline, more or less, is consistent with the year-to-date shipment decrease of 3.7%, 3.8%? Do you think that the 2 are fairly similar?

Daniel M. Delen

Yes, David. I think maybe if we're going for a little bit more detail there, I would -- we're estimating the year to be 3.5% to 4% down. I think it's fair to say that, that decline rate is maybe a little bit higher than we might have expected given what's happened with price movements and where we're seeing the absence of significant tax increases this year. In fact, happy to report that the SETs seem to be coming in at about $0.01 or $0.02 for the entire year 2011. But what we have noticed is some growth in some of the other smoking categories. And I mean by that, I mentioned this earlier on the call, but it's the little cigar category and that category that we're calling pipe-your-own, which is really products that are packed, as if they are pipe tobacco but tend to be used by consumers as a roll-your-own. And those categories have been growing. And I think once we factor that in, I think we're still very much in line with the historical price sensitivity of demand.

Operator

Our next question comes from Vivien Azer of Citigroup.

Vivien Azer - Citigroup Inc, Research Division

Just to turn back to Pall Mall quickly and some of the competitive pressure that you guys face, I was wondering if you could offer some color on how your pricing, both on an absolute and relative basis, evolved through the quarter. Did you pass through the price increase? Did you hold it back? And kind of how did the competition respond?

Daniel M. Delen

Yes, I think we largely passed through the price increase. I mean, we certainly saw some of the margins of the brand. So actually it's quite positive from that point of view. I think what we all need to understand is that Pall Mall is not the low-priced brand out there. There are significant competitive offers at or below Pall Mall's price. And so it isn't the absolute cheapest at retail. So we, as a company, obviously, even in our value brands try to optimize some of the long-term and quarter-to-quarter earnings on the brand with this market share performance.

Vivien Azer - Citigroup Inc, Research Division

Fair enough. And just quickly on the pension, can you guys offer some color on your comfort level that you won't need to step up your pension contributions in the fourth quarter given kind of the macro backdrop?

Thomas R. Adams

Sure. Right -- at the end of the third quarter, we were about 85% funded, Vivien, in that. And I'm including that $125 million that we put it in, in October in there. So pension assets are around $4.9 billion. We're comfortable with 85%, and that's because we actually reduced the discount rate. We're now modeling a 5% discount rate as opposed to 5.6%, and that's added some liabilities. And while I won't call where interest rates will go over time, I do believe that they're going to go up. And as I mentioned before, a 100-basis-point movement up in the discount rate eliminates $500,000 to $600,000 of our liabilities, and that would put us on a fully-funded basis. So we're pretty comfortable.

Operator

Our next question comes from Ann Gurkin of Davenport.

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

Just wondering with the decline in market share and what looks like acceleration in that decline sequentially, combined with consumer downtrading, weakness in Pall Mall, is there a need for Reynolds to step up brand support as we look out into '12? Can you comment on that?

Daniel M. Delen

Well, obviously, the brand supports, actually, those are decisions that we make in a competitive environment going forward. So it's really hard for me to comment in terms of our pricing plans going forward. But, certainly, when we look back, I think we're happy with the way that we have actually navigated through a quite competitive environment, and I'm particularly thinking of the second quarter. I think as the third quarter kind of unfolded, it progressively got -- became more normalized competitive environment. So these are the normal kind of cyclical to-ing and fro-ing that happens in the marketplace. So I'm happy with our strategies, and I think we are spending the appropriate amount of -- resources back into the marketplace.

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

You're happy with the balance you're seeing between market share movement and margin, brand performance. You're happy with that?

Daniel M. Delen

Well, yes. I mean, obviously, we'd all love to generate even more market share, and we'd all love to earn more money. But, yes, in terms of the balance and how the quarter actually played out, I would say that we're happy.

Operator

Our next question comes from Karen Lamark of Federated Investors.

Karen Lamark - Federated Investors

A couple of follow-up questions. On the buyback, can you update us on any timing of decisions or any anticipation on when you might decide whether or not to do a buyback?

Thomas R. Adams

Sure. This is Tom. We -- just let me talk a little bit about how we've used our cash through the first 9 months. Our largest use of cash was paying dividends. We paid about $900 million out in dividends. You may recall we put 400 -- we paid down debt, our floating rate debt of 1% in June. That was $400 million. We've contributed $200 million to our pension plan, and we spent, through the 9 months, $140 million in capital expenditures and expect to spend another $60 million in the balance of the year. The majority of which is being spent on those 2 manufacturing facilities, the manufacturing facility in Memphis for American Snuff and the leaf processing in Clarksville. And so what we've been doing is basically trying to strengthen the balance sheet, shore up the business and create capacity and make -- and for American Snuff for the foreseeable future. And so once we get through all this heavy lifting and we are about through that, we have been talking with our Board on an ongoing basis about additional ways to get money back to shareholders. And the dividend -- or excuse me, the share repurchase is one of those things that we talked about. And so they are aware of it. And, naturally, we would have to have our largest shareholder, BAT, participate in all that. But those discussions are ongoing.

Karen Lamark - Federated Investors

And then separately, as it relates to Pall Mall's volume growth, obviously, there'd be some deceleration from some very strong levels, but I'm just curious, do you have any opinion or any insight into where those volumes might have gone?

Daniel M. Delen

I think it's a combination of things, Karen. I mentioned earlier in the call that there are significant competitive offerings at or below Pall Mall's price, and then there's also some price competition way at the bottom into the market from some of these other smoking categories that I mentioned. So I think there is significant kind of downtrading going on in the marketplace. In the marketplace in general, Pall Mall is effectively competing for some of those downtraders, but there are significant opportunities for consumers if they want to go down below Pall Mall to be able to do so. So, really, I think the way I would characterize our strategy is not chasing volume at all cost, really trying to make sure that we make our margins along the way as well.

Karen Lamark - Federated Investors

Is it fair to assume that what you've just described is probably concentrated in your 2 largest domestic competitors?

Daniel M. Delen

I would say not exclusively just because many of the -- if you think about the other companies outside of the large 3, the -- all the other companies tend to compete on price in the marketplace. And then, certainly, these other smoking categories, the little cigars and this pipe-your-own category that I described, those are, again, not the largest 3 competitors in the marketplace.

Operator

[Operator Instructions] Our next question comes from Anton Kawalsky of Canyon Capital.

Anton Kawalsky - Canyon Capital

Do you have an update on the MSA disputed payments, maybe how the negotiations are going and when you expect to receive any cash?

Daniel M. Delen

Yes, Anton, I don't have anything new specifically. I would say that the process continues to evolve. I think we're quite happy with the panel of arbitrators that are there, which are 3 retired federal judges. They have brought a lot of order and defined a process that we're now going through. And I would say that, that process is evolving as we sit here. So I think we're happy with the procedural progress, but obviously look forward to the day when it is finally resolved and actually see some of the money back that we believe we're owed.

Thomas R. Adams

Right. And, Anton, just to clarify, I mean, what's being arbitrated right now is the 2003 payment, which is about $615 million for us. But in aggregate, we've got about $3 billion in dispute. And our view is, is that once and when this initial arbitration gets resolved, the balance of those years will go at a much faster pace.

Anton Kawalsky - Canyon Capital

Is there any kind of timeline as to when this -- the first year is supposed to be resolved?

Daniel M. Delen

No, I think really we're in the hands of the arbitrators. I mean, obviously, we are hopeful that, that can be resolved sooner rather than later. But we don't have a firm date or have been given any firm date by the arbitrators.

Operator

Our next question comes from Priya Ohri-Gupta of Barclays Capital.

Priya Ohri-Gupta

When you look at your current leverage versus your target and sort of the current debt rates that are out there, can you just speak broadly about how you view the potential for taking on additional debt?

Thomas R. Adams

Well, I mean, we watch the debt markets as well, and we see that they're actually quite attractive right now. We would have to have a reason to put on more debt. If you look at our debt portfolio right now, we're sitting with about $3.6 billion. It's at 5.9%, and durations are a little bit less than 7 years. We've got -- with the MSA cash and the way that, that comes in, we've got a lot of money on our balance sheet today. And having cash just in the absolute is not the best asset to have. In fact, it's quite expensive. So -- I mean, if we were to go out and borrow more money, we would absolutely need to have something to do with it. Otherwise, the negative carry on that is quite severe. So we do watch that, and we are very much aware of the current market and the debt markets.

Priya Ohri-Gupta

That's helpful. And just one quick follow-up if I could. When you do talk about your duration, is your target to sort of keep your maturity profile inside of 10 years? Or would you potentially, at the right moment, look to do something longer-term as well?

Thomas R. Adams

We could do something longer-term. In fact, we have some 30-year debt that's out there. So we're completely open to extending the duration.

Operator

I'm showing no further question. I'd like to turn the call back to Mr. Moore for closing remarks.

Morris Moore

Thank you, again, for joining us for the call today. If you have any additional questions, please contact us at Investor Relations.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all now disconnect. Thank you.

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