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Executives

Morris Moore -

Daniel M. Delen - Chief Executive Officer, President and Director

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

Analysts

Vivien Azer - Citigroup Inc, Research Division

Christina McGlone - Deutsche Bank AG, Research Division

Christopher Ferrara - BofA Merrill Lynch, Research Division

Nik Modi - UBS Investment Bank, Research Division

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

David J. Adelman - Morgan Stanley, Research Division

Michael Lavery - Credit Agricole Securities (USA) Inc., Research Division

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

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

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

Theodore Jenkins

Reynolds American (RAI) Q4 2011 Earnings Call February 8, 2012 9:00 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Reynolds American Fourth Quarter Earnings Conference Call. [Operator Instructions] As a reminder, today's conference call is being recorded. I'd now like to turn the conference over to your host, Mr. Morris Moore, Vice President of Investor Relations. Please go ahead.

Morris Moore

Good morning, and thank you for joining us. Today, we'll discuss Reynolds American's results for the fourth quarter and full year, as well as our outlook for 2012. As usual, our discussions will focus on adjusted results as the management believes this better reflects our 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. As we reported today, Reynolds American rounded out a challenging but successful year on many fronts, with significant growth in earnings and margins in the fourth quarter. And I'm pleased to say that this solid performance allowed us to continue to return substantial value to our shareholders. I remind you that in October, we announced another increase in our dividend, and that brought the total dividend increase for the year to 14.3%.

And in November, we announced the start of a $2.5 billion share repurchase program that will extend through mid-2014. These actions demonstrate not only our commitment to returning value to our shareholders, it also reflects our confidence in the business moving forward.

It's fair to say that over the past year, the market price environment has been a difficult one. And the year ahead is not likely to be an easy year. The weak economy and high unemployment rate continue to put pressure on consumer disposable income and competitive promotional activity remains intense. We don't expect these pressures to ease anytime soon, but are confident in our continued ability to deliver superior results.

This year, our operating companies intend to sustain the momentum on their key brands, and we'll continue to invest in innovation, while maintaining the financial flexibility to take advantage of competitive opportunities.

So with this in mind, we started a detailed review of all our key activities and resources to ensure that they're in line with today's business landscape.

As you saw on our earnings release this morning, RAI, RAI Services and most departments within R.J. Reynolds have started a comprehensive analysis of their program, activities and organizational structures. This review is just getting under way, and is expected to be completed by the end of the first quarter. As such, we're not in a position today to give specific details of this review.

RAI's operating companies had a strong track record of successfully managing through challenges, while also continuing to invest in and build their businesses for sustainable growth. Based on this track record, we expect good growth in earnings in 2012.

RAI's full year EPS is expected to increase by mid- to high-single digits over 2011 adjusted earnings. Tom will give you details on this in his financial update.

Now let's look at last year's performance at our operating companies. R.J. Reynolds delivered higher adjusted operating income and operating margin in both the fourth quarter and for the full year. Growth brand volume gains, higher pricing and productivity improvements more than offset the impact of cigarette volume decline.

As I explained earlier, R.J. Reynolds is operating in a tough environment and the company's cigarette volume was negatively impacted in the fourth quarter by heavily promoted competitive line extension, as well as the timing of the company's promotional activities. The company remains focused on balancing share, volume and profitability over the long term.

R.J. Reynolds volume performance was also affected by a strategic decision to move away from its private label brands. Excluding those brands, the company's fourth quarter volume decreased by 7.1% versus the industry decline of 2.7%. I would note here that nearly half of the volume decline came from the Doral value brand, for which the company derived only modest levels of pricing support.

Looking at the underlying volume performance over the full year, R.J. Reynolds' volume, excluding private label brands, was down 5.1% compared with an overall industry decline of 3.5%.

R.J. Reynolds cigarette market share, excluding private label brands, was down 0.3 of a percentage point to 27.3% for the year, as the growth brand gains were more than offset by declines on the company's support and nonsupport brands.

Moving on to R.J. Reynolds 2 growth brands. We're pleased to report that Camel and Pall Mall continued to perform well in 2011 despite the challenging environment. These brands increased their combined market share in both the fourth quarter and for the year. In fact, they gained 1.3 percentage points last year and now hold 16.4% of the market. This performance was supported by a 2.9% increase in volume. And these 2 brands have grown to account for about 60% of the company's total cigarette volume.

R.J. Reynolds premium Camel brand saw a modest increase in market share last year, which is quite an accomplishment for a premium-priced brand in this economic environment. Camel reported excellent growth on its menthol styles, which increased market share by 0.5 a percentage point. Camel menthol styles have been enhanced by last year's national expansion of Camel Crush's second style, Camel Crush Bold, which also offers the company innovative capital technology to adult smokers. These styles give Camel a solid platform for future growth in the premium menthol category.

Turning to Camel SNUS. I'm happy to say that Camel SNUS made great stride in the growing snus category last year. The preferences of adult tobacco consumers are changing, and Camel is transforming its offerings with the times. And the spit-free and smoke-free convenience of Camel SNUS allows adult consumers to switch from smoking, while continuing to enjoy tobacco. Camel SNUS finished the year with 75% share of this category, with the volume growing by double digit.

Now turning to R.J. Reynolds' value-priced growth brand, Pall Mall. Pall Mall continued to generate volume and share gains in the fourth quarter and full year. Pall Mall's market share increased by 1.1 percentage point in 2011 to 8.5% on volume growth of 8%. Pall Mall's reputation for high-quality, longer-lasting cigarette continue to attract value-conscious consumers, especially in this weak economy.

Now let's turn to American Snuff. The company ended the year with sustained momentum, reporting excellent growth in both market share and volume. Even with the intense competitive activity in the moist-snuff category, American Snuff market share increased 1.2 percentage points from the prior year of 31.5%, and that's on volume growth of 7.3% for the year. That compared quite well with growth of about 5% for the overall moist-snuff category. Once again, the main driver of the company's performance was Grizzly, which continues to benefit from enhancements to its brand equity.

With the recent investments in its new retail contract, Grizzly is now getting improved brand and pricing communication, as well as a better share of retail space. In addition, we expanded R.J. Reynolds field trade marketing organization, which now also serves American Snuff, it's providing greater benefits to Grizzly in stores.

Grizzly delivered outstanding share performance in 2011, with fourth quarter market share increasing by 1.4 percentage point from the prior year quarter. And for the full year, its market share was up by 1.6 percentage point, bringing the brand share to 27.7%.

Grizzly shipment saw strong growth last year, with a 9.4% increase. Grizzly pouch styles continued to perform extremely well in 2011, gaining 0.9 of a percentage point from the prior year. Grizzly pouches now represent almost 1/3 of all pouch sales. To put this in perspective, overall growth of moist-snuff pouch styles was up by more than 10% last year, and Grizzly captured more than 3/4 that growth. In addition, the company believes there is good potential for incremental growth for Grizzly, especially on its portfolio of natural flavor styles. To this end, American Snuff is focused on driving increased awareness and trial for these styles this year. So that's a terrific performance from Grizzly and we believe there's a lot more to come as the brand continues to enhance brand equity and build market momentum.

As we announced earlier, we have elected to report Santa Fe Natural Tobacco Company's domestic business as a reportable business segment. Based on its increasing importance to RAI's performance, we thought the time was right to provide more detailed information on this rapidly growing business. In fact, since its acquisition 10 years ago, we've seen an outstanding contribution from Santa Fe. Its super premium, Natural American Spirit brand has delivered a fivefold increase in market share. And in 2011, the company's performance continued to grow from strength to strength, even as overall demand for cigarettes declined.

Santa Fe generated double-digit gains in earnings, volume and market share last year, and its operating margins saw substantial growth as well. Natural American Spirit increased its market share by 0.2 of a percentage point for the year and now stands at 1%, with volume growth of 13.5%. This kind of powerful performance is testament to the company's unique high-quality tobacco offerings, and they're intensely loyal franchise and Santa Fe is well positioned for continued growth in the years ahead.

So to wrap up, RAI's operating companies demonstrated their resilience and their ability to successfully manage the challenges of 2011. And they continue to strengthen their platforms for sustainable growth by enhancing their key brands and identifying new opportunities for their innovative smokeless tobacco products as part of RAI's strategy to transform the industry over the long term.

Now Tom will provide some financial details. Tom?

Thomas R. Adams

Thank you, Dan, and good morning, everyone. I'm very pleased with Reynolds American's financial performance in 2011, which allowed us to continue to return excellent value to our shareholders through the increased dividend and new share repurchase program.

Dan has spoken about the difficult environment in which our companies are operating. Even so, they made solid progress in many areas during the fourth quarter and across the year, which resulted in higher earnings and margin at RAI.

I'll start with RAI's results. On an adjusted basis, fourth quarter EPS was $0.72 per share, up 12.5% from the prior year quarter. These adjusted results exclude noncash charges of $0.05 per share for trademark impairments, as well as $0.15 per share for the mark-to-market adjustments for pension and post-retirement plans.

For the full year, adjusted EPS was $2.81, up 6.8% from the prior year. These results exclude the items I just mentioned, as well as the accruals for 4 Engle progeny lawsuits, the charge for the Scott lawsuit, implementation costs and tax items. They also exclude 2010 charges related to goodwill impairments, plant closings, federal health care changes and Canadian government settlements.

On a reported basis, fourth quarter EPS was $0.52 per share, up 15.6% from the prior year quarter. And for the full year, reported EPS was $2.40, up 25% from the prior year. I would also note that these results reflect the impact of the sale of Lane at the end of February last year, as well as the pension accounting change we announced in November.

Reynolds American delivered a significant increase in adjusted operating margin in the fourth quarter, which was up 2.9 percentage points from the prior year quarter at 34.1%, driven by higher pricing and productivity improvements at our operating companies. That brought full year adjusted operating margin to 32%, up 1.8 percentage points from the prior year period.

As I review the individual operating company's performance, I'll focus on adjusted results to provide perspective on their underlying businesses. The adjustments I've just covered are also excluded from the operating companies' adjusted results.

Now turning to R.J. Reynolds' performance. R.J. Reynolds fourth quarter adjusted operating income increased 9.2% from the prior year quarter to $594 million, as higher cigarette pricing and productivity gains more than offset cigarette volume declines.

For the full year, adjusted operating income was up 4.3% at $2.3 billion. The company made significant improvements in its fourth quarter adjusted operating margin, which increased 2.9 percentage points from the prior year quarter to 33.6%. And for the full year, was up 1.5 percentage points to 32%.

Now turning to American Snuff. As we have mentioned, the sale of Lane negatively impacted profit comparison throughout the year. Fourth quarter adjusted operating income was $88 million, down 15.4% from the prior year quarter, when Lane contributed about $10 million to American Snuff operating income. For the full year, American Snuff's adjusted operating income was $346 million, down 8% from the prior year, which was driven by the Lane sale. The company's fourth quarter adjusted operating margin was 53%, down 1 percentage point from the prior year quarter, but for the year, it increased by 1 percentage point to 53.2%.

And at Santa Fe, the company again delivered outstanding performance. Santa Fe's fourth quarter operating income increased 39% from the prior-year quarter to $50 million. And for the full-year, adjusted operating income was $199 million, up 41.3%. Santa Fe's operating margin was 45.6% in 2011, up 6 percentage points from the prior year.

Now I'd like to give some other financial highlights. As Dan mentioned, our new share buyback program got underway in the fourth quarter, and the company repurchased approximately 6.7 million shares for $276 million during that period. This program is a further demonstration of our commitment to returning value to our shareholders, together with our dividend, which was increased by an additional 5.7% in the fourth quarter.

Reynolds American once again delivered outstanding value in 2011, with a total shareholder return of 34.4%, significantly outpacing the S&P 500's return of just 2.1%.

With respect to our balance sheet, Reynolds American ended the year with cash balances of $2 billion, that was after contributing an additional $125 million to the pension plans in the fourth quarter, bringing our total pension contributions in 2011 to $220 million. As a result of our contribution and a strong return on our pension assets, we ended the year with a funded status of about 90%.

I'd also like to point out that we are lowering our estimate for long-term pension asset returns to 7%, to reflect the change in asset allocation that reduces risk and volatility. I'm pleased to report that the capital program at American Snuff was essentially completed at the end of last year, with capital spending of just over $100 million on their new facilities in 2011. Total capital spending for the year was $190 million.

So as you've just heard, Reynolds American and its operating companies delivered strong performance last year, and they offer a solid foundation for continued growth even in light of the challenges ahead. Based on this, RAI is projecting EPS growth in the mid- to high-single digits for 2012, with EPS guidance in the range of $2.91 to $3.01. That's an earnings increase of 3.6% to 7.1% from the 2011 adjusted results.

Thank you. Now we'll turn to the Q&A portion of the call. Operator, would you remind our callers how to get in the queue.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Vivien Azer of Citigroup.

Vivien Azer - Citigroup Inc, Research Division

I was hoping that we could dive into a little bit, the competitive landscape and the tough backdrop you guys have highlighted a couple of times this morning. Can you just talk a little bit about where you're feeling the most competition? Is it from the high end or the low end? Because I was surprised to see that value underperformed premium on an industry basis in the quarter. So I was hoping you could just expand on that a little bit.

Daniel M. Delen

Yes. I would say that generically and across the board, we see much more competitive pressure at the bottom end of the market, so in the value segment. And I think it comes back again to how we define value and how we define premium in our segments, something that we've talked about many times in the past. But when we look at value holistically from a consumer point of view, those are our premium -- our sort of value line extensions to premium brands, as well as through value propositions out in the marketplace. And I think there's a significant downward pressure for downtrading across the category.

Vivien Azer - Citigroup Inc, Research Division

Understood. In terms of the focus on innovation, to be sure Camel Crush has been a nice growth engine for you guys. As you think ahead, towards the innovation on -- can you give us an update on the FDA review? I know you guys had a couple of products. Have you gotten an update from the FDA on that review process?

Daniel M. Delen

No. I would say, to date, from an FDA point of view, we have not received any sort of post-substantial equivalence sort of review from the FDA. In fact, it's been quite quiet on that front and, of course, we're doing everything within our power to move the process along as quickly as possible. But of course, we're in the hands of the FDA and they seem to be taking their time about it.

Vivien Azer - Citigroup Inc, Research Division

Good. Fair enough. And one last question if I could. Do you have any comment on the TPSAC reports or the draft report on dissolvables, as you guys have followed those hearings?

Daniel M. Delen

Yes. I think this is an area that we're frankly particularly enthused about. Because being in direct dialogue through the TPSAC with the FDA, I think it's very exciting for us because it's very much central to our long-term strategy as a company. As you know, we're a strong believer in the continuum of risk, that all tobacco categories don't present the same risk profile to consumers. And frankly, we're enthused to be able to engage on that front. And no matter what way they go, I think it's frankly about building allies and getting our opinion across to more and more people over time. And we think that benefits our corporate strategy, benefits society and frankly, benefits the public health. And that is our belief, and so we really look forward to the ongoing engagement on that front.

Operator

Our next question comes from the line Christina McGlone of Deutsche Bank.

Christina McGlone - Deutsche Bank AG, Research Division

The first question is just on smokeless. If I strip out Lane, it looks like growth was pretty flat. And first, I want to make sure that's correct. And then second, in terms of the outlook for '12, should we be thinking about growth in American Snuff in '12?

Daniel M. Delen

Yes. Let me talk a little bit, maybe about the dynamics that's going on in the moist category. During 2011, we increased our investment behind our growth brands, which is basically Grizzly. We launched some new retail contracts out there. And frankly, invested more behind the brand to reaccelerate its growth. And I think, if we take a look at the share performance, Grizzly did particularly well. It's up 1.6 share points year-on-year and that's for the full year, and 1.4 share points, when we look at it fourth quarter to fourth quarter. But we did do some additional investments to actually generate that growth. In addition to that, we now have the R.J. Reynolds tobacco field force actually servicing American Snuff. So really the brand now, I would say, is sort of -- has played the phase of catch-up and is now getting its fair presence of visibility, shelf space, proper pricing at retail, which has all contributed to that very strong market share performance. On the financial side, you'd be correct in your analysis that the financial performance is relatively flat, once we take out the Lane divestiture, and that's largely due to those investments. But of course, those now gets sort of measured into the base, and we see good prospects for operating income growth over time for the moist category and particularly for Grizzly.

Christina McGlone - Deutsche Bank AG, Research Division

That's very helpful. And then on the state excise tax front, at the Investor Day, you talked about moderate increases in '12. And I'm just curious, if the legislative activity that we've seen to date is consistent with your expectations and maybe if you could quantify a range of expectation for state excise tax this year?

Daniel M. Delen

Sure, Christine. I'll do my best and go out on a limb here because, as you know, making predictions on the political front is fraught with danger. But our estimates on the SETs on cigarette for 2012 would be in the $0.05 to $0.10 range. And maybe to give you a bit of color to that, I think there's really one particular state that's on our radar screen as we speak, which is the State of California. They have a ballot initiative to increase the SET by $1 a pack, and that would equate to $0.07 sort of national increase all on its own. Depending on how that ballot initiative goes. If we compare that estimate that I gave you, of the $0.05 to $0.10 range, that comes on the back of almost no increase for 2011. In fact, the year came in at less than $0.01 a pack national average. So I think that $0.05 to $0.10 range is our best estimate as we see the environment currently.

Christina McGlone - Deutsche Bank AG, Research Division

Okay. And last question, I guess, just following up on Vivien's questioning, something that I'm still a little confused on. But with the competitive activity and discount picking up, how do you preserve the momentum that you've been having on Pall Mall?

Daniel M. Delen

Yes. Here's the way I would describe it. The brand has obviously grown very substantially over time. It came in for the full year at 8.5 share points, it's up 1.1 percentage points year-on-year. But its growth rate did slow somewhat quarter-to-quarter during the year. We continue to see 50% rates of retention after trial on the brand. And that number's actually been consistent throughout this significant growth spurt of the brand. This spurt has been on for the last couple of years. So I think our challenge during 2012 is to reignite trial, maintaining those conversion rates and, of course, there is a lot of competitive activity at the bottom end of the market. I think when I looked at it, it's really coming from 3 fronts. Really, the pricing activity. The first one is we see the advent of, really, a new segment out there, which is value line extensions to premium brands from our competitors. Our competitors have also launched and continue to support through standalone value propositions in the marketplace. And then there's the non-big 3 category out there, which is also quite aggressive in the marketplace. I think within those 3 categories, we see the first 2 categories growing quite significantly. So those are the value-line extensions to premium in addition to the value brands offered by our largest competitors. And I think the good news in all of this is that we see the non-big 3 category being relatively stable through all of this. And I think if we were to back up a few quarters ago or a few years ago, given the downtrading environment that we see, I think it would have been a logical prediction to have seen significant growth coming out of the non-big 3. So all in all, I think the industry is playing quite rational given the poor consumer sentiment out there and the consumer downtrading that we're observing.

Operator

Our next question comes from Chris Ferrara of Bank of America.

Christopher Ferrara - BofA Merrill Lynch, Research Division

I guess, I wanted to start out -- look, I know you're not giving any details right now. It's kind of early. But can you at least talk conceptually about what's incremental about the comprehensive analysis on cost. At the risk of sounding dramatic on the margin, I mean, do you feel like there's more of a need for cost savings than you previously thought to maintain the current earnings and dividend growth trajectory? I mean, maybe that's obvious. But I guess, could you provide some color, I guess, including your view of the sustainability of competition in cigarettes.

Daniel M. Delen

I think, Chris, the way I would characterize this program is, we've been on a long-term program that really started with the merger of Brown & Williamson and R.J. Reynolds Tobacco and have been consistently focused on our productivity and efficiency initiatives at the company. And that's coming in different phases throughout. Now I would characterize our efforts on this front, and I would really characterize those as being in 3 buckets. The first bucket is the one that -- this latest effort is also an example of. It's the stuff that really makes it into the press release. So that's really where it impacts headcount and where it impacts our facilities. And we've had a number of different efforts on that front over the years. The second bucket is much more about the internal processes and the way we work. And that includes things like outsourcing activities, capability reviews. It includes a lot of things, IT systems. And that is maybe not as transparent, but from a total savings point of view, actually adds up to more than that first bucket. And the third bucket where we've done a, I think, a phenomenal job as a company has to do with the pricing and promotions sort of simplification and the efficiency of spend on that front. And that last bucket also had a very significant impact on our operating margins as a company. And I think what we have embarked upon during the first quarter is really a good example of what we do in that first bucket that I described to you earlier. So we've announced a comprehensive review that touches most aspects of our company. It does not include the American Snuff company. It does not include Santa Fe Natural Tobacco Company, and does not include the field at R.J. Reynolds Tobacco. But everything else is in scope and we're looking again and continue to look to see exactly how we should be allocating resources. And by that, I mean, not just financial resources, but also the human resources we have as a company to make sure we're as efficient and effective as possible, and that we really have all those resources lined up to continue our growth trajectory. Now you're right in your assumption that it's too early for us to actually be able to detail the full impacts of that, but we've made a commitment to our employees. And in that sense to you as well, that by the end of this quarter, we'll have more details about the impacts of that program.

Christopher Ferrara - BofA Merrill Lynch, Research Division

And I guess on a different note. The growth of Pall Mall has sort of only given you the ability to make a lot of progress on shifting the cigarette portfolio away from your private label and support brand. I guess, looking ahead, how close are you to the end of total portfolio market share declines? Or I guess, does the competition and slowdown at value end in Pall Mall make the end of that total portfolio share decline more difficult? And for next year in particular, do you think the portfolio will probably see share erosion again for 2012?

Daniel M. Delen

Well, I'm quite confident about our prospects going forward. Of course, we don't guide on specific market share numbers. But when I look at the R.J. Reynolds' tobacco performance during 2011, and I do that on an x private label basis. Year-on-year, the company was down 0.3 market share points. Then I would also add that, that doesn't include, does not include the results for Natural American Spirit. And that's brought to market by Santa Fe Natural Tobacco Company, which actually grew 0.2 of a market share point. So when we look of those 2 things in aggregate from an RAI point of view, the total company was down just 0.1 market share point. And in addition to that, I would say that at R.J. Reynolds, what's important to bear in mind from that volume performance in the fourth quarter, is that about over half of the volume declines actually came from the value brand Doral. And I think that's important because, of course, within the support brand -- the brands in the support category, that actually is the one that delivers the lowest margin. It tends to overtrade in some of the southeastern states, which are the more price-sensitive states out there today. And also in states where Pall Mall is actually doing phenomenally well. So when I look at it in aggregate, I would say I'm very bullish on our prospects going forward.

Christopher Ferrara - BofA Merrill Lynch, Research Division

That makes sense. I appreciate that. I guess, the fact that Doral was half of that volume decline, I guess, the question going forward is, how much further down do those support brands need to be rationalized until you get to a point where -- you're probably where you want to be?

Daniel M. Delen

Well, Chris, what I was trying to describe it, I think, we're already really at that point. Because when we look at R.J. Reynolds sort of being down 0.3 and NAS being up 0.2, I think we're very close already. And of course, on any brand that's declining, its declines only happen once over time. And I'm very confident about our ability to continue to grow our growth brands. So I think implied within that, you have your answer.

Operator

Our next question comes from Nik Modi of UBS.

Nik Modi - UBS Investment Bank, Research Division

Just a quick question, Dan, on the whole WTO and the clove with menthol. And I don't know if you saw the Obama administration basically appealed the WTO's gesture that they, I guess, unreasonably banned cloves but not menthol. I'm just curious if you had any thoughts on that. Because it seems like it was a pretty strongly worded response saying that clove is a starter product and menthol is not. And it's just seem kind of odd given the FDA is going to this review and the Obama administration made that statement. So just curious on your thoughts on that.

Daniel M. Delen

Nik, really, I think at this stage, I actually haven't read that statement. And I think it would be a little bit premature for me to wager an opinion on that. So, really, I think I'll need to get back to you on that. And to be very frank, not so focused on the cloves segment here in the U.S., which is very, very tiny.

Nik Modi - UBS Investment Bank, Research Division

Yes, yes. No, I was just trying to understand. It seem like they're almost supporting the fact that they banned cloves but they did not ban menthol and they had clear justifications for doing so. And so it was just curious statement coming out of the Obama administration, so I just wanted to get your thoughts. But I'm happy to follow up with Morris afterwards. The second question is just, obviously, a lot of proliferation of e-cigarettes and a lot of talk within the industry. Curious about Reynolds' positioning on that particular segment of the industry.

Daniel M. Delen

Yes. I think what we see in the e-cigarette space is, it's not a category we participate in. But I think we see a lot of entrants in that category. I think we see some trial in that category, but relatively low conversion rates. And it's obviously something we as a company keep an eye on, because we believe that we are a total tobacco company. And so really looking at that category, I would say that there is consumer interest, at least, enough consumer interest to try. But it doesn't appear to be enough consumer interest to convert permanently to products like that.

Operator

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

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I was hoping you could talk a little bit more about the price caps that currently exist between the premium brands and then the very cheaper deep discount brands, sort of where that gap is, which I believe is pretty narrow today versus the last several years. But then also, I'd really like to hear where you see the gap from the premium to the second tier where Pall Mall competes. And is it narrow enough as we think about the downtrading pressure? And then, Dan, you mentioned also some heightened activity even from the non-big 3 brands, and so where that gap is? And yes, just so, are you in a comfortable place or you think gap needs to narrow further?

Daniel M. Delen

No. I think the way I would describe it is this way, Bonnie. I think if we look over time, I think it's right, your observation that we've seen compression of some of the gaps over time, basically between premium and value. And I think from a competitive point of view, I think that's fairly rational given the downtrading environment that we're in. And then I think also, if we take a look at it over the long term, is that percentage gaps as prices tend to go up and SETs increase, the percentage gaps tend to go down because a lot of those taxes and industry price increases tend to be an absolute term. But I'm actually comfortable with the pricing structure that's in the market as it sits. I think it's a rational response from most players in the market to the consumer sentiment that's out there.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Okay. And then I wanted to ask a little bit more about Santa Fe and big companies portfolio brands. In thinking about it, what would your vision be for that business and potential opportunities to introduce more brands within the organic segment either in the premium category, for instance, not a super premium? And then, possibly a price value line and the ability to innovate into smokeless?

Daniel M. Delen

Bonnie, the way I would describe it is, we're obviously extremely, extremely pleased with the performance of Santa Fe Natural Tobacco Company. In fact, I think this is that kind of a big moment in the life of that company that we're now disclosing more details about how it's actually performed for 2011. It's over a share point in the marketplace. And for the full year, it delivered adjusted operating margin of 45%, over 45%. And that brand and that company continues to go from strength to strength. I think a lot of that is due to its unique product propositions, which you highlighted. And frankly, an extremely sort of intense and loyal consumer franchise. In terms of us actually extending some of those propositions to other price categories, those are obviously things that we think about and that we look at regularly. But also very difficult for me to comment upon any concrete plans we may have or not at this juncture. Having said that, I think the Santa Fe Natural Tobacco Company with its growth brand Natural American Spirit, has certainly hit a very significant and growing trend in the marketplace, which is consumers looking for additive-free products.

Operator

Our next question comes from David Adelman of Morgan Stanley.

David J. Adelman - Morgan Stanley, Research Division

Dan, obviously, now in the fourth quarter and through '12, you're buying back stock fairly significantly. You haven't done that in the last few years. And yet your earnings per share growth targets really haven't changed, mid- to high-single digit. So I think it begs the question, at least to me, are you being conservative? Or realistically, do you envision this year there to be slowdown in your rate of operating profit growth versus what you've generated the last few years?

Daniel M. Delen

Yes. David, let me kind of put -- give you a little bit of perspective on this. We do have the $2.5 billion share repurchase program. We repurchased $276 million worth of shares in the fourth quarter. And the way I would kind of describe it is, I think, it's really early days. We sit here just at the beginning of February. I think there's a lot that hasn't been written about the year yet. Of course, we need to keep a very close eye on consumer sentiment out there. We need to watch what happens from a downtrading dynamic. And also need to watch what happens from a category size point of view, given what's going on with the pipe-your-own category and with the little cigar category. And of course, some of the ongoing competitive dynamics. So in my mind, I would say, it's really a little bit early in the year to be very definitive about how it's going to turn out. But I'll let you put the correct adjective on it.

David J. Adelman - Morgan Stanley, Research Division

And the range, internally that you're using for your forecast of cigarette volume decline is what for 2012?

Daniel M. Delen

Our estimate at this stage is sort of a 3.5% to 4% in the cigarette category.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then lastly, Dan, a competitor of yours called out that their fourth quarter results were flattered somewhat by an increase in trade inventory levels during the fourth quarter. I assume for R.J. Reynolds that, that was not the case. Is that correct?

Daniel M. Delen

That would be correct. We have, as you know, David, we have an ongoing policy of actually not trying to limit any volatility we have to trade the inventories.

Operator

Our next question comes from the line of Michael Lavery of CLSA.

Michael Lavery - Credit Agricole Securities (USA) Inc., Research Division

I wanted to dig into your comprehensive review a little bit more. You say that you're hoping to have financial flexibility to take advantage of competitive opportunities. Is that pointing to discounting or is there something else you would imagine that -- this playing out to be? Could you give us a little color there?

Daniel M. Delen

No. I think it's really, it's part of an ongoing effort to make sure we have the resources to actually focus on the right growth drivers in the marketplace. And so I don't think there are any specific opportunities that come to mind at the moment. But really, it is to make sure that we have each dollar allocated as effectively and as efficiently as possible. But of course, when we allocate resources, we do that in the context of what our competitors are doing as well.

Michael Lavery - Credit Agricole Securities (USA) Inc., Research Division

So part of it, your hope would be to do more brand investment type things. But obviously, you can't rule out having some discount flexibility too?

Daniel M. Delen

I think it's exactly what you described. And in addition to that, it's obvious -- we pride ourselves on our ability to keep innovating in each of the categories that we participate in. And really, it's about continuing our growth trajectory and continuing our investments in innovation.

Michael Lavery - Credit Agricole Securities (USA) Inc., Research Division

That's helpful. And following up on David's question. You actually -- it looks like last year you had 4% to 8% EPS growth in your guidance. So it seems like you even may be slightly more conservative. Would part of that be because you haven't finished this review, so therefore, that's not reflected in the guidance as well?

Daniel M. Delen

I think it's fair to say. We obviously have a general idea of where this might turn out. But we're really doing our due diligence through this process and don't know finally where it's going to end up. And we'll let you know more details at the end of this quarter when we have them as well.

Operator

Our next question comes from Judy Hong of Goldman Sachs.

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

Dan, why don't you just probe a little bit into the price elasticity. I think the last comment, the last meeting that we've had, I think your view of the elasticity in the category was a little bit more cautious. Just wanted to get your perspective on sort of what you're seeing today, a lot of the growth that's coming from the pipe tobacco. How much of that is really driving the elasticity to come in worse than the cigarettes? Is there anything that you can point to secularly that might be changing from an elasticity perspective?

Daniel M. Delen

I think it's a fantastic question, Judy. I mean, from my perspective, I don't think the price sensitivity of demand has changed in the aggregate. And it seems to be kind of holding at the long-term sort of norm. Having said that, I think a lot of it has to do with how we define the category. Because there are lower-priced options out there outside of the traditional cigarette category for people to consume and smoke tobacco in a different way. Be that the little cigar category or this pipe-your-own category. And I think that is having an impact and is making the decline in the cigarette category look larger than it otherwise could be explained by the price sensitivity of demand. And so we obviously look at that very closely. We also have an active strategy as a company to try to eliminate some of these distortions in the marketplace and some of the tax advantages enjoyed by these other categories. And I think if everything was equal and was equally taxed, you would see that the cigarette categories price sensitivity demand has actually remained relatively constant despite some of the pressure that consumers are under. Now I think the bigger dynamic that's actually going on there is obviously the downtrading impact, and that is where we do see the economic environment having an impact.

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

And then, is that something because of sort of maybe a temporary nature of the tax advantage that you are not actively trying to address with potentially looking at price gap and other measures to stem that downtrading?

Daniel M. Delen

I'm not sure I quite understood the question, Judy.

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

To the extent that the growth in pipe tobacco right now is coming from the tax advantage nature of that category and to the extent that, that changes, it doesn't -- it probably stems the growth of that category. And if that's what is likely to happen, do you sort of just watch the tax situation and not go aggressively in addressing the downtrading to those segments?

Daniel M. Delen

Yes. I think the way I would describe it is, because there's lower-priced options out there for consumers, they're taking them, right, in certain cases. And so when we look at the holistic kind of smoking category, I would say that, that total category volume, if you define it that way, is very much in line with some of the historic price sensitivity of demand that we've seen.

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

Okay. And then, Tom, just in terms of the cost savings. So when you benchmarked your cost structure versus the competitors, where do you see the most upside? I know Dan talked about some of the buckets where headcount, processes, pricing, promo, efficiencies. I looked at your cost per unit and you actually have the lowest within the industry. So I'm just wondering where is the opportunities sort of benchmarking versus your peer group either within the cigarettes or maybe even broader consumer packaged goods industry?

Thomas R. Adams

I mean, your point is well taken. I mean, we're already low. That doesn't mean there aren't opportunities to go even a bit lower. And that's part of what Dan was referencing when he said, we're looking at our capabilities. And what we really need to do, I mean, do we -- are we doing redundant things across functions and can we do that in 1 place as opposed to 2. Or -- I mean, just looking at the things that we do and do we need -- and at what level do we need to do them. Do we need to do them the best? Do we need to do them good? Or don't we need to do them at all? And it also -- we further refine that by saying, what things do we need to that are strategic and what things are support? So there's different kind of levels that we go through and look at all these things. And as Dan said earlier, since 2004, we've been constantly looking at this. And this is just a bit of a deeper dive at this particular point in time.

Operator

Our next question comes from Chris Growe of Stifel, Nicolaus.

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

I just had a couple, I guess, now they become follow-ups. First off, do you have a -- I guess a question for Tom, an expectation for a decline in shares or amount of share repurchase expected for 2012?

Thomas R. Adams

We have -- well, our program was announced through beginning in the fourth quarter of 2011 and would extend to the middle of 2014. And so if you just do the math, that's roughly $250 million a quarter. We also are -- we don't buy during blackout periods. And so for instance, we haven't been in the market since the middle of December and we will reenter the market a few days after this call. So I mean, we'll moderate the amount of share repurchase based on market conditions. But it should be fairly consistent across the year.

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

Okay. And then in relation to the current amount of cost savings you have coming through the business. Do you have -- what do you expect for 2012? Is there any leaning in 2013 from previous programs?

Thomas R. Adams

On the cost savings side, we really don't announce targets. I mean, it goes back to some of the remarks that Dan made earlier. I mean, you see the press release kind of targets where there are restructurings and those make the headline news. But the balance and the majority of our cost savings actually comes through day-to-day activities and is in the DNA of the organization, whether it be in the way that we manage our pricing or whether the way that we manage the cost side of the equation. So we don't give targets because we think it's better to just execute these things as we go along.

Daniel M. Delen

An then, Chris, maybe just as a company philosophy as well, just to follow up on Tom's remarks. I think, we, as a company really prefer to be measured on our adjusted operating margin and our growth at that line. Just to announce sort of cost savings programs, if they don't show up on the bottom line, we haven't really saved it. And it just means that resources are being reallocated. And I think if you look at our trajectory over the years, I think we've done a phenomenal job as a company on that side for the full year of 2011. At total RAI, we came in at 33%, which is up 1.8 percentage point year-on-year. I'm very proud of our sort of continued growth on that front. And I think the recent announcements and some of the noise that you're hearing is just a reflection of our ongoing efforts on that front to really keep the focus on increasing our adjusted operating margin.

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

Okay, agreed. My final question sort of a quick one would be, these key activities review, if we can call it that. Does it include a brand review as well? We may be looking at maybe whether it's a characterization of brand, of support or nonsupport, that kind of thing. Is that part of the scope of what you're looking at in this quarter?

Daniel M. Delen

No, Chris. That's not what we're looking at. It's really what we're looking at, is we're looking at all the activities that our employees perform across the company to make sure that all those efforts are as focused as possible on those things that help generate growth and are innovation drivers. So it's just about having a larger proportion of our resources focused on the right things that actually deliver for shareholders.

Operator

Our next question comes from Ann Gurkin of Davenport.

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

I just want a little more discussion, we'll love your insight as to consumer purchase patterns. Are they staying within the premium segment and buying more on deal? Or are they moving, trading down more out of the premium segment? Can you just comment kind of what you're seeing in the marketplace right now?

Daniel M. Delen

Yes. I think, Ann, it's some of both to be fair. Of course, I think the, let's call it, deal sensitivity at retail has increased. And it would be fairly obvious for me to give that answer given the sort of growing segment of, let's call it, premium values, let's call it the value line extensions of the premium brands, which has seen significant growth over the last few years and that's continued all the way up to today. So I think that segment is growing, but we've also seen growth in sort of freestanding value brands. And so I think there's some of both happening. And so generically, what I would say is that there is downtrading going on in the category, and fundamentally, consumers are more price-sensitive. In fact, they're just shopping the category a bit more than they have in the past when times were good.

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

Okay. And then secondly, can you help me understand a little bit the latest update on the Star Scientific case, and it looks like it's going to a settlement. Can you comment on the timing of that and the strategy behind that at all?

Daniel M. Delen

Yes. I would not characterize this as settlement discussions. The judge in the case actually invited us to participate in a mediation session, and I think sort of that's fairly common in cases like this. And it's also fairly common for us to attend those -- the mediation sessions. And that's fairly common in the federal court system. I think we feel very strong and very good about our defenses. If you remember, the original lawsuit indicated that we did not infringe upon the Star patent. And on appeal, those patents were upheld but so was our non-infringement. So I think we feel very, very strong about our position. But that doesn't mean we can't go in and listen to what a mediator may or may not have to say.

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

And what's the timing of that potential?

Daniel M. Delen

I don't have that for you at this stage, timing. But it might be worth of your interest just to give Morris a call every once in awhile, to see if there's any new news on that front.

Operator

And our final question comes from Ted Jenkins of Oppenheimer.

Theodore Jenkins

On the back of the comments for the patent litigation. Given those developments, I mean, despite the jury result absolving RJR of a 2-year window of direct infringement. I am concerned that there's still seemingly additional years of potentially a significant subsequent liability. But I am heartened that you would agree to enter into a mediation process. But more to my point, given these developments and given the new regulatory oversight with the FDA. And given that there are technologies that removes tobacco [indiscernible] levels. Do you believe it would be a competitive edge to be possibly first amongst your peers to offer tobacco products embodying zero-cancer-causing agents and would that be a strategy in concert with your mission to transform tobacco, increase your share and protect your customers to the utmost of your ability?

Daniel M. Delen

Frankly, I think we're very, very confident in our sort of defenses in this case. And very confident in our position for the years going forward as well. And I think that's really all I'd like to comment at this stage on that front. We, as a company, obviously believe very much in our sort of mission in harm reduction, particularly as it applies between different product categories over time. And I think that's what our focus is. And as I described in some of the Q&A earlier is really where we are focused as a company.

Operator

I'd now like to turn the conference back over to Mr. Morris Moore for any closing remarks.

Morris Moore

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

Operator

Ladies and gentlemen, that does conclude today's conference. You may all disconnect and have a wonderful day.

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