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Wall Street Breakfast

Reynolds American Inc. (NYSE:RAI)

Q2 2007 Earnings Call

July 25, 2007, 9:30 AM ET

Executives

Morris L. Moore - VP, IR

Dianne M. Neal - EVP and CFO

Analysts

Judy Hong - Goldman Sachs

Eric Lundquist - JP Morgan

Unidentified Analyst

Tommy J. Payne - EVP, Public Affairs

Nick Moody - UBS

David Adelman - Morgan Stanley

Ann Gurkin - Davenport & Company

Christine Farkas - Merrill Lynch

Presentation

Operator

Good day everyone and welcome to this Reynolds American Incorporated Second Quarter Earnings Conference Call. As a reminder, today's conference is being recorded.

For opening remarks and introductions, I will now turn the call over to Mr. Morris Moore, VP of Investor Relations. Please go ahead, sir.

Morris L. Moore - Vice President, Investor Relations

Good morning and thank you for joining us. This morning, we'll discuss Reynolds American results for the second quarter and first half as well as our revised guidance. We'll discuss our results primarily on an adjusted non-GAAP basis. A reconciliation of our GAAP to adjusted non-GAAP earnings is in our press release, which also contains additional details on our performance. Our press release can be found on our website at www.ReynoldsAmerican.com.

Joining me on the call this morning are Dianne Neal, Reynolds American's Chief Financial Officer; and Tommy Payne, our Executive Vice President of Public Affairs.

Before I turn the call over to Dianne, I need to cover the Safe Harbor provisions. During the call, we will discuss forward-looking information, where we talk about future results or events there are a number of factors that could cause actual results to be materially different from our projections. These factors are listed in this morning's press release and in our SEC filings. Except as provided by Federal Securities Laws, we are not required to publicly update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

And now, I'll turn the call over to Dianne.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Good morning everyone. As we said in this morning's release, our results for the second quarter and the first half of this year fully met our expectations. And we saw demand on track to deliver significant earnings growth for the full year. Both of our reportable segments performed well in the first half, R.J. Reynolds, improved its margins versus full year 2006 and continue to increase total growth-brand share. And Conwood, delivered share and volume gain as well as double digit profit growth. Given our confidence in the year, this morning, we announced that we are raising our quarterly dividend by more than 13%. The new dividend is $3.40 per share on an annualized basis. That keeps ourselves inline with our policy of returning about 75% of current year net earnings to our shareholders in the form of dividend.

This morning, we also reported that we will be raising the low end of our guidance by $0.05. We now expect EPS of $4.45 to $4.50. That’s growth of 9% to 12% for 2006. And our first half reported earnings of $2.21 per share position us well to achieve those results. As we said in this morning’s release, our prior year comparison met the progress we continue to make in building our business through responsible growth.

Let me spend a few minutes talking about the difficult comparisons we face for the second quarter and the first half. Understanding this is important, because the same dynamic that drove unfavorable comparisons in the first half of the year, they will result in very favorable comparisons in the second half. And there are two unusual factors in 2006 that are driving these dynamics. First, there are taxes. You will recall that during the first half of last year, we posted an extraordinary tax gain of $74 million, with $9 million of that in the second quarter. The absence of that benefit this year contributed to our 9.4% drop in the reported EPS for the first half. Our first half comparison will also hurt by last year’s build up of about 1 billion unit of undiscounted cigarette inventory of wholesale. That second quarter build came in advance of the July 4 holiday and R.J. Reynolds launch of a new SAP system. That’s why the first half of last year, look especially good. And while this year’s first half was down considerably in comparisons with those results.

With that mind, let’s look at our second quarter and first half results. I will start with RAI consolidated second quarter performance. On a GAAP basis, our operating income of $595 million was down 3.4% and our reported EPS of $1.10 was down 13.4%. Those declines were driven by the tax and inventory dynamic I discussed which more than offset the effective positive factors. Those included higher pricing and the benefit of the full quarter of Conwood’s results.

Reported and adjusted EPS for the second quarter was also negatively impacted by about $.0.04 per share and expenses associated with our debt refinancing. On an adjusted basis, second quarter operating income was down 4.2% and adjusted EPS was down 9.8%, and also quick look at our RAI results.

Now, let me turn to R.J. Reynolds and Conwood. I will start with R.J. Reynolds. On an adjusted basis, R.J. Reynolds second quarter income of $496 million was down 12.8%, and adjusted income for the first half was essentially flat at $984 million. The primarily factor driving those results was volume. Cigarette volume in the second quarter was down from the prior year period by about 3 billion units or 7.2%. About half of that decline was due to build in the wholesales inventory levels in the second quarter of last year. The Company’s second quarter operating margin of 24.1% put R.J. Reynolds on track to improve its margins for the year. Contributing to that is $75 million to $100 million of productivity improvement, we expect primarily from R.J. Reynolds this year. With regards to marketplace performance, R.J. Reynolds also continues to post gains in total growth-brand share market, with innovation continuing to drive results. The Company’s three growth plans, Camel, Kool, and Pall Mall has combined share of 12.99% in the second quarter, a gain of 0.63 points from the prior year period, driving that gain with continued growth on Camel, Kool, and Pall Mall.

Let’s look at those brands, starting with Camel. Camel had a 7.82 share of market in the second quarter, up 0.49 percentage points from the second quarter of last year. That gain was driven by continued innovation by cigarette introduction of Camel No. 9. Camel No. 9 comes in two styles with feature smooth blends and stylish packs. It broadened and strengthened Camel’s appeal among adult smokers. In the second quarter, Camel No.9 averaged almost half a share point. Another Camel innovation is Camel Signature, which was introduced in May. Tens of thousands of adult smokers help to design the distinct blends and packaging for the first style of this new cigarette.

The last Camel innovation I will discuss is CAMEL Snus, smokeless and spitless tobacco product that we introduced in two test markets last year. Camel Snus provides tobacco pleasure where adult tobacco users choose not to smoke. R.J. Reynolds is expanding Camel Snus to six additional test markets in the U.S. After the results, the Company will continue to gain valuable learning about this innovative product and its potential.

Pall Mall, it also continues R.J. Reynolds’ overall growth-brand gain. For the quarter, it shares 2.09. That’s up 0.18 share points versus the prior period and that growth made Pall Mall one of the nation’s top 10 brands.

Moving to Kool. There was a slight decline in Kool share of market compared to the second quarter of ’06 and the first quarter this year. Kool’s performance was impacted by increased competitive activity in the menthol category. That category continues to grow, and now represents almost 28% of the total cigarettes market. We expect to see Kool’s performance improve over the next several quarters and the strength of new initiatives designed to increase Kool’s appeal. Those include the expansion of Kool XL and the introduction of a new milder style called Kool XL Blue, both of which will be available nationally.

Let’s, of course, look at the performance of R.J. Reynolds growth brands. During second quarter and the first half, the Company’s support and non-support brand continued to decline inline with expectations. Consequently, R.J. Reynolds’ total share of market for the second quarter was 29.14%, down 0.64 share points from the prior year quarter.

Now let’s look at Conwood’s results. We provide perspective I will talk about Conwood as if we owned the company at the beginning of last year. On this adjusted pro forma basis, Conwood, again, grew volume, share, margins, and profits in the second quarter compared with the prior year period. Second quarter profits of $90 million were 14% higher than a year ago quarter on the strength of higher volume and pricing. Conwood’s second quarter operating margin was up over the prior year period as just over 50%. The Company’s second quarter results were primarily driven by continued volume share gain by Grizzly, the growth leader in moist-snuff category.

Grizzly’s second quarter volume grew 17% from the prior year and accounted for more than 40% of the incremental volumes in the moist-snuff category. Grizzly shared shipments for the second quarter was 20.64%, an increase of 1.9 share points from the prior year period. On a sequential basis, Grizzly share has been relatively stable for the past two quarters. That share performance is the result of Conwood’s decision to focus its resources on profitable share growth rather than reducing profitability to drive higher share. You will recall the common the Conwood’s relative price increases towards the end of last year and the Company knew that this could impact usually [ph] of share growth, but would also increase profitability for the longer term. The Conwood action combined with increased competitive promotion have resulted in the brands holding share in the growing category. Conwood’s total share of moist-snuff shipments in the second quarter was 25.73%, up 1.1 share points from the prior year period. Grizzly’s year-over-year share gain was partly offset by [inaudible]. Conwood’s in part of RAI for full year now and we are very pleased with the financial and strategic benefit that is added to RAI’s portfolio. And we will continue to carefully evaluate opportunities that will need to maximize in Conwood’s long-term potential.

Now, let’s look at our external challenges starting with what’s happening on the federal fund. As you know the Senate Science Committee for the last week has firmed its expansion of the State Children’s Health Insurance Program with a cigarette tax hike of 156% with similar dramatic increases on the other tobacco products. The $0.61 in cigarette increase would bring the Federal Tax on cigarettes to $1 a pack. We have said the House Committee to enact a legislature including consideration of tobacco as far as tax increases reporting almost $0.03. This bill is a controversial bill. The administration has threatened to detail. In addition the Senate, Health Education Labor Intention Committee is scheduled to meet today to consider FDA regulations. We expect the bill to be approved by the Committee. We support the adoption of Federal Regulation of tobacco product. It has serious disagreements with several of the provisions in the Kennedy Legislation. There is still a long way to go before these two proposals are filed, and we are working hard on a number of fronts to achieve reasonable resolutions with these important issues.

Now let’s look at how things are going at the state level. You will recall that the Texas State tax increase, which is effective 1st of this year, raise the national average state excise tax by $0.07 a pack. And we begin the year expecting 2007 state tax initiatives to drive the national state average up another $0.10 to $0.15 per pack. But at this point, it looks like the increase would be held through rate of $0.05 to $0.10. I will point out because there are a few states that we are continuing to monitor.

With that, let’s first look at the external environment. Now, I will spend a minute talking about cash. RAI’s use of cash is an important factor in delivering shareholder value. We continue to generate strong cash flows, and are focused on maintaining a strong and efficient balance sheet. A good example of our focus on efficiencies on our second quarter refinancing of $1.55 billion in debt. We were able to reduce our cost of carrying this debt by more than 50 basis points, in addition to smoothing out our debt maturity. We faced the first half of the year with cash and short-term investments of about $2 billion. That included a $300 million debt repayment and the return of our $100 million appeal bond in the Engle case.

And there are several opportunities on the horizon to significantly enhance our cash positions. First, the strong returns of our pension investments in 2006, coupled with our contributions of about $300 million a year in each of the past several years, make our pension plan fully funded on an accounting basis. As a result, our pension funding requirements for the next several years will be significantly lower than we previously expected. Second, we recently gave notice that we are terminating our joint venture in Europe. When the termination and evaluation process is complete, we expect to begin receiving a significant stream of payment. Our third opportunity to increase cash comes from our settlement payments. We paid a total of $1.2 billion internal escrow account related to the dispute regarding NPM adjustments. We continue to work with the state to resolve this issue. And we are optimistic that once this resolved, we will see the meaningful amount of cash. With regard to timing, we will see the benefits of lower pension contribution in joint venture proceeds beginning next year. The timing of the NPM cash is just too difficult to predict with any certainty. But what we can predict is that we will focus on putting all of these funds to work, to enhance shareholder value.

So, in closing, I would just like to reiterate a few points. Our first half performance fully met our expectations. This morning, we announced a dividend increase of more than 13%. We have raised the low end of our guidance by $0.05 and we are solidly on track to deliver full year earnings growth of 9% to 12%. 2007 is shaping up to be another good year for Reynolds American.

Thank you. Now, we turn to Q&A portion of the call. Alicia, so, please just reminds our caller to how to get into the queue.

Question and Answer

Operator

Certainly. [Operator Instructions].

We will go to our first question from Judy Hong of Goldman Sachs.

Judy Hong - Goldman Sachs

HI, Dianne.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

HI, Judy.

Judy Hong - Goldman Sachs

Is this interest… if I… if we just look at your guidance for the full year now that implies a pretty strong second half performance. Can you just talk about some of the factors that you think will drive the second half performance improvement?

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Yes, Judy, as you say, adjusting EPS being up to short of 2% in the first half, and we are guiding 9% to 12%. We expect it does imply let’s call it roughly 20% growth in the back half. It is several dynamics going on there, and we try to reiterate with market what those are. I know you will recall, Judy, that 2006 the quarterly imbalances because of this volume and the fact that the volume we shipped in the second quarter was undiscounted. And so, the volume paid back in the second half of the last year, the discounting flew through the P&L in the second half of last year. We had what we consider a very successful outcome with the valid initiatives, the bad investments within the second half of last year. So, we have really a lot of these, driven by what happened in 2006. We're on track within the terms or in the scope of 2007. We are very much on track to deliver the guidance that we provided today.

Judy Hong - Goldman Sachs

Okay. And then just turning to Kool's performance, obviously, in the quarter, the share was down slightly. If you look at the retail data and the menthol category as you alluded to, is still a growing category. So, can you just maybe assess the brand equity of Kool as it stands? I know you have been supporting the brand where do you think the brand equity of that brand is? And is this some of the new initiatives that you are planning for the second half is really enough to kind of get that brand to grow again?

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Yes, I do. Look every brand goes through cold time period, a quarter even there where growth does not continue. But we are not overly concerned. We have seen a step up in the activity in the menthol category, but we are going to stay true to increasing the equity on Kool, and clearly, Kool's equity is not going to be as strong as a brand like Camel that has been repositioned for many, many years. But the fact of it is delivered steady growth for several years now, and we feel to have these innovations decked up in the marketplace with XL and XL Blue. We'll continue to focus on those equity building initiatives and feel very good about this underlying strength on the brand, and so come up against some increased competitive activity, and we'll overcome through innovation and an appeal to smokers.

Judy Hong - Goldman Sachs

Okay. And just my last question, Dianne. Can you quantify how much of the benefit from the lower pension expenses and the determination of the JV to help your cash flow next year? And then as that happens would you rethink differently about maybe piece of the dividend increase or any sort of other uses of cash that you are looking at for the next couple of years?

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Sure, one of these are quantified than the old. In our prior expectations we had thought that pension funding each year would be around $300 million, because of the great returns that we have got and the funding that we have done we now expect that to be $100 million or less a year. And we are continuing to work through that process, but that gives you some ballpark on that side.

On the joint venture, these are negotiations that will happen over the next… I don't know… lets call it a year now. And there's a process of determining that valuation working with Japan Tobacco to rather right solution and that process completes no later than June 2008. We'll have a better feel for that as the process continues. Now with regard to RAI use of cash, we feel very good about the 75% dividend payoff policy that Board has reiterated that several times since we have become together Reynolds American. What we would like to do is we will continue to look at strategic M&A opportunities. I think it has proven that we have strong track record on that front. It’s not a long list of alternatives, but we will continue to look at those, and assuming that we don't need the cash for reinvestment organically against our growth initiatives. What we would like to do is balance the dividend with something like the share repurchase program. But clearly, with CAT at 42% we would wants a need for them to participate to do the share repurchase. So, we'd rather go down that path of strategic M&A or growth initiatives still require funding, we'd rather go down that path.

Judy Hong - Goldman Sachs

Great. Thanks, Dianne.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Thank you, Judy.

Operator

We will move next to Eric Lundquist at JP Morgan.

Eric Lundquist - JP Morgan

Hi, good morning.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Hi, Eric.

Eric Lundquist - JP Morgan

Hi. I just wonder if you could clarify what was restated in the operating divisions, looking at Conwood, that’s worth about $6 million.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Eric, I am not sure I understand your question. At the beginning of this year, we had moved some businesses from Lane up into Reynolds and combined Lane with Conwood, and there was a whole restatement that's happened. Is that what you are referring to?

Eric Lundquist - JP Morgan

Yes, I just wanted to make sure I wasn't missing something in terms of where the numbers where coming. I can follow-up offline on that one.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Okay. Great. I appreciate it.

Eric Lundquist - JP Morgan

In terms of this new category growth, you are… in the release you noted 6% to 7%. Is that the figure you see being maintained through the rest of the year? And then secondly, with respect to competition for Grizzly, have you seen the step up mainly from Husky or is it also coming from Timberwolf and Longhorn? Thanks.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Okay. First of all, let me talk about the 6% to 7% [inaudible] smokeless category, the business is so small right now we are just going to pick up [inaudible] so on the smokeless category it is 7%, something close to that her to date and we do expect a full year to be in that 6% to 7% range as far as total category growth. With respect to competitive activity it is our two largest competitors that we have seen increasing the percent of their volumes that is on promotion as opposed to the premium end and if anything I say more so [inaudible] change at the volume end. And clearly this is intense competition and its in many ways directed at Grizzly so its across pretty much all the brands you mentioned.

Eric Lundquist - JP Morgan

Okay in terms of thinking about how in the moist enough category share of Husky sorry Grizzly will develop over the course of the year, is it fair to assume then, it sounded like you are pretty confident that Grizzly would be able to maintain its share of the category, you have done well in the first half despite intense competition. Is it fair to think it will continue to keep its share going forward?

Dianne M. Neal - Executive Vice President and Chief Financial Officer

I think its fair to assume that Grizzly will maintain its strength in the marketplace. We will continue to assess this competitive activity but the management of that company is of course at RAI agree with they don't want to do anything in the short term that’s going to sacrifice the long term. You know this is a very strong brand with over 21 share points. It is at a great price point, typically sells for about $2.25 a can and so its positioning in the marketplace is very strong. We don't want to do anything that impacts its long term trajectory. Its difficult for me to give you a precise share forecast for the latter half of this year but we expect it to maintain its momentum.

Eric Lundquist - JP Morgan

That’s terrific. Last question is on Camel's news. You mentioned you are going into six additional markets. Would there be a meaningful increase in cost in terms of capacity or distribution if you wanted to take that national?

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Well there are some defer [ph] cost with regard to manufacturing and packaging itself so we will definitely do go national, which again we are just going into six more cities. If we do go national we'll make sure that this provides a good return to Reynolds American and so we are not worried about that. This is an investment in a new category that we would like to seek any attraction in the US and we'll adjust our investments accordingly so that shareholders get a good return.

Eric Lundquist - JP Morgan

Okay. Thank you.

Dianne M. Neal - Executive Vice President and Chief Financial Officer

Thank you, Eric.

Operator

Our next [inaudible]

Unidentified Analyst

Yes, good morning everybody.

Unidentified Company Representative

Good morning

Unidentified Analyst

The first question is actually for Mars. Mars do you have the MS safe payment number for the second quarter?

Unidentified Company Representative

Yeah [inaudible]. I'll give you offline if you want

Unidentified Analyst

Yeah certainly. And then moving on to Tom. Tom can you give us an update as to your current expectations as it relates to the Prime line for both the SEP as well as the FDA approvals in the respective committees?

Tommy J. Payne - Executive Vice President, Public Affairs

Certainly. The short term time line is we are having a busy weekend in Washington, this particular week. At 10 o'clock today as Dianne mentioned the Senate Help committee chaired by Senator Kennedy will mark up his version of the FDA regulations. We do expect as Dianne mentioned that they will be approved by the committee. Then the question is whether to what extent Senator Kennedy and other supporters of the bill might be able to secure full time between now and the end of this year. [inaudible] both houses of Congress are set to adjourn for month recess through August on August 7. As you know from reading the paper they have a number of Bills, including a number of the appropriation bills to be completed. Before the end of this calendar year, the Congressional fiscal year ends September 31st. We don’t know to what extent we may be able to schedule floor time given the contentious nature of that Secret [ph] Bill. On the half side of FDA there is still not been any movement this year in the Health Synergy and Commerce Committee in terms of having hearings or consideration of FDA regulation. I don’t anticipate that there will be any serious consideration of FDA in the House this calendar year. We also keep in mind that those bills are all over Congress sports [ph] volunteers' cycle so they are still viable for consideration through 2008. As it relates to the Federal Excise Tax and its inclusion in the [inaudible] legislation, first in the Senate.

I mentioned the action of the Senate Finance Committee last week. It is the expectation of the Senate leadership and the House leadership to try and put [inaudible] Legislation on both floors before they join in August, don’t know if that will happen. We don’t know if SCHIP will go to the floor in the Senate before the August break but it might, and if not I certainly would expect that it would be on the Senate floor sometime in September or October. And in the House we have two committees dealing with SCHIP. One is the Energy and Commerce Committee it’s scheduled to act later today on the rate of expansion that they would send to the full house for consideration. Our Senate expanded the program by $35 billion, it’s expected that the house expansion would be somewhere in the $70billion to $100 billion. And tomorrow, we expect that the House [inaudible] mains committee which is the tax committee in that body, will deal with the funding for that expansion. And the current runner as you have probably seen in the press this morning is that it is likely to include in that excise tax increases on tobacco products, including a $0.45 increase in the Federal Excise Tax on cigarette's as opposed to $0.61 that the Senate Finance Committee approved.

Again it is the desire of the leadership to have those bills on the floor before the August break. Now what will happen when after floor consideration on the SCHIP legislation as you got two different versions in those respective bodies and they will probably move to a Conference sometime in the fall, and will... will try to work out any difference that they may have in the progress. That's a little bit of a timeline.

Let me just reiterate what Diane said, it is a very contentious bill for reasons well beyond the Federal Excise Tax increases. And the administration has been very consistent in public in saying that any expansion of the bill beyond a $25 billion over a five year period is likely to cause them to seriously consider vetoing the legislation.

Unidentified Speaker

Tom a quick follow-up on this and given the fiscal year of our Federal government is there a drop back date over the current deliberations in order for it to be a part of the 2008 budget?

Tommy J. Payne - Executive Vice President, Public Affairs

Theoretically yes, but the practice is that they do… what they would a call continuing resolution to provide funding for a variety of Federal agencies and programs until they have reached agreement on a budget for the 2008 fiscal year.

Unidentified Speaker

Great. Thanks, so much Tom. A couple of questions for Dianne, if I may as well, in the end you reiterated your commitment for the $75 million to $100 million in productivity gains for '07. Can you give us an update in terms of how much you have visualized so far.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Sure, this year the $75 million to $100 million is pretty straight line. So we are about the 50% mark.

Unidentified Speaker

Okay. Then going to the joint venture, any current thinking Dianne in terms of how you may want to replace that lost international distribution potential?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

We are looking at that very carefully Phillip [ph], just to clarify on the current joint venture, the joint venture is self dissolvent [ph] and it should pretty solution period in November of this year. But that doesn’t mean that our infrastructure what we worked with Japan tobacco and our former colleagues that we all were to achieve, dissipate. We will feel this is going to a contract arrangement where they will continue to help us with NAS for example and [inaudible] we just launched those products. So, that doesn’t go away at midnight on a certain day. That lasts for another couple of years if we want it to. But to your point for the longer term and what is the right strategic platform to continue our investments behind NAS for example internationally, that’s what we are currently evaluating. Our preferred approach would be to partner with someone as we have in the past, so we are looking at different options, it is just too early to say. So I guess I will leave that with more to come.

Unidentified Speaker

Okay. Then on the use of future cash flow Dianne, obviously we are very pleased to hear the comments in terms of the potential upside there. Now if you also look at let’s say potential share buyback, would you only seriously consider doing so if you have the buy in of [inaudible] In other words, you will only do it if the DAP would participate or would you not object again over the day against them increasing their stake in Reynolds’ American today.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Yes.

Unidentified Speaker

By some of their competitors, did you guys increase at all towards the end of the second quarter promotional spending or it was on an apples-to-apples basis throughout as we have seen as last year?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Yes. Actually it was relatively the same as last year and let me talk about that for a minute. If you look at for example CAMEL and COOLS promotion in the first half of 2007, they are at or below either the second half of '06 or the first half of '06, okay. Now within the year more than the first quarter we talked about the unusually strong margins at R. J Reynolds and that we had lower promotional spending in the first quarter. So there was an increase between first and second, but it was because first was pretty low in the sequential world. So that kind of gives you a feel for it. CAMEL moved to a mid year very much in line with what they were doing last year and in some cases below, and just this first quarter was a little abnormally low versus what had been happening on those brands for the past year.

Unidentified Speaker

Okay. Great. Thanks a lot, Dianne.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Thank you.

Operator

We will go next to Nick Moody at UBS

Nick Moody - UBS

Hello everyone.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Hello.

Nick Moody - UBS

Just a few quick questions. Was there any timing differences on…. in around July 4th holiday with shipping in the MST category. I know that sometimes it gets kind of gets dicey from second quarter to slight third quarter

Dianne M. Neal - Chief Financial Officer, Executive Vice President

Yes. No, nothing that I am aware of Nick in what snuff around July 4th this year or last year for that matter.

Nick Moody - UBS

Okay. That’s well. And just the last question on KODIAK. It’s clear the competition up and premium is getting pretty intense given all the promo march of these from the industry leader. And I am just trying to understand if you guys have formulated a strategy to really bring that brand back to health, in terms of share and if you just prep a little bit of perspective there.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Yes. Nick, you were talking about KODIAK right?

Nick Moody - UBS

Yes.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Okay. KODIAK has a lot of appeal and most of that appeal is concentrated in the wintergreen part of the moist snuff category ,and it’s a strong brand, its got good equity. But we just don’t think that there may be additional opportunity to expand its appeal beyond Wintergreen. And we are looking at those options because one of the opportunities with income would have clearly strengthened its position in the premium side in the… of a short-term nature some of our competitors are big [inaudible] has definitely increased with the spending on the premium promotion side and core has passed an impact on KODIAK. But for the longer term though we are really looking at what are the options to build its equity and increase its positioning in the premium spot of moist snuff. So a key focus right now is KODIAK.

Nick Moody - UBS

Okay. Thanks very much.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Thank you.

Operator

Next from the line of David Adelman at Morgan Stanley

David Adelman - Morgan Stanley

Hi, good morning everyone.

Dianne M. Neal - Chief Financial Officer, Executive Vice President

Hi David.

David Adelman - Morgan Stanley

A few things I wanted to ask, first as it relates to share repurchase Dianne, obviously the million dollar question is what's the ATs willingness to participate. So can you answer that?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Again we have not approached them formally at all.

David Adelman - Morgan Stanley

Okay. Secondly Dianne, as it relates to cash flow and the use of cash flow, absence in acquisition, is it fair to say that over the medium to longer term there is no reason to de lever the balance sheet.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

I think that’s fair. You had a pretty good point. We were [inaudible] round about two times debt to EBITDA which was very much in line with the strategies that we have developed for Reynolds American. The debt refinancing that we did in June has really smooth out our maturities. We have got a maturity on average not in 2008, but 2009, there’s 2000…. Somewhere 2018 about one maturity a year. So things look well positioned on this front.

David Adelman - Morgan Stanley

Okay. And that is it related to pricing, Dianne in the moist smokeless category, obviously coming into this year, your reigning competitor didn’t take a premium price increase, you did. On the discount segment you took a price increase, that’s now a pricing gap somewhat. Now there’s increased promotional, competitive promotional spending at the lower end. What do you think that says about the pricing power and the category going forward?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Tom, I think that it’s too early to say. Clearly, we have got some competitors that are focused on the value segment showing us in our premium shares. But what we are going to say some [inaudible] on would then insure that we get a great return on the $3.5 billion that we invested behind the Company. GRIZZLY as a said is the 21 shared brand and it’s got the strong dynamics on underlying it and really our challenge is to continue to introduce innovations on both KODIAK and GRIZZLY, and make sure that we address the meaningful differentiation with what consumers want. So we are going to stay focused on that. The pricing dynamics and moist snuff will just have to play out depending on the difference of strategies with the competitors.

David Adelman - Morgan Stanley

Okay. And let me shift gears on the MSA tax growths fund, Dianne. If… if you go fully through the arbitration route, and I think there is only one state today that’s said it needs to be litigated rather than go through the proposed arbitration framework.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Right.

David Adelman - Morgan Stanley

Would you actually get a cash return or would you rather again not if you settle it but if you actually go through the arbitration process would that Escrow cash rather be returned to you?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Allow me to get one positive in there, yes there’s been one state that has ruled against arbitration but there’s been 46 that have against it.

David Adelman - Morgan Stanley

All right.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

So yes, that was true a member of the audience said that this is such a great number. With regard to the MSA and the cash within Escrow, we will take it in cash if you will but there may be an opportunity. It could be in our negotiations with the Attorneys Generals as there are other proposals that are viable. So we just have some less stock to forego, clearly the arbitration was the Escrow accounts are returned to the prevailing parties. So at least…. Fulfilling the parallel CAF [inaudible] with equal, equal vigor, when there is arbitration or trying to work through [inaudible] to resolve this dispute not only for the past but for the going forward world, because the NPM adjustment doesn’t go away. So, if assuming both of those and we will continue to do so and very much fight for the funds that, we believe should be part of Reynolds American and shareholder value.

David Adelman - Morgan Stanley

Okay. And just a follow-up on that specific point Dianne, if in the end you got a credit against future payments, that wouldn’t change your competitive or pricing behavior in the marketplace, correct. I mean you would look at that as the shareholders money that’s been historically earned and we are just going through a credit methodology to get those funds and return them and buyback cash to shareholders, correct?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

No. Dan, I would like to agree with you but no. Just depends on what that credit might be and how it would be accounted for, I think it is just too speculative for me at this point to answer that not getting clarity. I understand the point that you are making, but unless I am not pretty sure about something and I can give you all the plans that is around it, it is a bit too difficult for me to answer that.

David Adelman - Morgan Stanley

Okay. As it relates to your U.S. retail market share performance, Dianne and these are the last several years you have had a sequential reduction in your pace of market share erosion. Half way through the year do you think that is likely to occur this year or do you think that’s becoming an increasing challenge?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

I think last year to your point we were down about half a share point in the cigarette market and I think this year might save up to be around the same because of the pricing activity and the State Excise Tax activity that was initiated earlier this year, and in some cases continues on. Because of that and its impact on the marketplace, lets say we are probably looking more like around the same level of decline in ’07, but clearly our longer term strategy is to reduce that rate of decline as we have since the merger in 2004, such as the [inaudible] in several years.

David Adelman - Morgan Stanley

And Dianne, if there were a large scale Excise tax, Federal Excise tax increase, obviously, traditionally the industry has been able to pass that on directly to consumers. What do you think is the feasibility and do you think the competitive marketplace architecture would allow the industry to collectively raise prices sufficiently to offset the likely… the lost profitability from having simply lower unit volumes.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Well, there is a long way to go before we have to address something like that. The magnitude of what our increase might be will [inaudible] answer to that question. As you rightly point out in the past the Federal Excise Taxes happen to pass along to consumers. It’s hard to say whether that would also include some dollars offset, a natural volumes decline. So we will just have to see how that plays out because there are so many factors that will come into play. Another factor is that North American is uniquely situated in the United States to benefit from trading across tobacco categories, and this excise tax would probably impact cigarettes more so than other categories like moist snuff and roll your own So, how those dynamics that play out across the categories could impact the overall profitability.

David Adelman - Morgan Stanley

Okay. Two last quick things, Dianne. One was where do you point year to date consumption decline in the U.S. cigarette market?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Probably a little over 3% in April, when we were stricken with it That we think industry consumption be down about 3% for the year. I think it is probably a little worse than that in the first half and maybe a little bit better in the second.

David Adelman - Morgan Stanley

Okay.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

So, we don’t have all the factors in for the first half. What we do have, I think I am directionally correct in my statements.

David Adelman - Morgan Stanley

Okay. And have you seen any change I know it’s early days in commonwealth competitive behavior, I know that you have some new product launches planned. But to this point in retail or in tax rates do you see any change with the ownership shift?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

No. We don’t.

David Adelman - Morgan Stanley

Okay. And then Tommy, just one question for you, what do you think the industry’s strongest arguments are opposing the Federal Excise Tax increase? Where do you think you are getting the most traction and impact?

Tommy J. Payne - Executive Vice President, Public Affairs

I think if you look at today’s Wall Street Journal in the letters to the editors that actually is the end of the debate between those three writers as to harm reduction, and what policies should we follow around harm reduction. That is a nice synopsis of the most critical issues associated with this Bill from many perspectives not just the industry’s perspectives.

David Adelman - Morgan Stanley

Okay. Thank you.

Operator

Thanks, David. We will go next to Ann Gurkin of Davenport & Company.

Ann Gurkin - Davenport & Company

Good morning.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Hi, Ann.

Unidentified Company Representative

Morning.

Ann Gurkin - Davenport & Company

Point on your expectations for the domestic cigarette industry in the back half to be down, maybe a little bit less than what we saw in the first half. What is the reason for that and what gives you the confidence in that statement?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Well… the pricing activity that was really concentrated around the beginning of this year, the major manufacturers went up on an average of $1 a carton and there was the Texas State Tax Excise increase of, I think it was $1 a pack that went into effect from January 1, with all of that exciting activity concentrated in a short time period beginning this year. That’s where consumers make choices and they adjust their patterns whatever their taste maybe and over time that impact works its way through the market. So that’s why we believe that the first half would be a little stronger defined than the second half.

Ann Gurkin - Davenport & Company

Right. Putting some moist smokeless in Conwood we announcing premium increase as a percentage of your mix and is that a trend we are going to see through the year as you focus on profitable growth and what kind of is the biggest driver of that? Is it bringing up the price gap of GRIZZLY or is it focusing on promotions, can you help me understand that?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Well Anne, when I look at Conwood mix it’s about 80% value and 20% premium. Even the overall category in moist stuff versus a year to date versus year to date last year [inaudible] categories up at 43% versus 40.5% last year. This transport value we see continuing and we see it in our year-over-year comparison both for the [inaudible] category.

Ann Gurkin - Davenport & Company

So you look for the shares of the respect to categories to remain about the same going to the year?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

The shares of individual brands.

Ann Gurkin - Davenport & Company

Premium price value as a percentage of this category and premium --?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

It’s a good question, because it depends on competitive activity and how consumers respond to it. We are going to stay focused on KODIAK [inaudible] KODIAK from the long-term perspective of what’s the right answer there. But clearly on… GRIZZLY we expect continued growth on that brand over the long-term.

Ann Gurkin - Davenport & Company

Okay. And as there, have you seen any impact from higher GAAP prices on sales of more smokeless tobacco?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

No we haven’t. I think the year-to-date growth in the category being very close to 7%, speaks through it. We historically Ann, I know you have got to be in the industry for a long time. You’ve continued to see the full price cigarettes category inch upwards. So, we just don’t tend to see it in the tobacco categories like some other consumer goods do.

Ann Gurkin - Davenport & Company

Okay. Great. And then switching to SNUS , can you comment on ways you are going to convey to consumers, information on the SNUS category, the SNUS products. Are you changing any way, you can communicate to the consumer on those very limited? And then secondly given the test market, is there any information with respect to the impact of SNUS on the moist smokeless category or on cigarettes?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

I am sorry, would you repeat your second question?

Ann Gurkin - Davenport & Company

Have you notice any impact of SNUS [ph] sales, have you taken away any sales from more smokeless from--?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Okay. Thank you for repeating that one. I will take that one first. As we have been in two, very small test markets this is for a year. So our ability to draw any broad sweeping conclusions at this point is very limited. What we have seen in those two small test markets is that CAMEL SNUS has appealed more so to cigarettes smokers than to moist snuff. The majority has come from smoking adult consumers versus moist snuff. So that’s all I can tell you just didn’t probably seen in today.

And on the communication side as you said, communication is very important for SNUS because it is a new category in United States There is education about where do you put pouch, all those kinds of things. And so we are working with our trade representatives, are interacting with tobacco users in the stores, will continue with them our adult only venue, marketing and of course the education itself through the materials that we might send out in the mail or put at point of sale. So, we will do education and communication across all of the vehicles that are open to us because it is a very important aspect of introducing this product in the United States.

Ann Gurkin - Davenport & Company

Great. Thank you.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Thank you, Ann.

Operator

Next we will go to Christine Farkas at Merrill Lynch.

Christine Farkas - Merrill Lynch

Thank you very much. Good morning.

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Hi, Christine.

Christine Farkas - Merrill Lynch

A Question just back Dianne, on your second half guidance, I think in terms of the quarterly variance and year-over-year comparisons that obviously known based on what you have experienced a year ago. So with the upped guidance in the second half, how much of that have to do with just better saving coming within that $75 million to $100 million range or is there anything that we should read into that with respect to your reinvestment plans?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

No. We are in general we have strong position when we started the year and there are two factors that are contributing to that. One is as you say it is very good day to day cost management most notably in the RJ Reynolds. And the other factor is that when we set guidance at the beginning of the year there are [inaudible] series that we included there that could cause… it’s going to be a little bit better over the work. And for example [inaudible] we have been pretty transparent about what our expectations with the beginning of the year, this is really all new. And so you put all that together and we feel very good about just to put a new perspective 221 for the first half of the year at EPS and we are expecting 445 to 460 for the back half. We are probably on track to deliver that and we feel pretty good about it.

Christine Farkas - Merrill Lynch

Okay. Great, that’s helpful. And I guess this may be related, but do you have any comments on your SAP system and the implementation and if there is any impact there this year or year-over-year?

Dianne M. Neal - Chief Financial Officer and Executive Vice President

Yes. There is impact and it will continue to manifest itself over the next couple of years. There is a tangible thing that we can point to with regard to system improvement and not spending on a diverse late of Legacy systems that we are no longer investing behind and then there are the process improvements and being tightly aligned with what's happening throughout the supply chain so those benefits are starting to come through and they will continue to do so over the next couple of years. For example, working capital. We expect improvements in working capital so they will continue to flow in, its gone pretty well I think the teams are very pleased with not only how we implemented the advances they are seeing throughout the organization.

Unidentified Analyst

Okay great and then last question. Can you tell us what these fixed additional biz test markets are?

Unidentified Company Representative

Sure. Indianapolis, Mali [ph], Orlando, Colombia, Columbus sorry, correction there Columbus. and Kansas city and Dallas.

Unidentified Analyst

Terrific. Thanks a lot.

Unidentified Company Representative

Thank you Christine.

Operator

Next we will go to Scott of HSBC. Your line is open, please go ahead. You may have your cell muted. [operator instruction]. We'll go next to Reid Male of casanov [ph]

Unidentified Analyst

Hi just a quick one on your guidance again. I see the second quarter include the charge of $0.04 so presumably that’s reflecting guidance as well.

Unidentified Company Representative

Yes it is that was to associated with refinancing our debt and we were able to absorb that $0.04 in our guidance this year and we feel very good about it.

Unidentified Analyst

On a like for like basis your guidance as you would have been $4.49 $4.64 remember we were struggling to work out why our half two forecast was so low. Actually we've got to find another $0.04 on top of that as well.

Unidentified Company Representative

Thank you Greg.

Unidentified Analyst

Is that fair?

Unidentified Company Representative

Yeah that’s fair. Thank you.

Unidentified Analyst

Thank you.

Operator

[Operator instruction] And we'll go back to Scot Pardy of HSBC. Scott?

Unidentified Analyst

Hullo can you hear me there?

Unidentified Company Representative

Yes I can

Unidentified Analyst

Your aggression [ph] seems to be a little bit weak but regarding balance sheet leverage are you waiting the kind of the way you want them to be or are you trying to be higher rated as far as debt rating is or the idea a kind of leveraged metric and then sort of let the ratings ship follow the main [ph]

Unidentified Company Representative

You know our leverage right now this is about 50 [inaudible] about few. I think thats a good place we've got clearly some flexibility to be higher than that if we had the for example nice M&A opportunity made itself available we could go higher than that but I think on a normal day to day basis it’s a good place to be.I think the rating agencies are very supportive of that level and again I think their flexibility to be higher for the right use and over time we do expect the ratings to continue to go up. Our corporate credit ratings are not quite at investment grade with two, but they do have a positive outlook and [inaudible] even our corporate credit ratings to invest grade in the last few weeks. So with positive outlook by the two rating agencies we continue to see… continue to expect to see positive movement in our credit ratings.

Unidentified Analyst

Thank you very much.

Unidentified Company Representative

Thank you, Scot.

Operator

And at this time we have no further questions. I will turn the conference back to management for closing remarks.

Unidentified Company Representative

I would like to thank you for joining us. As a reminder a reply of this call will be available on our website and reynoldsamerican.com until August 24.

Operator

And that does conclude today’s conference. Again thank you for your participation.

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Source: Reynolds American Q2 2007 Earnings Call Transcript
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