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Reynolds American, Inc. (NYSE:RAI)

Q3 2007 Earnings Call

October 25, 2007 10:30 am ET

Executives

Morris Moore - Vice President of Investor Relations

Dianne Neal - Chief Financial Officer

Analysts

Nik Modi - UBS

Erik Bloomquist - J.P. Morgan

Filippe Goossens - Credit Suisse

Judy Hong - Goldman Sachs

Ann Gurkin - Davenport

David Adelman - Morgan Stanley

Operator

Good day, ladies and gentlemen, and welcome to the ThirdQuarter Earnings Conference Call hosted by Reynolds America Incorporated. Allparticipants are in a listen-only mode. At the conclusion of our preparedremarks, we will conduct a question-and-answer session (Operator Instructions).As a reminder, this call is being recorded.

And I would now like to introduce your host for today'sconference call, Mr. Morris Moore, Vice President of Investor Relations. Mr.Moore, you may begin your conference.

Morris Moore

Good morning and thank you for joining us. In our call thismorning, we'll discuss Reynolds American's results for the third quarter andthe first nine months of 2007, and we'll provide our outlook for the remainderof the year.

We'll discuss the results primarily on an adjusted non-GAAPbasis. A reconciliation of GAAP to adjusted non-GAAP earnings is in our pressrelease, which also contains additional details on this morning's topics. Ourpress release can be found on our website, at reynoldsamerican.com.

Joining me on the call this morning is Reynolds American'sChief Financial Officer, Dianne Neal. Before I turn the call over to Dianne forher comments, I need to cover the Safe Harbor provisions.

During the call, we'll discuss forward-looking information.When we talk about future results or events, there are a number of factors thatcould cause actual results to be materially different from our projections.Those factors are listed at the end of our press release this morning, and inour SEC filings. Except as provided by federal securities laws, we are notrequired to publicly update or revise any forward-looking statements, whetheras a result of new information, future events or otherwise.

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

Dianne Neal

Thank you, Morris, and good morning everyone. It's verysimple -- to sum up our results for the third quarter and first nine months of2007, Reynolds American continues to perform well, and we are building momentumfor strong earnings growth for the full year.

With the guidance increase we announced this morning, weexpect to deliver full year EPS of $4.55 to $4.65. This represents an increaseof 11 to 13% over last year's results. Our enhanced guidance is driven by thecigarette price increase announced late in the third quarter.

In my comments this morning, I'll primarily focus on ourthird-quarter adjusted results, since they provide a better perspective on ourunderlying business performance. I will point out that our results for thethird quarter are the same on both an adjusted and reported basis.

Last year, they were different. The reconciliation of ouradjusted to reported results is available on our press release, which can befound on our website. RAI's third quarter adjusted EPS was a $1.21. That's anincrease of 12% over the prior year quarter, as lower cigarette volume andhigher settlement expenses were more than offset by pricing and productivityimprovements.

Conwood's volume and profit gains also contributed to thethird quarter results. Adjusted EPS for the first nine months was $3.43, up5.5% from the prior year period. And based on our full year guidance, it'sobvious we also expect a strong fourth quarter. That's on the continuedstrength of our underlying business and the benefits of the September priceincrease.

In addition, we expect a favorable comparison to last year'sfourth quarter, when trade inventory reductions and the timing of promotionalexpenses negatively impacted our results. So that's a quick look at RAI's thirdquarter results and what we expect for the balance of the year.

Now, let's look at hour R.J. Reynolds and Conwood performed,starting with R.J. Reynolds. We are pleased with their performance and theresults of their integrated brand portfolio strategy and their continuing focuson productivity.

A number of factors are contributing to R.J. Reynolds'results. First and foremost, innovation -- innovations like Camel No. 9, CamelSnus and Kool XL. One of R.J. Reynolds' core strengths is identifying emergingtrends and satisfying consumers' changing desires by creating innovativeproducts and programs.

A good example is Camel No. 9, which was developed to offera level of taste and style that was missing in the market. This product isbeing very well received. And based on the increasing popularity of Camel No.9, we've recently launched two longer styles into national distribution,regular and menthol 100's. These longer-length cigarettes extend the appeal ofCamel No. 9 to the one out of every three adult smokers who prefer100-millimeter cigarettes.

Another innovation, Camel Signature, was developed incollaboration with tens of thousands of adult smokers who helped design theunique blends and packaging of these four styles. Camel No. 9 and CamelSignature are both helping to enhance Camel's image as a brand that listens andresponds to the evolving desires of adult smokers.

And R.J. Reynolds innovations don't stop with cigarettes.The company is pioneering the U.S. development of a category of smokeless andspitless tobacco products with Camel Snus. Camel Snus offers adult smokerspleasure for wherever. How? By extending their ability to enjoy tobacco whenthey otherwise can't or choose not to smoke.

These types of innovations and consumer interactionscontinue to enhance Camel's image as a vibrant, relevant brand for adults whoenjoy tobacco. On the strength of these types of efforts, Camel continued itslong-term growth adding more than 4/10th of a share point over the prior yearquarter. Camel's total third quarter share was 7.99%.

Moving to Kool. Kool is also focused on innovation, and theincreasing popularity of Kool's XL styles is adding to the brand's overallappeal. Kool XL, a smoother, wider cigarette, and a new milder style called XLBlue, rolled out nationally in the third quarter.

However, over the past year, Kool's share has remainedrelatively stable at just over 3% of the market. We think that's due toincreased competitive activity in the menthol category. Consequently, Kool hasnot quite met our expectations, and R.J. Reynolds is very focused on improvingKool's trends.

The company's third growth brand, Pall Mall, continues todeliver volume and share growth. For the third quarter, Pall Mall's share was2.14%, up 0.2 share points from the prior year period. With the brand's volumeand share continuing to grow, the focus is now on further enhancing Pall Mall'smargins.

So with gains on Pall Mall and Camel, the company's totalgrowth brand share in the third quarter was 13.22%, an increase of 0.59 sharepoints from the prior year period. R.J. Reynolds' overall third quarter marketshare was 29%, with the decline in support and nonsupport brands in line withthe company's portfolio strategy.

As you saw in our release this morning, the company's volumefor the third quarter was 25 billion units, down 4% from the prior year quarter.Now, there were two primary factors that contributed to this. Lower thanexpected wholesale inventory, and the above-average price increases on selectedbrands. Those price increases generated higher profits on lower volumes.

Profits were also higher on the strength of continuedimprovements in R.J. Reynolds premium-to-value mix. Premium shipments were62.6% of R.J. Reynolds' volume, up almost 0.5 percentage point from the prioryear quarter.

Productivity was another factor driving R.J. Reynolds' profitgrowth. The company is on track to deliver about $85 million in productivitysavings this year. So pricing, price mix, and productivity gains contributed toR.J. Reynolds' third quarter operating income of $497 million, a gain of about5% over the prior year quarter.

In addition, the quarter-over-quarter comparisons didbenefit from unfavorable volume and discounting dynamics in the prior yearquarter. So that's a look at R.J. Reynolds' third quarter performance, and itkeeps the company on track for solid full year growth.

Now, let's look at Conwood's results. Conwood has, again,delivered very strong results with double-digit third quarter volume and profitgains. To provide more meaningful comparisons, I'll discuss Conwood's resultson an adjusted pro forma basis, as if we'd owned the company with its currentline of products at the beginning of last year.

On that basis, the company's third quarter adjustedoperating income of $90 million was up more than 18% on the strength of higherpricing and volume. Conwood's moist-snuff volume grew more than 12% from theprior year quarter.

Driving Conwood's growth were additional gains on Grizzly,which continues to be the growth leader in the moist-snuff category. Grizzly'svolume was up 18%, more than twice the growth rate of the moist-snuff category.As a result, Grizzly's share of market grew quarter-over-quarter andsequentially to 21.23%.

To further build on Grizzly's momentum, Conwood will begintesting two new styles, Grizzly Pouches and Grizzly Snuff. While moist-snuffhas traditionally been offered in the form of loose tobacco, pouch productsrepresent a growing segment of the market.

Pouches contain pre-measured amounts of moist-snuff inpackets that look something like small teabags. They offer a more convenientway to use moist-snuff. Conwood's test of Grizzly Pouches represents thecompany's initial entry into this growing style of moist-snuff. It nowrepresents about 6% of the overall market.

The company's second test product, Grizzly Snuff, featuresultra fine-cut natural tobacco in a premium can with a metal lid. This is amore traditional style that is preferred by a large segment of the moist-snuffmarket. Our research indicates that both of these products have great potentialto strengthen and expand Grizzly's appeal.

Kodiak, Conwood's premium moist-snuff brand, continued to beimpacted by aggressive competitive promotional levels. And as a result,Kodiak's volume was down about 7.5% in the third quarter. Its share ofshipments declined 7/10ths of a share point to 4.29%. Improving Kodiak'sperformance is a high priority, as Conwood works to strengthen and expand itsoverall position in the premium segment.

Conwood's total third quarter share of shipments was 25.95%,up more than a third of a share point from the prior-year period. Conwood'smargins improved to 53.5% for the third quarter, up 2.8 percentage points fromthe year ago period. So the bottomline on Conwood is its continued strongperformance. And Conwood is well positioned for another great year.

So that's a quick update on the performance of our twooperating segments. Now, let's take a look at the external environment and howthat's impacting our business this year. I'll start with what's going on inWashington. First, FDA legislation.

Earlier this month, the FDA commissioner presented testimonyopposing this legislation. In particular, he opposed making the FDA theenforcement agency. At this point, we don't expect any additional movement onthis bill this year. However, it will carry over to 2008 and will continue tobe an area of focus going forward.

As we said before, Reynolds American would supportreasonable regulation as long as it maintains our operating company's abilityto compete for the business of adults who enjoy tobacco.

Now, let's look at taxes. Efforts to raise the federalcigarette tax to fund an expansion of the SCHIP healthcare program have notbeen approved. Last week, Congress failed to override the President's veto ofthis measure. However, the issue of funding SCHIPs isn't over.

There's a lot of speculation on the next steps by Congressthis year and possibly into 2008. Opponents of this bill intend to introducemodified legislation that would still include a federal tax increase ontobacco. A vote could come as early as this afternoon. At this time, it'sdifficult to predict the timing or the amount of any potential tax increase.

Moving to the state level, we expect this year's increase inthe national average state excise tax to be about $0.17 per pack, including theTexas increase this past January. After November 6, we'll know the result ofthe Oregon ballot initiative, and tax legislation is still being considered insome other states. We're watching these efforts closely and working hard todefeat any additional increases.

State initiatives to enact cigarette fire standards alsocontinue. R.J. Reynolds announced this morning that it plans to voluntarilymake all of its cigarettes fire-standards compliant by the end of 2009. Theseproducts will be phased into additional states, as the special paper becomesavailable from suppliers. In the meantime, the company will continue to complywith all existing standards and deadlines.

So that's a quick update on external issues. Now, let's lookat guidance. As we announced this morning, we have increased our full year EPSguidance to a range of $4.55 to $4.65, driven by cigarette price increaseannounced late in the third quarter. Our new guidance represents growth of 11to 13% over last year's reported EPS of $4.10.

Our current guidance is up from what we expected at thebeginning of the year, primarily due to the September price increase and thepension favorability we announced in April. And, of course, our higher guidancealso includes the charges we incurred in June to refinance our debt.

It's clear that the strength of our business model ispropelling us towards a strong fourth quarter and another strong year. Insummary, all of our operating companies continue to build momentum to supportRAI's focus on delivering sustainable earnings growth and increased shareholdervalue. Thank you.

Now, we'll turn to the Q&A portion of the call. Debbie,would you remind our callers how to get into the queue, please?

Question-and-Answer-Session

Operator

Thank you, Dianne. (Operator Instructions) And we'll pausejust a moment to assemble the roster.

We will take our first question today from Nik Modi withUBS.

Nik Modi - UBS

Good morning everyone.

Dianne Neal

Hi, Nik.

Morris Moore

Good morning, Nik.

Nik Modi - UBS

Just a couple quick questions. On the NPM adjustment front,if you could just provide a quick update there, if you have any? And then onthe premium moist smokeless tobacco business, just curious on kind of how youthink about the business, in terms of reinvigorating growth there?

Is it going to be through Kodiak or, certainly, you couldhave a Camel or a Kool type product come out into the market? And then just thelast thing. What your Snus tests have showed you about converting where thesource of all the volume is coming from for that particular product? Thank you.

Dianne Neal

Thanks, Nik. Starting with NPM, there is not a lot to updateyou on there. We're continuing to work with the AGs to resolve the issue. Wewould prefer to work this through with the AGs, because it gives us anopportunity to not only solve the issue retrospectively, but alsoprospectively. So we welcome that, and we're working hard towards that end.

But there's nothing definitive to report to you. And as youknow, we still reserve the right to pursue the arbitration panel. At thispoint, I think, it's about 45 courts that have agreed with us that we have theright under the MSA to pursue the arbitration panel. So we're, again,continuing to work towards one of those that will resolve the 1.2 billion thatwe've got sitting in escrow and hopefully resolve it going forward.

On premium moist-snuff, I talked about in my comments thatKodiak has been impacted by the aggressive promotional levels in moist-snuffthese days, particularly at the premium levels, and that's really the source ofits decline quarter-over-quarter and year-to-date.

We're looking at Kodiak very carefully to determine whetherit has the legs and the equity to be a growth engine for us going forward. Andwe are solidifying what other avenues might be available to us to play astronger role in the premium moist-snuff category that continues to representabout 55%.

Kodiak to date has had very low levels of promotions, justsome slighted promotions every once in a while, and we're evaluating thatactivity as well. You referred to cigarette trademarks moving into moist-snufffrom the Reynolds American portfolio, and that's certainly an option.

So all of that is under careful consideration and evaluationright now. And when we've made some firm decisions, of course, we'll let youknow. Your third point -- I wanted to ask you to repeat it, because I wasn'tsure if you were talking about Snus or moist-snuff. Could you repeat that lastquestion for me, please?

Nik Modi - UBS

Yeah. It was really on the Snus. It seems like Camel Snus,at least from what I hear in the market, has done pretty well in the testmarkets. I guess that's why you're rolling it out to more markets. I'm curiousin the learnings you're taking away and where the source of volume is comingfrom, kind of, if you can just give us some context on what's going on withthat particular product and where the consumer is going or coming from?

Dianne Neal

Okay. Great. We are pleased with Camel Snus. Just to get thefacts out on the table, we were in two test markets for about the last year andseveral months. In the third quarter, we started rolling out to six additionalmarkets.

It's early days, but we're encouraged by what we're seeing.And in general, we're meeting the milestones that we set for this expandedintroduction of Camel Snus. As far as the source of volume, it does skew moretowards cigarette smokers.

But we are getting a lot of good repeat business. And theretailers -- we're working closely with our retail partners to do theintroduction the right way, because we have to keep in mind that this is a newcategory in the United States.

And it will take education and we want to do it right,because we do think long-term there is good potential here. But it will be slowgoing and it's early days. Some of the markets actually didn't even roll outuntil about September. So encouraged, but don't want to get ahead of ourselves.

Nik Modi - UBS

Thanks, Dianne.

Dianne Neal

Thank you, Nik.

Operator

We'll take our next question from Erik Bloomquist with J.P.Morgan.

Erik Bloomquist - J.P. Morgan

Hi. Good morning, Dianne.

Dianne Neal

Hi, Erik.

Erik Bloomquist - J.P. Morgan

I was wondering if we could focus again on the smokelesscategory. And one of the things that's been terrific this year has been thebenefit of a price increase that Grizzly took last year. I'm wondering if thereis anything that suggests we wouldn't be able to see another price increase atthe end of this year that would benefit next year. In other words, it seems tome that Grizzly has shown very strong volume growth, continues to lead theprice value category. Could it, again, lead -- potentially lead to a priceincrease in that category?

Dianne Neal

Grizzly certainly plays a key role in the pricing withinmoist-snuff, given that it's 45% of the value category and 21 share points. Itdid lead the price increase last year. Certain brands followed, certain brandsdid not.

So with regard to forward pricing, of course, that gets meinto a danger zone that I don't particularly want to go into. So I think I'lljust leave it with that we're very pleased with Grizzly, and we think these newproduct introductions will only help the brand build even more momentum.

Erik Bloomquist - J.P. Morgan

Okay. Thank you. And then switching gears into thinkingabout use of balance sheet. Have there been any discusses yet with BATregarding a potential agreement to allow a repurchase to begin, perhaps, in2008?

Dianne Neal

Yeah. Erik, we've had some preliminary discussions with BATalong those lines. But they are preliminary and that will take some time towork through the different dynamics. So that's about where we are.

Erik Bloomquist - J.P. Morgan

Okay. Thank you, Dianne.

Dianne Neal

Thank you, Erik.

Operator

Our next question will come from Filippe Goossens withCredit Suisse.

Filippe Goossens - Credit Suisse

Yes. Good morning. How are you today?

Dianne Neal

Good, Filippe. How are you?

Filippe Goossens - Credit Suisse

Not too bad. It's a busy day here. But moving up to my firstquestion.

Dianne Neal

Yeah.

Filippe Goossens - Credit Suisse

Was there any buy-in from the trades in advance of the thirdquarter price increases, Dianne?

Dianne Neal

Filippe, it was interesting. We had just started to see acouple of accounts start to build. But then the price increase was announcedearly to mid September, and so by the end of the quarter, we think that wasgone.

And actually, in the third quarter, R.J. Reynolds did seesome inventory deload, a couple of 100 million units. So we had just started tosee it when the price increases began being announced.

Filippe Goossens - Credit Suisse

Okay. And then moving on to my second question. Obviously,we have seen for a while now the premium end of the cigarettes market continuesto gain share. At what point in time -- and obviously, your focus on the growthbrands is partially responsible for that -- at what point in time, do you thinkwe'll have kind of reached a level where we will stabilize in terms of premium?

Dianne Neal

It's a good question. I don't really see anything that is aninherent limiter of that. It has increased share significantly. I think it's up0.7 or something like that year-to-date, the premium overall category.

Sometimes it depends on what's happening with the individualbrands, because at a premium price point, the brand should be differentiatingthemselves and reinforcing the -- with the consumer that it's worth paying thathigher price for the brand of choice.

So as the companies are more innovative, particularly R.J.Reynolds, it gives consumers that reason to stay at that price point. So thatis one of the key determiners about the full price category as well as thepromotional activity and everything that's going on in pricing. But the pricegaps between full price and deep discount have remained relatively stable overthe past year.

And I think the two price increases that have been takenover the last, I'll call it 9 or 10 month, demonstrate the continued pricingflexibility in the marketplace. So I don't think there's an inherent limitergiven the fact that there's an increasing amount of innovation in themarketplace, particularly within R.J. Reynolds.

Filippe Goossens - Credit Suisse

And then just as a derivative, have you seen anythingdifferent in terms of the pricing strategy of Commonwealth following thepurchase by (inaudible)?

Dianne Neal

We have seen some movement. Their deeper discount brands --we have seen increased pricing activity on a couple of their brands. But theoverall deeper discount category has been holding on a Marilyn share of marketbasis around 10%.

So what we've seen is this typical shifting among thosebrands, as Commonwealth has picked up some share. But again, there has beensome heavier promotional activity that has gone with that. Really haven't seenan impact on our business. But with Imperial's ownership, we will continue torespect them as a strong competitor and keep our eye on the situation.

Filippe Goossens - Credit Suisse

Okay. Then just shifting gears calendars Kool. Obviously,we've seen now a few periods of somewhat below expectations performance. And Imean I would have hoped that with Kool XL and now with Kool XL Blue that wouldstart to turn around.

Is there anything specific that you can point towards? Is itjust an issue of the fact that as more people have focused on the mentalcategory that typically the market leader tends to gain more than the peoplethat are actually bringing more attention to the marketplace? I'm just tryingto understand the dynamics a little bit more, as it relates to menthol and Koolspecifically here.

Dianne Neal

Sure. Kool has -- as I said, it's remained relativelystable. And we are very pleased with how Kool XL is performing in themarketplace. And as I said, we just started rolling out that and XL Blue in thethird quarter. It's doing pretty well. We're pleased with it. But it is thisincreased competitive activity. And we've seen it for some time.

It's continued in 2007 and increased focus on that. On ashare of market basis, the menthol category is up, I want to say, 0.8 sharepoints year-to-date. So I mean, that's a pretty good growth rate. And with thatcomes this increased competitive activity. Camel has done pretty well inmenthol over the past year through a variety of initiatives.

But Camel has that longer trend of growth and momentum andinnovation. And that's where we need to get Kool and that's what the brandteams are focused on. So it's -- we really put its softness down to competitiveactivity, but again the brand has to be strong enough to withstand that. Andthat is what the groups are working on.

Filippe Goossens - Credit Suisse

Okay. And then the final question for this morning, Dianne.If I'm not mistaken, (inaudible) is about to get up and running with theirR&D facilities. Are you guys doing anything in terms of accelerating yourown efforts to come up with game-changers that will allow you to kind ofmitigate somewhat the decline in consumption of traditional cigarettes?

Dianne Neal

Filippe, yes, we are very focused on R&D efforts thatdifferentiate our products and meet consumers' needs that are not met. CamelSnus is an example of that. We took the product that was -- had the tastesignature of the overseas markets, and we adapted it to this market in a veryshort time period.

The product has been very well received by consumers, andthat started with our R&D organization. So we are very focused on whatfuture products will satisfy those consumers' needs and serve ReynoldsAmerican's desires to continuously grow profits and margin. So we are -- havethe resources, human and financial, to continue to invest in that area, andit's a key area of focus.

Filippe Goossens - Credit Suisse

Great. Thank you so much, Dianne.

Dianne Neal

Thank you, Filippe.

Operator

(Operator Instructions) And we'll go now to Judy Hong withGoldman Sachs.

Judy Hong - Goldman Sachs

Hi, Dianne.

Dianne Neal

Hi, Judy.

Judy Hong - Goldman Sachs

First, I wanted to just reconcile the industry's shipmentnumbers, your shipment numbers, and kind of what's going on at the consumerlevel. So first, in terms of the industry shipment numbers in the thirdquarter, down 2% -- is that a fairly accurate reflection of the underlyingconsumption trend?

Dianne Neal

For industry, we don't have all of our final numbers in, butI do think -- whereas for the year, we think, industry consumption we've beensaying 3%, it might be more like 3.5% -- that it was probably a little betterthan that overall rate in the third quarter.

Your number -- I can't tell you exactly that's what it was,but we do think it was a little better in the isolated third quarter period.But for the year, again, I think, it will be more like 3 and probably 3.5%given the pricing activity.

Judy Hong - Goldman Sachs

Okay. And then just in terms of your shipments down 4%, Irecall last year there was an inventory deload and so the comparisons wereeasy. And then you talked about another inventory deload this year. So I'm justtrying to understand how those factors really impacted your shipment numbers?

Dianne Neal

Yeah, that's fine. You're remembering absolutely everythingcorrectly. Last year, in the third quarter, remember we had that 1 billionunits that had loaded up prior to the beginning of the third quarter.

Judy Hong - Goldman Sachs

Right.

Dianne Neal

And what we saw last year was about half of that deloaded. Alittle bit of a surprise to us. We did see a couple of hundred million unitsdeload again this third quarter. There can be a variety of reasons for that.And it was across several different wholesalers. So it's not like there was onebig thing going on. But that did offset that easy comparison of the straightdeloads last third quarter.

Judy Hong - Goldman Sachs

Okay. So your shipment numbers this year, down 4%, is fairlyreflective of kind of the consumption, underlying numbers if you adjust for --those two act as an offset in the quarter.

Dianne Neal

Yeah, it is. R.J. Reynolds' consumption volume for the yearwill probably be down 4% to 4.5% -- maybe closer to 4.5%, because we have takensome additional pricing. For example, when we had the September price increasethat was generally $0.50 a carton on brands like Camel and Kool, there weresome of our brands in the non-growth categories where we took as much as 6% andin a couple of cases a 10% price increase because that is part of the strategyon those brands is to improve profitability, balance share or just plain outharvest a brand.

So we did take extra pricing and that does show up in volumeand share, of course, as I referenced in my comment. So those kind of thingsprobably put us more toward the 4.5% consumption decline for the year.

Judy Hong - Goldman Sachs

Okay. And then in terms of your operating profit number atRJRT, I would have thought that the number would actually be a little bitbetter, given, again, a year ago where you had, I think, 40 million of spendingon ballot initiatives in California and obviously you have continued benefitson the pricing front.

So I was just wondering if there's any sort of timing issuesthat -- on the spending side that may have hurt the third quarter. And inrelation to that, I think, your guidance does imply a very strong fourthquarter. So does that mean that some of the spending was actually pulledforward to the third quarter?

Dianne Neal

No. We've had a somewhat more stable quarter-to-quarteractivity this year than we have had in prior years, particularly at R.J.Reynolds. With Reynolds profits up quarter-over-quarter 5%, we were prettypleased with that. And as you say, RJR will have a great fourth quartercomparison to last year for the dynamics that you know about and I've top-linedin my comments.

The only other factor in the third quarter that may havetapped down the profits somewhat was the little tickup in merchandisingspending. We had good success with our retail contracts this year by the cigarettecompany. And at some levels of our contracts, we are going back in with somefixturing.

So we did see an uptick in those costs in the third quarter,kind of a price of reentry, because we had been out of that mode for severalyears. But as with any company, you have resource reallocations that happenover time, and that was one that happened in the third quarter.

Judy Hong - Goldman Sachs

Okay. And then just in terms of the big increase that we sawin other income in the third quarter, can you explain what that was?

Dianne Neal

Yeah. Let me just make sure that I'm on the same page withyou, if you will. In the third quarter, other income, are you looking at thesegment reporting?

Judy Hong - Goldman Sachs

I'm looking at -- no, sorry, below the operating incomeline. So you have other income expenses up to 7 million.

Dianne Neal

7 million. What flows through there are things like incomefrom the joint venture as well as some modest currency fluctuations. So it'sbetween those two and just some other non-operating items would cause thatincrease.

Judy Hong - Goldman Sachs

Okay.

Dianne Neal

Nothing real core to the business other than the jointventure. And as you know, that's going away.

Judy Hong - Goldman Sachs

Right. Right. Okay. And then just going back to your commentabout you're having a preliminary discussion with BAT. Do you have a sense ofhow long that discussion could take place before both parties make thedecision? And to the extent that BAT isn't willing to sell down their stake inReynolds America, are you willing to maybe pay a special dividend or increasedividend more to return more money to shareholders if the share repurchaseactivity is constrained?

Dianne Neal

Yeah. Those are all questions that we are working through.We do have a strong balance sheet, and we do expect Reynolds American togenerate strong cash flows. So we're looking at all those initiatives. Clearly,our top priority would be organic or M&A type transactions that enhance thegrowth trajectory -- the long-term growth trajectory of the business.

But if those are either not needed or not available, thenshare repurchase is a strong alternative. That's not to say that specialdividends couldn't come into play. But what we'll do is continue to focus onthe best use of the balance sheet and the cash, as I think, we have done overmany years. With regard to the timing on BAT, it's just too early to give youany kind of timeline on that one. As I said, we just had some preliminarydiscussions.

Judy Hong - Goldman Sachs

Great. Thanks, Dianne.

Dianne Neal

Thank you, Judy.

Operator

Our next question will come from Ann Gurkin with Davenport.

Ann Gurkin - Davenport

Good morning.

Dianne Neal

Hi, Ann.

Ann Gurkin - Davenport

Just wanted to ask you about the announcement in yourrelease that you're going to convert to the use of fire-safe paper by the endof 2009. Why now? Is it driven by complexity or is it driven by a feeling thatmaybe we won't get FDA regulation of tobacco products anytime in the near term?Can we talk about that?

Dianne Neal

Sure. You hit one of them on the head. It's the complexity.If you're shipping the same Camel light skew into New York that has firestandards on the paper, and you're shipping the exact same skew other than thepaper into New Jersey, you multiply that by all of our brand styles and thematerials that go into our products, you have increased complexity, you have shortermanufacturing runs.

So it is, we believe, in our best interest to go ahead andmake this change, because at this point we've got 22 states that have enactedthis legislation. So you reach a tipping point where it's in the best interestto go ahead and make this move. And right now, the projections are that we'llhave all of our products on cigarette side compliant with the standards by theend of 2009. So it's the state trends as well as the complexity you referenced.

Ann Gurkin - Davenport

Okay. And then talking about the Snus segment, do you thinkthe whole industry is being effective in terms of educating the consumers as towhat Snus are, how to use them, or do you think a change needs to be made interms of education, the education process in line, like the timing in line withwhat you expect? Can I get an update there?

Dianne Neal

Yeah. The education is very important. And we're prettypleased with how those efforts are going. Through the first two test markets,we continued to enhance our program around the education, the consumerengagement. So we'll continue to learn and improve.

But we're pretty pleased with where we are. For example,when the retailers are on board and they understand the product, that's apowerful source of word of mouth and education for consumers in addition to ourown internal resources where we engage with adult smokers and other tobaccousers. So it will continue to be a key focus for the company in building thisnew category.

Ann Gurkin - Davenport

Okay. And then may I get an update on your duty-freesegment?

Dianne Neal

Duty-free?

Ann Gurkin - Davenport

Cigarette sales, how are they going?

Dianne Neal

Yeah. I think they're doing well. I haven't seen a realupdate that lately, but it is a viable channel for us. We tend to combine thatwith our overseas, other outlets like military, and I think all of those aredoing quite well this year.

Ann Gurkin - Davenport

Great. Thank you.

Dianne Neal

Thank you, Ann.

Operator

We'll go to Filippe Goossens, Credit Suisse.

Filippe Goossens - Credit Suisse

Yes, Dianne, just a follow-up on Judy's question and I thinkyour comment on joint ventures. With regard to the termination of the Gallagherjoint venture, at what point in time, will you have a better view in terms ofthe total amount that will be coming in your direction?

Dianne Neal

I'm sorry. I didn't catch the last part of your question.When will we have…

Filippe Goossens - Credit Suisse

With regard to the joint venture with Gallagher, any ideawhen you will have a better feel in terms of the total dollar amount that willbe coming back towards you?

Dianne Neal

Sure. Yes. Thank you for repeating that. Sure. The actualtermination/valuation date with the Gallagher joint venture is November 30. Sowe've had some preliminary dialog on that. But given that the evaluation dateis about a month from now, nothing definitive.

And there is a process in the joint venture agreement thatallows for the process, which has to conclude by June of 2008, and we expect tofirmly be on that timeline. So it may be that it goes till June. If the partiesare able to resolve it earlier than that, of course, we'll keep you updated.But I think at a minimum, you can expect midyear next year.

Filippe Goossens - Credit Suisse

Okay, great. Thanks very much.

Dianne Neal

Thank you.

Operator

We'll go next to David Adelman with Morgan Stanley.

David Adelman - Morgan Stanley

Good morning.

Dianne Neal

Hi, David.

David Adelman - Morgan Stanley

Dianne, what would cause you to de-emphasize a level ofsupport on Kool? In other words, if it's 18 months from now and the brand moreor less has this same level of share, would that do it? I'm just curious.

Dianne Neal

Yeah. Given the increase in the menthol competitiveactivity, the fact that Kool has stayed relatively stable, that's not bad news.It's doing okay. And we are seeing good things on Kool XL. As far as adefinitive answer of what -- at what share loss and in what time period wouldwe reduce the support, we really haven't even talked about that because we feelso strongly that we can make a difference on the brand. The XL launches are goingreally. But it is time to adjust and strengthen kind of the platform, theequity of the brand, and that's what we're focused on.

David Adelman - Morgan Stanley

Okay. And then the comment, Dianne, in the release, yourquote referencing a longer-term growth algorithm, I think, you talked about midsingle-digit EPS growth.

Dianne Neal

Yes.

David Adelman - Morgan Stanley

I wanted to ask you two things about that. First, that isnot taking on board the potential benefit of a share repurchase program. Am Icorrect?

Dianne Neal

You are correct.

David Adelman - Morgan Stanley

Okay. And then, secondly, it's not assuming any draconianincrease in the federal excise tax?

Dianne Neal

Once again, you are correct.

David Adelman - Morgan Stanley

Okay. Let me shift for a second to the smokeless business.Is it fair to say, Dianne, relative to the purchase model and the assumptionsthat you made that Conwood's profitability is running somewhat above plan, but atthe same time that the competitive dynamic in the category might be just atouch more challenging than you thought it would have been a year and a halfago?

Dianne Neal

Definitely, Conwood's profitability is beating the businesscases -- the base business cases that we used to evaluate the acquisition. Sothat is definitely true. On the competitive activity side, I really can'twholeheartedly agree with you. We had access to the price gaps and the dynamicsin the marketplace and did a good bit of due diligence. New entrants were partof the evaluation, and the scenarios we ran around that, so maybe marginallyso.

But we went into it with our eyes wide open and that was onereason that Conwood was so attractive to us because Grizzly from a price-valueequation was so well situated in that market, we thought, and it has been ableto withstand a lot of the increased competitive activity. So on the margin, Iagree with you, but not by leaps and bounds would I say the activity hasgreatly surprised us.

David Adelman - Morgan Stanley

Okay. And going back to an earlier question about pricingtactics that was asked, Dianne, in essence, you went for profit on that brandthis year. But because of what happened competitively, your actions narrowed thepricing gap in the category. And I guess the question I have, whether it's fornext year or longer-term, are you willing to continue to make that tradeoff orwould you make that tradeoff given where the pricing gaps are today goingforward, again?

Dianne Neal

I think I'm going to answer that in a real broad fashion.Reynolds American and the two primary subsidiaries that operate with the clearpricing strategies, R.J. Reynolds and Conwood, we are very focused onsustainable margin and earnings growth. That is a balance against share andvolume that is a delicate balance.

But you have seen Reynolds American, R.J. Reynolds andConwood improve their margins this year. And that is a key determinant of whatwe consider success in our business. And whatever the mechanisms are and thebalances that we have to strike to improve our margins and deliver thatmid-single-digit EPS growth, that's where we will put a lot of energy andcareful evaluation.

So I'd rather answer that question at that broad level thanget into the specifics of one category and what future pricing actions on ourpart might be.

David Adelman - Morgan Stanley

Okay. And then Dianne, how has the fine-cut natural flavoredproduct tested versus the market-leading premium brand in that segment? And Iask that question because, obviously, historically it's on flavored products inthe category where price-value brands have had the bulk of their success.

Dianne Neal

Yeah. Both the Snuff and the Pouches that Grizzly is startingto test in two or three states have tested very well among the consumers thatwe've interacted with prior to test markets. So, again, we're enthusiastic butthat's why you go to test market. But we feel very good about the quality andthe initial response we got from the limited number of consumers that we testedit with before going to market.

David Adelman - Morgan Stanley

And that product, does it have a -- the intent it would havean ultimately have a wholesale list price, line price with the other Grizzlyproducts?

Dianne Neal

Yes, those products are priced in line with the balance ofthe product line on Grizzly.

David Adelman - Morgan Stanley

Okay. And then one last thing, Dianne, am I right inthinking right now there are around about a 1,000 individual cases that havebeen filed? Is that in the ballpark?

Dianne Neal

Let me just clarify. The number of cases is a little lessthan 200, but there are multiple plaintiffs per case, which would get youcloser to 8, 900, a 1,000 people. And as you know, the one-year deadline is --I think it's January 11. So we'll see what happens between now and then.

David Adelman - Morgan Stanley

Okay. Thank you very much.

Dianne Neal

Thank you, David.

Operator

Ladies and gentlemen, having no questions in queue at it,I'd like to offer you a final opportunity. (Operator Instructions) And Mr.Moore, having no further signals at this time, I'll turn it back to you forclosing remarks today.

Morris Moore

Thank you for joining us. As a reminder, a replay of thiscall will be available on our website until November 26.

Operator

Ladies and gentlemen, thank you so much for yourparticipation. This does conclude the conference, and you may now disconnectyour line.

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