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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

Reynolds American, Inc. (RAI) Q3 2007 Earnings Call October 25, 2007 10:30 AM ET

Operator

Good day, ladies and gentlemen, and welcome to the Third Quarter Earnings Conference Call hosted by Reynolds America Incorporated. All participants are in a listen-only mode. At the conclusion of our prepared remarks, 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's conference 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 this morning, we'll discuss Reynolds American's results for the third quarter and the first nine months of 2007, and we'll provide our outlook for the remainder of the year.

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

Joining me on the call this morning is Reynolds American's Chief Financial Officer, Dianne Neal. Before I turn the call over to Dianne for her 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 that could cause actual results to be materially different from our projections. Those factors are listed at the end of our press release this morning, 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 our CFO, Dianne Neal.

Dianne Neal

Thank you, Morris, and good morning everyone. It's very simple -- to sum up our results for the third quarter and first nine months of 2007, Reynolds American continues to perform well, and we are building momentum for strong earnings growth for the full year.

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

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

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

Conwood's volume and profit gains also contributed to the third quarter results. Adjusted EPS for the first nine months was $3.43, up 5.5% from the prior year period. And based on our full year guidance, it's obvious we also expect a strong fourth quarter. That's on the continued strength of our underlying business and the benefits of the September price increase.

In addition, we expect a favorable comparison to last year's fourth quarter, when trade inventory reductions and the timing of promotional expenses negatively impacted our results. So that's a quick look at RAI's third quarter 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 the results of their integrated brand portfolio strategy and their continuing focus on productivity.

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

A good example is Camel No. 9, which was developed to offer a level of taste and style that was missing in the market. This product is being 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 of Camel No. 9 to the one out of every three adult smokers who prefer 100-millimeter cigarettes.

Another innovation, Camel Signature, was developed in collaboration with tens of thousands of adult smokers who helped design the unique blends and packaging of these four styles. Camel No. 9 and Camel Signature are both helping to enhance Camel's image as a brand that listens and responds 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 and spitless tobacco products with Camel Snus. Camel Snus offers adult smokers pleasure for wherever. How? By extending their ability to enjoy tobacco when they otherwise can't or choose not to smoke.

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

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

However, over the past year, Kool's share has remained relatively stable at just over 3% of the market. We think that's due to increased competitive activity in the menthol category. Consequently, Kool has not quite met our expectations, and R.J. Reynolds is very focused on improving Kool's trends.

The company's third growth brand, Pall Mall, continues to deliver volume and share growth. For the third quarter, Pall Mall's share was 2.14%, up 0.2 share points from the prior year period. With the brand's volume and share continuing to grow, the focus is now on further enhancing Pall Mall's margins.

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

As you saw in our release this morning, the company's volume for 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 than expected wholesale inventory, and the above-average price increases on selected brands. Those price increases generated higher profits on lower volumes.

Profits were also higher on the strength of continued improvements in R.J. Reynolds premium-to-value mix. Premium shipments were 62.6% of R.J. Reynolds' volume, up almost 0.5 percentage point from the prior year quarter.

Productivity was another factor driving R.J. Reynolds' profit growth. The company is on track to deliver about $85 million in productivity savings this year. So pricing, price mix, and productivity gains contributed to R.J. Reynolds' third quarter operating income of $497 million, a gain of about 5% over the prior year quarter.

In addition, the quarter-over-quarter comparisons did benefit from unfavorable volume and discounting dynamics in the prior year quarter. So that's a look at R.J. Reynolds' third quarter performance, and it keeps 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 profit gains. To provide more meaningful comparisons, I'll discuss Conwood's results on an adjusted pro forma basis, as if we'd owned the company with its current line of products at the beginning of last year.

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

Driving Conwood's growth were additional gains on Grizzly, which continues to be the growth leader in the moist-snuff category. Grizzly's volume 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 and sequentially to 21.23%.

To further build on Grizzly's momentum, Conwood will begin testing two new styles, Grizzly Pouches and Grizzly Snuff. While moist-snuff has traditionally been offered in the form of loose tobacco, pouch products represent a growing segment of the market.

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

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

Kodiak, Conwood's premium moist-snuff brand, continued to be impacted by aggressive competitive promotional levels. And as a result, Kodiak's volume was down about 7.5% in the third quarter. Its share of shipments declined 7/10ths of a share point to 4.29%. Improving Kodiak's performance is a high priority, as Conwood works to strengthen and expand its overall 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's margins improved to 53.5% for the third quarter, up 2.8 percentage points from the year ago period. So the bottomline on Conwood is its continued strong performance. And Conwood is well positioned for another great year.

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

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

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

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

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

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

State initiatives to enact cigarette fire standards also continue. R.J. Reynolds announced this morning that it plans to voluntarily make all of its cigarettes fire-standards compliant by the end of 2009. These products will be phased into additional states, as the special paper becomes available from suppliers. In the meantime, the company will continue to comply with all existing standards and deadlines.

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

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

It's clear that the strength of our business model is propelling us towards a strong fourth quarter and another strong year. In summary, all of our operating companies continue to build momentum to support RAI's focus on delivering sustainable earnings growth and increased shareholder value. 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 pause just a moment to assemble the roster.

We will take our first question today from Nik Modi with UBS.

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 on the premium moist smokeless tobacco business, just curious on kind of how you think about the business, in terms of reinvigorating growth there?

Is it going to be through Kodiak or, certainly, you could have a Camel or a Kool type product come out into the market? And then just the last thing. What your Snus tests have showed you about converting where the source 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 update you on there. We're continuing to work with the AGs to resolve the issue. We would prefer to work this through with the AGs, because it gives us an opportunity to not only solve the issue retrospectively, but also prospectively. So we welcome that, and we're working hard towards that end.

But there's nothing definitive to report to you. And as you know, we still reserve the right to pursue the arbitration panel. At this point, I think, it's about 45 courts that have agreed with us that we have the right 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 that we've got sitting in escrow and hopefully resolve it going forward.

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

We're looking at Kodiak very carefully to determine whether it has the legs and the equity to be a growth engine for us going forward. And we are solidifying what other avenues might be available to us to play a stronger role in the premium moist-snuff category that continues to represent about 55%.

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

So all of that is under careful consideration and evaluation right now. And when we've made some firm decisions, of course, we'll let you know. Your third point -- I wanted to ask you to repeat it, because I wasn't sure if you were talking about Snus or moist-snuff. Could you repeat that last question 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 test markets. I guess that's why you're rolling it out to more markets. I'm curious in the learnings you're taking away and where the source of volume is coming from, kind of, if you can just give us some context on what's going on with that particular product and where the consumer is going or coming from?

Dianne Neal

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

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 expanded introduction of Camel Snus. As far as the source of volume, it does skew more towards cigarette smokers.

But we are getting a lot of good repeat business. And the retailers -- we're working closely with our retail partners to do the introduction the right way, because we have to keep in mind that this is a new category 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 slow going and it's early days. Some of the markets actually didn't even roll out until 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 smokeless category. And one of the things that's been terrific this year has been the benefit of a price increase that Grizzly took last year. I'm wondering if there is anything that suggests we wouldn't be able to see another price increase at the end of this year that would benefit next year. In other words, it seems to me that Grizzly has shown very strong volume growth, continues to lead the price value category. Could it, again, lead -- potentially lead to a price increase in that category?

Dianne Neal

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

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

Erik Bloomquist - J.P. Morgan

Okay. Thank you. And then switching gears into thinking about use of balance sheet. Have there been any discusses yet with BAT regarding a potential agreement to allow a repurchase to begin, perhaps, in 2008?

Dianne Neal

Yeah. Erik, we've had some preliminary discussions with BAT along those lines. But they are preliminary and that will take some time to work 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 with Credit 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 first question.

Dianne Neal

Yeah.

Filippe Goossens - Credit Suisse

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

Dianne Neal

Filippe, it was interesting. We had just started to see a couple of accounts start to build. But then the price increase was announced early to mid September, and so by the end of the quarter, we think that was gone.

And actually, in the third quarter, R.J. Reynolds did see some inventory deload, a couple of 100 million units. So we had just started to see 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 continues to gain share. At what point in time -- and obviously, your focus on the growth brands is partially responsible for that -- at what point in time, do you think we'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 an inherent limiter of that. It has increased share significantly. I think it's up 0.7 or something like that year-to-date, the premium overall category.

Sometimes it depends on what's happening with the individual brands, because at a premium price point, the brand should be differentiating themselves and reinforcing the -- with the consumer that it's worth paying that higher 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 that is one of the key determiners about the full price category as well as the promotional activity and everything that's going on in pricing. But the price gaps between full price and deep discount have remained relatively stable over the past year.

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

Filippe Goossens - Credit Suisse

And then just as a derivative, have you seen anything different in terms of the pricing strategy of Commonwealth following the purchase 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 the overall deeper discount category has been holding on a Marilyn share of market basis around 10%.

So what we've seen is this typical shifting among those brands, as Commonwealth has picked up some share. But again, there has been some heavier promotional activity that has gone with that. Really haven't seen an impact on our business. But with Imperial's ownership, we will continue to respect 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 I mean I would have hoped that with Kool XL and now with Kool XL Blue that would start to turn around.

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

Dianne Neal

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

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

But Camel has that longer trend of growth and momentum and innovation. And that's where we need to get Kool and that's what the brand teams are focused on. So it's -- we really put its softness down to competitive activity, but again the brand has to be strong enough to withstand that. And that 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 their R&D facilities. Are you guys doing anything in terms of accelerating your own efforts to come up with game-changers that will allow you to kind of mitigate somewhat the decline in consumption of traditional cigarettes?

Dianne Neal

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

The product has been very well received by consumers, and that started with our R&D organization. So we are very focused on what future products will satisfy those consumers' needs and serve Reynolds American's desires to continuously grow profits and margin. So we are -- have the resources, human and financial, to continue to invest in that area, and it'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 with Goldman Sachs.

Judy Hong - Goldman Sachs

Hi, Dianne.

Dianne Neal

Hi, Judy.

Judy Hong - Goldman Sachs

First, I wanted to just reconcile the industry's shipment numbers, your shipment numbers, and kind of what's going on at the consumer level. So first, in terms of the industry shipment numbers in the third quarter, down 2% -- is that a fairly accurate reflection of the underlying consumption trend?

Dianne Neal

For industry, we don't have all of our final numbers in, but I do think -- whereas for the year, we think, industry consumption we've been saying 3%, it might be more like 3.5% -- that it was probably a little better than 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%, I recall last year there was an inventory deload and so the comparisons were easy. And then you talked about another inventory deload this year. So I'm just trying to understand how those factors really impacted your shipment numbers?

Dianne Neal

Yeah, that's fine. You're remembering absolutely everything correctly. Last year, in the third quarter, remember we had that 1 billion units 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. A little bit of a surprise to us. We did see a couple of hundred million units deload 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 one big thing going on. But that did offset that easy comparison of the straight deloads last third quarter.

Judy Hong - Goldman Sachs

Okay. So your shipment numbers this year, down 4%, is fairly reflective 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 year will probably be down 4% to 4.5% -- maybe closer to 4.5%, because we have taken some additional pricing. For example, when we had the September price increase that was generally $0.50 a carton on brands like Camel and Kool, there were some of our brands in the non-growth categories where we took as much as 6% and in a couple of cases a 10% price increase because that is part of the strategy on those brands is to improve profitability, balance share or just plain out harvest a brand.

So we did take extra pricing and that does show up in volume and share, of course, as I referenced in my comment. So those kind of things probably 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 at RJRT, I would have thought that the number would actually be a little bit better, given, again, a year ago where you had, I think, 40 million of spending on ballot initiatives in California and obviously you have continued benefits on the pricing front.

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

Dianne Neal

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

The only other factor in the third quarter that may have tapped down the profits somewhat was the little tickup in merchandising spending. We had good success with our retail contracts this year by the cigarette company. And at some levels of our contracts, we are going back in with some fixturing.

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 several years. But as with any company, you have resource reallocations that happen over 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 saw in 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 with you, if you will. In the third quarter, other income, are you looking at the segment reporting?

Judy Hong - Goldman Sachs

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

Dianne Neal

7 million. What flows through there are things like income from the joint venture as well as some modest currency fluctuations. So it's between those two and just some other non-operating items would cause that increase.

Judy Hong - Goldman Sachs

Okay.

Dianne Neal

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

Judy Hong - Goldman Sachs

Right. Right. Okay. And then just going back to your comment about you're having a preliminary discussion with BAT. Do you have a sense of how long that discussion could take place before both parties make the decision? And to the extent that BAT isn't willing to sell down their stake in Reynolds America, are you willing to maybe pay a special dividend or increase dividend more to return more money to shareholders if the share repurchase activity 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 to generate 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 the growth trajectory -- the long-term growth trajectory of the business.

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

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 your release that you're going to convert to the use of fire-safe paper by the end of 2009. Why now? Is it driven by complexity or is it driven by a feeling that maybe 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 fire standards on the paper, and you're shipping the exact same skew other than the paper into New Jersey, you multiply that by all of our brand styles and the materials that go into our products, you have increased complexity, you have shorter manufacturing runs.

So it is, we believe, in our best interest to go ahead and make this change, because at this point we've got 22 states that have enacted this legislation. So you reach a tipping point where it's in the best interest to go ahead and make this move. And right now, the projections are that we'll have all of our products on cigarette side compliant with the standards by the end 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 think the whole industry is being effective in terms of educating the consumers as to what Snus are, how to use them, or do you think a change needs to be made in terms of education, the education process in line, like the timing in line with what you expect? Can I get an update there?

Dianne Neal

Yeah. The education is very important. And we're pretty pleased with how those efforts are going. Through the first two test markets, we continued to enhance our program around the education, the consumer engagement. 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 a powerful source of word of mouth and education for consumers in addition to our own internal resources where we engage with adult smokers and other tobacco users. So it will continue to be a key focus for the company in building this new category.

Ann Gurkin - Davenport

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

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 real update that lately, but it is a viable channel for us. We tend to combine that with our overseas, other outlets like military, and I think all of those are doing 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 think your comment on joint ventures. With regard to the termination of the Gallagher joint venture, at what point in time, will you have a better view in terms of the 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 idea when you will have a better feel in terms of the total dollar amount that will be coming back towards you?

Dianne Neal

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

And there is a process in the joint venture agreement that allows for the process, which has to conclude by June of 2008, and we expect to firmly be on that timeline. So it may be that it goes till June. If the parties are 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 of support on Kool? In other words, if it's 18 months from now and the brand more or less has this same level of share, would that do it? I'm just curious.

Dianne Neal

Yeah. Given the increase in the menthol competitive activity, 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 a definitive answer of what -- at what share loss and in what time period would we reduce the support, we really haven't even talked about that because we feel so strongly that we can make a difference on the brand. The XL launches are going really. But it is time to adjust and strengthen kind of the platform, the equity of the brand, and that's what we're focused on.

David Adelman - Morgan Stanley

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

Dianne Neal

Yes.

David Adelman - Morgan Stanley

I wanted to ask you two things about that. First, that is not taking on board the potential benefit of a share repurchase program. Am I correct?

Dianne Neal

You are correct.

David Adelman - Morgan Stanley

Okay. And then, secondly, it's not assuming any draconian increase 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 assumptions that you made that Conwood's profitability is running somewhat above plan, but at the same time that the competitive dynamic in the category might be just a touch more challenging than you thought it would have been a year and a half ago?

Dianne Neal

Definitely, Conwood's profitability is beating the business cases -- the base business cases that we used to evaluate the acquisition. So that is definitely true. On the competitive activity side, I really can't wholeheartedly agree with you. We had access to the price gaps and the dynamics in the marketplace and did a good bit of due diligence. New entrants were part of the evaluation, and the scenarios we ran around that, so maybe marginally so.

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

David Adelman - Morgan Stanley

Okay. And going back to an earlier question about pricing tactics that was asked, Dianne, in essence, you went for profit on that brand this year. But because of what happened competitively, your actions narrowed the pricing gap in the category. And I guess the question I have, whether it's for next year or longer-term, are you willing to continue to make that tradeoff or would you make that tradeoff given where the pricing gaps are today going forward, 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 clear pricing strategies, R.J. Reynolds and Conwood, we are very focused on sustainable margin and earnings growth. That is a balance against share and volume that is a delicate balance.

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

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

David Adelman - Morgan Stanley

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

Dianne Neal

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

David Adelman - Morgan Stanley

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

Dianne Neal

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

David Adelman - Morgan Stanley

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

Dianne Neal

Let me just clarify. The number of cases is a little less than 200, but there are multiple plaintiffs per case, which would get you closer 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 for closing remarks today.

Morris Moore

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

Operator

Ladies and gentlemen, thank you so much for your participation. This does conclude the conference, and you may now disconnect your line.

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Source: Reynolds American Q3 2007 Earnings Call Transcript
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