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Lorillard (NYSE:LO)

Q1 2012 Earnings Call

April 25, 2012 9:00 am ET

Executives

Robert Bannon - Director of Investor Relations

Murray S. Kessler - Chairman, Chief Executive Officer and President

David H. Taylor - Chief Financial Officer and Executive Vice President of Finance & Planning

Analysts

Matthew C. Grainger - Morgan Stanley, Research Division

Nik Modi - UBS Investment Bank, Research Division

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

Vivien Azer - Citigroup Inc, Research Division

Thilo Wrede - Jefferies & Company, Inc., Research Division

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

Andrew Kieley - Deutsche Bank AG, Research Division

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

Christopher Ferrara - BofA Merrill Lynch, Research Division

Erik A. Bloomquist - Berenberg Bank, Research Division

David J. Adelman - Morgan Stanley, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Lorillard Inc. First Quarter 2012 Earnings Conference Call. My name is Ashley, and I will be your conference operator for today's call. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

At this time, I would like to turn the conference over to your host for today's call, Mr. Bob Bannon. You may begin, sir.

Robert Bannon

Thank you, Ashley, and good morning, everyone. I'm Bob Bannon, Lorillard's Director of Investor Relations, and joining me on today's call are Murray Kessler, Lorillard's Chairman, President and Chief Executive Officer; and David Taylor, its Chief Financial Officer.

By now, you should have received a copy of our first quarter 2012 earnings release. It can be found on the company's website, lorillard.com, under News Releases.

Before we begin, I'd like to remind you that some of the comments on today's call and some of the responses to your questions may contain forward-looking statements. These statements are subject to the risks and uncertainties as described in the company's earnings release and in other filings with the SEC. Also, certain financial information such as adjusted net income and adjusted earnings per share that will be discussed on today's conference call is presented on a non-GAAP basis. Description of most directly comparable GAAP measure and reconciliation between the non-GAAP and GAAP measures are provided in the company's earnings release, which is available on our website.

I'd now like to turn the call over to Murray Kessler.

Murray S. Kessler

Thank you, Bob. We have a lot to talk about this morning. I'll cover both our business results and then an overview of our acquisition of blu ecigs.

Starting with the business. Our reported results, unfortunately, didn't reflect the continued strength of our underlying fundamentals, which remain intact. This is because the first quarter reported results were masked by a very significant comparative reduction in wholesale inventory. This negative comparison adversely affected our reported volume by over 400 million units or 4.3 percentage points in the quarter. Generally, 400 million full revenue units would have contributed about $34 million in operating profit, which would translate to $0.16 per share, and that would have translated to a level of EPS growth I expect from the business instead of the 1.8% adjusted EPS growth we reported. Absent that inventory comparison, which was primarily a timing issue, our business performance was consistent with the positive trends we saw last year.

If you look at total Lorillard domestic wholesale volume, we reported a 2.5% decline versus year ago. Adjusting for the negative inventory comparison, total Lorillard domestic wholesale volume increased 1.8% versus year ago. Underneath that, the trends were also very consistent with what we had seen. Newport Menthol adjusted shipment volume was up slightly, plus 0.5%, just as before and just as we had expected. Maverick adjusted shipment volume was up double digits, plus 12.5%, just as before and just as we expected. And Newport Red volume was up slightly, just as we expected, now that we have fully lapped the introduction, and we are selling at a higher price.

As retail shipments are unaffected by wholesale inventory reductions, Lorillard's outperformance versus an industry that is estimated to have declined at retail by 2.3% versus year ago in the first quarter once again resulted in significant share gains on all segments of our business.

Lorillard's total market share reached an all-time high of 14.5%, up 40 basis points versus year ago and up 50 basis points sequentially. Total Newport share increased to 12.2%, up 20 basis points versus year ago and up 50 basis points sequentially. Newport Red share was basically stable, up just a little bit. Newport share of total menthol was 36.8%, up 50 basis points versus year ago and up 120 basis points sequentially. And Lorillard's share of total menthol was 40%, up 100 basis points versus year ago and 130 basis points sequentially.

Lorillard had no unusual or incremental trade promotions nor any new products during the quarter to drive these additional share gains. So net-net, absent the inventory change, our strong fundamentals were unchanged and our business model remains solid. Accordingly, we expect going forward that the underlying fundamentals will be reflected in the reported results. We believe that our continued strong fundamentals, traits of the strength of brand Newport and the superior execution of our strategic plan, including the expansion of products and promotions into new geographies and the broadening of our product portfolio in the closed-in adjacencies.

Speaking of pursuing closed-in adjacencies, I'm pleased to announced Lorillard's acquisition of blu ecig. For a relatively modest investment, we believe this acquisition can open up a significant avenue of growth for the company long-term. I'd say this because e-cigarettes is a rapidly expanding segment, which is very early in its development, and blu ecigs is the leading brand and innovator in this segment.

For perspective, e-cigarette revenues are estimated to be significantly higher than the snus and dissolvable market in the U.S. combined. We think e-cigarettes are the perfect adjacency for us to participate in the smokeless market, but in a Lorillard way. That is, e-cigarettes offer many of the benefits of other smokeless products, such as no tobacco smoke or odor, increased convenience and increased value, but do so in a way that is familiar and enjoyed by current adult cigarette smokers who are looking for an alternative. It also gives Lorillard a meaningful seat at the table in the harm reduction debate.

Blu ecigs, in our opinion, has the opportunity to lead the development of this new and highly fragmented category in a responsible manner. Blu ecigs is the leading brand, with the highest brand equity as measured by the Net Promoter Score methodology and has the highest brand awareness, loyalty and consumer public scores among the leading brands in that category. Blu ecigs uses vegetable-based and U.S.-made ingestible ingredients, which gives it another competitive point of difference, an advantage on future regulatory oversight. The list of advantage is quite extensive.

The point is, we believe that through technology that will continue to get better and better, e-cigarettes have the long-term potential of becoming a large segment within the tobacco category, and we firmly believe, based on significant consumer research, that we have purchased the best asset in this emerging category. Furthermore, we believe that blu ecigs will benefit from Lorillard Tobacco's regulatory experience and sales infrastructure, which are needed for it and the category to reach its potential in a responsible manner.

While we expect this acquisition to be accretive and meet our cost of capital, we won't be measuring its success based on short-term financial impact to total Lorillard. I view this more as a meaningful R&D investment to unlock a potentially large, long-term growth opportunity. Likewise, let me reassure you that while we are excited about this investment, we won't let it distract us from our core business. Our plan is for blu ecigs to remain a Charlotte-based stand-alone company that will have access to certain resources of Lorillard. We have confidence in blu's management, who will remain in place.

So in conclusion, we remain confident in our ability to deliver industry-leading fundamentals, execute against our strategic plan, deliver a double-digit total shareholder return this year and over the long-term. And with the acquisition of blu ecigs, the company will have even more growth opportunities going forward.

I'll now turn the call over to David

David H. Taylor

Thanks, Murray, and good morning, everyone. I'll make just a few comments, and then we'll open the line for questions.

Net sales for the first quarter of 2012 declined 6/10 of 1% to $1.526 billion as compared to the first quarter of 2011 as a result of the lower wholesale shipment volume offset by higher average net selling price.

As Murray indicated a moment ago, we saw a modest build in wholesale inventories in last year's first quarter, but a rather significant decline in this year's first quarter. The combination of those wholesale inventory dynamics impacted the quarter-over-quarter comparison by approximately 4.3 percentage points. So after making an adjustment for this wholesale inventory fluctuation, we estimate that our domestic wholesale shipments were up by 1.8% rather than down by 2.5%.

As Murray indicated and as we experienced in the third quarter of last year, the impact of the fluctuations in wholesale inventory levels impact our results in a number of ways. Aside from the obvious unit volume and sales impact, these inventory disruptions also impacted net pricing. Remember that the pattern of consumer promotion buydown programs follow movement at retail, not wholesale. These costs are accounted for as a reduction in sales, so in a quarter like this one, they disproportionately impact the consolidated net price comparison to last year. The actual cost of consumer buydowns was about flat to last year. But because of the decline in our units shipped, they did impact the net price comparison.

Net sales per unit, calculated before excise taxes on a simple consolidated basis, increased 3.1% from last year's first quarter. We estimate that this impact of the trade inventory pattern reduced that net price comparison by almost 1.5 percentage points. In addition, our net price per unit comparison was negatively impacted by the mixed effect of the more rapid volume growth of Maverick when compared to the rest of our portfolio, and the migration of volume that was sold non-promoted on Native American reservations last year to other promoted channels this year.

Adjusted gross profit, adjusted operating income and adjusted net income and earnings per share all exclude the impact of a $7 million charge that arises from a competitor's adjustment to certain elements of the industry volume adjustment offset or profit penalty for prior years. Those adjustments were made in the first quarter of 2012 but related to the 2001 to 2005 years. As you will recall, we made a similar adjustment to our reported earnings last year -- last quarter, although in the opposite direction, when Reynolds American adopted mark-to-market pension accounting and gave Lorillard an unusual benefit from the profit penalty.

Now as a refresher, the provisions of the State Settlement Agreements that govern the amounts due from each of the participating manufacturers are rather complicated. One of those provisions, known as the volume adjustment offset, requires the companies to pay additional amounts if the industry profit pool exceeds certain benchmarks. Lorillard is the only participating manufacturer that currently pays any of this profit penalty. So as a result of a competitor's adjustments for prior year's calculations, the industry profit pool was increased. The impact on Lorillard was an increase in our tobacco settlement expense of approximately $7 million.

I will, therefore, be addressing our results on an adjusted basis. Adjusted gross profit declined by $13 million in the first quarter compared to last year's first quarter, and adjusted gross margins declined from 35.4% of sales last year to 34.7% of sales this year. This margin decline is a result of the lower unit sales volume combined with the increased costs related to the State Settlement Agreements, FDA fees and some increased raw material input costs, primarily tobacco and other direct costs. Gross margin is also impacted by the effect of the inventory fluctuation on net price, as I mentioned before.

Selling, general and administrative costs increased $9 million from last year's first quarter. Increases in legal fees and expenses associated with the Engle litigation activity this quarter accounted for almost all of that increase.

A number of things were at work here to drive this, but foremost among those is that we continue to see a very high level of activity and, therefore, defense costs in the Engle cases, including many newly activated cases in the Federal Court system. We expect that the high cost of defending these Engle cases will vary based on the case activity and trial load. In addition to the legal defense costs, SG&A also included some diligence and other transaction-type costs associated with the blu ecigs acquisition.

First quarter adjusted operating income decreased by $22 million, or 5.2%, to $399 million from $421 million in last year's first quarter. Fully diluted earnings per share on an adjusted basis for the fourth quarter increased 1.8% from last year's first quarter to $1.74 per share. Reported diluted earnings per share declined by $0.01 to $1.70. The lower share count is compared to the year ago quarter added $0.16 per share to EPS for this year's first quarter.

We have completed the $750 million share repurchase program that was authorized last fall, adding repurchased approximately 1.6 million shares during the first quarter. We made our annual payment of $1.1 billion under the State Settlement Agreements in April, with $98 million going into the disputed payment account in a similar fashion to prior years.

Our acquisition of the assets of blu ecigs for $135 million was funded out of available cash. Murray indicated that we would expect this investment to be accretive to EPS as compared to a similar-sized share repurchase over a short period of time. And it will be, likely by 2013. But those metrics are not the way we evaluated this opportunity. This is not a short-term game changer. Rather, we kind of like the game we are in, and we think we're winning it. Instead, this is Lorillard's chance to explore and lead a market segment that has the potential to become something big and has the potential to be an important element of the national harm reduction discussion.

We remain confident in the fundamentals of the business and in our ability to deliver superior results and value to our shareholders. With that, we'd like to open the line for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of David Adelman with Morgan Stanley.

Matthew C. Grainger - Morgan Stanley, Research Division

This is actually Matt Grainger calling in for David. So Murray, when we look at the drivers of results today, there were clearly some elements that you probably were aware of in advance, such as lapping last year's inventory load and the step-up in MSA costs and others like the Engle timing and what happened incrementally with inventories that may have been unexpected. So just taking all those factors into account, did the underlying business really perform up to your internal plan heading into the quarter? And just to address sort of the competitive dynamic, was there any level of competitive pressure that was more significant than you expected?

Murray S. Kessler

I mean, the business performed exactly the way I thought it would perform. And if you look at the last few investor conferences, I said to everybody the way they should think about volume is that our business model is based on Newport Menthol being flat. Sometimes -- some quarters, it's a little bit above that. Some quarters, it's a little bit below that. It performed exactly the way we expect it to. Our Maverick business continue to grow double digits. A big portion of the change, which we obviously expected, was this is the first quarter that we didn't have incremental new product activity because we fully lapped the Newport Non-Menthol business. We had a heck of a quarter in the Menthol segment. We had some of the strongest gains we've seen in the past year or so in the Menthol business, gained a full share point in total Menthol and made strong gains on Newport Menthol, made gains in our core markets and full-flavor menthol. So there were no surprises on the business. See, the only surprise that I had was the inventory, and we just can't predict that. You just don't -- the inventory is a game by the wholesalers trying to improve their inside margins on trying to estimate when they think a price increase is and build some inventory, and they build it and they deload it depending on price increase timing. And they decided to do it differently or -- and we'll see what they'll actually do. But they didn't build inventory in the first quarter. In fact, they tightened up inventories in the first quarter versus building a year ago, and that had a significant impact. For me, the business is -- was unchanged, and there were no surprises. Legal expenses were a little higher than I expected in the first quarter, and that was due to activity and some other transition costs we had going on.

Matthew C. Grainger - Morgan Stanley, Research Division

Okay. And just one question for David. David, can you just walk through the drivers of the increase in per pack MSA cost during the quarter? And I'm thinking about this on an adjusted basis, excluding that $7 million. But even taking that into account, they look to be up around 6% year-on-year. How much of that reflects one-time true-ups during the quarter? Or should we think about that as a sustained level of MSA per pack inflation over the balance of the year?

Murray S. Kessler

Well, some of it was -- is true-ups in the first quarter from prior year billings, but maybe 1/4 of that increased. The rest of it is inflation increase, as well as our forecasted increase in this profit penalty for the entire 2012 year, absent these special things. So we have several things working. We have increased market share, so we get a bigger piece of the fixed portion of MSA. We have the inflation adjustment on the entire pie. And then we have an expected increase in the load that we expect to bear on the profit penalty increase. But about $0.25 or so per thousand is probably the amount due to the adjustments -- the true-ups.

Operator

Our next question comes from the line of Nik Modi with UBS.

Nik Modi - UBS Investment Bank, Research Division

So 2 questions. Just following up on Matthew's question on the competitive environment. So it seems like you didn't really see anything abnormal in the marketplace, because I know that's been a big concern of a lot of folks. That's question number one. The second question is any more clarity on new product launches? What's going on with the FDA? Why it's taking them so long to approve some of these kind of what I would call -- not really breakthrough products in terms of non-menthol, light or what have you?

Murray S. Kessler

Sure. On the competitive activity, I kind of leave that for our competitors because we have a different geographic skew, a different demographic, different geography. And we seem to be and continue to be insulated from that. And I think a good example of that is Maverick, that just clicked right along your double digits while you saw some real big changes in some of the competitive brands in that market that were significant. And the same thing with Newport. We had no major change in trend. And the way I read competitive market, Nik, is despite a lot of new product activity that did exist from our competitors, we had a very robust market share gain with not a penny of additional buydown spending. So we didn't have to adjust programs. We -- the volume clicked along just the way we expected it to. So I won't say there's not increased competitive activity out there, but it certainly didn't affect us. Relative to new product launches, that does affect us. We -- you know we have SE launches. And I've said, SE, substantially equivalent products, in for approval with the FDA. That's taking them a long time. We've been in contact with them. They're communicating with us, and we are anxious for them to approve these. Because as you said, these are relatively minor adjustments. Now I'm encouraged that I think Dr. Dayton gave a speech yesterday. I'm trying to remember where he actually gave the speech, and he was asked directly about the SE process and said it was ramping up and -- but that he expected on an ongoing basis for it to be transparent and expeditious. So we'll hope that will get these approved shortly.

Nik Modi - UBS Investment Bank, Research Division

And Murray, just quickly on that. I mean, let's just say this takes even longer than everyone is thinking. I mean, is there any legal recourse the industry has on this topic?

Murray S. Kessler

I think we're premature to be talking about legal recourse. We have a good dialogue going with the FDA, and we have follow-up conversations that are happening with them. I'm hopeful this will work its way through the normal system here in the near -- if it doesn't, we'll decide what to do next.

Operator

And your next question comes from the line of Judy Hong with Goldman Sachs.

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

Murray, just to clarify, the $0.16 per share that you called out that you -- that was negatively impacted by the inventory reduction. That's only the volume impact, correct? So if -- David talked about the pricing impact. So if you actually adjust for the pricing impact, the impact would've been much greater?

David H. Taylor

Correct.

Murray S. Kessler

That's correct.

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

Okay. And then just -- Murray, just going back to the competitive landscape, and I understand that you've been able to sort of stay under the fray, just given the geographic exposure and segment exposure. But maybe just broadly speaking, it seems like Q1 was an environment where there's a lot of focus on volume at the expense of pricing on behalf of your competitors. And I guess, you sort of see that when you look at price realization at retail. You see that with the industry volume, maybe decline moderating as there's been pretty heavy promotion. So do you sort of characterize this as a maybe a one-off or kind of a temporary situation where everyone's tactically trying to get some volume? Or is this something that you think, potentially, could be concerning just in terms of the longevity of this promotional environment? And to what extent, if it does get prolonged, it sort of impacts your pricing and promotional strategy?

Murray S. Kessler

Yes. Look, Judy, I think we sit in a strange place here at Lorillard, it didn't feel that terribly unusual to us in the first quarter. There were some new products -- there are always new products being launched at discount prices. There were some adjustments in contract programs. There's always adjustments in contract programs. So there was nothing that -- and you would have to ask those direct questions on those competitors. As it relates to us, there was nothing that struck us as we needed to -- we need to adjust our plans going forward or do something significantly other than a minor adjustment that we made in select markets on Newport Non-Menthol. In some locations where it was a little bit more competitive and we're not a price leader, we're a price follower, so we just stayed competitive and that wasn't broad scale. So I don't see these affecting our plans or the way I think about this business. I mean, if this inventory adjustment didn't happen, we would've had great EPS results, good solid volume. And to Nik's point, at some point, when these SEs start to get approved, then we can continue on our adjacency expansion plans and we can put up some bigger numbers.

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

Okay. And then just on Newport Reds, Murray, just your thoughts in kind of where you stand with the brand? Just balancing kind of share and profit for that brand at this point and...

Murray S. Kessler

I'm very happy with Newport Non-Menthol, because that does play in markets where it's more competitive. And our share has been stable. It's -- our net sales were up north of 20% on Newport Non-Menthol. Our profitability was way up. We are promoting a little bit more. But -- we didn't in the first quarter, but we've announced some modest changes in some select markets, as I said. And the volume is building on it now, which is great. Coming out of the winter, this is the time of year you'd start to like to see your weekly numbers building and the weekly numbers are building, which says to me that this is the brand that's going to be around and -- for a long time and continue to grow. And again, not to beat a dead horse on it, but as the opportunities for filling out that line comes through SE approvals with the FDA, I think we'll continue to make solid gains in the non-menthol market.

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

Okay. And then finally, Dave, just going back to the SG&A expenses. So if I look at fourth quarter, you had $108 million, and then it stepped up to $131 million in Q1 this year. I know in Q1 2011, you also had elevated expenses. So it just seems like SG&A expenses are pretty lumpy and, whether it's coincidence or not, very skewed to Q1. So if you can just give us a little bit more clarity in terms of the step-up between fourth quarter 2011 to Q1 2012? And then, is this sort of 30-million level kind of the run rate that we should be thinking about for the balance of the year per quarter?

David H. Taylor

Okay. Sure, there's a lot of elements to that. Yes, we did have an increase in SG&A in last year's first quarter. And we told you at that point in time that it was also due to heightened trial activity in Florida around these Engle cases and more legal defense costs. And again, in this quarter, the same major driver was increases in legal fees and the like, which drove SG&A up. Now those things are a bit unpredictable, and they're going to be based on the trial calendar, as I said before. Now this first quarter is a little bit different than both the fourth quarter of 2011 and the first quarter last year, and that is that we are transitioning major law firms. We have reached the conclusion that we needed to change our lead defense firm from one major litigation defense firm to another, and we've been involved in this transition from one firm to the next during the first quarter of 2011. And with that transition, that's a big deal for us and it's a big deal for them. And with it comes the inevitable redundancies and inefficiencies associated with transitioning a lot of those files and a lot of that expertise. We would expect that pressure to abate moving forward. And so we won't see the same level of upward pressure on legal fees from that element. But again, I need to say that it's primarily going to be variable based on the case activity and trial load. Now there are other things that go into SG&A too. I said a little while ago that we had a little bit of fees and expenses associated with the diligence and transaction costs on the blu ecigs acquisition, and there are other increases and decreases in various different pieces of the SG&A compared to last year's first quarter. But the biggest single element would be this -- the legal fees.

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

Okay. And is there any way you can quantify if you were to make a full transition in terms of the law firm?

David H. Taylor

We will make a full transition, and that should be complete during the second quarter of 2012. And you'll see, I will not quantify the amount that legal fees will be reduced specifically as a result of that transition. But that element of the upward pressure will go away. But that's not a huge -- I would guess that that's not going to be a major element of it moving forward.

Operator

And your next question comes from the line of Vivien Azer with Citi.

Vivien Azer - Citigroup Inc, Research Division

My first question has to do with kind of external expectations and kind of how we should think about things going forward. I fully appreciate that the results came in, in line with your expectations, netting out kind of one-time items and anniversary-ing certain issues. But I think -- from the top line, I think there was a negative surprise in terms of the market share because of the Native American cigarette volume that's now flowing in the C-store that we weren't seeing before. So as we think ahead, is there a framework that you can provide for us to better kind of dissect the C-store data and better manage expectations in terms of your market share and volumes for that -- for rest of the year, please?

David H. Taylor

Yes. Our C-store market share might have been higher. We don't buy the scanner data that you guys buy, and that's because a lot of our volume isn't sold in those scanner-based C-stores. We're in much more urban centers. So if you look at those numbers all year long last year, we never got close to those kind of volume growth numbers and share numbers that were reported in C-stores. And even if Native American, some -- the effect and you're right, that would boost that. But we measured -- just to be clear, our database, called EXCEL, measures shipments from wholesale to retail. So in any given quarter, if a new product -- and there were in this quarter, if a new product is shipped in by a competitor or buy us from wholesale to retail, that's going to affect those numbers, whether one consumer buys a pack of cigarettes of that new product or not. So there's some of that effect. But in general, over the long term, it's been a consistent measure for us that captures a lot of volume that is not captured in those C-store, IRI and other kinds of scanner-type numbers. I got to tell you, Vivien, I don't like the inventory situation. I'm not happy about it. But I am delighted that without a new product in place for us to gain a full share point in menthol, to gain a half to share point overall, to continue to make Newport share gains, we had a great quarter on market share and without spending another dollar of promotion. So I feel super about that part of it. As far as expectations go going forward, I will repeat what I said in public conferences. I expect that -- and the Newport model is built on Newport Menthol being basically flat, Maverick having low double-digit growth. Right now, on Newport Non-Menthol, now that we've lapped it and have more emphasis on pricing, good net sales growth but basically flattish volume and share right now. And that accelerated growth would then, therefore, come when you hear us announce an additional adjacency expansion initiative. So that's what I'd model if I was you.

Vivien Azer - Citigroup Inc, Research Division

Understood, and I fully agree on the market share gains. They are really good. As you think about kind of the rest of the year from an earnings growth kind of cadence perspective, I know you guys don't like to give specific guidance, but is there anything that you want to highlight just in terms of earnings growth over the next 3 quarters that we should be watching out for from a comparison issue?

Murray S. Kessler

Can you repeat the question one more time?

Vivien Azer - Citigroup Inc, Research Division

Sure. As I look at kind of the earnings growth expectations for the next 3 quarters, there's some lumpiness there. And I just wonder if you guys wanted to highlight anything that would present a comparability issue that might come as a surprise to us.

Murray S. Kessler

Well, the -- look, I expect that the underlying results will show up in reported results. I said that in my comments. We don't give earnings guidance, so I don't give a specific number other than to say that I continue and still expect a double-digit total shareholder return, and I expect it this year. And we have not changed our internal forecast for the year. We view the inventory as primarily timing. And now that the surprises that are going to hit you, because they hit us too, is that inventory issue. It plays out depending on when and if the industry takes pricing and -- but you're always going to have sort of an estimate or guess by wholesalers in advance. And then they're going to reduce those inventories again after any kind of pricing action by the industry. And then you have to sort of look at what happened last year, because we always give you these inventory adjustment numbers, and if it happens during a quarter. So let's take last year, third quarter. There was a meaningful reduction in inventory in the third quarter. Well, that was because there was a -- day one of the quarter, there was a price increase. And so for the next few months, they deloaded their wholesale inventories. Again, this has nothing to do with us. This is them. Depending on timing, you know it'll go up and down accordingly, and you have to try to anticipate that in your estimates. But we haven't taken down our annual estimate of our volume based on changes in inventory. We just see those as fluctuations within the year.

Operator

And our next question comes from the line of Thilo Wrede with Jefferies.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Murray, one more question about the inventory shift. Do you expect this $0.16, as you called out in the beginning, do you expect those to come back during the rest of the year?

Murray S. Kessler

That's a hard question to answer. Relative to -- I can't speak to relative to your estimates. But like I said, we haven't changed our estimates for -- we have our internal budgets, et cetera. So I think that, that was primarily timing, yes.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Okay. And then maybe 2 quick questions on the acquisition. Why are e-cigarettes better way for Lorillard to play in smokeless than what would be more of conventional smokeless product like dip?

Murray S. Kessler

Well, I got a lot of experience in this. And we've done a lot of work on this relative to a consumer standpoint. In a traditional dip product, I think that game's been played out pretty well with the acquisitions by our competitors and an organic of a traditional moist smokeless product, that I think the Newport name brings nothing to the party. And that's been done. Relative to snus, I'm sorry I've never been a believer. I've -- and I've said that for 10 years or so. The e-cigarette market is estimated by the Wall Street Journal as an example of somewhere between $200 million and $500 million, and it's just getting started and it's doubling every year. If you go to the NAC's Convention or you talk to retailers or wholesalers, it's showing up in more retail locations than it's selling. I like it because you get all the benefits of not having combustion, but on the other hand, you're maintaining the behavior that cigarette smokers enjoy. And you ultimately are going to make any of these alternate -- cigarette alternatives work is going to be based on enjoyment. And the challenge was always trying to get -- in my old job, get cigarette smokers to do something that's very foreign to them, where here, they're doing something that's exciting. And what I love about blu ecigs is that they don't market it on any kind of health claims or cessation claims. They market it on enjoyment and convenience and value. And it's just a -- it's a terrific brand that's already creating super equity. So I think because of the familiarity of this, this thing could be, down the line, could be quite significant. And the technology will get better, too. I mean, we're just starting. I don't think it's anywhere near as good as it can be.

Thilo Wrede - Jefferies & Company, Inc., Research Division

Could there be a Newport branded e-cigarette?

Murray S. Kessler

Could there eventually be? I guess, it's -- anything's possible. But when we study this, we think there's much more power now on building a brand with its own identity, and blu is a stronger name. So blu is the horse we're -- blu ecigs is the horse we're going to ride with this. And if there was ever a Newport down the line, I wouldn't want to cut our potential into converting smokers down to just Newport smokers. We want this to appeal to all cigarette brand, existing consumers. And I think blu ecigs and what the management team has done down at Charlotte is terrific. So we'll build that brand as our way to go for now.

Thilo Wrede - Jefferies & Company, Inc., Research Division

And how would you characterize the user profile of a blu ecig user?

Murray S. Kessler

I would characterize, from what I've seen and all the testing that we've done, that it is existing adult smokers who have converted. And that they tend to be slightly older than sort of the average cigarette smoker. Not -- sort of late 20s, early 30s.

Operator

And your next question comes from the line of Chris Growe with Stifel, Nicolaus.

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

Let me ask you a question, and I'm sorry this is inventory question. But the question I have was, do you regard the inventory levels today for your business to be low or an unusually low level? And then have you seen those increasing already in the second quarter? I've heard that, but I wanted to see what you're seeing in your business.

Murray S. Kessler

Well, I would say Q1, for sure, it was -- we came out of Q1 low. So last year -- we came into the Q1 of this year and Q1 of last year at basically the same inventory level. Last year, inventories built, right? And they -- so they increased from there. This year, they actually decreased. And more of the comparative change was a reduction this year than the increase last year, if you're following me. So yes, let's say, they were low. So presumably, they'll build, but I can't comment on second quarter right now.

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

Okay. And then I want to ask in relation to the promotional activity behind the Newport brand, be it Menthol or Red, or I should say combined, was that promotional spending down in the quarter? And would that have been driven by Red, if that is the case?

Murray S. Kessler

No. There was no changes to either plan for either brand in the first quarter. And it was basically flat.

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

Okay, got you. And then I just want to get a quick update on the expansion markets. Any change there? Or -- just how you're seeing the Newport brand perform in those markets where you've expanded, how does it compare to the first 4 or 6 markets?

Murray S. Kessler

Yes, let me correct myself on the last statement. Newport Red, from -- we reduced the off invoice versus last year. That's how we executed the price increase. So Newport Red promotional spending was down in the first quarter versus year ago, but it shows up as a retail price. The expansion markets are going terrific. They continue as we roll out to get the same results. I'm delighted now that we're in some of these initial couple of markets. We're now going into -- we fully lapped 4 of the markets, and we're into -- well into year 2 and beyond in some of those markets. So -- and they're continuing to grow. The difference now between the trajectory they were on versus where they'd be now, that is going to be 30, 40 percentage points. It's significant. So those markets are doing great.

Operator

Your next question comes from the line of Andrew Kieley.

Andrew Kieley - Deutsche Bank AG, Research Division

Murray, I wondered if you could talk about the Newport market share increase this quarter. Can you just talk about the interplay between Newport Red and Green behind that market share increase at the retail level?

Murray S. Kessler

Yes, on market share? Market share Newport Red was flat. Newport Menthol grew, Maverick grew, should drive total Lorillard. And I think about half the gain was Newport -- I reported numbers on Newport Menthol. I don't have it right in front of me, but I think we gained 0.5 overall, and it was half Newport Menthol and half Maverick.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And then just -- I was wondering if you could just make a general comment on the state of the sort of Newport Menthol consumer in the core eastern -- East Coast markets. Are you seeing the spending patterns improve at all? Do you feel the brand is acquiring more promotion or just any sort of inflection you're seeing at the consumer level?

Murray S. Kessler

The one measure that I like to use, which I showed as part of the -- when I announced our strategic plan is this notion of -- that our core, which provides the stability in the business, is how our market share is and the category is in full-flavor menthol in our core market. And we gained a share point in full-flavor menthol in our core markets this quarter. The only thing that has a negative drag on right now is New York, where, 9 months ago, you had the law changed and Native American reservations were shut down. And for us, that was a big piece of volume that is now moving out of stores, out of reservations and going into normal convenience stores. But in effect, that was -- Native Americans were somewhere around 4% of our volume. And on 4% of your volume, the effect of that was a tax increase, right? Because they used to be able to buy the products untaxed. And now when you're buying in New York or neighboring areas, it's anywhere from $2 to $4 tax increase. And the good news is while it had a negative drag on our buydown spending because they go into stores where there are promotions today, we didn't feel much of -- the volume got made up for the most part elsewhere. But I am encouraged, and we haven't talked much about it. We only got one more quarter to go on that overlap. So back to another question that was asked earlier, some of the things that could happen in the second half of the year, you're going to have that negative drag of promotional spending go away -- additional promotional spending go away in the second half, starting the third quarter, and any volume we might have lost from that significant impact will have also lapped in the second half -- or lapped it in the second quarter, and it'll have a positive -- or remove the negative in the second half.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And I just wanted to ask a follow-up on the acquisition. Understanding that's a good growth category, but should we expect a -- any kind of significant EBITDA margin depression to youth, to the overall company for the rest of the year because of the acquisition?

Murray S. Kessler

I think the numbers are pretty immaterial to our total numbers overall. I mean, revenues for this company are around $50 million. Operating profit is immaterial at this point. And we'll have normal transition costs, and it's still in an investment mode. The margins on it -- the gross margins on it are quite good. We'll get an opportunity in the future as we get our hands around the business to share with you how we view it going forward. But right now, it's not going to move the needle.

Andrew Kieley - Deutsche Bank AG, Research Division

Is the state of regulation, either at the FDA or the state level, is that a concern? Or how do you think that plays out? Because I think as of now, these products are fairly loosely regulated, I guess.

Murray S. Kessler

Well, I think that's why we believe it was important for us to get in now because there is a huge disparity in sort of the way the different brands market the way the products are. I mean, I gave some examples, but we -- the brand that we have has a vegetable-based glycol as the key ingredient or is made -- the juice that goes in it, the smoke juice that's made in the U.S. A lot are made in China, that worries regulators. So we think, with our regulatory expertise and we welcome partnering with the FDA on this opportunity, that we can help guide those regulations going forward, because I think it has gotten to the scale that it's going to create attention. And we don't want that regulation to go the wrong way because there's no one leading the way on it. And we're in the position to do that.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And just finally for David. I was wondering, when you look at the balance sheet, should we expect any further leverage added to the balance sheet this year to -- behind the dividend and share repurchase? Or is this a year where the company would stick more to just paying out close to 100% of the free cash flow? You've spoken a little bit in the past about the view of credit agencies. I just wanted to understand how you're thinking about that now.

David H. Taylor

Well, our view really hasn't changed from the way I've explained that before, and that is that we want to protect that investment grade rating. And should the rating agencies view the menthol issue with the FDA to be less of an issue in their minds, I believe that we have an opportunity to increase leverage and still protect those investment grade ratings. But that is not the case yet. I imagine that once this menthol report is finally released from the FDA and we can sort through what that says and what it doesn't say, it'll give us a basis to have a furthermore meaningful dialogue with the rating agencies to really test that. But as of now, I don't see our way clear to changing that leverage ratio in the short term without that clarity.

Operator

Our next question comes from Ann Gurkin with Davenport.

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

Just have 2 questions left. One, you commented on higher raw material costs in the quarter. How should we think about these costs as the year unfolds?

David H. Taylor

Well, some of the raw material costs, primarily tobacco, we've seen some upward pressure. That probably impacted the quarter's cost of sales in the $5 million neighborhood. We've seen mid-single-digit upward price pressure on our tobacco input cost, and that's going to remain moving forward because of the way we buy tobacco. We buy it and store it for 2 years and use it. So those kinds of increases in tobacco cost will remain with us through 2012.

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

Okay, that's helpful. And then secondly, should we expect another share repurchase program? Can you update us on that?

David H. Taylor

I can't really comment on whether we will have another share repurchase program, but as I've said before, we intend to stick to the 70%, 75% dividend payout ratio. And if there's not another significant use of cash available to us, then we would expect to use that remaining 25% to 30% to fund share repurchases. That's what we would expect. But exactly when that might occur, I can't give you any guidance.

Murray S. Kessler

Yes, and I think -- don't take the acquisition of blu as a -- some kind of change towards a acquisition strategy. It's not. This is a very strategic opportunity for the company that took a relatively modest investment. We -- our priority is and remains returning cash to shareholders.

Operator

And our next question comes from Chris Ferrara with Bank of America.

Christopher Ferrara - BofA Merrill Lynch, Research Division

Guys, I guess, is there any near-term reasons you can speak to as to why inventory levels might have been taken down so low? And I guess, as a follow-up to that, is there anything at all on a secular basis that would make you think there's a change in how inventory's managed in the trade?

Murray S. Kessler

Well, your -- you want me to speculate on why wholesalers might have tightened it up? I think there's pressure on margins from wholesalers and retailers from the economy. I think there's pressure on it from changes in contract programs from our competitors. There's a lot of demands on them, like there is on every business. But it's -- we've seen these kind of ebbs and flows before. In general, this is not an industry, given the very accelerated terms that exist in terms of 0 days, et cetera, where they hold a lot of inventory anyway. So they need to have sufficient amounts of inventory to be able to service the business. So this is not something that's going to continue to work its way down and get tougher and tougher. I won't say that there couldn't be a couple of hundred-million-unit adjustment at a year end or anything like that, but nothing of significance. I think they're facing the same pressure that all businesses are facing, and they tightened it up some in the first quarter. But I wouldn't necessarily expect that to continue.

Christopher Ferrara - BofA Merrill Lynch, Research Division

So nothing new relative to what we've seen in the past, in your view?

Murray S. Kessler

No, not in my opinion.

Christopher Ferrara - BofA Merrill Lynch, Research Division

Yes, okay. And then sorry to ask you a tired question, but what do you make of the protracted delay? I understand your position on FDA and their view on menthol, but what do you make of the protracted delay specifically?

Murray S. Kessler

What I make of it is that, I think that they're a organization that is still relatively new, that has had a number of -- a lot that they had to get done in the first year, 2 years by congressional mandate, and that they were ramping up with staff and with -- and had to get menthol reports out, dissolvable reports out, SEs and other rules and that they've been swamped. And that they had to manage through all that. And I think you add to that, that they have to put in the process for approving these and that, that process, once they approve the first one, then that becomes the guideline that all future ones are approved. So I think that's what slowed them down. And pretty much the Director of Center for Tobacco Products had said that, and has said that they expect for this to be a transparent and expeditious process. But it's -- I think it's start-up, honestly. If we think it's something -- I don't think you can read into it anything other than that. And again, they are communicating. And we look forward to them getting results because it is supposed to be by -- the bill itself suggests, but doesn't mandate, a 90-day process so -- for SEs. And it's obviously taking them longer than that. So we're hopeful that they get going.

Christopher Ferrara - BofA Merrill Lynch, Research Division

Right. And on the menthol piece of it, does it -- does the protracted delay at all change your view of what you think? I mean, I know you have -- you seem to have a great deal of confidence in what you think the outcome will be. But does the protracted delay kind of make you feel that that's more supported or does it really have any impact on how you view it?

Murray S. Kessler

It doesn't have an impact on how I view menthol. I think they're entirely different situations. I think the SEs, they had -- remember they had thousands of SEs that were from June -- from the 2007 to the March 2010 period of time that -- March 2011 period of time where you had to basically submit SEs for everything, for almost every single product on the marketplace because they had gone through some change over that past 3 years. I think that's one pile. I think then there's a second which are new SEs. And I know, I don't think, that they've separated those 2 processes, which is good, and they have to work through those and get the process in place for those as well. As it relates to the menthol report, we know what you know, which is they put out a brief statement a few months ago that said that the peer review is in, they were processing it and it'll be out when they're ready. And we remain optimistic, as long as the peer reviewers were truly objective, that there's no other conclusion to come to other than that the times doesn't support disproportionate regulation on menthol. And nothing -- and the only thing that's happening -- that happened in the first quarter make us feel stronger in that conviction. You had a Surgeon General issue a 900-page report on sort of youth usage of cigarettes. And in that, it looked at initiation in menthol and came to the conclusion that it needs to be studied further. You had a report come out of staff member of the FDA himself that looked at the science relative to lung cancer and came out to the conclusion that if anything, that lung cancer rates are lower among menthol smokers. And we're not saying that. I'm just repeating what the study said, but it certainly doesn't support additional regulation on menthol. And despite what sort of happened with the pushback from the WTO appeals panel, the Department of Justice put together a very strong argument that clove and menthol cigarettes are very different because any kind of change you would make to menthol cigarettes would have huge black market and contraband impact, which are also mandated to consider. And you have a government agency that is acknowledging it as part of their evaluation in menthol. So yes, we feel that the evidence is firmly, and the science is firmly on the company's side that all cigarettes are dangerous, but a menthol cigarette is no more dangerous to the public health than a non-menthol cigarette.

Operator

Our next question comes from the line of Erik Bloomquist with Berenberg Bank.

Erik A. Bloomquist - Berenberg Bank, Research Division

I just wanted to follow up on the blu cig acquisition and, specifically, on Lorillard's ambitions for the regulatory environment. You'd mentioned one of the things that was attractive was that it isn't making any relative risk claims. But do you see that as something that becomes possible down the road? And what do you see as the key hurdles to developing the e-cigarette category in the United States?

Murray S. Kessler

Okay. Well, the e-cigarette category is rapidly growing in the United States. In our opinion, e-cigarettes offer a significant harm reduction opportunity. We will partner with the FDA to try to validate and prove that, so ultimately, claims could be supported in a responsible manner. But look, the fact of the matter is there's no combustion, right? So there's nicotine in a liquid base and there's no smoke. There's vapor. So there clearly is an opportunity for this product, and we will pursue that, but we will pursue it responsibly to the extent that you eventually can convince those in the public health community that perhaps the quit-or-die strategy of the past 50 years that has had limited success could have much more success if they were to pursue a harm reduction strategy. And I believe that for e-cigarettes, I believe that for smokeless, for dip, I believe that for snus, I believe that for all these products. That needs to be the wave of the future.

Operator

Our next question comes from the line of David Adelman from Morgan Stanley.

David J. Adelman - Morgan Stanley, Research Division

Murray, so just one quick follow-up on the outcome of the WTO dispute settlements on cloves. Question is do you have a sense of how actionable or binding this type of ruling might be on the U.S. government? Any -- based on your understanding of how these disputes typically work, do you have any view on how the government might try and resolve this outside of actually amending the legislation, which, to be honest, I would consider unlikely?

Murray S. Kessler

Look, the first and foremost, I think it's not going to have any influence on the FDA and how it evaluates menthol. I mean, there's like 2 or 3 options they could do. But -- and they could trade other areas. They could give concessions in other areas to offset this. I think the important thing is we don't believe that this ruling is going to affect the menthol evaluation.

Operator

And there are no further questions. I would like to turn the call back over to Mr. Kessler for any concluding remarks.

Murray S. Kessler

Well, thank you for your interest in Lorillard. The company's fundamentals remain solid. Personally, I'd like to put bigger numbers in this, but I will just say once again, I don't feel like that sort of the inventory effect had any impact on what's really happening and how consumers are buying cigarettes. All the initiatives we have in place remain strong. I feel great about those. I feel great about the blu ecigs acquisition, and we look forward to our reported results reflecting the underlying fundamentals going forward. Thank you for your support and attention on the call.

Operator

This concludes the Lorillard Inc. First Quarter 2012 Earnings Conference Call. For replay of this call, please dial (855) 859-2060. You may now disconnect.

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