Reynolds American, Inc. Q4 2007 Earnings Call Transcript

Reynolds American Inc. (RAI)

Q4 FY07 Earnings Call

February 07, 2008, 9:30 AM ET

Executives

Morris Moore - VP of IR

Susan M. Ivey - Chairman, President and CEO

Thomas R. Adams - EVP and CFO

Analysts

Erik Bloomquist - J.P. Morgan

Judy Hong - Goldman Sachs

Filippe Goossens - Credit Suisse

David Adelman - Morgan Stanley

Christine Farkas - Merrill Lynch

Erik Bloomquist - J.P. Morgan

Marc Greenberg - Deutsche Bank

Ann Gurkin - Davenport

Presentation

Operator

Good day ladies and gentlemen and welcome to the fourth quarter, full-year 2007 earnings conference call hosted by Reynolds American Inc. At this time, 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, today’s call is being recorded.

I would now like to introduce your host for today's conference call, Mr. Morris Moore, Vice President of Investor Relations. Please go ahead.

Morris Moore - Vice President of Investor Relations

Good morning and thank you for joining us. This morning, we'll discuss Reynolds American's fourth quarter and full-year 2007 results. We'll also provide our outlook for 2008. 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 is on our website at reynoldsamerican.com.

Joining me this morning are the Reynolds American's, Chairman and CEO, Susan Ivey and RAI's Chief Financial Officer, Tom Adams.

Before I turn the call over to Susan, 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 the actual results to be materially different from our projections. These 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 Chairman and CEO, Susan Ivey.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Good morning. As you saw in this morning's release, 2007 marked another strong year for Reynolds American. R.J. Reynolds continued to build financial and marketplace strength. Conwood again delivered double-digit volume and earnings gains. And Santa Fe and Global Products, both expanded their reach and strengthened their platform for future growth.

The solid results that our companies continue to deliver confirm the strength of our business model and the strategic framework that is driving RAI's success, and their performance continues to enhance Reynolds American's position as the innovative tobacco company that is totally committed to responsible growth.

Why are we so focused on innovation? We believe that over the long term there will be significant change in the tobacco category. We're seeing it today. Increasing social pressures and smoking restrictions are accelerating the growth of the smokeless tobacco category and creating desires for new products that make tobacco use more convenient, more acceptable, and more discreet.

The Reynolds American's family of companies is at the forefront in recognizing and pursuing the many opportunities that these shifting dynamics create. How? By continuing to introduce product innovations that meet the emerging preferences of today's' adult smokers, like new styles from Camel and Kool and Santa Fe's portfolio of super premium brands.

By recognizing and continuing to lead the shift to smokeless and new types of smoke free alternatives with products like Grizzly pouch and Camel Snus, as well as other new products that will expand the opportunities for adults to enjoy tobacco. And by focusing not just on profitable growth, but also on responsible sustainable growth. Growth that factors in the perspectives of all over stakeholders from consumers to critics to our partners in the trade.

For the past three years, our results have confirmed that our strategic initiatives are delivering value, while we continue to build strength throughout the Reynolds American family. For example, in 2007, RAI's consolidated margins of 26% were up almost 2 points from the prior year. Adjusted earnings rose more than 12% and we increased our dividend by more than 13%. Our dividend yield continues to exceed 5%, keeping at the highest in our industry and among the highest of the S&P 500.

How are we driving these results? By being champions of change in the way our company has engage consumers and monitor emerging trends, in the way we listen and try to address our critics' deepest concern, and in our core commitment to create more pleasurable and acceptable ways for adults to enjoy tobacco.

We're making great progress on all these fronts. For example, in 2007, we expanded and enhanced our Corporate Social Responsibility program. CSR is an integral part of Reynolds American’s efforts to deliver sustainable responsible growth. And R.J. Reynolds' intense focus on innovation and efficiency is another important element in long-term profitable growth.

Successful innovations, like Camel No. 9, Camel Signature, and Kool XL, demonstrate the power of consumer engagement, and they're helping R.J. Reynolds continue to build marketplace strength. R.J. Reynolds listens to consumers and gives them a voice in designing the products that they want. This creates ownership in R.J. Reynolds' brands and it drives continuing gains in total growth brand share.

Last year, the combined share of R.J. Reynolds three growth brands, Camel, Kool and Pall Mall, reached 13%, up 0.6 points from the prior-year. Kool was stable, while Camel and Pall Mall continued to grow. And innovations are expanding Camel's appeal beyond cigarettes with high potential products like Camels Snus. This smoke free product was in eight test markets last year, and will expand the major metro markets across the country in the next few months.

The Camel Snus test is providing R.J. Reynolds with valuable learning on how to best educate consumers about the Snus category, which offers a convenient and discreet way for adults to enjoy tobacco. Another innovation is Look XL, a wider smoother menthol cigarette. It was expanded nationally in 2007 along with a new milder style called XL Blue.

Kool XL is enhancing the brand’s appeal among younger adult smokers. And these new styles helped Kool maintain its market share in 2007, despite intense competition in the menthol category and above average price increases. This year, the company is further strengthening Kool, geographically targeting high opportunity markets.

The company's third growth brand, Pall Mall, continued to gain share on the strength of its positioning as a longer lasting cigarette at a great price. Last year, the brand increased its visibility and appeal with the introduction of Pall Mall Ultra Lights in a distinctive orange pack. R.J. Reynolds' total share of market in 2007 was 29%, down 0.7 points. That decline was somewhat greater than the prior year as the company continued to optimize the balance between profit growth and share gain.

In keeping with R.J. Reynolds' brand strategy, about half of last year's share declines came from private label and other lower margin non-support brands. R.J. Reynolds has aggressively raised prices on these brands and that has accelerated their decline. The company's focus is on increasing volume, share, and margins on its more profitable growth brands. R.J. Reynolds ultimate goal is a return to total share growth and to achieve that without sacrificing profit for short-term share gain.

Now, let's take a look at industry volume trends. Last year cigarette shipment volumes declined by about 5% compared with a typical rate of 2% to 4%. Industry consumption was down about 4%. This decline was driven by a number of factors, including price increases, higher state excise taxes, and shifts in trade inventory levels. R.J. Reynolds' volume and consumption declined about 1% more than the industry’s. However, as with share, these losses were disproportionately skewed to private label and other lower margin non-support brands. As a result, despite a 6% decline in shipments, R.J. Reynolds continued to post strong margin and earnings growth. And the company has positioned for additional gains in 2008.

Now, let's look at Conwood. 2007 was Conwood's first full year as a member of the Reynolds American family, and we continue to be exceptionally pleased with the company's performance and potential. Last year, Conwood again delivered double-digit volume and profit growth, as well as excellent margins.

Conwood's full-year profits climbed more than 13% on higher pricing and volume and the strength of its Grizzly brand, which leads the category growth. Last year, the moist snuff category grew more than 7% and we believe it will continue to deliver strong volume growth this year as preferences in the tobacco category continue to shift.

In 2007, Grizzly captured more than 40% of total category growth. With 21% of the moist snuff market, Grizzly continues to develop new products to satisfy shifting consumer preferences, great examples of the test markets of Grizzly's new pouch and snuff products. Pouches are a rapidly growing style. It now represents more than 6% of total moist snuff sales. They offer a more convenient way for adults to enjoy moist snuff.

Grizzly Wintergreen Pouch, the brand's first pouch product, was launched in three test markets late last year. It's been a big success. Conwood plans to expand this new Grizzly style nationally over the course of this year. Grizzly Snuff and natural flavored fine cut product competes in a category that represents about 25% of all moist snuff sale. Grizzly Snuff was designed to go head-to-head with the industry's leading premium brand. And that test market results were outstanding. Grizzly Snuff will be available nationally in the second quarter.

In 2007, Conwood's premium Kodiak brand experienced volume and share declines in the face of heavy competition. Conwood is engaged in a variety of efforts to make Kodiak more competitive and the company continues to evaluate other premium options. Conwood share of shipments in 2007 was up almost a full share point to 26%. Given the company's strong volume and earnings results, 2007 was another outstanding year for Conwood. And before I turn the call over to Tom, I'd like to provide a quick update on the external environment.

Last year, there were lots of headlines about proposed tax increases and increased regulations on both the state and federal levels. But, by the end of the year, many of those initiatives were defeated or postponed and there were not dramatic changes on the external front. Ongoing efforts by Congress to raise federal tobacco taxes and pass FDA legislation run successful.

We don't anticipate any significant action on either of those issues in 2008. But, we are well aware that they're not going away. At the state level, there were 23 excise tax proposals in 2007 and 15 of them were defeated. We were especially pleased that voters defeated the tax ballot initiatives in Oregon. Last year's state tax increases were in line with our expectations and we believe that this year presents a similar level of challenge.

As you are aware, the litigation environment remained relatively stable in 2007. R.J. Reynolds latest tally for the Engle Progeny Cases is about 920 cases, with about 4,500 plaintiffs. However we believe the number of plaintiffs could reach about 7,500. The company continues to have strong defenses and they are confident in their ability to defend these cases.

Turning to the NPM adjustment. As you know, there has been an ongoing dispute concerning the credit on MSA payments arising from the NPM adjustment. R.J. Reynolds has paid $1.2 billion into the disputed account and that amount could increase in April when the next MSA payment is due. The company continues to seek resolution of this dispute and we are disappointed that it is not yet resolved. R.J. Reynolds will continue to rigorously pursue the amounts due to them under the terms of the MSA. So, that is a quick review of the external environment.

Looking back on everything that RAI accomplished last year, I think it's clear that 2007 was another year of innovation and growth. I'm proud of our performance and the results that all of our companies delivered as we continued to strengthen our platform for sustainable success.

And now Tom will provide more detail on our financial performance and our outlook for 2008. Tom?

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

Thanks, Susan and good morning, everyone. As you can see from our full-year results, 2007 was another year of strong accomplishments for Reynolds American, with double-digit earnings growth on an adjusted basis. On this basis, both of our reportable segments increased margins and profits and all of our companies strengthened their financial and marketplace position.

This morning, I'll focus on adjusted results since they provide a good perspective on our underlying business performance. A reconciliation of our adjusted to reported results is in our press release, which is on our website.

Let's start with RAI's consolidated results. During the fourth quarter, Reynolds American's adjusted EPS was $1.15, up 42% from the prior-year quarter. That increase reflected a favorable comparison to the fourth quarter of 2006, which was negatively impacted by trade inventory reductions and the timing of promotional expenses. For the full year, reported EPS of $4.43 was up 8%. That included a fourth quarter non-cash pretax charge of $65 million for trademark impairments on some non-focused brands.

For the full-year, RAI's adjusted EPS of $4.57 was up 12.6%, as higher pricing, moist snuff volumes, and productivity more than offset lower cigarette volumes and higher settlement expense. Results also reflect a full-year inclusion of Conwood and that company's continued pricing and volume growth. So, that's a quick look at RAI's 2007 results.

Now, let's take a look at R.J. Reynolds. R.J. Reynolds' full-year adjusted operating income of $1.97 billion was up 8.8% as higher pricing, productivity, and pension favorability more than offset the effect of lower volumes and higher settlement expense.

Fourth quarter adjusted operating income was $486 million. That was up 39.7% from the prior-year period despite a volume decline of 8.6%. Contributing to that decline was a reduction in trade inventory levels late in the fourth quarter. R.J. Reynolds' strong increase in fourth quarter earnings was the result of higher pricing and a favorable comparison I've already discussed.

Full-year 2007 volume was down 6%. As Susan explained, a large part of that decline came from losses on private label and other low-margin non-support brands. The company's full-year price mix improved almost a full point to 62.4%. That mix improvement, coupled with higher pricing and productivity savings, helped drive R.J. Reynolds' adjusted operating margins to 24.8%, up 1.3 percentage points from the prior year. R.J. Reynolds' delivered its productivity savings for 2007 and the company remains on track to achieve its longer-term savings goal.

However, these productivity improvements are now an integral part of the company's operations. Going forward, productivity savings will be integrated into overall goals and will not be separately quantified. Their effect will be evident as R.J. Reynolds continues to deliver margin and earnings growth.

Now, let's take a look at Conwood. Since 2007 was Conwood's first full year as part of RAI, I'll discuss their earnings on an adjusted pro forma basis as if we owned Conwood with its current line of products since the beginning of 2006.

In 2007, Conwood continued to post solid gains in volume, share, and profit. On an adjusted pro forma basis, full-year earnings of $344 million were up 13.7% driven by higher pricing and volume growth of 17.3% on the Grizzly brand. Conwood's full-year operating margins were 51.4%, up almost a full percentage point from 2006. Conwood has consistently delivered strong volume and profit growth since its acquisition in 2000. The company is focused on new products that meet the emerging consumer desires positions them well for future growth. That's a quick update on Conwood.

There are a couple of other initiatives I'd like to discuss now. First, debt refinancing. As you recall, during the second quarter of 2007, we refinanced a $1.55 billion term loan to reduce debt expense, extend maturities, and increase financial flexibility. Our average debt maturity is now about nine years and our next maturity isn't until 2009. Our leverage ratio is now at about two times debt-to-EBITDA, at the mid-point of our target range, which is a ratio of 1.5 to 2.5 times.

Next, a quick update on the Gallaher joint venture. There is really nothing new to report here. As we've said, the JV was terminated in the fourth quarter and the valuation process is scheduled to be completed by the end of June.

Finally, a few points about RAI's ongoing commitment to delivering shareholder value. A major component of that commitment is RAI's 75% dividend payout ratio. And as we've said before, we continue to evaluate additional rate to return value, including the possibility of a share repurchase program. We've had some discussion with BAT about their participation in the repurchase program, and we're continuing to explore this option. We are mindful of the broader economic environment and any action we take will be consistent with our ability to maintain an appropriate level of financial flexibility.

Now, lets' take a look at guidance. For the full year, we expect to deliver EPS percentage growth in the mid-single digits. That is based on our 2007 adjusted EPS of $4.57. Our guidance does not include any potential favorabilities during the termination of the Gallaher joint venture or resolution of R.J. Reynolds' disputed NPM adjustments.

Since the JV was terminated last year, we won't have that profit stream going forward. In addition, given the lower tax rate on the joint venture earning and certain state tax adjustments, we expect RAI's effective tax rate to increase by about 1% this year.

Looking beyond this year, we continue to expect to deliver mid-single digit EPS growth over the next several years, in line with the guidance we have given during the past year.

So, in summary, Reynolds American's 2007 results continue to highlight the fundamental strength of our business model and its ability to deliver sustained earnings growth in the years ahead.

Thank you and we'll now turn to the Q&A portion of the call. Alia, would you please remind our callers how to get into the queue.

Question and Answer

Operator

[Operator Instructions] Let's go first to JP Morgan's Erik Bloomquist.

Erik Bloomquist - J.P. Morgan

Good morning.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Good morning, Erik.

Erik Bloomquist - J.P. Morgan

Just wanted to start of with the volume reduction in the fourth quarter from inventories. Should we expect some kind of working capital benefits from that? And then I'd also wondered if you could comment on the outlook for 2008 consumption?

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

There is a small working capital benefit. We saw our inventory levels move sequentially in third quarter, fourth quarter down about $0.75 billion. So, we'll pick up a little working capital from that.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Erik, on the consumption side, last year, as Tom said, the industry unloaded about 2.5 billion for us, that was about 0.75 billion. We hadn't anticipated that size of an unload, to be fair. But, we see on the consumption side, in '07, as we said, the industry was about 5% down, Reynolds was about 6% down, our outlook for '08 is that the industry will be more in the 3% to 4% and Reynolds would be more in the 4% to 5%. We don't have a significant pricing activity that is flowing through in 2008. We don't expect quite the level of state excise tax increases in 2008 and we haven't seen anything in January that causes a significant concern.

Erik Bloomquist - J.P. Morgan

Okay, great, thank you. I understand you are not going to break out productivity savings for us going forward. But, I was wondering if you could help us understand about how much was in numbers for this year and where we are at in terms of that $500 million target by 2011 at this point?

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

Sure Erik. We’ve captured about $85 million in 2007 and we are on track to complete just over $500 million [inaudible].

Erik Bloomquist - J.P. Morgan

How much of that $500 million is left approximately, is that roughly $200 million?

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

About $300 million.

Erik Bloomquist - J.P. Morgan

About $300 million. Great. With respect to FDA regulation, I know you commented on that briefly in terms of 2008, are there any implications that are developing in terms of the outlook for smokeless as a lower health risk product that might be developing in that?

Susan M. Ivey - Chairman, President and Chief Executive Officer

As you know the FDA bill that was running around in Congress last year was that ten-year old bill and that bill actually did not provide for sort of a relative risk information for consumers. That was one of the biggest problems we had with that bill. We are encouraged by the dialog that is happening in the external environment about the need to provide consumers with information on relative risk and to identify the differences between smokeless style products and traditional cigarette. So, we are working hard to make that part of any future regulatory package and we're optimistic.

Erik Bloomquist - J.P. Morgan

Okay. Great, thank you. Last question is just one on the smokeless category. You noted that you expected to continue to grow next year. Is it fair to assume that's somewhere in the neighborhood of 6% to 7% is a reasonable run rate?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Yes. We're looking at 7%. There was strong growth last year. There were an enormous number of launches in the moist snuff category last year. If you think about 2006, I think the number was about six launches. In 2007, there were 29 launches in the moist snuff category. So, obliviously... and also when you look at the shares that we talk about in moist, those are shipment shares and of course those are affected by pipelines and new launches, as well as promotional packaging. But, we are continuing to see strong growth, we continue to see it in January, and we are very excited about Grizzly's new national launches in that pouch and snuff category.

Erik Bloomquist - J.P. Morgan

Those sound like great products. Okay. Thanks so much.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks Erik.

Operator

And moving on to our next question coming from Judy Hong with Goldman Sachs.

Judy Hong - Goldman Sachs

Hi everyone.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Hi Judy.

Judy Hong - Goldman Sachs

Susan, just going back to the consumption trend in the US and looking at cigarettes, you talk about 3% to 4% snuff decline for 2008. Is that sort of an ongoing trend that you think that we'll see going forward? I mean, it used to be around 2%, I think going back 20 plus years, and now you're talking about 3% to 4%. I'm just wondering, if this is sort of the ongoing trend as far as the consumption decline is concerned? And what's kind of changed in that equation?

Susan M. Ivey - Chairman, President and Chief Executive Officer

I think, Judy, over the medium term, we would still stay in that 2% to 4% historical range. Obviously, it is dependent on pricing and taxes, but we're... I would say we're still in 2% to 4%. This year, we do see 3% to 4%. I wouldn't change that it's an ongoing definitive... different rate, if you will.

Judy Hong - Goldman Sachs

Okay. And then a question on the menthol segment. Obliviously, I think we're hoping to see a better share performance from Kool within the growing menthol segment. Can you just give us your sense of how some of the new innovation is performing? Why aren’t we seeing much stronger growth out of Kool at this point?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Sure, Judy. We were slightly disappointed in Kool. I mean, the menthol segment… the category continues to grow. It was up to 27.7% share last year, that's up 0.7%. Kool held share. And I talked about this a little bit when we had our Analyst Day in November. Kool, of course, has an older price sensitive franchise and then Kool has sort of new entrants into the franchise, which are younger adult smokers, obviously, as we continue to try to compete with Newport. Kool XL performed very well for us this year. As I said in my remarks, I think Kool XL ended the year about 0.3%, but that is bringing new people into the Kool franchise. Now, we also last year and you'll have seen this in the pricing, but we took price increases on Kool last year in the order of 8%. Now, that is against an industry rate of about 6.3%. And the reason we did that is that our analysis showed that we were really over promoting and too aggressively pricing Kool. And we are looking for sustainable share growth on Kool, which will be built by its equity and innovation going forward. So, we were pleased that Kool held share. We are going to focus in 2008 on high-potential geographies. So, basically east of the Mississippi where the menthol category is so strong and we are counting on growth this year on Kool.

Judy Hong - Goldman Sachs

Okay. And then just looking at Conwood, obviously, the full-year profit growth was pretty strong, but the fourth quarter, it looks like the profit growth slowed down to about 5%. Can you just talk about what happened in the fourth quarter?

Susan M. Ivey - Chairman, President and Chief Executive Officer

In the fourth quarter, as you'll recall, actually it was incremental marketing spend for both of those test markets. We put that Grizzly snuff and the pouches out in multiple markets and so we invested in those markets and as I said in my remarks, we are delighted with those results, and we've actually accelerated our national rollout as a result of those tests.

Judy Hong - Goldman Sachs

Can you just give us a little bit more color in those test markets? What you are seeing there in terms of how that's affecting the premium brand’s performance, first? And secondly, how much cannibalization that you are seeing on your existing Grizzly line?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Sure. Let's talk first about pouches. As you know, pouches is about 6% of the moist snuff category, but it's been growing at about 20% a year. It's interesting because what we found out certainly the pouches are taking some volumes from skoal pouches, we also found that our Grizzly consumers, there are many dual users that use sort of loose snuff and then sometimes use pouches. So, lot of our Grizzly consumers, when they were using a pouch, were using skoal pouches, and of course, we are now capturing that in the Grizzly family. So, I don't have a specific number on the cannibalization, but certainly the results gave us the momentum to make the determination to roll this out nationally, and we are very excited about its potential. On this snuff side, as you know, that brand was designed to compete with Copenhagen. Conwood sales force has really built Grizzly over the last five years through consumer engagement and trial and we are doing that in those test markets, we're aggressively seeking trial of our Grizzly Snuff, the product is excellent and it's performing very well. And we will get a little bit of cannibalization from our natural styles on Grizzly. But, the predominant inflow to Grizzly will come from Copenhagen because it is a very similar product style at a great price.

Judy Hong - Goldman Sachs

Okay. And then just final question. Tom, can you quantify how much Gallaher JV profit was in 2007, so we can back that out going forward?

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

It was a small amount.

Judy Hong - Goldman Sachs

Like less than $5 million?

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

Less than $20 million.

Judy Hong - Goldman Sachs

Okay. Okay, thank you.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks Judy.

Operator

And our next question now comes from Credit Suisse's Filippe Goossens.

Filippe Goossens - Credit Suisse

Hi, good morning Susan, Tom, and Morris. How are you?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Hi, Filippe. Very well. Thanks.

Filippe Goossens - Credit Suisse

Just a few questions here on our side as well. Conwood's impairment charge, was that a negative [inaudible]?

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

The impairment... I am sorry Filippe I didn't quite hear you. Did you ask whether the trademark impairment charge was related to Kodiak? No, it was not. It was the non-focused brands at both Conwood and R.J. Reynolds.

Filippe Goossens - Credit Suisse

Okay. Then the trade de-loading, Susan, in the fourth quarter, we got a little bit surprised given that we have seen that already happen last year as well and then and just kind of thought it would be a one-time event. Can you just tell us... share with us your observations in terms of what kind of led to that industry-wide de-stocking again?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Filippe, you're breaking up and I couldn't hear the last part of your question, I know it is related to the fourth quarter and the inventory de-load, but I couldn’t hear the question part.

Filippe Goossens - Credit Suisse

I was just kind of wondering, if you could share with us what the dynamic was behind that de-stocking, given that we had that happening also in 2006. We kind of thought that would be the end of it, so can you just kind of share what your observations are in terms of what was behind that kind of second back-to-back de-stocking here?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Sure, Filippe. I think, as you recall, people had built... the trade had built inventories in speculation of a price increase and they were also building inventories in speculation on a potential federal excise tax. So, there was kind of double whammy in the system. They then de-loaded to the point of carrying actually a fewer number of days then they have historically. So, I think we will see them going forward carrying this lower number of days. Obviously, as prices go up, turns become very important, but they're managing those inventories tightly and they had speculated on both of those events and then the subsequent de-load of that was a significant number.

Filippe Goossens - Credit Suisse

Will that have an impact on your first half '08 P&L, because I remember last year that trade reloading had an impact based on how your promotional allows to flow through the P&L with a lag, will that be the same here?

Susan M. Ivey - Chairman, President and Chief Executive Officer

I don't think so Filippe. We don't see much impact on the '08 P&L. We expect that our wholesale partners will continue to carry a tight level of inventory going forward. So, it would be marginal.

Filippe Goossens - Credit Suisse

Okay. With regards to the Engle case, you mentioned that you might see a further increase in the plaintiffs. Can you just kind of explain how that [inaudible] in January, it was basically the deadline for cases to be filed?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Yes, you're absolutely right and the deadline has actually passed Filippe. But, what we have been told is that the courts in Florida are so log jammed with foreclosures in the real estate market that many of the cases that were filed by the deadline had not gotten through the process yet. So, our current count is 4,500, it could go as high as 7,500. But, as I said, our expectation is that we will prevail in these cases. In this year, we would expect to try maybe two to five of those cases kind of as a benchmark and then move on from there. But, we'll report that number once these things had had an opportunity to get through that fourth quarter court system.

Filippe Goossens - Credit Suisse

Okay. And then yesterday you made an announcement about a change on the senior management side and there was reference in the press release to the Asia-Pacific initiatives of Reynolds. Could you just share some light on what some of the things are that you're thinking about doing in that market, particularly within the context of… the fact that it’s Japan Tobacco that owns the rights outside of the US?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Sure Filippe. As you know, we have stated that one of our strategic platforms is sort of looking at selective international expansion opportunities and it really is just that. We are exploring opportunities in Asia, we are exploring those primarily in this smokeless category because as you stated, we don't have our other R.J. Reynolds trademarks. It also refers to Natural American Spirit. Natural American Spirit has a pretty strong presence relative for Natural American Spirit in the Japan market and we want to continue to grow that business.

Filippe Goossens - Credit Suisse

Okay. With regards to Camel Snus, any initial takeaways from Marlboro moving into Indianapolis as well now or still it’s early?

Susan M. Ivey - Chairman, President and Chief Executive Officer

We continue to really watch the performance of that sort of comparison in the Dallas market. We do understand that they are going to expand into Indianapolis, there has been no impact of that. We continue to be very pleased with Camel Snus. We have a great product. We have learned a lot about how to educate consumers about the category, how to work with our trademark partners to educate consumers through their clerks, to explain how to use it, and as we roll it out... I mentioned in my remarks, we are going to put it into many major metropolitan markets here in the second quarter. And I think we have learned a lot and we know how people consume it, how to educate, and we really do think we're on the forefront and that Snus will be successful.

Filippe Goossens - Credit Suisse

Great. And then my final question Susan. Obviously, it was discussed at your Analyst Day in New York, but again looking forward more, do you see Camel eventually expand into the moist category as well?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Filippe, you always want to ask that. I would say at this stage, we are very pleased with Camel Snus. We see Camel as a leading edge innovator. So, we are very focused on it participating in Snus. Obviously, we will continue to watch the category, we will continue to look for other opportunities in premium moist, and we won't miss an opportunity, but our focus is on Camel Snus.

Filippe Goossens - Credit Suisse

Great. Thank you very much Susan.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks Filippe.

Operator

Our next question comes from Morgan Stanley's David Adelman.

David Adelman - Morgan Stanley

Good morning everyone.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Good morning David.

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

Good morning David.

David Adelman - Morgan Stanley

Susan, firstly, in this presentation, in your press release today, in the Analyst Meeting you had in New York, you haven't talked to the goal as much as you had in the past of stabilizing and then growing R.J. Reynolds' market share. And I am just curious is that still a priority, has that become less of a priority to you?

Susan M. Ivey - Chairman, President and Chief Executive Officer

That's the right question David. The way we are looking at it and you are actually right, we were focused on a specific point in time where those lines would cross and the growth brand growth would surpass the non-support and support decline. We are now focused on ensuring that we have that balance right. As I said in my remarks, our ultimate goal is still for R.J. Reynolds to return to overall share growth, but not at the expense of over promoting, over discounting, and achieving short-term share gains at the expense of short-term profit. We have got to grow the volume and the share and the margins on those growth brands, and so it's a slight shift, a slight moderation of emphasis I would say, we are our committed to delivering sustainable earnings growth, we are committed to growing those growth brands. But, an example of the balance is what I described earlier on the question about Kool. Our analysis showed that we were overly aggressive in our pricing and promotion, and the gap for instance between Camel and Marlboro was too big, and we took the prices up on Camel by reducing our promotion in 2007, and that did result in slightly less share growth, but we grew the margins on Camel, and the share growth that we did have is built on equity and innovation and consumer engagement and not a short-term rental. So, we are still on track to stabilize Reynolds' market share in that '09, '10 period, but it's going to be a slower build as we ensure that we balance margins and sustainable share growth.

David Adelman - Morgan Stanley

Okay. And then, secondly, does the '08 guidance… am I correct to assume that it doesn't anticipate additional cigarette manufacture or price increases?

Susan M. Ivey - Chairman, President and Chief Executive Officer

David, we won't comment on that. We don't talk about price.

David Adelman - Morgan Stanley

Okay. Thirdly, Susan, how are you [inaudible] to think the Grizzly Snuff product could be that brands largest SKU 12 or 18 months from now?

Susan M. Ivey - Chairman, President and Chief Executive Officer

That would be great.

David Adelman - Morgan Stanley

But, I mean, given what's happened in the test markets, given the opportunity, given the consumer reaction, do you think that's a realistic objective?

Susan M. Ivey - Chairman, President and Chief Executive Officer

I think it will be a strong player. As you know, Grizzly has performed very well, I mean superbly in that Wintergreen sector. Whether we'll see that same kind of thing in this snuff product arena. But, we are very confident in the test market results and we do expect significant growth on Grizzly, and certainly that Snuff will be a big contributor.

David Adelman - Morgan Stanley

Okay. And then lastly I wanted to ask about the prospect of a buyback. It's been some months now obviously since you've talked about this prospect publicly. It's been some months since BAT has talked about it. It would have struck me that if you are going to go forward with it, this should be a natural time to unveil it, and yet you are not. So can you speak to sort of the likelihood of there being ultimately a buyback because it hasn't been announced to date? What's the stumbling block, is it BAT's ultimate willingness to participate, is it something in the marketplace that makes you uncomfortable at this moment in time to buy back your stock and so forth?

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

David, this is Tom. We are actively evaluating a share repurchase program, and as we've said, we would like BAT to participate in that. We've had ongoing discussions with BAT and I'm optimistic that we'll get those things resolved and those details worked out. We'd like to get an agreement in place with them before we announce things publicly. And, of course, once we get that agreement, as I said, which I'm optimistic that we will get, then we'll just need to take a look at the economic conditions, and also the competitive dynamics in marketplace. If everything's right, we'll get back to you and announce our intent.

David Adelman - Morgan Stanley

Would you only announce the intent if you actually have a program, which you announce there… would you make a preliminary announcement hypothetically of their commitment to doing it?

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

Probably not.

David Adelman - Morgan Stanley

Okay, that's what I have always thought. Okay, thank you very much.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks, David.

Operator

Our next question comes from Merrill Lynch's Christine Farkas.

Christine Farkas - Merrill Lynch

Thank you very much. A couple of follow-up questions, if I could. Susan, can you just confirm how much the de-stocking or the inventory decline impacted your volumes in the fourth quarter and for the full year?

Susan M. Ivey - Chairman, President and Chief Executive Officer

In the fourth quarter we see the total... the industry de-loaded 2.5 billion and it affected us about 750 million units.

Christine Farkas - Merrill Lynch

Okay, that's right, you didn't mention that. And if I could just turn to Lane for a second. Looking at the margins year-over-year, they are a little bit softer, I am wondering is it just investment in the brand there that is driving the lower margins?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Christine, do you mean Conwood?

Christine Farkas - Merrill Lynch

No, Lane.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Lane has been completely integrated into Conwood and Conwood's margins were up a full point to 51.1% last year.

Christine Farkas - Merrill Lynch

Okay... now that is... sorry about that.

Christine Farkas - Merrill Lynch

And then the last question I have Susan or for Tom. I am just curious because some of your competitors have taken a charge on Scott. Do you intend to do the same?

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

This is Tom. We do not, we have talked with the Council and Council is very confident that we have appealable… first of all, we don't have a final judgment. And even if we did, we believe that we have appealable ground.

Christine Farkas - Merrill Lynch

Okay great. That's it from me. Thanks.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks Christine.

Operator

And next up that from J.P. Morgan we have Erik Bloomquist. Mr. Bloomquist your line is open.

Erik Bloomquist - J.P. Morgan

Hi, good morning again. Just one follow-up question in terms of litigation costs in 2008. Do you expect any meaningful increase in that relative to 2007 given the Engle Progeny Cases?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Not really Erik. We have continued to see a stable environment, we saw many more dismissals versus cases filed last year. I think this year will be kind of a year of progress, as we see what happens in these Engle Cases and wait for this Schwab ruling etcetera and some clarity. But, we don't see significant increases in cost.

Erik Bloomquist - J.P. Morgan

Okay, super. Thank you, Susan.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks Erik.

Operator

Next we have Marc Greenberg with Deutsche Bank.

Marc Greenberg - Deutsche Bank Securities

Susan and Tom, good morning.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Good morning Marc.

Marc Greenberg - Deutsche Bank Securities

I'm encouraged by your comments about considering other ways to create value for shareholders. Following on David's question about buyback, do you have any specific leverage ratios in mind when you're thinking by either share repurchase or other ways to return cash to shareholders? I wonder if you might talk about besides the share repurchase other things that you might consider to return cash to shareholders. Thanks.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Sure Marc. I think our first priority and our desire is to do a share repurchase program and obviously that as Tom mentioned requires us to have an agreement exactly on the implications of that and how it will transact with British American Tobacco. Obviously, another way for us to return value would be a special dividend and that would be number two in line because we think that there is more benefit to shareholders in the medium-term with the share repurchase. But, we would not make... if we couldn't work through any implications at that, we would consider a special dividend. We want to retain our financial flexibility or we don't see a lot of big M&A opportunities on the horizon. We continue to keep our eyes open and we are happy really today with where are debt ratios sit, we don't anticipate levering up to do the share repurchase, but we are committed to returning value to shareholders.

Marc Greenberg - Deutsche Bank Securities

Great. Thank you.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thank you.

Operator

Our next question now comes from Ann Gurkin with Davenport.

Ann Gurkin - Davenport

Good morning.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Hi, Ann.

Ann Gurkin - Davenport

Susan, you talk about Reynolds is going to be the champion of change. Can you give us some more color on that? Does that mean change driven from internal actions or joint ventures, alliances? Can you comment at all that?

Susan M. Ivey - Chairman, President and Chief Executive Officer

Sure Ann. When we talked about the champions to changes, I think, as you understand, Reynolds business model is very focused on effectiveness and efficiency and growing its growth brand and innovation is absolutely critical to that. So, championing innovation both internally and driving our speed to market with innovation is a priority at Reynolds. The other thing I think you can you see Reynolds is that at the forefront, they highly value consumer engagement and consumer interaction. If we think about how the Camel based upgrade, the new Camel packaging for the whole family, which is just hitting retail this month, how that was developed as was Camel Signature. The Camel Group engaged with thousands and thousands of Camel consumers to design that packaging and we really believe that the power of listening to our consumers and engaging with them to produce cutting-edge innovation and the products and packaging and programs that they want is a competitive advantage that Reynolds will continue to develop. We have done some restructuring at Reynolds, which also will manifest itself in more and more consumer engagements in the trade marketing arena. And we think that that will continue to be a powerful addition to Reynolds consumer connection. So, it’s really across productivity and innovation, driving change, expecting change and embracing it, throughout the organization.

Ann Gurkin - Davenport

At your Annual Day in December you all talked about changes and price tiers and eliminating free goods in a number of states. Can I get an update on how that what... how that's gone since you implemented those changes?

Susan M. Ivey - Chairman, President and Chief Executive Officer

What we are doing actually, R.J. Reynolds is going to not have any free goods in the 25 states that they talked about in the month of March. That is sort of a test because obviously we're offering similar values to consumers through [inaudible] but it is not a free product promotion. We will evaluate that. We will also then evaluate the competitive arena because we will not make ourselves unilaterally uncompetitive by discontinuing these promotions. So, really, it's early days, we are testing it in March. We will see what happens and then we will advice you kind of how we see that going forward after those results.

Ann Gurkin - Davenport

And then last, just returning to the... returning value to shareholder and discussions with BAT, is it a larger issue as BAT wrestles... a decision on what to do with its investment in Reynolds. Is that what's the stumbling block and that's what’s taking longer to reach some kind of resolution with BAT?

Susan M. Ivey - Chairman, President and Chief Executive Officer

No, I don't think so at all actually, Ann. It is simply that they... there are certain tax implications and then how do you pick what timing to buy shares back. It’s much more just simple technical transactional detail that needs to be agreed with the two parties as they are 42%.

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

And we are now moving forward with this and as I said we are optimistic that we [inaudible].

Ann Gurkin - Davenport

So it's on a large a issue as BAT is trying to make a decision about their investment in Reynolds.

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

No…

Susan M. Ivey - Chairman, President and Chief Executive Officer

That you have to ask BAT.

Ann Gurkin - Davenport

Great, thank you.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thanks Ann.

Operator

And we do have time for one final question. That question will be a follow-up from Filippe Goossens.

Filippe Goossens - Credit Suisse

Susan, good morning. Thanks again.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Hi, Filippe.

Filippe Goossens - Credit Suisse

Obviously, without moving too much into the area of speculation because nobody likes to do that. But, let me just try to kind of frame this question so that we may at least get your insights. If for whatever reason PMUSA want to decide that organically it's really not going to work moving to small [inaudible] or that it might take too much time before it has a meaningful impact on their bottom line and they decide to go outside. And we all know there are two other potential players out there that they look [ph] at. If they were to go in that direction, particularly if they were to go for the industry leaders, do you feel that that would change in a material way the competitive environment within smokeless? And then kind of as a follow-up, how do you think Conwood is positioned to address that potential change in the competitive environment?

Susan M. Ivey - Chairman, President and Chief Executive Officer

I think, Filippe, in your scenario if PM buys UST because they don't want to go organically, I think it would not affect necessarily at the consumer level the comparative environment. Now, it could change the trade environment and how the companies go to market in the tobacco category. But, we are very confident about Conwood's continued growth prospects. It has been competing exceptionally well with UST and will continue. Last year, UST upped its promotional percentages from 5% in '06 to 20% in '07 and Grizzly still had a fabulous year. And with our new line extensions, we are even more bullish. So, I believe we will have to wait and see. It's obviously Philip Morris' decision, but we feel very good about Conwood's continuing prospect in the moist category as well as R.J. Reynolds’ prospects in snus and in potentially other smokeless alternatives.

Filippe Goossens - Credit Suisse

Great. Thank you, Susan. again.

Susan M. Ivey - Chairman, President and Chief Executive Officer

Thank you.

Operator

And that does conclude our question-and-answer session. I would like to turn the conference back over to our presenter for additional or closing remarks.

Morris Moore - Vice President of Investor Relations

Thank you again for joining us. As a reminder, a replay of this call will be available on our website at reynoldsamerican.com until March 7. Thank you.

Operator

And that does conclude today's conference call. Thank you for your participation. Have a good day.

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