Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

Lorillard (NYSE:LO)

Q2 2012 Earnings Call

July 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

Vivien Azer - Citigroup Inc, Research Division

Nik Modi - UBS Investment Bank, Research Division

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

David J. Adelman - Morgan Stanley, Research Division

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

Andrew Kieley - Deutsche Bank AG, Research Division

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

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

Christopher Ferrara - BofA Merrill Lynch, Research Division

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

Priya Ohri-Gupta - Barclays Capital, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Lorillard, Inc. Second Quarter 2012 Earnings Conference Call. My name is Paula, and I'll be your 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, Paula, 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 second 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. The description 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. In a quarter that saw heightened competitive activity and was measured against extremely difficult comps, I'm pleased that Lorillard's underlying results were solid and outperformed the industry as a whole. The company increased net sales 2.3%, gained market share, protected gross margins and grew adjusted EPS by 6.8%. These gains compare to the second quarter of last year when our unit volume was up 9.9%, net sales were up 11.3% and EPS was up 18.5%.

Let me give you some detail on the quarter, why I expect the company to perform well in the second half and why we are reaffirming our 2012 goal of a double-digit total shareholder return as measured by EPS growth and the dividend yield. I'll also give you brief updates on the FDA's review of menthol and our acquisition of blu ecigs.

Let's start with second quarter volume. First, total Lorillard wholesale unit volume decreased 1.2% versus a year ago with Newport Menthol down 0.9%. While still outperforming the industry, this trend is modestly below our typical trend on the core business and primarily traces to the impact of the tax status change on Native American reservations in New York.

For the last 3 quarters, the volume impact in New York was more than offset by the launch of Newport Non-Menthol, our geographic rollout of Newport Menthol promotions, and robust Maverick growth that drove a remarkable increase in volume. So the impact to the business was previously strictly limited to a negative drag on net pricing, as consumers shifted their purchases to outlets that carried buydown promotion.

Those strategic initiatives that previously more than offset New York's losses continue to perform well, but in this quarter did not fully offset the loss. The good news is, as we enter the third quarter, we have now fully lapped the New York changes so this drag on volume and pricing is behind us. And while we look forward to the next phase of our strategic plan, and once again delivering strong volume growth, I'll remind you that the vast majority of our profitability comes from Newport Menthol. So it's always good news when we see our flagship brand continue to outperform in the category, while preserving its strong brand equity despite multiple launches and promotions into the menthol segment by competitors.

In regards to the next steps on our cigarette adjacency strategy, we had planned and are fully ready to launch additional new products this year that were intended to keep last year's level of accelerated growth going. Unfortunately, substantially equivalent products like these now require FDA approval prior to launch.

The FDA has not approved one single substantial equivalent application since premarket approval was required starting March 2011. Even though the statutes suggest this preapproval process should only take 90 days. As a result, our strategic expansion plans have been temporarily slowed down, but all indications from the FDA is that they are in process.

On a 6-month basis, shipment comparisons are still being affected by inventory. As our price increase was mid-June this year versus July 1 last year, our first half comparison is still being negatively affected by the 400 million units we spoke about during the first quarter conference call. That is, wholesalers built inventory during this year's second quarter and then mostly reduced it during the final 2 weeks of the quarter following the implementation of our price increases. This reduction in inventory took place in the third quarter last year. So for Lorillard, while there was no meaningful inventory effect in Q2, there still is in the 6-month comparison.

For perspective, Lorillard's first half domestic shipment volume was down 1.9%, but adjusted for the first half inventory effect, it was flat. And we entered the second half this year with nearly 300 million fewer sticks in wholesale trade inventory than the year ago period. This bodes well for the second half in general and the third quarter in particular.

As we saw no real change in trend on Newport in the quarter or 6-month numbers, we continue to believe that significant competitive activity, so far, has had only a modest effect on Newport consumers. In fact, we held promotional spending flat to year ago in the second quarter despite the environment.

It does appear that heavier price competition did slow Maverick from high single-digit growth to mid-single digit growth in Q2, just under 5%. Maverick results were still pretty solid given the competitive environment. While we didn't see competitive activity have much effect on our Newport trends, it did improve the industry's numbers overall. So instead of a 3% to 4% decline in industry shipments, we saw only a 1.7% decline. With these dynamics, we continued to outperform and gain share, but the improvement was less dramatic.

Total Lorillard Q2 share was 14.3% up 0.1 points and Newport was essentially flat. Given the level of marketplace activity, I'm pleased with that performance and the continued stability of our core Newport full flavor menthol business. I'm also pleased with the level of pricing realization we were able to achieve in the quarter and its positive impact on gross margin.

Gross margin stability and the continued benefit of share repurchases contributed to the 6.8% adjusted EPS gain versus a year ago for the quarter.

On the FDA menthol review, there's not much to report, and we haven't changed our opinion. We expect the peer-reviewed menthol report to eventually be issued but we remain of the belief that it will be carry no proposed rule-making. To the contrary, we believe that it is clear that the hard scientific evidence does not support any disproportionate regulation of menthol cigarettes versus regular cigarettes, and we believe FDA leadership has alluded to this in recent speeches. We think the likely outcome of the peer review will be a call for additional behavioral research which has already been put into place and is a long-term process.

And remember, the law still requires that the FDA deal with the biggest issue associated with any new menthol regulation, and that is the unintended consequences that would result, such as counterfeiting, contraband, lost tax revenue, lost jobs and increased crime. As always, we will continue to monitor the situation and stay engaged in the process.

On blu ecigs, I'm even more convinced about this opportunity now that we have gotten to better know the business and its management team. The business is rapidly growing, there is a clear path to improving the technology over time, and consumer research supports that there is strong trial and repeat. We are taking a leadership position in the industry regarding responsibility and quality control and we look forward to working with the FDA so that it allows this segment to continue to responsibly grow. We also look forward to working with the FDA to assess the role ecigs can play within a comprehensive harm reduction strategy. We are convinced ecigs can, and should, play a major role.

And while I still view this as more of a longer-term R&D investment, we are on track to achieve our internal valuation goal. We will keep you posted on this exciting long-term initiative.

So in conclusion, we feel good about the quarter and year-to-date as underlying fundamentals remain positive and results were solid relative to a heightened competitive environment and in comparison to an incredibly strong second quarter last year. We are bullish about the second half as we have strong plans in place, we should benefit from a wholesale inventory position going into the third quarter and we have lapped the Native American situation in New York, which has had a negative effect on our business for the last 4 quarters. Our plans for the rest of 2012 do not rely on new products but we are ready with fully-tested products, so approval by the FDA could quickly follow with the launch that we would view as upside to our plans.

With that, I'll hand the call over to David, who will review the financial in more detail.

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 second quarter of 2012 increased 2.3% to $1.7 billion as compared to the second quarter of 2011, driven by higher average net selling prices, partially offset by a lower unit sales volume. Net sales of blu ecigs included in the second quarter totaled $8 million for the 2 months after its acquisition.

Total wholesale shipment volume declined 1.2% compared to last year's second quarter. Fluctuations in wholesale trade inventory levels quarter-to-quarter didn't really impact to the comparison to last year because the timing and pattern of the trade inventory build last year was a bit different.

The absolute and relative level of units in wholesale trade inventories as of the end of June this year, is significantly lower than last year. So as we look forward, we would not expect to see the same sort of inventory deload that impacted last year's third quarter to repeat this year.

Net sales for cigarette calculated before excise taxes on a simple consolidated basis increased 4.5% from last year's second quarter, reflecting the impact of the price increases taken over the last 12 months combined with no increase in our promotional spending. The net price per cigarette unit comparison was once again negatively impacted by the migration of volume that was sold nonpromoted on Native American reservations last year to other promoted channels this year. But as Murray said, this effect is now behind us.

Negative mix effect of Maverick's growth in relation to the rest of our portfolio continued to be a factor in this comparison, but it was a much smaller impact than in prior periods.

Adjusted operating income and adjusted net income and earnings per share all exclude the impact of $5 million of acquisition-related costs and expenses incurred in connection with the acquisition of blu ecigs in April.

I will therefore be addressing our results on an adjusted basis.

Gross profit increased by $13 million in the second quarter compared to last year's second quarter, and gross margins were flat to last year at 35.4% of sales. Cost of sales and gross margins are impacted by the increased cost related to the state settlement agreements, FDA fees and higher raw material input costs, primarily tobacco and other direct costs. However, the net price realization offset these effects as reflected in the stable gross margin percentage.

Total reported selling, general and administrative costs increased $16 million from last year's second quarter. SG&A includes $5 million in acquisition-related fees and expenses related to the blu acquisition I mentioned a moment ago.

Increased legal fees and expenses associated with the Engle litigation activity this quarter, as compared to last year, was the primary driver of the remainder of the increase. We discussed the same dynamic for the last few quarters.

I mentioned last quarter that we were in the process of transitioning major law firms and experienced some cost inefficiencies that are inevitable in that sort of move. We expect that while this is behind us, we will continue to see elevated costs associated with defending Engle cases just due to the case activity.

Second quarter adjusted operating income increased by $2 million to $489 million from $487 million in last year's second quarter. Blu really had no impact on adjusted operating income for the quarter.

Fully diluted earnings per share on an adjusted basis for the second quarter increased 6.8% from last year's second quarter to $2.19 per share. Reported diluted earnings per share increased 5.9% to $2.17.

Lower share count as compared to a year ago, added $0.17 per share to EPS for this year's second quarter. So as we look forward, we're confident in our ability to deliver superior results.

You've heard we entered the third quarter with a much cleaner wholesale trade inventory position than last year. Our second half marketing plans will build on the strong underlying fundamentals of our business and we will not see the comparative anomalies to volume and price that came from the change in sales to Native American reservations.

We continue to be on track for a strong 2012, and we have confidence in a much stronger second half both for operating earnings and EPS growth.

And with that, we'd like to open the line for questions. Operator?

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Vivien Azer of Citi.

Vivien Azer - Citigroup Inc, Research Division

My first question has to do with your plans ex any new products, given that you're waiting on the FDA. What else, kind of, do you have in place to potentially reaccelerate your market shares? Because I was really surprised by how strongly your market share gains decelerated in the quarter.

Murray S. Kessler

Well look, Vivian, the question of how much they decelerated is a little bit a question by the way we measure. In my opinion, the deceleration of market share have less to do with the performance of the Newport brand and our performance, which really didn't change that much, as much as it did on the industry by the way we measure market share. And as a reminder, because this question's going to come up again on sequential market share, we measure from wholesale to retail, okay? So that means -- and we do that for a reason because a large percentage of our business isn't sold in stores with scanners. We think over the long term, that's the most accurate way to measure the business. But in a quarter like this, where our competitors shipped a lot of factory packed promotions, launched a new pack product with pipeline inventory, you're going to see our share lag what you would see in a consumer takeaway database like Nielsen. So I'm not actually sure we had a deceleration. The numbers that we would show because of the competitive activity are going to look a lot different than what our competitors were reporting. So I think on Nielsen, you would see that our shares were higher and the gains were more significant because of the amount of push-type promotions that occurred especially at the end of the quarter by our competitors. Having said that, we have had 13 years of consecutive share growth and other than last year where it was 1 point, it's been historically 0.1, 0.2 point over time and we're right on track with that. The accelerated share will come from our strategic initiatives and in the life of the Newport brand and this company's future, if it takes us a few more months to get approval, that's not going to change the long-term outlook.

Vivien Azer - Citigroup Inc, Research Division

Fair enough, that all makes good sense to me. My second question has to do with your guidance for double-digit shareholder returns. Given the volatility that you've seen in your share price, I'm just curious what kind of dividend yield is embedded in that guidance?

David H. Taylor

Well, you're trying to back into the EPS number. What it implies is a significantly higher level of EPS growth in the second half than you saw in the first half.

Operator

Your next question comes from Nik Modi of UBS.

Nik Modi - UBS Investment Bank, Research Division

Just a couple of questions, first on just -- Murray, if you could update us -- the question is on Newport Non-Menthol. If you could just give us an update on how that is trending, post the -- all the big price increases and the reduction of promotional activity. The second question is, and this is kind of -- I hate talking about your competitors on your call, but do you think that this Marlboro share incentive program had an impact this quarter in a sense that retailers were clearly trying to make some incentive targets, especially at the end of the quarter. So I know you're talking a lot about wholesale inventory but there's also a lot of retail inventory out there because they were trying to get the product through so they can get these incentive payments, though I think the measurement period was the end of the June quarter. So I don't know if you guys have looked at it that way, but do you think that, that had kind of a temporarily blip to impact this quarter?

Murray S. Kessler

Yes, and I want to be clear, what I was trying to just explain to Vivien was retail inventory, not wholesale inventory. The wholesale inventory is on a 6-month number and affects the financials. When I was talking market share, based on our database, Nik, which measures wholesale to retail, that is what wholesalers ship to retailers whether a consumer buys anything. To give you some perspective, in the month of June some competitors -- and I'm not going to name which any particular one, there was over a -- in the final weeks of the quarter, there was over 0.5 billion units shipped in from wholesale to retail -- oh excuse me, for the quarter, there was over 0.5 billion, close to 600 million units. In the month of June, the final 2 or 3 weeks of the quarter, 2/3 of that shipped. So 400 of the 600 shipped in the last 2 or 3 weeks of the quarter. Now if you want to make the link to that to the incentive plan, that's possible but I'm not the one to speak on that but that would have affected our share number for the quarter even though it had no major impact on us. It's also a plausible explanation of why retailers were so quickly able to, after the price increase, return our inventory levels to normal levels where at least what I've heard on some of the other calls, that wasn't seen as the case across the board. But for us, it very quickly went back to normal levels.

Nik Modi - UBS Investment Bank, Research Division

Okay. It all makes sense now, okay, that's great. And then just on Newport Non-Menthol, if you can kind of give us an update on that?

Murray S. Kessler

On Newport Non-Menthol, did you say? Newport Non-Menthol grew shares slightly, or sequentially during the quarter but it was down versus a year ago, but it's on a great trend. So sort of the big spike, the best quarter we had on Newport Non-Menthol was previous to the price increase going into July. And again, our goal is not to keep that thing down. We've taken -- our net sales, our price realization is up 26%, 27% or more on Newport Non-Menthol. We have now returned to weekly averages, we've held our share for a year, it's slightly growing. I expect to gain market share in the third quarter with Newport Non-Menthol, and the business is really solid. I'd like to get on with some additional opportunities to flush out that line but I need some help from the FDA in that regard.

Operator

Your next question comes from the line of Thilo Wrede of Jefferies.

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

Was there any difference in the competitive pressure that you saw between menthol and non-menthol?

Murray S. Kessler

There was, yes, I think so. Although the Non-Menthol segment had a good quarter and a lot of the competitive new products, based on their portfolio. For example, Marlboro Black still outsells non-menthol to menthol, 2:1 so to some of that effect, I think helped it. But on the factory pack pricing side, we saw some direct push directly against, on the Menthol segment. And that was where the -- almost all of the increase in -- and when I call it factory pack, I'm talking about packs of cigarettes that carry a $0.50 coupon or a wrap around it that temporarily reduces the price that shipped in and then sell back. And a lot of that activity was directed at Newport Menthol. On our Newport Menthol business, we shipped 0 units like that. I mean, Newport full mint flavored menthol is not a promoted brand, we set the price on buy downs, and so it is our management's choice -- and in a heightened competitive environment for the long-term health and brand equity to sort of withstand that right now. And it's worked for the brand over the long-term, we think it's the right decision, we grew share and volume in most states in the country. Almost the entire decline is attributable to New York and for the long-term health of the brand, I'm pretty pleased with the way we withstood a pretty aggressive competitive environment. Having said that, there's some states we can adjust plans in the second half like we always do and we'll do that.

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

Okay, and then, Murray, you talked about once the FDA approves substantially equivalent product, you can introduce more innovation. Wouldn't that be the case for peers as well, that they're being held back right now and so once these approvals from the FDA come there's going to be this onslaught of innovation and nobody really stands to gain anything because it's a stalemate?

Murray S. Kessler

No, I don't think that's the case at all. I think that major competitors, the major share leader in the brand has continued to launch new products and there's reasons that they were able to do that, because they had products in test market prior to the March 23 deadline. That's very different than this company. If you remember, this company historically had not participated in new products at all. We ramped up our new product activity when I joined the company, but you're talking months after when I joined it, and not to mention, we were in the heat of the menthol fight which was our top priority going into March 2011. So you've seen a steady stream of new products over the past 1.5 years from Philip Morris, and as an example, you've seen less from Reynolds. And having said that, I still believe, when you look at the strategy that I've presented in our strategic plan that those competitors already have multiple product lines in every single segment of the category. And what I hope to have demonstrated, and I hope you remember, is that for Lorillard, there was a lot of white space. Areas where we completed with 0 activity. So for them, you're fragmenting the line, fragmenting it again, fragmenting it again, where we've got a 14 item line compared to 50 and 100 item lines from some of our competitors that already play in every segment. So for them it's a lot of cannibalization. For us, it's a whole lot of incrementality.

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

Okay, and then last question for you. What gives you the confidence that retailers don't have -- settled into, kind of, new inventory levels, be it that they want to measure working capital better, that they have become more efficient at managing inventory levels. What gives you the confidence that eventually inventory levels will come back up to historical levels?

Murray S. Kessler

You're talking wholesalers now, right?

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

Well, the entire -- the entire downstream supply chain.

Murray S. Kessler

All right, well, let's talk wholesalers first because it's always a complex issue. So week went into this quarter, we saw a lower number in inventory that we had historically saw exiting the first quarter, okay? So we not only didn't see the normal build that we would see, we saw them really tighten it up to the point where they were having a hard time keeping up with their retail demand and filling orders, and they have really pressed as far they could be pressed. During the second quarter, that number built back up again to it and it built pretty aggressively and then came back down to a level that they -- we exited the second quarter of this year near 300 million units less than when we exited the second quarter last year. So all things being equal, even if they went back, sort if, to that really tightened level they were at the end of first quarter, you're still going to pick up a few 100 million units on the relative comparison. If they hold it where the inventory level was at the end of the third quarter last year, you're going to pick up 300 million units. And if they build -- it's hard for us to predict and we're more effective than the other competitors on inventory because we're such a good seller and we have such a narrow product line, it's one of the reasons I hate giving guidance. Because had the price increase taken place on the same timing as last year, we would have shipped 300 million, 400 million more units this quarter and been above your estimates and it would've had no impact on the year at all. In fact, the price increase coming a couple of weeks earlier, adds profitability to the year. So -- and market conditions dictated that we needed to do that. So I wouldn't get caught up too much in the inventory numbers, I mean, the effect that it could have is minor. The big issue here is like Newport Menthol to be flat, and Newport Menthol was down 0.9%. It's not a huge number, it's a 100 million units on a 10.5 billion-unit-quarter but in a heightened competitive environment -- you saw a little bit of a decline. But the big decline, the big decline on our business for the last 4 quarters has been New York, it's just we did so well everywhere else we made it up and we still did well everywhere else this quarter, it just didn't make up the full impact of New York.

Operator

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

David J. Adelman - Morgan Stanley, Research Division

Murray, I'm curious, do you think that the strategic brand efforts, both product and geography have made the business, in total, more subject to competitive activity?

Murray S. Kessler

No. I think that -- I think we got killed in New York and we had great growth everywhere else that more than offsets -- I think it's a New York issue, David. We didn't lose more -- I saw your note this morning, or question that -- I don't see a difference in core markets versus noncore markets, you saw a slight pullback overall. But you know this better than anybody, New York was 7%, 8% of our volume prior to this change in Native American. You're talking -- excuse me -- 13%, excuse me. And New York, just to put it in perspective, is down 40%, 50% since the Native American change. So we lost, in a year-on-year comparisons in New York over the last year, close to 1.2 billion, 1.3 billion units that was more than made up in other initiatives within the business. And this quarter, it was more than made up, but it came up about 100 million units short. That is, by far, the biggest factor. So even if you say, out of New York those consumers went back into other stores and you made back 80% of the volume. But the business has performed so well that it covered what was a huge, huge hit. And that's not to count that those 1,200,000,000 units went into -- or the ones that we didn't lose. Let's say 80%, 90% of that, when those consumers went into stores to shop and went into stores with buydown proportions. So the net impact of that over the course of the last year had to be $50 million, $60 million. But the long and short of it, if you were losing 300 million, 400 million units a quarter because of New York that was being offset, and that negative drag is now gone.

David J. Adelman - Morgan Stanley, Research Division

Right. But isn't that the case, if you look backwards, that you couldn't overcome that dynamic this quarter because the competitive environment was more challenging?

Murray S. Kessler

Yes. I mean, what I'm saying is if I look at the geographic markets, they continue to contribute -- look, there are a number of factors that were in there. We had other quarters when Newport Menthol was down 1% in the last year. But we had 200 million, 300 million, 400 million incremental units of Newport Non-Menthol where we -- actually, this quarter Newport Non-Menthol was down a little bit because it was compared to sort of the biggest quarter and like I said, I expect that to grow going forward. You had Maverick that was growing 3 percentage points, 4 percentage points, 5 percentage points higher than it was growing now. But we had, I saw sort of strong growth in many markets. But if you just look at it, it was sort of a little bit everywhere that made that difference in that 100 million units. But I don't think that being out in the West had an impact on, sort of, the variability on what happened in our core market on the Northeast. I mean, I ...

David J. Adelman - Morgan Stanley, Research Division

No, I agree with that. I just meant, in other words, I meant in totality. The Newport urban East Coast franchise is what it is. And let's assume that the total trajectory if you adjust for the Native American shift is what it is, out that to the side. To the extent that the growth of the business has come from these other initiatives, aren't they, by the very nature, because the franchises aren't as strong more susceptible to what competition is doing?

Murray S. Kessler

Well, sure, that makes sense. But I just want to say they still grew, they just didn't grow as fast.

David J. Adelman - Morgan Stanley, Research Division

Right, okay. Let me ask you a different question about cost in the operating leverage in the business. David went through some of the items, there are a long list of issues that are probably individually small. But I'm just curious, if you step back from it, this quarter, your volumes are more or less flat, down slightly. Pricing was up 4.5%, normally that would generate high single-digit operating income growth for Lorillard and yet operating income was flat. And I guess the question is, looking forward, has there been any change in the underlying operating leverage in the business once you, sort of, transitioned through some of these cost increases?

David H. Taylor

I don't think there's a difference in the underlying leverage in the business, David. We've cited some of the increases in some of the input costs and back when Murray explained our strategic plan we did talk about some modest increases in costs associated with building out our capabilities, whether it's in product development, whether it's in compliance, whether it's in other areas in manufacturing. So yes, there are some structural cost increases that we've experienced over the last year. But once we transitioned through those, I don't think there is a change in the fundamental operating leverage in the business.

David J. Adelman - Morgan Stanley, Research Division

Okay, two last things. Why wasn't the company in a position, during the second quarter, to repurchase stock if you wanted to? In other words, whether it's the board authorization or capital structure, funding perspective, whether you buy back stock or not, that's not what I'm questioning. I'm questioning, why weren't you in the position in this situation, in retrospect, not to be able to buy back stock? Shouldn't -- isn't that sort of, shouldn't you always be -- have that flexibility?

Murray S. Kessler

You’re just asking why the board -- why we don't have an authorization which can be quickly done, a blanket authorization creates speculation...

David H. Taylor

David, you're familiar with our paradigm for returning cash to shareholders and share repurchases. And to the extent that we have available cash over and above the expected dividend, it's a reasonable expectation to see us return that in share repurchases. We've finished a pretty large share repurchase program during the first quarter, we bought blu for $135 million in the second quarter. As we see visibility toward levels of available cash that can be put towards share repurchases, in a reasonably significant level, you could expect us to approve further share repurchase programs and that could include potential proceeds from debt issuances. So we've just adopted the paradigm of doing those in shorter term programs once we have visibility to the available cash.

David J. Adelman - Morgan Stanley, Research Division

Okay. And then one last thing about the FDA and substantial equivalency. Murray, in your prepared remarks, you mentioned that the FDA had not approved any substantial equivalent applications. To your knowledge, have they rejected any?

Murray S. Kessler

To my knowledge, they have not. And those are words directly from the FDA. We had a meeting with the FDA during the quarter, they have said it's growing pains, that they had started out the process, that it was a new process for them, that they had to restart the process, they had to go out and hire people, we saw ads for them hiring people that -- for reviewers during the quarter. They expressed frustration with it but that they were getting on track and that things were moving and that they had assigned reviewers to different companies and/or to different submissions and that we -- and that, that was in process. As early as last week, we had another conversation. They just won't give you a specific of how -- you just don't know whether you're 90% of the process or the 50% of the process. And David, you know this is a big deal to this company. We have tried to use every avenue possible. We, besides just talking and having conversation and trying to encourage it, we use every means possible to us. Included in that is, in the last few weeks, we have submitted a citizen's petition. And a citizen's petition, and that is on the FDA's website, and a citizen's petition requesting them to exercise enforcement discretion. Because, clearly, by the language in the actual Act itself, it suggests a 90-day preapproval process. And if there were substantial equivalent products submitted within the first month, so you're 14, 15 months out on a 90-day process. We use that as the basis for our citizen's petition that says that the FDA has the right to exercise enforcement discretion. Meaning they could let these products start to go to market, complete the reviews in however long it takes them to get the process complete and if they have issues later on, ask us to make changes in the marketplace. Or even worse if they gave, they exercise enforcement discretion and decided it was not substantially equivalent, make us pull them from the market. But we're confident our products are of substantial equivalent. So, that's another avenue we're pursuing. I mean, as a reminder, everything from February 2007 to March 23 had a substantial equivalent submission as well, and they granted provisional approval on all of those products, however many years it takes them to review that. I believe it would be appropriate for the FDA, given their administrative struggles, to provide provisional granting of approval on these as well.

Operator

Your next question comes from the line of Judy Hong of Goldman Sachs.

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

So just a few follow-ups, and I just don't want to just go through this here in too much detail. But just to clarify what you're saying about the share performance, and I think in your data you're basically saying, you measure wholesale to retail which could be influenced by some of the noise that you've alluded to, whether it's some inventory movement, competitive activity, et cetera. But then if you look at retail data, and we get retail data which actually shows your performance is better. Sequentially, it looks like your share is actually flat to maybe even up a little bit. So is that kind of what you're alluding to in terms of your data, which measures the wholesale to retail and then the retail takeaway data from a share performance perspective?

Murray S. Kessler

Exactly what I'm -- I'm more than alluding to it, it's the case. And just again, the category by the way we measure it showing the -- industry shipments off 1.7% and I mean I don't believe that the industry went from minus 3% to 4% to minus 1.7%. There's no fundamental change even with rolling your own change and all that, that could have had that kind of effect that quickly. And to me, that's pushing wholesales to retail. I told you that just in the month of June alone, in the final weeks with new products pipeline inventory on a new product launch by a competitor and 300 million, 400 million factory packs, if you just take that affect alone out, it had a couple 1/10s of effect on our share for the quarter which would be a difference in wholesale versus retail. So consumers have to buy it. It's a catch-22 for this company because scanner data doesn't capture enough of our business to manage the business and perform well at retail on an ongoing basis, it just doesn't give us -- it only covers 60%, 70% of our volume. But I think, directionally, in a quarter like this where you had a lot of push promotion, it's at least a good second indicator.

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

Okay, got it. Yes, okay. And then just following up on the FDA, the substantive equivalency issues. So when you say you've filed the citizen's petition and then you've talked about the -- I wasn't clear on just the 90-day approval issue, but is there anything from a legal perspective that you can pursue which -- does the statute say something that the FDA has to really follow and they're not abiding by certain aspects of that statute?

Murray S. Kessler

Well, that's all spelled out in the citizen's petition and you can read that. I don't think we're at a point of talking about any kind of legal action. I take the FDA at their word that they're trying to get this done. I just, we think it's a good idea that given the troubles they're having -- and I understand them, it's hard, once they -- this is going to set the precedent for all future approvals. I just believe that they have evidence of other categories where they have exercised discretion and the time has come where that's appropriate here as well. The statute itself says, "a substantially equivalent product must be submitted to the FDA 90 days before marketing." It doesn't say they must give a response. They have interpreted that to say it's a guideline but they're not required to do it. We didn't -- look I was around when we were crafting the bill. This wasn't -- the whole notion here was it was supposed to get harder from substantial equivalent to a real new product to a modified risk product. And they've said it's sort of a 360-day process for a modified risk, though the statute, it actually says they must give an answer on a new product in 180 days, so surely it couldn't have meant that on a 90-day approval, that it could go longer than a new product. And we spelled all that out in the citizen's petition. So the long and short of it is, I understand that they're going through growing pains, they ought to exercise enforcement discretion and let the playing field be leveled. Because right now you have seen some of our competitors because of their test market activity, they continue to be able to launch new products.

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

Okay. And then just switching gears to blu ecigs. So the financial impact in the quarter, you said $8 million for 2 months of revenue and then any profit impacts?

David H. Taylor

No, Judy, essentially nothing. You'd count it as a breakeven for the quarter. For those 2 months post acquisition.

Murray S. Kessler

Yes, and remember, we sort of take the one-time cost but you have purchase accounting adjustments and all kinds of things with the acquisition. Right, and there's a little bit of that admin cost, but it's immaterial to the total number. Keep thinking of blu right now as a long-term R&D project that we're very excited about. The trial numbers are incredible, the consumer responses to the thing is super, I believe the products have a long way to go but that we've got the right vehicle. It's the one that consumers like and are excited about. And now, over time, we just need to make the product performance stronger and better and closer to the levels that they expect from a cigarette.

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

Okay. And would you disagree with some of the comments from other companies that for ecig, there's a huge interest in the category and there's -- the trial numbers are good but the repeat numbers haven't really been that great and I'm just wondering, you've talked about the trials being really great but just what are you seeing on the repeat side? And is there some tweaking that you need to do on the product to really get those repeat numbers up more strongly?

Murray S. Kessler

It reminds me when I first joined UST and I used to stand up there and say that smokeless tobacco was, we were going to switch smokers and all the major manufacturers said that would never happen. And then 10 years later, they're all on the smokeless business, and believers. The answer is, we have strong consumer research, the repeat numbers are solid and they continue and we have more experience in this than anybody else. Because what we see is the difference between somebody purchasing a disposable product moving onto a rechargeable product and then the repeats that come in the actual purchase of the refills. And the refill sales are solid and strong. And we have unproprietary consumer research on it. Having said all that, I think the product's 20% of the way to where it could be. But we have the vehicle right. The category already sells more than snoots and all these other efforts at getting into a cigarette alternative. So I mean that the key thing is that the technology works and consumers love it. And, over time, we need to get the satisfaction performance, flavors, get the taste even stronger, get quality-control even stronger. There's tremendous opportunities. But I'm convinced this is the right vehicle.

Operator

Your next question comes from the line of Andrew Kieley of Deutsche Bank.

Andrew Kieley - Deutsche Bank AG, Research Division

Murray, sorry, just to go back to the quarter-to-quarter retail share on Newport. If really that sequential dip is due more to the timing of the promoted shipments by the competitors and the pull-through from retailers, you're saying you don't expect the similar timing dynamic at the end of Q3 and Q4?

Murray S. Kessler

You know, it's hard to predict that number. I think the sequential share is off a couple of tenths of a point. We've had this discussion in the past. We almost always have had it in the third quarter in the past because of our promotional flighting [ph] differences, but still, the relative comparison is year-over-year. So the question is, is Newport gaining share year-over-year and once again, it gained share this quarter. So you view that as more of a concern than I do, especially given I didn't think the trends of the business changed that fundamentally much, I just thought that the category as a whole, performed a little better. It would be different if the category performed exactly the same and that slowdown was because our trends went from being kind of flattish to down 3% or 4% aligned with the category. But that's not what happened. So can I predict it? No, I can't predict it. I think, over time, we will continue to gain share, I think our business will be relatively flattish until we get approval. I think we're having a discussion over 100 million units on a 10.5 billion-unit-quarter. When the real issue is getting to a point where we get back on track with our strategic plan where I expect these new products to deliver billions of units.

Andrew Kieley - Deutsche Bank AG, Research Division

Okay. And it sounds like you're pretty confident that the competitors aren't really impacting your, sort of, underlying consumer loyalty or the trend on Newport. Can you just talk a little bit about the price gaps on Newport Menthol, how you feel about those. You've been very stable on promotion in the past few quarters, do you feel a need to adjust at all since the promotion is so competitive this year?

Murray S. Kessler

Yes, well, just to clarify, what I said is that I didn't think it had a significant impact, I think it had a minor impact. You saw a lot of factory pack promotions out there and new products and our trend on Newport versus being up 0.5% last quarter was down 0.9%. So it had some effect, clearly, I just don't think it had an effect in a level that would make me want to engage in brand equity-destroying tactics. We resist that, so it's our intent to weather the storm on that and I'm pretty pleased with the play the brand performed in the face of that. There's always opportunities for adjust plans. And I talked about strong second-half plans. Given those strong -- I think we will achieve a level of net pricing realization in the second half that will please you, but we gave ourselves some flexibility in our, in the pricing actions that we took to adjust specific markets that were required. These are minor adjustments for GAAP and it's pretty scientific in the process that it's done here. But yes, of course, so where we need to adjust a market or two or more, we'll do that. I mean that -- but we do that all the time, that's standard operating procedure.

Operator

Your next question comes from the line of Chris Growe of Stifel, Nicolaus.

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

I want to ask you, first of all, Murray, on the New York situation, with the shift which has been going on for a while. Is there -- do you have a better sense of how much that really resulted in a drag on your price realization that is the incremental promotion that was spent to sell those units in New York? Any sense of how much that affected the quarter for your price realization?

Murray S. Kessler

You know I, I'm looking over at Dave, and I thought we've said for about a 1% drag -- do you know the exact number?

David H. Taylor

If you do the math on it, over the course of 12 months it was probably -- had a $40 million effect.

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

Okay, that's helpful. And then I wanted to ask on Newport, I think I know the answer to this based on some of your previous answers. But just to ask the question, is there any reason why that brand should -- you should use it to be a little bit more aggressive with your, with price points on that product, given what's going on in the market today.

Murray S. Kessler

Newport Red, we adjust and modify that like we do everything else. Newport Red, if you drop the price, you'd have a significant hit on profitability and you might gain 0.1 share point or 0.2 share point and I expect to gain that on the brand any way, maybe it gained another 0.1 point. I still take the position that it's our job to launch a brand, we have less vehicles to get that launch but over time, we want that to come up to the price because we want to protect the overall equity of Newport. I don't fundamentally buy into the strategy of some of my competitors that take a large portion of their franchise and sell it at a different price. So yes, I've been aggressive but it's my job as the steward of the brand.

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

Understood, that's good. And one final question and with regard to repurchasing shares and -- I guess I just want to understand going forward, you've talked before about having a gross debt to EBITDA ratio, somewhere in that 1.5% range -- 1.5x range and you're close to that. So as long as EBITDA grows, that would imply you could take on more debt in the future. But I wanted to just check that, that has not changed, that we shouldn't expect any kind of material debt issuance in the relatively short run?

David H. Taylor

Well, I'm not going to really to talk about debt issuance plans on this call. Yes, the 1.5x leverage target still remains today and that's really a rating agency and ratings driven, what we want to do is protect that investment grade rating. And I've said before in private meetings and the public, that should the conditions change or the views change in our rating agencies such that we could protect that investment grade rating and increase that leverage target from 1.5 to 1.75 or to 2x, we would consider doing that.

Operator

Your next question comes from the line of Ann Gurkin with Davenport.

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

Murray, I wanted to ask you about your bullish outlook for the second half, and what's the biggest driver for that kind of feeling that, that belief in the business? And are you seeing signs in Q3 so far that supports that outlook?

David H. Taylor

Well, we never talk about Q3. We never look forward. But I thought I outlined it, but just to reiterate, the first thing that's going to happen is you've lapped New York. So that was, as a starting point, you were losing 350 million to 400 million units every quarter for the last year. Now a lot of that was being made up in other stores outside of the Native American reservations, but not all of it. But you've lapped that major impact so that absence of a negative is a big one. The second thing that's going to help profitability is the same issue. Those promoted units, there was a pricing effect in the last 4 quarters of incremental buydown that were associated with those consumers going from a nonpromoted location to a promoted location. And that was a drag on the financial performance of the company. The third issue is this first half of the year was negatively impacted by 400 million units of inventory in comparison to last year. Add that back, $30 million something like that of operating profit. So just again on, at the very least, the absence of that negative, you start adding these up, in the last year $40 million from one, $30 million from other, the volume effect of others, we had an unbelievable performance in the last year despite all that. So those negatives go away. And then from a planning standpoint, we have always had some meaningful initiatives that were in the second half and I'm optimistic about those as well. The part of the plan that I am disappointed in, relative to this year, is the inability to have launched the next strategic initiative. Because I would have, while I believe we are still on track and against our internal budgets, we're right on track on a financial standpoint, we're not on track from a volume standpoint. So given that we made up the -- we had plans for new products, they were going to contribute significant profitability, we've covered that. And we're still on track, we would've been at a positive position. But we don't need that for the acceleration, we'll get an acceleration, I believe, in the second half of the year, mostly from the absence of negatives.

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

Was there evidence in Q3, so far, of inventory rebuilding in the system?

David H. Taylor

Well, it's not -- I'm not going to talk Q3. What I told you is we entered the quarter with 300 million units less inventory. So that day 1 starting wholesale inventory position this year is 300 million units lower than the starting wholesale inventory position last year.

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

Okay, okay. And then my other question was in terms of, I think that's -- sorry, that's on my -- shelf space. Any issue with shelf space, any change in terms of shelf space at retail?

David H. Taylor

No.

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

Then that's still just stable?

David H. Taylor

Yes.

Operator

Your next question comes from the line of Chris Ferrara of Bank of America.

Christopher Ferrara - BofA Merrill Lynch, Research Division

Murray, I guess, last quarter you were fairly clear about how competition wasn't really affecting you very much and I guess this quarter, you're talking about a little bit more, you're clearly saying it doesn't seem catastrophic, I guess not enough to engage in brand destructive activity plans to weather the storm. But I guess can you characterize the progression of your view of the competitive environment on your business as it changed, if it did, from Q1 into Q2?

Murray S. Kessler

Yes, I think that's a fair observation that at the end of the first quarter plus 0.5%, with 0 change at all but the level of activity was higher in the second quarter and we felt it a little bit. I can't go in -- I mean I've analyzed this six ways to Sunday and whether -- there wasn't, where markets whether there were a ton of factory packs affected us more than other markets or what, there's no clear correlation. But in general, that heightened level, I attribute to a slight change in trend, not of a significant level. I mean having said that, there was a quarter last year when Newport was down 1%, it's just nobody wanted to talk about it because of the launch of Newport Non-Menthol and Red, we were up 4%, 5% in total. It's just when you're on the core business. But, look, it's hard for me not to pay attention to a major competitor that basically spent back its entire net or most of its net pricing gains which has an effect on price gaps and things like that, so that's why I still maintain I'm pretty darn pleased of how well the business continues to hold up. But we're watching it, we'll make adjustments and if things change, you'll be the first to know.

Christopher Ferrara - BofA Merrill Lynch, Research Division

And I guess on a totally different note. I think also, not to be the last quarter police, but I guess last quarter, you said something to the effect of taking legal action or seeking legal remedy around the substantial equivalent issue which was kind of premature. And now you filed the citizen's petition, right? And I don't want to make too big a deal out of this, but I mean does that signal, at all, a change or a heightened level of frustration for you? Maybe that's the most obvious thing in the world, but I mean, how do you characterize the change in thinking from -- regarding this filing this citizen's petition?

Murray S. Kessler

No, that's not a change quarter-to-quarter, I was pretty frustrated last quarter too.

Christopher Ferrara - BofA Merrill Lynch, Research Division

Right. But, okay, so tying together the comment that legal remedy wasn't something you necessarily thought was necessary. Now, you're doing this. Is there, I mean --

Murray S. Kessler

It's not really a legal issue. You know it's -- going to the citizen's petition, we continue to look at that, we continue to look at putting as much pressure on. But at least from the advice that I get, a legal solution to this is not obvious. The reason I say, I don't think it's necessarily necessary, unless they're flat out lying and they haven't been liars, the message that we're getting is not something devious. It is process and there is evidence that supports that. So if I believe the director has said directly to me, he expects this to be a more transparent, more expeditious process and they're working hard to get it there. We're going through some growing pains here through the regulation.

Operator

Your next question comes from the line of Bonnie Herzog of Wells Fargo.

Bonnie Herzog - Wells Fargo Securities, LLC, Research Division

I just had one quick question on Maverick, as you mentioned, volume growth slowed in the quarter and I don't think you have a lot of promotional support behind the brand or it didn't change much during the quarter, which could have contributed to the slowdown. I guess I'm wondering, could you talk about your strategy for the brand going forward? And if, in fact, you're willing to step up promotions behind the brand to support it, strategically does this make sense to you? Or are you just willing to let the growth slow assuming that competitive pressures continue?

Murray S. Kessler

You know look it's -- first off, just to be clear, Maverick is not promoted. It gets 0 promotions and always has gotten 0 promotions. The growth has come from increased distribution and visibility which continues as the Newport brand has grown and we've sold new contracts. So that's been the source of growth. The biggest issue to the slowdown over time, because a couple of years ago, we were going at 30% it's just gotten big now. It's a brand of scale that we make a lot of money on, we have taken aggressive pricing, pricing at a faster pace than our traditional premium business, so it still offsets that mix issues. And I'm pleased with Maverick and I guess if Maverick got into a decline, I might have to consider some of those tactics, but it's not my instinct. My instinct is, as long as that thing continues to be positive, and grow, and contribute and be a meaningful segment in that area, that's super. And I can continue to grow net pricing and realization from that. That's a pretty good place to be.

Operator

Our final question comes from the line of from Priya Ohri-Gupta at Barclays.

Priya Ohri-Gupta - Barclays Capital, Research Division

A very quick debt-related question, if I may. In the past, you've sort of targeted minimum debt offerings of at least $750 million as a total. I just wondered if I can get a sense of your appetite for doing a smaller sized debt issuance maybe to get you to that 1.5.

David H. Taylor

I don't think we've targeted a minimum of $750 million. We did a $500 million offer in the past, Priya, so we do have an appetite for smaller offerings.

Priya Ohri-Gupta - Barclays Capital, Research Division

Oh, I meant your total across tranches when you came to market?

David H. Taylor

We would certainly consider -- you have to consider minimum sizes when you're trying to approach the market and $750 million is not a lower limit for us.

Murray S. Kessler

Yes, I mean look, the message on share repurchases is, we view our job and that has not changed. The vehicle here is, and the business model in no ways this quarter or this first 6 months can change in any way that we believe that we have a pure cigarette peer play that our business is solid, that we get to the pricing realization that exceeds the category in the performance of the fundamentals, that exceeded. We generate a lot of cash we pay a big dividend and we buy back shares and returning cash is a priority, and remains a priority.

Operator

This concludes today's question-and-answer session. I would like to turn the call back over to Mr. Kessler for any concluding remarks.

Murray S. Kessler

Well, thank you for your continued interest in Lorillard, we'll keep building the business and we look forward to a bright second half. Thank you.

Operator

This concludes the Lorillard, Inc. second quarter 2012 earnings conference call. For a replay of this call, please dial 1 (855) 859-2056 and enter your ID number 97837890. You may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: Lorillard Management Discusses Q2 2012 Results - Earnings Call Transcript
This Transcript
All Transcripts