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Reynolds American, Inc. (NYSE:RAI)

Q1 FY08 Earnings Call

April 30, 2008, 09:30 AM ET

Executives

Morris Moore - VP of IR

Susan M. Ivey - Chairman, President and CEO

Thomas R. Adams - EVP and CFO

Analysts

Judy Hong - Goldman Sachs

Ann Gurkin - Davenport Company

Erik Bloomquist - J.P. Morgan

Christine Farkas - Merrill Lynch

David Adelman - Morgan Stanley

Operator

Good day, ladies and gentlemen. Welcome to the First Quarter Earnings Conference Call hosted by Reynolds American Incorporated. 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, this call is being recorded.

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

Morris Moore - Vice President of Investor Relations

Good morning and thank you for joining us. This morning, we will discuss Reynolds American's first quarter results and our outlook for the full year. We will discuss our results on both the GAAP and 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 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 provision. During the call, we will discuss forward-looking information. When we talk about future results or events, there are a number of factors that could cause actual results to be materially different from our projections. 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 from this morning's earnings release, Reynolds American's operating companies continued to post gains on key cigarette and smokeless tobacco brands in the first quarter. R.J. Reynolds' growth brands gained half a share point. Conwood continued to post double-digit volume growth. And our Santa Fe and Global Products subsidiaries continued to build super premium share, both here and overseas.

We also recorded a $328 million gain from the successful termination of the Gallaher joint venture. As a result of that gain, our first quarter reported results were significantly higher than the prior year quarter. However, as you also saw, Reynolds American faced a number of challenges in the first quarter of 2008, and that resulted in an adjusted earnings decline of about 10% compared with the first quarter of 2007.

While we're disappointed with last quarter's results, we remain confident in Reynolds American's underlying strength, and that's demonstrated by the $350 million share repurchase program that we announced this morning. It reflects Reynolds American's continuing commitment to return value to our shareholders.

Let me spend a minute discussing the dynamics that drove our first quarter performance. As you'll see, the difficulties that affected us in the first quarter were the result of an unusually high volume decline at R.J. Reynolds as well as an adjustment to their MSA settlement expense. Other factors that had a negative impact on Reynolds American's first quarter earnings included investments to further strengthen our Conwood, Santa Fe and Global Products subsidiaries and a comparison to a strong prior year quarter, which benefited from higher cigarette volume and decreased promotional expense due to timing.

Based on our first quarter results, we've lowered our forecast. Excluding the joint venture gain, we now expect to deliver 2008 earnings that are consistent with our 2007 adjusted results. We are disappointed in R.J. Reynolds volume performance. We expected R.J. Reynolds decline to exceed the industry average, because the company's older, more price sensitive consumers are disproportionately affected by economic pressure. However, in the first quarter, there were several additional factors that contributed to an unusually large decline in the company's lower margin non-growth brands.

I'd like to point out though that we are not seeing a significant effect from the economy on the tobacco industry as a whole. We are, however, continuing to see shifts between tobacco products and categories. Those shifts are feeding the growth of other tobacco products like little cigars, roll-your-own and moist-snuff. And that trend does benefit Conwood. We're also seeing shifts in cigarette sales, with some growth in deep discount cigarettes and the continued sale of grey and black market product.

Tom will talk to you in more detail about the factors that affected R.J. Reynolds' volume. In contrast to the volume declines that are being driven by the company's non-growth brands, R.J. Reynolds growth brands gained an additional half a share point in the first quarter. During the quarter, Camel enhanced the packaging and blend of its core style and Camel's ongoing focus on providing adult smokers with relevant innovation continue to strengthen the brand. Camel's continued growth was driven by innovation like Camel No. 9 and Camel Signature. The brand's latest innovation, Camel Crush is a new unique product that lets smokers change each cigarette from regular to menthol by crushing a small capsule in the filter.

Camel Snus, a smoke-free, spitless tobacco product continues to lead the development of this tobacco category. We are continuing to see good awareness in trial in the eight Camel Snus test markets and the products being expanded to nine additional major markets in the second quarter. So, R.J. Reynolds continues to benefit from its focus on growth through innovation.

Now, turning to Conwood. Conwood continues to deliver double-digit volume gains, growing at about twice the rate of the moist-snuff category as a whole. In the first quarter, the company's Grizzly brand continued to capture more than 40% of the industry volume growth.

During the quarter, the company also made significant investments to support the national launch of two new products; Grizzly Snuff and Grizzly Wintergreen Pouch. These two products have been very well received in their initial markets and we are excited about their potential to further enhance Grizzly's strong momentum.

Conwood's premium Kodiak brand also added strength in the first quarter, with enhancements to its products and promotions. Kodiak also launched the brand's first product to compete in the growing pouch segment. Conwood is very well positioned for continued growth as smokers migrate to moist-snuff products and Conwood continues to broaden its portfolio with new products that meet consumers' desires.

So, that's the first quarter update on Reynolds American and the environment within which our businesses compete.

Now, let's take a look at litigation and regulation. The overall litigation environment remains fairly stable. There was, however, an important ruling in the Schwab Lights class action case that was favorable to the industry. Early this month, an appellate court decertified the nationwide class in this case. This ruling reaffirms our belief that claims of this type cannot be tried as class action.

Concerning the NPM adjustments to R.J. Reynolds MSA payments, we are continuing to work with the Attorneys General to resolve this dispute through negotiation. We also continue to pursue arbitration in the event that an agreement can be reached.

Moving to regulation. As you are aware, attention is again focused on the FDA bill. Early this month, the House Committee passed the bill. At this point, it has not been scheduled for a floor debate and vote. Reynolds American continues to believe that this bill would impede efforts to reduce the death and diseases caused by tobacco and we remain hopeful that a more reasoned and effective approach will be considered and put into place.

In terms of taxes, things remain quiet on the Federal front. We continue to see activity at the state level and we continue to believe that this year's increase in state excise taxes will be similar to 2007. So, that's a quick look at the external issues.

As I have noted, the first quarter had its share of challenges. However, we are taking steps to improve our performance going forward, and we are continuing to find ways to return value to shareholders. In the first quarter, each of our companies made investments to build their businesses. These investments are consistent with our long-term focus and our commitment to continue enhancing Reynolds American's long-term strength.

Reynolds American's total tobacco portfolio positions us well for future growth. And we remain confident in our ability to build value for our shareholders over the longer term.

And now, Tom will walk you through some of the details of the first quarter. Tom?

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

Thanks Susan and good morning everyone. As Susan said, RAI's first quarter reported results were significantly higher than the prior year period. First quarter earnings per share of $1.71 was up 54% from the year ago quarter. That included a pre-tax gain of $328 million or $0.71 a share from the termination of the joint venture, which was completed in the first quarter. This month, the company received 40% of the total payment of €265 million. That payment was €106 million or about $166 million. The balance will be paid in annual installments over the next six years.

These proceeds are invested overseas and will be available for future opportunity either internationally or here in the United States. While we provide the taxes on the total gain however, tax payments will only be required for cash that returns to the United State s. Excluding that gain, adjusted earnings per share of $1 was down $0.11 a share from the prior year quarter. I would point out that about $0.06 a share was related to a first quarter MSA adjustment for the prior year. In addition, an effective similar magnitude resulted from the timing of promotional expenses that benefited the prior year quarter. Excluding those two factors, R.J. Reynolds' first quarter operating income and therefore RAI's adjusted EPS would have been consistent with the year ago results.

Now let's look in more detail at R.J. Reynolds volume decline. As you'll see, we expect some of the dynamics in the first quarter to moderate as we move through the year. Compared with the year ago quarter, R.J. Reynolds volume was down 11.8%. Almost 4% of that decline was due to reductions in wholesale inventory and the elimination of some low volume lower margin brand styles. We expect the impact from both of those to moderate through the year.

Excluding the effect of inventory adjustments and brand style elimination, R.J. Reynolds' first quarter volume would have declined about 8%. That decline resulted from a combination of factors. In the first quarter, we saw a significant increase in competitive discounting and promotional activity. That came at a time when R.J. Reynolds was focused on enhancing margins through two initiatives; increased promotional efficiency and above average price increases on certain brands. As a result, the company's brands were disadvantaged and R.J. Reynolds lost volume in share.

The company continues to seek opportunities to enhance margin through more efficient promotion. But they will take a more measured approach to ensure that those efforts are in line with marketplace conditions. R.J. Reynolds remains focused on profitable share growth, the company is taking steps to strengthen performance and expects improvements through the balance of the year.

So that's in detail on first quarter's cigarette volume and those volume declines also impacted the company's market share. R.J. Reynolds' first quarter share was 28%, down 1.4 share points from the year ago quarter. As with the volume decline, this share loss was driven by the company's lower margin non-growth brands. In contrast and despite a difficult environment, the company's three growth brands; Camel, Kool and Pall Mall had a combined per share first quarter share of 13.2%, up a half a point from the year ago quarter. That performance was driven by continued growth at Camel and Pall Mall.

Camel grew half a share point from the prior year quarter for a total share of 7.9%. Kool share of 3.1% was down slightly in the first quarter and Pall Mall was up an additional two-tenths of a point to a market share of 2.2%. R.J. Reynolds' premium mix continued to improve, up more than 1 percentage point at 63.2%. The company's first quarter operating margin of 23.2% was 2.4 percentage points lower than an unusually high margin in the year ago quarter, which benefited from higher volume and promotional timing.

R.J. Reynolds' first quarter operating profits of $415 million were 15% lower than the year ago quarter. That was due to its volume decline, the MSA adjustment for the prior year and a difficult comparison to a prior year quarter when operating profits were up more than 16%.

As Susan mentioned, we are continuing to seek resolution of the disputed MSA payments. R.J. Reynolds made its full payment of $2.3 billion on April 15th. That included $431 million that was deposited in the disputed payment account. At this point, R.J. Reynolds has $1.6 billion in that account, and it's still difficult to predict when this matter will be resolved.

Now turning now to Conwood. Conwood's first quarter volume was up 10.8% driven by a 13.7% gain on Grizzly, the nation's third largest brand. In the first quarter, Grizzly share was 22.1%, up 1.6 share points from the prior year period. That growth was aided by two new Grizzly styles that are now being expanded nationally.

During the quarter, Grizzly Pouch captured more than 20% of Wintergreen Pouch sales in its initial markets. That represents 0.7% of all moist-snuff sales in those markets. Grizzly Snuff also posted strong results with 1.7% of total category sales in its first market.

Conwood's focus on making its premium Kodiak brand more competitive resulted in a volume increase of almost 2% during the quarter. We are pleased with Conwood's continued strong growth, especially at a time when many new products are being introduced and well established brands are aggressively competing for moist-snuff share.

Conwood's net sales increased 7.7% in the first quarter. First quarter income growth was reduced by the company's investment on new brand initiatives as well as one less shipping day. Operating income of $81 million was up 1.9% from the prior year period. These investments further strengthen Conwood's ability to consistently deliver volume and earnings growth again this year and in the future.

Our other subsidiaries, Santa Fe and Global Products, also continued to invest in their businesses as they further strengthened their position and potential, through the growth of Natural American Spirit and additive free super premium brands. In the first quarter, Natural American Spirit continued to deliver volume growth in key markets both here and overseas. So that's a look at how Reynolds American businesses performed in the first quarter.

Based on that performance and our current expectations for the remainder of the year, we're reducing our full year forecast. We now expect to deliver full year earnings that are in line with our 2007 adjusted results. That doesn't include the impact of the joint venture gain. That gain provides value for our shareholders and a stream of cash flow over the next six years.

As you saw in our announcement this morning, the Reynolds American Board of Directors has approved a $350 million share repurchase program. We plan to opportunistically purchase these shares in the open market over the next 12 months. I will point out that our largest shareholder BAT has agreed to participate in this repurchase, in a manner that is intended to maintain their ownership interest at approximately 42%.

Additional details concerning the share repurchase are in the 8-K that we filed this morning. This share repurchase along with our ongoing 75% dividend payout policy demonstrates Reynolds American's ongoing commitment and ability to return value to our shareholders. We plan to use cash from operations for our share repurchase program. This maintains our financial flexibility and our strong balance sheet.

This positions Reynolds American well to take advantage of opportunities to further increase shareholder value. Moving forward, we will continue to identify and evaluate opportunities to build and return value to our shareholders. Thank you, and now we will turn to the Q&A portion of the call. Anthony, would you remind our callers how to get in the queue.

Question And Answer

Operator

Absolutely. [Operator Instructions]. We will take our first question from Judy Hong at Goldman Sachs.

Judy Hong - Goldman Sachs

Hi, good morning every one.

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

Hi, Judy.

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

Goodmorning.

Judy Hong - Goldman Sachs

Hey Tom, can you first quantify how much the settlement adjustment in the quarter was?

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

It was about $0.06 a share.

Judy Hong - Goldman Sachs

Okay. Now if I just look at the operating income for your cigarette business and even if you adjust for the settlement expenses, it seems like your profitability was down on a per unit... sorry, was up pretty modestly when you saw actually pretty healthy price growth. I am just wondering if you can sort of look at the profitability on a per unit basis and just walk us through how much savings you got in the quarter, was it really the negative operating leverage that kind of depressed that number because it looks like pricing was actually up pretty healthy?

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

Pricing was up and as we said, we took our pricing up and some of our other competitors went the other direction in terms of promotional activities, so our pricing was up but our volumes were down. You also need to look in the year-over-year comparison, as we mentioned, we had some timing of promotional expenditures in 2006 that benefited the first quarter of 2007 and our operating margins then were actually inflated by the fact that some of those volumes weren't burdened by the costs that resided in '06.

Judy Hong - Goldman Sachs

Okay. And then Susan, I just wanted to just get your perspective on some of the adverse dynamics that depressed your number in the first quarter. You've talked about those dynamics becoming more moderate going forward, but at the same time it also sounds like you may emphasize volume a little bit more in the near term, so how do we think about the competitive dynamics in the first few quarters as you sort of assess your strategy and focus maybe a bit more on volumes, you have got your competitors in the first quarter that really have become more promotional, how do you think the dynamics will play out and how do you think that these dynamics will impact the industry wide profit pool for the next few quarters.

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

Sure, Judy. I think we do see the industry decline this year more in sort of a 4% to 5% decline rate and that is higher than we had projected previously. And remember that, that segment that we're talking about really is the measured cigarette universe. We saw of course in the... from the fourth quarter to the first quarter, we did see growth in the non-big three savings sector, about a half a share point, but that seems to stabilize actually in the last couple of months and we did expect and we continue to expect that R.J. Reynolds will lose volumes disproportionately.

We normally run about 1.5 times the industry decline rate and that is our expectation on those non-drive growth brands. But clearly the inventory adjustments will not repeat themselves. We also discontinued, there was about 400 and something million units that we discontinued last year in our low price very low margin business and that volume will lap going forward. So, we are expecting that the growth brands, we are committed to keeping those more competitively priced and being mindful of that competitive environment and so that is really kind of how we see the rest of this year. We've got pieces that will moderate, will be more competitive with the growth brands and that leads us to the expectations that we forecast.

Judy Hong - Goldman Sachs

Okay. And then just in terms of the Conwood's profit in the first quarter, I know you've talked about the investment that you made in the first quarter, if you could just talk about how you think that the profitability of that part of the business will unfold as the year progresses?

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

We would expect Conwood to continue to grow its profits probably at a greater rate than they did in the first quarter because of the investments that we made around the new brand launches.

Judy Hong - Goldman Sachs

And it was that just kind of a ramp-up one time brand investments that sort of disappears in the subsequent quarters or does that stay in support of the new product that you really need to see volume growth pick-up to get higher profit growth?

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

This expenditure in the first quarter really was to drive those two national launches. So, we are launching both pouches and snuff on a national basis. We will continue to support Kodiak and of course it benefited in both volume and share terms from that promotion, but that is very specifically targeted to be profit enhancing, it's a balanced promotional investment.

Judy Hong - Goldman Sachs

Okay, thanks.

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

Thanks, Judy.

Operator

And we'll go next to Ann Gurkin at Davenport Company.

Ann Gurkin - Davenport Company

Good morning.

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

Hi, Ann.

Ann Gurkin - Davenport Company

Beginning with Conwood, is there anyway to get a volume number excluding the new product launches?

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

We don't have that in front of us Ann, we can... we'll get back to you on that one.

Ann Gurkin - Davenport Company

Okay. And for the year for Conwood, do you expect premium to increase as a percentage of the mix on a volume basis?

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

No, we can... and that's actually largely driven to the continued growth of Grizzly.

Ann Gurkin - Davenport Company

Okay.

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

Yes, we're delighted with Grizzly's growth, I mean as I mentioned, it's commanding more than 40% of the category growth. We continue to see that category growing 6% to 7%. It was 7% up in the first quarter, if you discount the one less shipping day and of course Grizzly is benefiting from this economic environment and we continue to see that growing.

Ann Gurkin - Davenport Company

And what is your outlook for the over all growth of the smokeless category in the U.S. for the year?

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

It will be about 7% for the year, Ann.

Ann Gurkin - Davenport Company

Okay. Switching to cigarettes, do you believe that the industry needs to reset prices, do you think prices are too high given what's going on in the economy that seems to be the theme going around.

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

I think we got a little bit caught in the cross fire with a lot of competitive promotion, and we obviously will rectify that on the growth brand. But we are seeing stabilization now in the last couple of months of the non-big three and so I would expect prices to be relatively stable.

Ann Gurkin - Davenport Company

Okay. And I believe in March, you all pulled back on your strategy to 'buy one, get one free' to see what happened, I guess can I get an analysis on the results from your study for the month of March.

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

It's a little bit early for us to really have digested all of that. As you know, we did not use 'buy one, get one free' in a number of states, and we will continue to evaluate that, but it is very important that our growth brands remain competitively promoted.

Ann Gurkin - Davenport Company

So, you are putting that strategy back on in those states behind your growth brands?

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

Well, we will be competitive.

Ann Gurkin - Davenport Company

Okay. And then last, do you have any plans to increase your presence in the little cigar segment?

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

Conwood, as you know, participates somewhat in that little cigar segment with Winchester and Captain Black, but that's not really the segment of little cigars that is growing. So we are making them available, but we are not planning to invest any disproportionate dollars in those two brands.

Ann Gurkin - Davenport Company

Okay, thank you.

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

Thanks, Ann.

Operator

And we will go next to Philip Gosan [ph] at Credit Suisse.

Unidentified Analyst

Thank you so much. Good morning, Susan and Tom.

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

Good morning, Philip.

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

Good morning, Philip.

Unidentified Analyst

First question, Susan perhaps for you, kind of going back on the prior two questions here, as it relates to the change in behavior by the two largest competitors, Susan, based on your insight of the industry, to what an extend do you believe was that change in pricing behavior the result of these companies outlook for the economy trying to play into people's concerns about higher fuel prices, rising excise taxes versus perhaps more corporate event, as you know Altria was going to the last stage of its restructuring program. Therefore, the new Altria was kind of the new kid on the block, if I may use that expression and therefore perhaps, wanted to take advantage of some opportunities to gain momentum on the market shares side. Carolina Group, as far as we know, is also still going to be spin-off from the Lowe's, most likely at the end of the second quarter, maybe they wanted to kind of take advantage of that opportunity to show some market share gains as a newly listed company. What's kind of your take, is it corporate event type driven or it was really kind of like the industry trying to see how to react against some of these more macro economic type questions that are out there.

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

Philip, I would say it is a little bit of both. I think some of our competitors clearly outlined that they wanted to take advantage of the first quarter in terms of their promotional investment and they did that. And I think that had certainly, a corporate event piece of it. I think all of the companies are mindful of the recessionary pressures in the economy, but the timing in the first quarter, I would lay a little bit more the seed of a corporate event.

Unidentified Analyst

Okay. And then as people kind of wonder, is there going to be a reset of prices like we saw, when your largest competitor, a number of years ago rolled out its national sales leadership program. Shouldn't we kind of say that things are different now because when they adjusted their price and when it came out with this whole new program, it was basically on the back of a number of years, I'm referring now to the fourth MSA years of significant price increases in order to cover these payments and that today, if you look at the average price increases over the last few years that they said is up about 5%, that the dynamics are really quite a bit different and therefore we should not expect such a major reset?

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

Yes Philip, I don't like to speculate too much on pricing, but in terms of the environment, I agree with you. It is not... we are not sitting here with years of significant industry decline, we are not sitting here with rapidly growing non-big three share, nor are we coming off in the last three years, significant increases in pricing. So, our expectation is that it would be relatively stable.

Unidentified Analyst

Okay. Then second question Susan, in terms of again, macroeconomic picture, people were asking about a downtrading, I would have thought that given that compared to the two largest competitors, your price... your mix is still skewed a little bit more toward value type products. I would have thought that you would actually have benefits from that, am I wrong in that assumption?

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

What we are seeing Philip, and we saw that actually, if you do go back into '02 and '03, that, many consumers are skipping the, if you will, mid-price value where the big three players compete and dropping down to lower prices. So we saw, as I referred, we saw a half a share point growth in the non-big three savings brands in the first quarter over the fourth. And then, it's our belief that the non-measured deep discount category is certainly growing in certain states. So while you would intuitively think we would benefit some from value and we did see growth in Pall Mall, but we are seeing, as you do in this kind of an economic environment, people going to the bottom and obviously the last five years in relative economic stability we saw those brands in that bottom tier remaining very flat really for about four years and we will see how this economy evolves. But people in good times come back to the brands they love.

Unidentified Analyst

Okay. Then the other question is Susan, and I missed part of your comment related to FDA. Did I understand that the way that the current house bill is written that, that version is one that you cannot support and if that's the case, can you just elaborate in terms of what you would like to see different?

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

Sure, Philip. We've said from the beginning that Reynolds American supports reasonable regulation. We do not support the current FDA Bill and there are a couple of primary reasons for that. First of all, we don't really believe it belongs at the FDA, but more importantly, we believe that it does not provide for relative risk communication to consumers and therefore we believe it's a bad bill. It also has sincerely severe marketing and administrative requirements that we believe are sort of anti-competitive, if you will, and we would support regulation that provides for fair competition among adult smokers and for communication of relative risk information.

Unidentified Analyst

Okay. And then my final question, Susan, with the announcement of the share buyback, I know that Tom mentioned that despite the share buyback, you maintain your financial flexibility. But what does that really mean in terms of your appetite for looking at potential acquisition opportunities for you guys and may be within a broader context as you know, we are kind of taking the view that with some of these headwinds that are out there whether it is the economy, whether it is the excise taxes, whether it's FDA regulation et cetera, that there may be kind of a final round of consolidation within the U.S. tobacco sector. Given the announcements of the share buyback, does that change at all your thinking as it relates to your potential appetite to play a role in that potential consolidation?

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

It really doesn't Philip, we've always said that we will look for opportunities that will strengthen our businesses strategically and financially and be accretive to shareholders and we have the $350 million share repurchase program with... over this 12 months window retains our flexibility. Now, we've also said, there is not a lot out there, but to your point, there may be some more opportunities for consolidation and we would certainly evaluate those.

Unidentified Analyst

Great thank you so much, Susan.

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

Thanks, Philip.

Operator

We'll go next to Erik Bloomquist at J.P. Morgan.

Erik Bloomquist - J.P. Morgan

Hi good morning, Susan.

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

Good morning Eric.

Erik Bloomquist - J.P. Morgan

I just wanted to come back to the snuff profitability and is it... not only a combination of the increased spending behind the Grizzly nation-wide growth, but are you also seeing increased competitive pressure within that segment in a similar way to what you are seeing in the cigarette segment?

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

We are seeing consistent investment by the competitors in that moist segment. As you know, USST significantly increased their promotional level last year and we are sort of seeing that in the same context. And as... we did see Red Man launch this year at the end of last year actually, and it gained some traction but Grizzly continue to be a star performer, at 22.1% market share and growing and growing in the growth category, we are very pleased with that and we continue to expect very strong results from Conwood during the year.

Erik Bloomquist - J.P. Morgan

Okay. Moving on to cigarette, the expectation that you're giving today is that we should see an improvement through the rest of the year. I mean, I guess I'm just trying to understand how we can be confident in that, what markers we should be looking for in terms of a more reasonable competitive environment? I mean, clearly, you're suggesting today that there will be a step up to maintain the position of the growth brands, I mean are we kind of in a situation where we risk going into a very negative spiral in terms of competition at the same time underlying volume growth is declining. Are there some markers that we can be looking forward to have confidence for not getting into that kind of situation?

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

Erik, this is Tom. As Susan mentioned, our volume decline is just on phase value at 11.8, but, adjusted for the inventory adjustments and these discontinued brands, we're more like 8% for the first quarter and we see that moderating over the year. Just... as information, our April volumes were improved over what you saw in the first quarter and we believe that there is strength there and we believe that we will continue to do well at Reynolds tobacco through the balance of the year, quarter-over-quarter.

Erik Bloomquist - J.P. Morgan

Okay. Thank you, Tom. Last question then is on the buyback. You said that, that will be equivalent to operating cash flow of 350 million. Given the sell-off today in the stock, and perhaps if there is continued weakness, is there a possibility to be more flexible in that amount and take advantage of share weakness to buyback more.

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

Yes, well, we are going to look at this over the year and yes, I mean, we will be opportunistic about when we go into market and buy. It is a 12 month program and we will just look at it over that 12-month period. So, yes, we will take advantage of opportunity such as a share decline.

Erik Bloomquist - J.P. Morgan

Super, thank you.

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

You're welcome, thank you.

Operator

We'll go next to Christine Farkas at Merrill Lynch.

Christine Farkas - Merrill Lynch

Thank you very much. Good morning, Susan and Tom.

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

Good morning, Christine.

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

Good morning, Christine.

Christine Farkas - Merrill Lynch

If I heard you correctly, Susan and I certainly don't expect you to show your hands completely, but if I heard your statement correctly, if stable pricing for the rest of the year, though I am assuming you intend to cover the step up in the MSA, this suggest little net price benefit to Reynolds. Is this the kind of thought that's built in to your full year flat EPS guidance?

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

Actually, it is Christine. We've looked at that, we have also looked at our volumes for the balance of the year and so we are comfortable with those at this point. We... as Susan said, we have not seen... we have... we play a little bit more into the economy and we are a little bit disadvantaged more than the balance of the industry because of the age profile of our smokers. But right now, we are comfortable with the guidance that we are giving.

Christine Farkas - Merrill Lynch

Okay. And just as a clarification then on the pricing, in the quarter given your programs, I'm assuming that despite the fact that Camel won share, it's pricing was up, correct?

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

It was up ever so slightly.

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

Marginally.

Christine Farkas - Merrill Lynch

Okay, okay great. With respect to Conwood, the volumes were up almost 11%, your revenues up about eight or so, should we read into that gap as the promotional spend in the quarter rather than any mix effects?

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

That's the way that we would read it.

Christine Farkas - Merrill Lynch

Okay. And then a question on your buyback, 350 million, pleased to see the announcement certainly. I'm just curious given your cash flows, your free cash flows on an annual basis are tremendous. Was there anything preventing you from putting a bigger number out there? For example, were there any restrictions from BAT as to how much they would participate?

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

There were no restrictions from BAT. We just really believe that you know giving ourselves the flexibility to look at other opportunities is important and that's why we choose a12-month program, given the volatility that we are seeing out there in the industry as opposed to looking out beyond that 12 months. But we would look to re-evaluate this on an annual basis and determine the best use of our cash.

Christine Farkas - Merrill Lynch

Okay, great. And then a final question on Santa Future. With your comments about trading down, certainly some impact of trading down to the deep discount segments, there are some clear winners in terms of premium. Can you comment on the growth of Santa Fe or perhaps what your volumes were in the quarter?

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

Yes, Santa Fe was actually up 8% on Natural American spirit in the United States and of course, as you say there are winners and losers, but Santa Fe has a very robust profile. It's demographic profile is probably one of the best in the industry and the least affected, if you will, by the overall economy. So as you know, we invested last year in Natural American spirit, we built that sales force and we are starting to see the benefits of that, the Natural American spirit is performing well.

Christine Farkas - Merrill Lynch

Great, thanks a lot.

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

Thank you, Christine.

Operator

And we'll go next to David Adelman at Morgan Stanley.

David Adelman - Morgan Stanley

Good morning, Susan and Tom and thanks for being on the call, Susan.

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

Thank you, David.

David Adelman - Morgan Stanley

Let me ask you first of all, Susan, when you look at the profit pool in the U.S. cigarette market over the next few years and you try to calibrate the risks to its prospective growth or decline, do you think volume or pricing is the greater risk going forward?

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

Certainly, it's both David. But... I mean, prizing as we saw here in the first quarter, does drive some consumers into deep discount cigarettes and into other tobacco category. We don't have evidence on a consumer basis that a lot of people are leaving the tobacco category, so I don't think so there is a huge out flux of quitting or otherwise. But people when they get force to make choices with other economic pressures, I think we can see how it affects the higher price, if you will, pieces in the sector.

David Adelman - Morgan Stanley

And other than the economy, Susan, do you think there is something else going on that's creating perhaps a greater proclivity to shift out of the conventional cigarette category that may have been the case in the past?

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

Well, I think we've talked about people migrating, if you will, as we look at cigarettes to moist, and certainly, the opportunities that we see for Snus, we are very excited about Snus and the opportunity for that category as we see increasing smoking ban. As you know, this business has always been seasonal and one of the hypothesis is that it will get even more seasonal because it is very difficult for people to smoke in the winter month, anywhere there is cold weather, but I do see those smoking bans driving people to other categories and obviously in some states where we have significant tax increases, this can drive people to deep discount brands or also into other category.

David Adelman - Morgan Stanley

But Susan, the volume decline in the quarter and sort of the outlook over the intermediate term make it more feasible to contemplate closing one of your manufacturing facilities?

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

No, it really doesn't David, and as you may be aware, we do a fair amount of export volume.

David Adelman - Morgan Stanley

For BAT, right?

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

For British American Tobacco, so we don't see this... I think we agree with you that the industry decline is more in that 4% to 5% range, but that doesn't impact our operations at this time.

David Adelman - Morgan Stanley

Okay. And then going back to a question perhaps for Tom on the economic model, something I wanted to revisit, volumes down 12, price mix is up about 6 and profitability at R.J. Reynolds adjusting for the MSA about $30 million, is down 9%. To me, that's not how the business should behave, the profitability should be better and am I mistaken in thinking that or is there some other variable that I'm missing?

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

Well, you're not mistaken in thinking that, but what you haven't put into your calculation is the fact that our year ago quarter was benefited by these promotional active... by the trade promotion that were recorded in 2006 and worked to the market place in 2000... in the first-quarter 2007. And that amount was actually slightly larger in our MSA adjustment. So adjusting for that quarter-over-quarter, we're very consistent.

David Adelman - Morgan Stanley

Okay. And then one... go ahead, I'm sorry.

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

Go ahead.

David Adelman - Morgan Stanley

I was going to ask you a different question. Susan, one last thing, you're obviously familiar with sort of the business paradigm in many tobacco markets in U.S. and elsewhere. What is sort of your view of sort of the likelihood and the potential attractiveness of the U.S. competitive set evolving to be more like the UK economic model, which when faced with more difficult volume trends shifted to one where there is much more aggressive manufacturing... manufacture of pricing, significantly weaker volume in part because of the pricing and substantial secular downtrading and yet every year I can remember profits have grown in that market?

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

Yes, you're right in terms of your memory and it's an interesting thing to evaluate. As you know, the UK also has enormous import, shall we say, because of the high pricing and high taxation in that market. And we continue here to see black market and other trafficking, if you will, in cigarettes even in a state-to-state basis. But overall, I think we are still a little ways away because we have quite a wide price spread in the market, but we will have to continue to see how this economy perform and how the tax situation evolve.

David Adelman - Morgan Stanley

And on the price rate point, I assume what's underlying that or the difficulty that's creating in the U.S. is that the... your profitability per pack in the discount segment, that's quite a trade-off in the U.S.?

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

Yes, it is.

David Adelman - Morgan Stanley

Right, okay. Thank you very much.

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

Thanks, David.

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

Thank you.

Operator

We'll go next to Dominique Neil at Canyon Capital [ph].

Unidentified Analyst

Hi. Can you comment again on the actual size of the buyback, it seems fairly small to me. What are the competing potential areas of investing your cash flow, other than buying back your shares and giving the dividend?

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

We're actually... if I understood your question, you are questioning why our share repurchase program is only $350 million?

Unidentified Analyst

Precisely.

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

We are comfortable at that level. We did debate that internally. That's a good number for us that represent an additional value to our shareholders. We have said previously on the last call and another forum that we would... that we choose not to lever up to do share repurchase and especially in economic times like this, it's very important for us to maintain the financial flexibility in our strong balance sheet. So, we are very comfortable at this level for a one year program.

Unidentified Analyst

Thank you.

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

Thank you.

Operator

And we go next to And moving next to Jerry Gallagher at Austin Partners [ph].

Unidentified Analyst

Yes hi, good morning, guys.

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

Good morning, Jerry.

Unidentified Analyst

Hi. I'd just like to come back to this question of pricing in the market. Over the long-term, we're clearly faced with a position where volumes in the U.S. market are going to decline consistently, maybe around 4% level or greater as you suggested, they have in the first quarter and in order to maintain straight growth, the profitability of the industry, it is clear that prices will have to be put up over time and the industry play the elasticity game to drive profits higher through that mechanism. Now, you guys, with your removal of some of your discounting, which you talked about publicly, I would regard as a very sound message to industry participants about what drives profitability industry and while you guys can compete aggressively on certain levels, shooting the pricing regime just doesn't work.

Now, after one quarter of trying that, sending that message and trying that policy, we're in a situation where your competitors have turned around and ignored the message, perhaps was trying to be sent, and have taken industry pricing down or the level of discounting down. So, from an investor point of view, what looks like a pretty simple algorithm to generate additional profitability through the pricing regime seems to be ignored by the industry participants in totality, if not by or sales. I appreciate, you can't talk for your competitors, but is there anything more you can say about what level of comfort the investor base can have us with regard to the industry and its rationales down to over the long term to improve the profitability of the U.S. cigarettes pool?

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

Well, we agree with you Jerry, I would... as you said, it's not a mystery equation. Pricing is a key to growing the profitability of the industry over the medium term and we can't speak for our competitors, but I'm sure that there is a recognition of that and taking... we did expect that when they took prices up in the fourth quarter that they would take some of that to the bottom line. They chose not to do that, which obviously we did not expect. But I don't really believe that, that behavior will continue in the industry, it's not good for anybody's investors.

Unidentified Analyst

To what extent do you think the pricing architecture of the U.S. market has resulted in what we've seen in the first quarter? What I mean by that, do you think we need to see another tier of brands emerge that when prices are put up in the premium end of the market, the holders of those brands accept that volume will decline knowing that an element of the downtrading will be captured by their brands further down the pricing architecture, which essentially what happens in the UK, and do you think in that regard, the U.S. market is perhaps aversely immature and needs to see an emergence of a mid-tier category or do you think it's just a much more complex equation?

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

I think it's a little more complicated because of the master settlement agreement and therefore, the cause that the big-three players has built into their cost structure, that these very low tier brands are not faced with, makes that not so simple an equation. I think that we'll continue to watch what happens here. Again as I said, as a result perhaps of how long is this economic recession with us and what happens on the tax front and that will obviously cause people to evaluate alternative opportunities.

Unidentified Analyst

Okay, thank you.

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

Thanks, Jerry.

Operator

And our next question is a follow-up from Christine Farkas at Merrill Lynch.

Christine Farkas - Merrill Lynch

Thank you very much for the follow-up. Susan, just wondering based on your view of industry volume declines near the 4% to 5% range now. What really changed in your thinking, the outlook for your SET as per your comments are similar in '08 versus '07, is it just the reaction of volumes in the first quarter on the back of the pricing levels?

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

Yes, Christine, it really is. We... it is looking at the first quarter and backing out the things that won't repeat and taking a prudent view of the industry decline going forward and then of course, recognizing that Reynolds is disproportionately advantaged in this economy. So that is what's really driving that change in the forecast.

Christine Farkas - Merrill Lynch

But then your forecast was for industry volumes to decline 4% to 5%?

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

Yes, industry at 4% to 5%, Reynolds at 7% to 9%. But if you go back to the way we saw it last year when... in the third quarter, we were then looking at the industry more in that 3% to 4%.

Christine Farkas - Merrill Lynch

All right. Okay, got it. Thanks a lot, Susan.

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

Thanks, Christine.

Operator

Ladies and gentlemen, we have time for one final question. Our last question will come from Judy Hong at Goldman Sachs.

Judy Hong - Goldman Sachs

Hey, I just had a follow-up question on your dividend. I know that you guys have typically in the past raised the dividend in the middle of the year, just in light of your earnings outlook being flattish and your 75% dividend payout policy, earnings are coming in flattish, does that mean that the dividend is not likely to go up?

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

Judy, we will take a look at where we are at mid-year and discuss those matters with our Board and after we discuss them thoroughly with them and with management, we'll be prepared to respond to that.

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

Yes, and the Board does review the dividend every quarter.

Judy Hong - Goldman Sachs

Okay. So it's just because earnings are going to be flattish does not necessary mean that the dividend aren't going to go up?

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

Well, we have a 75% payout policy and we would have to look where we see the year as the year moves forward to evaluate the dividend.

Judy Hong - Goldman Sachs

Okay, all right, thanks.

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

Thanks, Judy.

Operator

And that will conclude today's question-and-answer session. Mr. Moore, I would like to turn the conference back over to you for any additional or closing remarks.

Morris Moore - Vice President of Investor Relations

Thanking for joining us. A replay of this call will be available on our website at reynoldsamerican.com until May 30th.

Operator

This will conclude today's presentation. We thank everyone for their participation. You may disconnect your lines at any time.

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Source: Reynolds American, Inc. Q1 2008 Earnings Call Transcript
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