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Executives

Morris Moore - VP of IR

Susan M. Ivey - Chairman, President and CEO

Thomas R. Adams - EVP and CF

Analysts

David Adelman - Morgan Stanley

Nick Modi - UBS

Adam Spielman - Citigroup

Judy Hong - Goldman Sachs

Christine Farkas - Merrill Lynch

Ann Gurkin - Davenport

Filippe Goossens - Credit Suisse

Reynolds American Inc. (RAI) Q2 FY08 Earnings Call July 30, 2008 9:30 AM ET

Operator

Good day, ladies and gentlemen and welcome to today's Second 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, today's conference is being recorded.

And now at this time I'd like to introduce to your host for today's conference, 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'll discuss Reynolds American second quarter and first half results and their outlook for the full-year. We'll discuss our results on both, a reported and adjusted basis. A reconciliation of reported to adjusted earnings is in our press release which is on our website at reynoldsamerican.com.

Joining me this morning are RAI's Chairman and CEO, Susan Ivey and our CFO, Tom Adams. Before I turn the call over to Susan, I need to cover the Safe Harbor provisions.

During the call we'll discuss forward-looking information. When we talk about future results or events, there are a number of factors that could cause 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 statement, 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 release, Reynolds American had a solid second quarter. And consistent with our April forecast, we are on track to deliver full-year earnings that are in line with those we delivered last year.

The second quarter was marked by progress on several fronts. At R.J. Reynolds, continued pricing and productivity gains along with additional increases in total growth brand market share drove higher second quarter profits. And Conwood had another outstanding quarter delivering record volume share and profit.

Conwood continued to benefit from the performance of Grizzly which continues to lead the growth of the moist-snuff category. Also in the second quarter, Reynolds American launched a $350 million share repurchase program. And as a result of second quarter upgrade from Standard and Poor's and Moody's, RAI's credit is now investment grade.

The progress we made during the quarter was helped by improvements in the cigarette marketplace. Price increases by R.J. Reynolds competitors brought their prices more in line with those already in effect at R.J. Reynolds. That along with lower levels of competitive promotion put R.J. Reynolds in position to further enhance profits by selectively reducing its own promotional expense.

Higher cigarette pricing along with continuing economic pressures on smokers did result in some growth in deep-discount market share. R.J. Reynolds is watching this situation closely and will respond as appropriate. R.J. Reynolds growth-brand share continued to climb in the second quarter with gains on Camel and Pall Mall, and continued stability on Kool.

Second quarter highlights include Camel's expansion of Camel Crush in Pennsylvania. This latest Camel innovation uses new technology. It gives smokers the choice of regular or menthol with each cigarette. We're seeing very positive results with limited promotional support, and we expect the excitement surrounding this technology to continue when R.J. Reynolds expands Camel Crush nationally in September.

During the second quarter, Camel also further expanded distribution of Camel Snus. Camel Snus is now available in major metropolitan markets across the country, and it continues to generate significant interest among smokers. R.J. Reynolds sees considerable potential for this smoke-free product, and the company continues to refine its efforts to create awareness and educate adult tobacco consumers about this new category. R.J. Reynolds is also pleased with the consumer response to its recent upgrades to Camel's core style.

R.J. Reynolds Kool brand remained relatively stable in the second quarter saw continued competition for premium menthol market share. And Pall Mall, the company's value growth-brand is especially well positioned in the current economy. During the second quarter, the brand again delivered strong growth.

R.J. Reynolds results for the second quarter and the first half of 2008 reflect the company's ongoing focus on its brand strategies, its effort to broaden its business with new types of tobacco products; its ongoing focus on continuous productivity improvement and its commitment to keep its cost structure in line with the company's performance. R.J. Reynolds focus on these initiatives, positions the company for long-term strength.

Conwood, our second largest operating company, had another outstanding quarter and we continue to be extremely pleased with Conwood's performance. The company's second quarter results demonstrate Conwood's powerful momentum in the growing moist-snuff category. And almost half of the category's total growth was captured by Conwood's Grizzly brand. Grizzly's two new styles, Snuff and Wintergreen Pouches played a significant role in the brand's second quarter results.

Conwood's first quarter investments to support the national rollout of those two styles contributed to the company's second quarter earnings growth. With the continuing expansion of the moist-snuff category and Conwood's increasing strength, we look forward to another very profitable year for our smokeless tobacco business.

Our Santa Fe and Global Products subsidiaries are also performing well. Those companies are focused on building natural American spirit, and both delivered double-digit volume growth for the first half of the year. That's an overview of our second quarter performance. And now I'd like to spend a few minutes on the external environment.

In terms of litigation, last week in the Scott case, the Louisiana trial court ordered the defendants to pay $263 million for smoking cessation program. We believe there are powerful grounds to appeal this order and we intend to do so.

On the regulatory front, we continue to see efforts to advance the FDA bill. Recent calls for a ban on menthol have been in the news, but we don't believe that there is widespread support, and we don't expect any changes to the menthol provisions. The administration has informed Congress that it strongly opposes this bill. There is a chance that the House will vote on the FDA bill this afternoon, but we don't expect the Senate to pass the bill this year.

Turning to taxation. State tax increases have been in line with our expectations, and this should turn out to be another relatively good year. We do, however, anticipate an increase level of tax activity in a number of states next year. We also expect considerable debate regarding a federal excise tax increase in 2009. So that's a quick look at the external environment.

I think that you can see from this overview that Reynolds American business strategies are continuing focus on productivity and our company's underlying strength serve us well in these challenging times, and they position us to continue building and returning shareholder value as we move forward.

And now Tom will provide some additional detail on our second quarter results.

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

Thanks, Susan and good morning everyone. As Susan said, RAI have a solid second quarter and we're on-track to deliver full-year earnings that are comparable to RAI's 2007 adjusted results.

Second quarter earnings per share was $1.24, up 12.7% over the year ago quarter. EPS for the first half was $2.95 that was 33.5% above the prior year period. Driving that increase was a first quarter gain of $0.71 a share from the termination of the Gallagher joint venture.

Excluding that gain, adjusted earnings for the first half were $2.24 per share, up 1.4% from the first half of last year. Contributing to those results were continued pricing improvements and share gains on key brands at our two largest operating companies. Those improvements offset the impact of cigarette volume declines and inflationary pressures, including CPI adjustments to settlement expenses.

Also of note, in May, RAI launched a $350 million share repurchase program that we announced on April 30. At this point, we bought about 2.2 million shares at a cost of approximately $118 million. That comes to just over one-third of the total dollar amount of the program. Our share repurchase program along with RAI's 75% dividend payout ratio demonstrates our ongoing commitment to return value to our shareholders. And Reynolds American solid fundamentals position [ph] us well as we move forward.

RAI's strong foundation is also reflected in the credit updates we received from Standard and Poor's and Moody's in the second quarter. Our credit is now investment grade and that provides us with additional financial flexibility going forward. So those are the highlights of the second quarter. Now let's look in more detail at our two reportable segments.

First, R.J. Reynolds. During the second quarter, R.J. Reynolds continued to streamline its operations and evaluate opportunities to further optimize its cost structure. As Susan noted, R.J. Reynolds selectively adjusted its promotion in discounting levels to increase profits while remaining competitive. R.J. Reynolds second quarter operating profits of $523 million were up 5.4% that was on the strength of higher pricing and continued productivity gains. The company also benefited from somewhat higher levels of trade inventory.

R.J. Reynolds second quarter margin of 25.7% was 1.7 percentage points higher than the prior year period. The company's total market share was 28.1%, down 1.1 percentage points from the year ago quarter. However, R.J. Reynolds continued to increase its combined growth brand market share. In the second quarter, growth brand share of 13.6% was 6/10 of percentage point higher than the prior year period.

R.J. Reynolds total volume declined 7.9% in the second quarter. That was due to a number of factors including the elimination of certain brands and brand styles over the past several quarters. Excluding those from the comparison, the company's second quarter volume would have been down about 5.4%.

Now let's take a look at the performance of the company's growth brands, starting with Camel. Camel continued to gain share in the second quarter. However, Camel's volume was down 7%. More than half of that decline resulted from the elimination of smaller, non-core styles like Camel Special Lights and Camel Turkish Jade. This has helped Camel intensify its focus on key growth styles at retail.

In the first quarter, the brand introduced new packaging for its core styles and those changes have been well received with these styles gaining share in the second quarter. Camel's total second quarter market share was 8%, up two tenth of a percentage point from the prior year period.

Turning to Kool, Kool's second quarter market share was 3.1%. That was level with both the previous and the prior year quarters. The menthol category as a whole remained at just under 28% of the market, up slightly from the prior year quarter. Kool's market share has been relatively stable for the past two years and R.J. Reynolds is evaluating the best strategy for Kool going forward.

Next, Pall Mall, Pall Mall, the company's value growth brand had an excellent second quarter with volume up 18.4%. That was the result of several factors including successful efforts to increase Pall Mall's purchases by adult smokers of competitive brands, the increasing relevance of Pall Mall's positioning as a longer lasting cigarette at a great price and adoption of the brand by some smokers of the company de-listed brand styles.

Pall Mall's second quarter share was 2.6%, up half a share point from the prior year period. Though R.J. Reynolds continues to make progress, the company is moving forward by remaining focused on its brand strategies and by continuing to streamline its operation, reduce complexity and improve productivity across its business.

Now let's look at Conwood. In the second quarter, Conwood's results again demonstrated the company's powerful momentum as the growth leader in the moist snuff category. Conwood's record volume, share and profits were driven by the accelerating strength of Grizzly.

Second quarter operating profits of $96 million were up 5.5% from the prior year quarter. The company's total moist snuff volume was 18.4% with a 25.6% volume gain on Grizzly. And Conwood's total share of moist snuff shipments was 27.8% up 2 percentage points from the year ago quarter. The Grizzly family continues to perform well with the market share of 23.4% up 2.7 percentage points from the prior year quarter.

Grizzly's growth benefited from the strong performance of the brand's two new style, Grizzly Snuff and Grizzly Wintergreen Pouch which are now available nationally. Grizzly Snuff has already captured eight tenth of a share point and Wintergreen Pouch has claimed four tenth of a point. And that's with distribution of both styles in only about half of the outlets where they will ultimately be sold.

The moist snuff category grew 7.7% in the second quarter, almost half of that total category growth went to Grizzly which grew volume by more than 15 million cans.

Kodiak, Conwood's premium brand was down 1.4 million cans with the second quarter volume decline of 9.6%. For the first half of the year, Kodiak declined 4.1% with a volume loss of just over 1 million cans. To put that in perspective, that compared with Grizzly's first half gain of almost 23 million cans. That's some detail on Conwood's second quarter. I think it's clear that Grizzly's continued outstanding performance keeps Conwood on track for another strong year. And that along with the improvements at R.J. Reynolds and the growth at Santa Fe and Global Products keeps Reynolds American on track for the full year.

Thank you and we will now turn to the Q&A portion of the call. Sarah, would you remind our callers how to get in the queue.

Question and Answer

Operator

Certainly. [Operator Instructions]. We'll pause for just a moment. We will go to Filippe Goossens of Credit Suisse First.

Unidentified Analyst

Good morning, Susan and Thomas it's actually Tilo Valetis [ph] in for Felipe. Question on the cigarette volumes. It looks to me like there is some significant downturn going on in cigarettes given that the price volume segment or the discount segment had much better performance than the premium segment. Is that a fair assessment or do we see something wrong here?

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

We have seen... we have seen growth in the non-big three in that deep discount sector in the second quarter. Actually, it kind of, it's sequentially accelerated, June was actually a big month for that non-big three area. It looks now like it's flattening out a little bit. I think it's worth saying that there are economic pressures on tobacco users and if you think about what's going on in the total tobacco category, moist is growing at an accelerated rate. Moist grew at 7.7% in the quarter. We continue to see growth in roll-your-own. We see growth in deep-discount. And so, we are seeing tobacco users making some trade-offs but across total tobacco, the sector is relatively, economically it is not challenged from the economy on a total sector basis. But we will continue to watch this growth of the deep-discount, and watch how it affects the pricing and promotion environment for the large competitors.

Unidentified Analyst

I think in the past you have told us that the down trading wouldn't necessarily benefit you given that your smokers are probably more economically pinched than smokers of your two big cigarette competitors. Do this quarters results change that opinion a little bit?

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

No, they don't change that opinion. Our consumers are more price sensitive. We have sort of the…an older brand portfolio, and we have talked about that over the last number of years. So, we would stay with that opinion.

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

And as I said, we also feel we also captured some of that in Pall Mall. We caught some of that down trading there. So we're…but on balance, you are right. I mean, I think there was more down trading.

Unidentified Analyst

Okay, fair enough. And then one last question on this topic on Conwood. How much of the Conwood Grizzly performance was driven by this down trading we just talked about? How much of it was promotion driven? And if it was promotion, was it more a one-time opportunity that you saw? Or was it…is it something that changed in your strategy with promotions for Grizzly?

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

I think Grizzly's momentum of course has been going strong for five years. And really if you look at the promoted volume in the segment, remember the segment grew 7.7% and Grizzly captured more than half of that. Grizzly had a little bit of value-added promotion in June but about 6% of Grizzly's volume was promoted volume in the second quarter and that compares to competitors percent over 30. So, there was not a change in promotional strategy. You saw the growth in margins, and we continued to be very enthusiastic about the Grizzly's new line extension because this is incremental share. As Tom mentioned, the Snuff product has got already 8/10 of a share point and it still hasn't reached its distribution targets. And the Pouches are at 0.4. So we see this as sustainable growth.

Unidentified Analyst

Okay. Then a question on Camel Crush, it sounds like the test in Pennsylvania is going really well given that you are expanding it nationally. Where are the smokers for Crush coming from?

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

It's interesting; because of course this technology allows you to have the same cigarette be a non-menthol or a menthol depending on your preferences. So it is appealing to both, non-menthol and menthol smokers. So we're very excited about it and we are launching it nationally in September.

Unidentified Analyst

But do you think the Crush smokers are coming more from the menthol side or non-menthol side? And are these smokers that previously smoked other Camel brands or are you drawing them from other brands?

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

As I said, they are coming from both, non-menthol and menthol. We don't really see Camel getting anymore than its fair share which means that there a lot of incremental smokers from competitive brands trying the product.

Unidentified Analyst

Okay. One question on Skoal Snus, if I still have time for that; UST announced that they have renamed Skoal Dry to be called Snus. Do you think that it's helping the Snus category overall that it's now more uniformly named across all of the brands that are out there? But don't you think it has an impact on Camel Snus?

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

I think that it is positive, that Snus has established as the spitless category. And I think that the more competitors that are working to educate consumers about the differences between this product and moist-snuff, that it will benefit the category. And we feel very positive because we believe we have the best product formulation on the market, and that Camel will prevail in the battle for market share as Snus developed.

Unidentified Analyst

Okay, that's it for me. Thanks a lot.

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

Thanks.

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

Thanks, Bill [ph].

Operator

Up next from Morgan Stanley, we'll go to David Adelman.

David Adelman - Morgan Stanley

Hi, good morning everyone.

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

Good morning, David.

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

Good morning.

David Adelman - Morgan Stanley

Susan, I wanted to ask you a few things. First, could you help us understand the scale and the magnitude of the reduction or the improvement in the competitive environment, the reduction in the promotional dynamics from Q1 to Q2?

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

Sure. I'm happy to talk about it, David. I mean as you know, our two largest competitors took pricing in the second quarter. We saw sequential improvement in the overall pricing and competitive promotion environment. So we saw promotion spend reducing, and we saw net pricing coming through, and it came through stronger as we went through the quarter. So we did see an improvement in that promotion and pricing environment.

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

I think, Dave this is Tom. We saw a reduction in the number of buy some activities and actually some buy some activities that were coupled with dollars off. And so that diminished overtime, there was some switching to more dollar offers than soft packs. And so that they may have been a shift in there but overall we did see a decline in promotional activity.

David Adelman - Morgan Stanley

And I correct, there was also somewhat reduced regional incremental promotional spend?

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

Yes, that is correct.

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

Yes, you are.

David Adelman - Morgan Stanley

Okay. And then on the issue of the non-big three doing better, do you think that this reduction in promotional spending although clearly fabulous development, do you think it is contributing to some extent to better trends on the, the low end of the U.S. cigarette category?

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

What you would have to say there's a relationship between price and the growth of that non-big three. And of course the big three manufacturers are trying to balance that promotional support and profitability and market share while being very weary of that non-big three growth. As you know that non-big three growth is really focused in about 11 states in the U.S. I think 90% of the growth we saw in the second quarter is actually in those 11 states. And so tactically I think you would expect to see some promotional activity to be sure that stays in check.

David Adelman - Morgan Stanley

And the non MSA states I assume are well over shared in that volume and is there any feasible legislative solution to that dynamic?

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

Certainly we work toward that.

David Adelman - Morgan Stanley

Okay. And then two last things. How much of a rethink are you giving to Kool? It appears from the release you are speaking to perhaps pulling back from promotional support in some of the lower menthol geographies for Kool but are you considering doing something beyond that?

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

We are certainly evaluating Kool David and you've heard us talk about it before. Kool has a franchise, a price sensitive side to its franchise and then we focused on trying to get new growth on the brand attracting competitive smokers. And we... you saw the results. Kool's relatively flat quarter-over-quarter, year-over-year. We have actually had more success in premium menthol building Camel's menthol market share. We got, we are at a full share point of Camel now with our menthol styles and certainly we are looking at Crush to make an impact in that menthol arena.

So we are evaluating Kool and the role of Kool and our resource allocation on Kool. But that will... and that will come to bare in our operating plan process from now to year end.

David Adelman - Morgan Stanley

Okay. And actually two more quick things. One is the outlets that the two new Grizzly line extensions are in you mentioned that's half of the physical location but approximately what percent of category volume is in now that's that account for? Do you know that offhand?

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

I don't, David. I mean I would say 60 something percent. But.

David Adelman - Morgan Stanley

Okay.

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

But there's still a good run way in these new line extensions.

David Adelman - Morgan Stanley

Okay. And then lastly... can you quantify for us the scale, the magnitude to which you think either volumes or operating profit at the U.S. tobacco business were flattered by this presumably some degree of trade-price speculation?

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

Probably in the, we are guessing our range would be in the 2 to 400 million units. But it's difficult to tell I mean be honest with you. We saw a little bit of an up tick in inventories and they diminished a bit but they didn't diminish by the upper end of my range.

David Adelman - Morgan Stanley

Got it. Okay, thank you for taking all of the questions.

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

Sure, David.

Operator

Pamela Mark [ph] of Federated Investors has our next question.

Unidentified Analyst

Good morning. A couple of them. Despite the beat on the quarter I am wondering why you didn't raise guidance for the year and maybe just a sense of where you might be sensitive through the rest of the year?

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

Sure, Carol. As you will remember, we will be lapping last year's price increase in the fourth quarter. And we... and so that obviously has an impact on that second half. We are also absorbing some fairly significant increases in the CPI estimate attached to that MSA calculation. As we are not really the price leaders it very much depends on what happens further in the pricing and promotion environment. We feel confident with our earnings guidance as we sit today, and we will continue to monitor that pricing and promotional environment and see how it, where it takes us in the second half.

Unidentified Analyst

Okay. And also, thanks for starting up the buy backs. I am just wondering especially that you have the investment grade rating and greater financial flexibility. How comfortable are you thinking about at least bumping up the buy backs at this point or the authorization? Excuse me.

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

We are pretty comfortable with where we are right new. When we came out with this we said it would be a one year program and we would evaluate it annually. And so we are going to execute against this and then take all of those factors into consideration in the first quarter of next year.

Unidentified Analyst

Okay. Great. Thanks.

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

Thank you.

Operator

Nick Modi of UBS, we will go to you for our next question.

Nick Modi - UBS

Thank you, good morning, everyone.

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

Hey, Nick.

Nick Modi - UBS

Just a couple of quick questions. Susan on the trade down topic, are you seeing just the middle price value segment getting impact in terms of those consumers going to, or are you seeing... premium once the consumers going straight down to the fourth tier. And then the second question is within the markets you are test marking Camel Snus. Are those units profitable? Meaning, are you making money or margin on that and how does that compare to your cigarette margin?

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

Sure, Nick. On the first question, we talked about Pall Mall's growth in the release, and Pall Mall is in that sort of mid-price value category. We did invest some promotional support on Pall Mall in the second quarter, and it responded very well. So I think you have really… it's a double phenomenon. So premium smokers may choose that mid-value category, or they are dropping all the way down. So I think it really is mix and match.

On the second question it was Snus, of course, we're in the investment stage with the rollout. We've rolled it out to all of the major metropolitan cities in the country, but certainly the medium-term margins on Snus are higher than they are on cigarettes, they of course don't have the same tax structure. And so, Snus as a strategy to offer adult tobacco users alternatives to cigarettes is both good for meeting consumer demand, as well as for enhancing margin.

Nick Modi - UBS

And in the market where you originally test marketed the product, I guess in Texas and Oregon, is the business profitable in those markets yet?

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

I couldn't hear the last part of the question, Nick. You're kind of cutting out. Could you repeat that?

Nick Modi - UBS

Sorry about that. In Texas and Oregon where you first started the Snus test market, are the businesses profitable in those markets today? Or is it still in kind of investment stage?

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

Yes, I would say they are profitable there today. I mean obviously, we look at these investments and the profitability on a sort of national theoretical basis. And those markets have been operating for a couple of years. And of course, we've learned a lot in those test markets and that has manifested itself in a new ten and new size pouch, and new ways of educating consumers on the category. But both of those markets… I think it's fair to say, the performance of Snus for us is on or ahead of our business case. And that is really the metrics that we use to determine the expansion.

Nick Modi - UBS

And so I guess the point I'm trying to get to is, if theoretically you launch Camel Snus nationally in every market, would it be a needle-moving event in terms of your profitability?

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

No, certainly not in the first year. In the fist year there is also significant investments to build the category. But you would expect to see it contribute to our profitability overtime, no question about that.

Nick Modi - UBS

Thank you.

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

Thanks Nick.

Operator

[Operator Instructions]. From Citigroup, we'll go to Adam Spielman.

Adam Spielman - Citigroup

Good morning. I've got a couple of questions.

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

Good morning, Adam.

Adam Spielman - Citigroup

I'd first go… good morning. I'd like to try and reconcile what you're saying with what Lorillard said on Monday, because they said that the promotional environment in the second quarter was very similar to the first quarter. They said it didn't get better sequentially. And you've obviously said something that is very different from that. And I was thinking perhaps, maybe that what they're saying on…their comments really refer to the menthol segment which obviously you understand, whereas you are talking about the general overall cigarette market. That would be my first question.

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

I… certainly, obviously, we're aware of what Lorillard said, and we've reported our view of the environment. You maybe right, I mean menthol is…always been very active and competitive in terms of promotional support. But we certainly saw in overall term across the market, really net pricing improvement which means reductions in promotion and some real pricing coming through. And Reynolds of course, it was able to reduce its promotional support by reducing discounting in certain geographies to participate in that, and that helped grow our margin.

Adam Spielman - Citigroup

Can you sort of repeat that comment with reference only to the menthol segment? Suppose I'm trying to guess that, whether the promotional environment stayed very intense within menthol?

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

I actually… I think they were probably, equally affected to the same degree. We don't have those statistics in front of us, but I mean anecdotally just looking at the data that came through, it looked like they were lightened up in both areas.

Adam Spielman - Citigroup

Okay, thank you very much. And the second question, if I may, is really referring to the… your market share performance and also the trading down in those states where we have seen quite a big increase in state excise tax. And I suppose I'm not only thinking about New York State because it's probably too early to say, but states like Wisconsin and Maryland, where we got a big excise tax increase right on January 1st.

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

Well I think we've talked Adam about our smokers being slightly more price sensitive.

Adam Spielman - Citigroup

Yeah.

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

And obviously those states where non-big three is a player, Reynolds is certainly affected by that. I don't have information in front of me on a specific state basis and we'd be happy to follow-up. But I think generally, we are impacted with pricing changes, but we have promotional strategies that help to counteract that.

Adam Spielman - Citigroup

Okay, thank you very much. I'd love to follow-up but obviously not now. Thank you very much.

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

Thanks.

Operator

We'll go to Judy Hong with Goldman Sachs.

Judy Hong - Goldman Sachs

Hi, good morning everyone.

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

Good morning, Judy.

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

Hi, Judy.

Judy Hong - Goldman Sachs

Susan, do you have an updated forecast in terms of the industry consumption outlook for this year?

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

Yes, Judy. I think we've been saying 3% to 5% and now we're sort of centering up around a 4% decline. We've seen the last two quarters 3.2 down. So that's really we are forecasting at the moment.

Judy Hong - Goldman Sachs

Okay. And then secondly, just in terms of the Camel volume being impacted by the elimination of some of the SKUs, when do we start to lap that? Is the volume continued to get impacted in the second half of the year as well?

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

We will lap that first quarter next year.

Judy Hong - Goldman Sachs

Right.

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

Those Camel style delistings happened.

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

In the first quarter, when we switched over to packaging.

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

Right. When we changed, upgraded the Camel core style packaging range. And really that is just to enable us to focus on Camel's core style. We felt that some of the proliferation was working against us. And so focusing on those core styles and making sure that any line extensions we add to that Camel family really perform. So we delisted nine out of the 37 styles and I think that's a good focus.

Judy Hong - Goldman Sachs

And are there other brands that you are looking at in terms of rationalizing the portfolio similar to what you are doing on Camel and potentially that also leading to better profitability.

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

Absolutely, Judy. As you know we have been on a long train to reduce complexity and attack this long tail of SKU. Since the merger, we have taken out hundreds of SKUs and part of that is looking at styles of existing families a part of that is looking at our very low margin, low price sort of store brand business, and that, a lot of the volume decline that you have seen in these last two quarters is lapping that delisting but certainly focusing on winning styles is part of a complexity production strategy.

Judy Hong - Goldman Sachs

Okay. And then in terms of your recent upgrade of your credit rating to investment grade, how significant is that in terms of assessing your balance sheet and thinking about utilizing that more aggressively going forward?

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

Pretty significant when we, if we were to do any refinancings or to go into the debt markets. I think that, so it is, it is most helpful there and I do think it does give us a bit more latitude to borrow.

Judy Hong - Goldman Sachs

Okay. And then, a couple of questions on the FDA regulation. Susan, to the extent that the house passes today, with the two third vote since it is on the suspension calendar, does that change the dynamic at all at the senate level? I know you've said that you don't think that there'll be enough support but if it does get the two third votes in the louse does that exert a little bit more pressure at the senate level in your view?

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

We really don't think it will get on to the senate floor this year, Judy. I mean certainly it is possible anything is and you never say never in speculating about government processes. But we really don't think it will reach the senate floor and as you know, the administration has also voiced its strong opposition to the bill. So we don't think it will get much further this year. Obviously, we continue to have dialogue to talk about potential alternative regulation and we prepare ourselves for any implications of this current FDA bill but it is our position now that it won't get through the senate this year.

Judy Hong - Goldman Sachs

Okay. And then you also talked about the, the menthol issue or potential ban or more regulation on menthol not having the widespread support at this point. But how would you assess the likelihood of more restricted regulation on the menthol over time?

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

It's very hard to speculate because it has not been placed with an agency; the agency is not set up its regulatory system. What you are referring to of course is that menthol, as a flavor, is excluded from the legislation in terms of being banned. It is allowed, but the agency in the bill is given a lot of latitude in terms of how it regulates products. I think as you heard from other competitors in the menthol category, there is no science to support any reason that menthol should be treated differently than other styles and I would expect that to prevail.

Judy Hong - Goldman Sachs

Okay. Thank you.

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

Thank, Judy.

Operator

Christine Farkas with Merrill Lynch has our next question. Please go ahead.

Christine Farkas - Merrill Lynch

Thank you very much. Good morning, everyone.

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

Good morning.

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

Good morning, Christine.

Christine Farkas - Merrill Lynch

Question just on your brands, you've certainly touched on Camel and discontinued SKUs there but looking at Santa Fe in the light of the current environment and trade down, how are the trends there and can you give us what the volumes were in the quarter?

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

I don't think Christine we normally release the volumes but as I stated, Santa Fe is experiencing double-digit growth in the super-premium cat choir which I think says a lot for it super-premium and truly differentiated positioning because even in this sort of economic situation that we face on a national basis, the smokers of Natural American Spirit and people interested in that category continue to try and enjoy Natural American spirit. So we are very pleased with that progress and of course that is delivers strong earnings, it is not discounted and it is at a premium price.

Christine Farkas - Merrill Lynch

Has there been much progress with respect to brand traction overseas?

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

We also achieved double-digit growth overseas. As you will remember we had businesses in Japan which is showing growth, businesses in Germany and Switzerland and of course the disillusion of the joint venture did impact our distribution opportunities that were, that had been delivered through that JV in France and Italy and Spain but we have subsequently signed deals with distributors in those markets so we start to see that volume coming through again. So we continue to be encouraged.

Christine Farkas - Merrill Lynch

Okay great. Then just on the overall brand portfolio, you have certainly talked about complexity reduction. How much of your strategy here with reducing the complexity or is there any part of your strategy that's based on pressure at retail on your shelf space?

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

That's a good question, Christine. I think we are certainly very well aware that if an SKU doesn't move, the retailer may remove it for you. As you know, there has been new retail contracts stalled in to the trade this year. And that has resulted in some reduction of space for Reynolds products and certainly making sure that the brands we have in front of consumers are our growth brand and brands that have the biggest opportunity and potential to grow is important in that whole inventory strategy.

So I think it is a win-win for us and for the retailer in terms of complexity reduction and we certainly do our best to try to move consumers from that style into another style of the same family or as Tom mentioned, if we for instance delisted the viceroy family and we tried to move those smokers to Pall Mall. We are using those sort of migration techniques to try to keep the consumers in the fold but we look at it as a win-win.

Christine Farkas - Merrill Lynch

Okay and then just a couple of financial follow-up questions. I noticed the MSA and growers numbers from a year ago seem to have been restated a little bit. Is there anything on going here that we would see throughout the year and with respect to your outlook of inflation on MSA, has those assumption changed in your own calculation for '08.

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

Yes. Well, let me answer the second question first. Yeah the going in assumption in our plan was about inflation at about 3% and we've seen that now tick up to I think the current estimates are about 5.1%. So we are in a fair amount of head wind in terms of the costs that are associated with the MSA. We reassess this and get updated estimates every month. So stay tune. And with respect to numbers changing on the quota buyout, there may have been some reclassifications, there are certainly more restatements.

Christine Farkas - Merrill Lynch

Okay. And then last question, Tom just on tax rate. A little bit later than what we were looking for this quarter, is your full-year target for about 38% still intact?

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

No. It's about 37.2, 37.4, I think.

Christine Farkas - Merrill Lynch

For the full-year?

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

37.5 for the full-year.

Christine Farkas - Merrill Lynch

Thank you very much.

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

Sure.

Operator

Ann Gurkin of Davenport has our next question.

Ann Gurkin - Davenport

Good morning.

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

Good morning, Ann.

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

Good morning, Ann.

Ann Gurkin - Davenport

Just some questions on Snus. In your comments I think you talked about good potential for the Snus category. Are you willing to comment as to when maybe we'll see that category accelerate or really take-off? Are we close to that inflection point for the Snus category in the US?

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

I think it's hard to predict an inflection point because we are in the process and obviously, as are our competitors, of driving awareness and trial and education about a totally new tobacco category. So I think we are working towards that. We have some momentum. But I think it is a slow build, Ann. I don't think it's all of a sudden going to take-off. But we certainly work for that.

Ann Gurkin - Davenport

Okay. And then with respect to Camel Snus, are you changing your level of promotional support for Camel Snus and maybe redirecting some of that promotional spending back to the core cigarette portfolio?

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

No, we are not. We are working in these major metro markets with Camel Snus. And of course, we've refined the promotional programs with our past two years of testing. So, we will still continue to drive trial and drive awareness of that category, and our core cigarette support is not suffering with that investment.

Ann Gurkin - Davenport

Okay. Then if I may, just ask on potential FDA regulation. We keep getting asked this question, so I just would be interested in your opinion. There's continued speculation that we'll have some kind of special meeting or session on the floor of the house to discuss menthol, maybe it should be investigated, maybe there should be more discussion. Is there any kind of special meeting aside from those this afternoon?

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

Not to our knowledge, certainly not. The way the bill is scheduled today is that there would be no amendments or discussion. And that if it receives a two-third's vote it will pass. We really don't expect that if it doesn't pass that it will resurface their only incision through tomorrow. But we'll have to watch this Ann; it's very difficult as you know to speculate on the Government.

Ann Gurkin - Davenport

Right, that helps. Thank you very much.

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

Thank you.

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

Thank you.

Operator

[Operator Instructions]. Filippe Goossens from Credit Suisse has a follow-up question.

Filippe Goossens - Credit Suisse

Yes, good morning everybody. Sorry for being a little late here, but I had another call I had to be on first, unfortunately. Susan, coming back a little bit to the topic about menthol and FDA regulation. If we were to assume, and we are in the same campus, you are in terms of thinking about the bill basically not being passed by Congress in 2008. If headline risk with regard to menthol as a result is here to stay, let's say for the near future, does that impact at all how you strategically think about consolidation in the tobacco space?

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

Filippe, I really don't want to speculate on that. I mean we have always said that we will look at for opportunities. We have the same views that you have on menthol today. So I would say no.

Filippe Goossens - Credit Suisse

Okay. Then secondly, just on one of your last comments in terms of… you've been pointing industry volume declines this year, more at the 4% level worse, but we have indicated to 5%. Impearl, a couple of weeks ago I think put out a trading update and they basically were signaling that the industry was perhaps trending more again towards the longer-term secular decline that we had seen as compared to the above trend line from last year and early this year. Their number is still a bit higher than some other people out there are saying, but would you basically kind of concur with their statement that we might be slowly moving back to the longer-term trend line that we had previously seen?

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

I think we believe that overtime we will return more to that secular trend line. We've talked about how the economy is affecting other categories in tobacco other than the cigarettes, and we continue to see that. I said, roll-your-own, I think was up 8%. Moist was up 7.7%. Little cigars continued to grow. And those are all economic alternatives, as well as in the case of moist of course, something you can use where you can't smoke. But I think as we look forward, if we come out the other side of significant tax increases, we would expect then to return eventually to the historical secular trend decline.

Operator

Anything further? And it appears there are no further questions at this time. Mr. Moore, I will turn the conference back over to you.

Morris Moore - Vice President of Investor Relations

Thank you for joining us this morning. As a reminder, a replay of this call will be available on our website at reynoldsamerican.com until August 29th.

Operator

And that concludes today's conference. We thank you all for joining us.

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Source: Reynolds American, Inc. Q2 2008 Earnings Call
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