Reynolds American Inc., referred to as RAI, is a holding company whose operating subsidiaries include the second largest cigarette manufacturer in the United States, R. J. Reynolds Tobacco Company, and the second largest smokeless tobacco products manufacturer in the United States, American Snuff Company, LLC, which prior to January 1, 2010, was known as Conwood Company, LLC. RAI was incorporated in the state of North Carolina on January 5, 2004, and its common stock is listed on the NYSE under the symbol “RAI.” RAI’s headquarters are located in Winston-Salem, North Carolina. On July 30, 2004, RAI combined the U.S. assets, liabilities and operations of Brown & Williamson Holdings, Inc., referred to as B&W, an indirect, wholly owned subsidiary of British American Tobacco p.l.c., referred to as BAT, with R. J. Reynolds Tobacco Company, a wholly owned operating subsidiary of R.J. Reynolds Tobacco Holdings, Inc., a wholly owned subsidiary of RAI, referred to as RJR. These July 30, 2004, transactions generally are referred to as the B&W business combination. As a result of the B&W business combination, B&W owns approximately 42% of RAI’s outstanding common stock. Also, as a result of the B&W business combination, Lane, Limited, referred to as Lane, became a direct, wholly owned subsidiary of RAI.
References to RJR Tobacco prior to July 30, 2004, relate to R. J. Reynolds Tobacco Company, a New Jersey corporation. References to RJR Tobacco on and subsequent to July 30, 2004, relate to the combined U.S. assets, liabilities and operations of B&W and R. J. Reynolds Tobacco Company. Concurrent with the completion of the B&W business combination, RJR Tobacco became a North Carolina corporation.
In 2006, RAI, through Conwood Holdings, Inc., completed its acquisition of a group of smokeless tobacco companies collectively referred to as the Conwood companies, currently only including American Snuff Company, LLC and Rosswil, LLC.
RAI’s reportable operating segments are RJR Tobacco and Conwood. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The Conwood segment consists of Conwood Holdings, Inc., the primary operations of the Conwood companies and Lane. Two of RAI’s wholly owned subsidiaries, Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe, and Niconovum AB, among others, are included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance. RAI’s wholly owned operating subsidiaries have entered into intercompany agreements for products or services with other RAI operating subsidiaries. As a result, certain activities of an operating subsidiary may be included in a different segment of RAI. For net sales, operating income and total assets attributable to each segment, see Item 8, note 18 to consolidated financial statements.
Changes Impacting the Tobacco Industry
On February 4, 2009, President Obama signed into law, effective April 1, 2009, an increase of $0.62 in the excise tax per pack of cigarettes, and significant tax increases on other tobacco products, to fund expansion of the State Children’s Health Insurance Program, referred to as the SCHIP. As a result, the federal excise tax rate for snuff increased $0.925 per pound to $1.51 per pound. The federal excise tax on small cigars, defined as those weighing three pounds or less per thousand, increased $48.502 per thousand to $50.33 per thousand. In addition, the federal excise tax rate for roll-your-own tobacco increased from $1.097 per pound to $24.78 per pound. RAI’s operating subsidiaries believe that these federal excise tax increases have had, and will continue to have, a significant and adverse impact on sales volume.
On June 22, 2009, President Obama signed into law the Family Smoking Prevention and Tobacco Control Act, referred to as the FDA Tobacco Act. Under the FDA Tobacco Act, the U.S. Food and Drug Administration, referred to as the FDA, has been granted broad authority over the manufacture, sale, marketing and packaging of tobacco products. It is likely that the FDA Tobacco Act could result in a decrease in cigarette and smokeless tobacco sales in the United States, including sales of RJR Tobacco’s and Conwood’s brands, and an increase in costs to RJR Tobacco and Conwood that could have a material adverse effect on RAI’s financial condition, results of operations and cash flows. For a detailed description of the FDA Tobacco Act, see “— Governmental Activity” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.
RAI’s strategy is focused on anticipating shifts in consumer preferences by becoming an innovative total tobacco company. RAI also is focused on delivering sustainable earnings growth, strong cash flow and enhanced long-term shareholder value through growth strategies for its operating companies. These strategies include growth in base brands of RJR Tobacco’s cigarette business, growth and innovation in smokeless tobacco products, super-premium cigarette brand growth, opportunistic international expansion and selective portfolio enhancements. RAI remains committed to maintaining high standards of corporate governance and business conduct in a high performing culture.
RAI’s largest reportable operating segment, RJR Tobacco, is the second largest cigarette manufacturer in the United States. RJR Tobacco’s largest selling cigarette brands, CAMEL, PALL MALL, WINSTON, KOOL and DORAL, were five of the ten best-selling brands of cigarettes in the United States as of December 31, 2009. Those brands, and its other brands, including SALEM, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. RJR Tobacco also manages contract manufacturing of cigarette and tobacco products through arrangements with BAT affiliates. On January 1, 2009, the management of tobacco products sold to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases was transferred to RJR Tobacco from R. J. Reynolds Global Products, Inc., referred to as GPI.
RJR Tobacco primarily conducts its business in the highly competitive U.S. cigarette market. The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to Japan Tobacco Inc., referred to as JTI and no international rights were acquired in connection with the B&W business combination. The U.S. cigarette market, which has a few large manufacturers and many smaller participants, is a mature market in which overall consumer demand has declined since 1981 and is expected to continue to decline. Management Science Associates, Inc., referred to as MSAi, reported that U.S. cigarette shipments declined 8.6% in 2009, to 315.7 billion cigarettes, 3.3% in 2008 and 5.0% in 2007. From year to year, shipments are impacted by various factors including price increases, excise tax increases and wholesale inventory adjustments.
Profitability of the U.S. cigarette industry and RJR Tobacco continues to be adversely impacted by the decreases in consumption, increases in federal and state excise taxes and governmental regulations and restrictions, such as marketing limitations, product standards and smoking bans.
Expanding beyond the cigarette market as an innovative tobacco company, RJR Tobacco offers two types of smoke-free tobacco, CAMEL Snus and CAMEL Dissolvables. CAMEL Snus, launched nationally in 2009, is pasteurized tobacco in a small pouch that provides convenient tobacco consumption. CAMEL Dissolvables include CAMEL Orbs, Sticks and Strips, all of which are made of finely milled tobacco and dissolve completely in the mouth. CAMEL Orbs were launched in three lead markets during the first quarter of 2009, and CAMEL Sticks and Strips were launched in those lead markets during the third quarter of 2009.
RJR Tobacco’s primary competitors include Philip Morris USA Inc., Lorillard Tobacco Company, Liggett Group and Commonwealth Brands, Inc., as well as manufacturers of deep-discount brands. Deep-discount brands are brands manufactured by companies that are not original participants in the Master Settlement Agreement, referred to as MSA, and other state settlement agreements with the states of Mississippi, Florida, Texas and Minnesota, together with the MSA collectively referred to as the State Settlement Agreements, and accordingly, do not have cost structures burdened with State Settlement Agreements-related payments to the same extent as the original participating manufacturers. For further discussion of the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 14 to consolidated financial statements.
Based on data collected by Information Resources Inc., referred to as IRI/Capstone, using a revised sampling model implemented in 2009 to better reflect the current retail environment, during 2009 and 2008, RJR Tobacco had an overall retail share of the U.S. cigarette market of 28.3% and 28.4%, respectively. During these same years, Philip Morris USA Inc. had an overall retail share of the U.S. cigarette market of 49.7% and 50.9%, respectively.
Domestic shipment volume and retail share of market data that appear in this document have been obtained from MSAi and IRI/Capstone, respectively. These two organizations are the primary sources of volume and market share data relating to the cigarette and tobacco industry. This information is included in this document because it is used by RJR Tobacco primarily as an indicator of the relative performance of industry participants. However, you should not rely on the market share data reported by IRI/Capstone as being precise measurements of actual market share because IRI/Capstone uses a sample and projection methodology that is not able to effectively track all volume. Moreover, you should be aware that in a product market experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes. RJR Tobacco believes that deep-discount brands made by small manufacturers have combined shipments of approximately 16% of total U.S. industry shipments. Accordingly, the retail share of market of RJR Tobacco and its brands as reported by IRI/Capstone may overstate their actual market share.
Competition is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other incentives to maintain or improve market position or to introduce a new brand or brand style. Competition among the major cigarette manufacturers has begun shifting to product innovation and expansion into smoke-free tobacco categories, such as moist snuff and snus, as well as finding efficient and effective means of balancing market share and profit growth.
RJR Tobacco is committed to building and maintaining a portfolio of profitable brands. RJR Tobacco’s marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokers of competing brands to RJR Tobacco brands. In addition to building strong brand equity, RJR Tobacco’s marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend certain brands’ shares of market against competitive pricing pressure. RJR Tobacco’s competitive pricing methods may include list price changes, discounting programs, such as retail and wholesale buydowns, periodic price reductions, off-invoice price reductions, dollar-off promotions, free product promotions and consumer coupons. Retail buydowns refer to payments made to the retailer to reduce the price that consumers pay at retail. Consumer coupons generally are distributed by a variety of methods including in, or on, the cigarette pack and by direct mail.
RJR Tobacco provides trade incentives through trade terms, wholesale partner programs and retail incentives. Trade discounts are provided to wholesalers based on compliance with certain terms. The wholesale partner programs provide incentives to RJR Tobacco’s direct buying customers based on performance levels. Retail incentives are paid to the retailer based on compliance with RJR Tobacco’s contract terms.
RJR Tobacco’s cigarette brand portfolio strategy is based upon three brand categories: growth, support and non-support. The growth brands consist of a premium brand, CAMEL, and a value brand, PALL MALL. Although both of these brands are managed for long-term market share and profit growth, CAMEL will continue to receive the most significant investment support. The support brands include four premium brands, WINSTON, KOOL, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The non-support brands, consisting of all other brands, are managed to maximize near-term profitability. The key objectives of the portfolio strategy are designed to focus on the long-term market share growth of the growth brands while managing the support brands for long-term sustainability and profitability. At present, RJR Tobacco’s smoke-free products are marketed under the CAMEL brand and focus on long-term growth.
Anti-tobacco groups have attempted to restrict cigarette sales, cigarette advertising, and the testing and introduction of new tobacco products as well as encourage smoking bans. The MSA and federal, state and local laws and regulations restrict or prohibit utilization of television, radio or billboard advertising or certain other marketing and promotional tools for cigarettes and smoke-free tobacco products. RJR Tobacco continues to use direct mailings and other means to market its brands and enhance their appeal among age-verified adults who use tobacco products. RJR Tobacco continues to advertise and promote at retail locations and in adult venues where permitted and also uses print advertising in newspapers and consumer magazines in the U.S.
Manufacturing and Distribution
RJR Tobacco owns its cigarette manufacturing facilities, located in the Winston-Salem, North Carolina area, known as the Tobaccoville manufacturing facility and the Whitaker Park complex. The Whitaker Park complex includes a manufacturing facility, a research and development facility, RJR Tobacco’s Central Distribution Center and a pilot plant for trial manufacturing of new products. RJR Tobacco has a total production capacity of approximately 160 billion cigarettes per year. RJR Tobacco continues to evaluate capacity rationalization, which may result in the consolidation or closure of some facilities.
RJR Tobacco sells its cigarettes primarily through distributors, wholesalers and other direct customers, some of which are retail chains. RJR Tobacco distributes its cigarettes primarily to public warehouses located throughout the United States that serve as local distribution centers to its customers. No significant backlog of orders existed at December 31, 2009 or 2008.
RJR Tobacco has entered into various transactions with affiliates of BAT. RJR Tobacco sells contract-manufactured cigarettes and processed strip leaf to BAT affiliates. Net sales, primarily of cigarettes, to BAT affiliates represented approximately 5.0% of RAI’s total net sales in each of 2009 and 2008 and approximately 6.0% in 2007.
In its production of tobacco products, RJR Tobacco uses U.S. and foreign, grown primarily in Brazil and Malawi, burley and flue-cured leaf tobaccos, as well as Oriental tobaccos grown primarily in Turkey, Macedonia and Bulgaria. RJR Tobacco believes there is a sufficient supply of leaf in the worldwide tobacco market to satisfy its current and anticipated production requirements.
RJR Tobacco purchases the majority of its U.S. flue-cured and burley leaf directly through contracts with tobacco growers. These short-term contracts are frequently renegotiated. RJR Tobacco believes the relationship with its leaf suppliers is good.
Under the modified terms of settlement agreements with flue-cured and burley tobacco growers, and quota holders, RJR Tobacco is required, among other things, to purchase a minimum amount, in pounds and subject to adjustment based on its annual total requirements, annually of U.S. green leaf flue-cured and burley tobacco combined, through the 2015 crop year.
RJR Tobacco also uses other raw materials such as filter tow, filter rods and fire standards compliant paper, which are sourced from either one supplier or a few suppliers. RJR Tobacco believes it has reasonable measures in place designed to mitigate the risk posed by the limited number of suppliers of certain raw materials.
RAI’s other reportable operating segment, Conwood, is the second largest smokeless tobacco products manufacturer in the United States. Conwood’s primary products include its largest selling moist snuff brands, GRIZZLY, the best-selling brand of moist snuff in the United States as of December 31, 2009, and KODIAK. The moist snuff category is divided into premium and price-value brands. Conwood offers KODIAK in the premium brand category and GRIZZLY in the price-value brand category.
In contrast to the declining U.S. cigarette market, MSAi reported U.S. moist snuff volumes grew over 4% in 2009, driven by the accelerated growth of price-value brands. Profit margins on moist snuff products are generally higher than on cigarette products. Moist snuff’s growth is partially attributable to cigarette smokers switching from cigarettes to smokeless tobacco products or using both. Within the moist snuff category, premium brands have lost market share to price-value brands, led by the growth of GRIZZLY, in recent years. However, during 2009, heavy promotion and competitive pricing of premium brands has slowed the growth of the price-value brands.
Leveraging RAI’s total tobacco business model, Conwood launched CAMEL Dip, a premium moist snuff, in lead markets during the second quarter of 2009. CAMEL Dip will be launched in additional markets in 2010.
Moist snuff has been the key driver of Conwood’s overall growth and profitability within the U.S. smokeless tobacco market. Moist snuff accounted for approximately 71%, 66% and 60% of Conwood’s revenue in 2009, 2008 and 2007, respectively. Conwood’s U.S. moist snuff market share was 29.4%, 27.6% and 26.0% in 2009, 2008 and 2007, respectively, based on distributor-reported data processed by MSAi for distributor shipments to retail. Although moist snuff volume grew over 4% in 2009, Conwood’s moist snuff volume grew over 6% in 2009, attributable to its innovation, product development and brand building. GRIZZLY brand moist snuff had a market share of 25.3%, 23.2% and 21.1% in 2009, 2008 and 2007, respectively.
Conwood also distributes a variety of other tobacco products, including WINCHESTER and CAPTAIN BLACK little cigars, and BUGLER roll-your-own tobacco. The operations of Lane are included in the Conwood segment.
Conwood is dependent on the U.S. smokeless tobacco market, where competition is significant. Similar to the cigarette market, competition is based primarily on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Moist snuff has developed many of the characteristics of the larger, cigarette market, including multiple pricing tiers with intense competition, focused marketing programs and product innovation.
Conwood’s largest competitor is U.S. Smokeless Tobacco Company LLC, referred to as USSTC, which had approximately 55.1%, 58.1% and 60.6% of the U.S. moist snuff market share in 2009, 2008 and 2007, respectively. The parent company of RJR Tobacco’s largest competitor in the cigarette market, Philip Morris USA Inc., completed its acquisition of USSTC in January 2009. Conwood also competes in the U.S. smokeless tobacco market with other domestic and international companies.
Conwood’s brand portfolio strategy consists of investment brands, KODIAK and GRIZZLY, and selective and non-support brands that include all other brands. Among Conwood’s newest offerings are GRIZZLY mint, straight and snuff pouches. GRIZZLY pouches provide pre-measured portions that are more convenient than traditional, loose moist snuff. Pouches represented approximately 8% of the total U.S. moist snuff market as of December 31, 2009, and demand continues to grow. Conwood also launched CAMEL Dip in Wintergreen Wide Cut and Dark Milled styles in lead markets during 2009. GRIZZLY 1900 Long Cut, a natural product with a traditional long cut, was introduced in the first quarter of 2010. Continuing with innovation and brand building, Conwood will feature embossed metal lids on KODIAK and GRIZZLY brands in 2010.
Conwood is committed to being an innovative industry leader and in the servicing of its customers’ needs, evidenced by the creative packaging of smokeless products, including the development of a plastic can.
Manufacturing and Distribution
Conwood’s primary manufacturing facilities are located in Memphis, Tennessee; Clarksville, Tennessee; and Winston-Salem, North Carolina. Other facilities are located in Tucker, Georgia; Bowling Green, Kentucky; and Springfield, Tennessee. Conwood owns all of its facilities. During 2009, Conwood began capacity upgrade and expansion projects at newly acquired sites in Memphis, Tennessee and Clarksville, Tennessee. The new Memphis facility will replace the current Memphis facility with production expected to begin in 2012, while the new Clarksville facility will provide for capacity expansion with initial production beginning in 2010. Both facilities will be FDA compliant. Conwood sells its products primarily to distributors, wholesalers and other direct customers, some of which are retail chains.
In its production of moist snuff, Conwood uses U.S. fire-cured and air-cured tobaccos as well as foreign, primarily Brazilian, burley and air-cured leaf tobaccos. Conwood purchases the majority of its U.S. fire-cured and air-cured leaf directly through contracts with tobacco growers. These short-term contracts are frequently renegotiated. Conwood believes the relationship with its leaf suppliers is good.
Conwood believes there is a sufficient supply of leaf in the worldwide tobacco market to satisfy its current and anticipated production requirements.
Santa Fe manufactures and markets cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand, as well as manages super premium brands licensed from BAT, including DUNHILL and STATE EXPRESS 555.
In January 2009, the activities of GPI were transitioned to other operating subsidiaries of RAI. The management and export of tobacco products to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases was transferred to RJR Tobacco, and sales of NATURAL AMERICAN SPIRIT in Europe and Japan were transferred to other indirect subsidiaries of RAI.
The largest customer of RAI’s operating companies is McLane Company Inc. Sales to McLane, a distributor, comprised 27%, 29% and 28% of RAI’s consolidated revenue in 2009, 2008 and 2007, respectively. No other customer accounted for 10% or more of RAI’s consolidated revenue during those periods. RJR Tobacco and Conwood each believe that its relationship with McLane is good. Sales of RJR Tobacco and Conwood to McLane are not governed by any written supply contract. No significant backlog of orders existed at RJR Tobacco or Conwood as of December 31, 2009 or 2008.
Sales to Foreign Countries
RAI’s operating subsidiaries’ sales to foreign countries, primarily to BAT affiliates, for the years ended December 31, 2009, 2008 and 2007 were $547 million, $611 million and $616 million, respectively.
In 2004, legislation was passed eliminating the U.S. government’s tobacco production controls and price support program. The buyout is funded by a direct quarterly assessment on every tobacco product manufacturer and importer, on a market-share basis measured on volume to which federal excise tax is applied. The aggregate cost of the buyout to the tobacco industry is approximately $9.9 billion, including approximately $9.6 billion payable to quota tobacco holders and growers through industry assessments over ten years and approximately $290 million for the liquidation of quota tobacco stock. RAI’s operating subsidiaries estimate that their overall share will approximate $2.3 billion to $2.8 billion prior to the deduction of permitted offsets under the MSA.
Research and Development
The primary research and development activities of RAI’s operating subsidiaries are conducted at RJR Tobacco’s Whitaker Park complex. Scientists and engineers at this facility continue to explore and develop innovative products, packaging and processes, as well as harm reduction technologies, potential reduced exposure products and analytical methodologies. A focus activity for research and development going forward is to prepare for the FDA regulatory compliance and adhere to future FDA guidelines and approval processes.
RAI’s operating subsidiaries’ research and development expense for the years ended December 31, 2009, 2008 and 2007, was $68 million, $59 million and $57 million, respectively. The increase in research and development expense in 2009 compared with 2008 and 2007 was attributable primarily to the development of harm reduction and smoke-free products at RJR Tobacco.
At December 31, 2009, RAI and its subsidiaries had approximately 6,400 full-time employees and approximately 150 part-time employees. The 6,400 full-time employees include approximately 4,500 RJR Tobacco employees and 1,000 Conwood employees. No employees of RAI or its subsidiaries are unionized.