Reynolds American (RAI) Susan M. Cameron on Q2 2016 Results - Earnings Call Transcript

| About: Reynolds American, (RAI)

Reynolds American, Inc. (NYSE:RAI)

Q2 2016 Earnings Call

July 26, 2016 9:00 am ET

Executives

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

Susan M. Cameron - President, Chief Executive Officer & Director

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Analysts

Nik Modi - RBC Capital Markets LLC

Matthew C. Grainger - Morgan Stanley & Co. LLC

Judy E. Hong - Goldman Sachs & Co.

Bonnie L. Herzog - Wells Fargo Securities LLC

Vivien Azer - Cowen & Co. LLC

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

Michael Lavery - CLSA Americas LLC

Adam J. Spielman - Citigroup Global Markets Ltd.

Operator

Good morning, ladies and gentlemen. My name is, Sally, and I will be your conference operator, today. At this time, I would like to welcome everyone to the Reynolds American Second Quarter Earnings Conference Call. All lines have been on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. Thank you.

I will now turn the conference over to Mr. Bob Bannon, Vice President, Investor Relations. Please go ahead, sir.

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

Good morning, and thank you for joining our call. Today, we'll review Reynolds American's results for the second quarter and first half, as well as our revised outlook for the rest of the year. As usual, our discussion will include adjusted non-GAAP results as management believes this provides additional perspective on our underlying business performance. RAI's use of adjusted results are intended to be supplemental in nature; and should not be viewed as a substitute for reported GAAP results. Reconciliations are reported to adjusted earnings are on Schedules 2 and 3 of our press release, which is available on our website at reynoldsamerican.com.

Joining me this morning are RAI's President and CEO, Susan Cameron; and Andrew Gilchrist, our CFO. The information we're about to discuss includes forward-looking statements. When we talk about future results or events, a number of factors could generate results that are materially different from our projections today. These factors include, but are not limited to, items detailed in our press release and SEC filings. Except as provided by federal securities laws, we are not required to publicly update or revise any forward-looking or cautionary statements. I'd also remind you that RAI's website is our primary source of publicly disclosed news, and that we also use Twitter to disseminate company news.

And now, I'll turn the call over to Susan.

Susan M. Cameron - President, Chief Executive Officer & Director

Thank you, Bob, and good morning, everyone. Reynolds American turned in a strong performance for the second quarter and the first half supported by continued excellent results across our operating companies, as well as a stable and positive macroeconomic environment for adult tobacco consumers.

As you can see from today's report, our transformational acquisition of Lorillard just over a year ago, and the steps we've taken since then have greatly enhanced the financial strength of RAI, and we're now at a point where we can deliver on our post-acquisition promise to refocus on ways to create even more value for our shareholders.

Andrew will discuss our progress on debt reduction and other positive developments shortly, but I do want to highlight our board's approval of an increase in our dividend payout target from 75% to 80% of adjusted net income with a corresponding increase in our quarterly dividend by 9.5%, as well as its authorization of a new $2 billion share repurchase program.

These decisions reflect our deep commitment to rewarding shareholders. It's there to say that these decisions also reflect the confidence that RAI's management and board have in our operating companies' business strategies, and in their ability to drive sustainable long-term growth in a dynamic environment.

I'm also very pleased to report that we passed a major milestone in June; the successful completion of the manufacturing integration of the Newport brand, much earlier than we initially expected. And Newport continues to outperform our expectations in the marketplace. So, all-in-all we are very pleased with where we currently sit, about one year after the Lorillard transaction.

In addition to profitable growth in the core businesses, our companies continued to advance their transforming-tobacco objectives in other key areas; led by the thinking and energy brought by the team within our new RAI Innovations Company subsidiary. In particular, RAI Innovations Company is focused on driving our speed to market of leading-edge products like RJR Vapor's VUSE Digital Vapor Cigarette. VUSE remains the category leader with nearly 30% of the market in traditional store channels, and the brand plans to expand its VUSE styles in the next few months.

Adult tobacco consumers have told us, they are interested in new technologies to improve product performance and consumer satisfaction, and work continues on enhancing VUSE formats with that desire very much in mind.

Offering innovative products like VUSE supports our efforts to lead the transformation of the tobacco industry by providing adult tobacco consumers with superior smoke-free options to consider. As you know, the U.S. Food and Drug Administration issued its final deeming regulation and draft guidance for vapor products on May 5. The Agency's product approval guidelines will inform our efforts as we consider ways to bring products with the potential to reduce risk to market.

In addition, in the weeks and months ahead, we look forward to working with the Agency to gain additional clarity on this process. With the deeming regulations as a backdrop, our team has been hard at work on new product formats for the VUSE portfolio that will allow RJR Vapor to be fully prepared for the newly-regulated environment. We have long supported reasonable regulation that recognizes the risk continuum, and we are committed to working with the Agency to establish a regulatory framework that offers the greatest potential to improve public health.

At Niconovum USA, ZONNIC nicotine replacement therapy gum continues to attract positive consumer interest. The brand introduced four styles in a 40-count package at two retail store chains in the second quarter, and has just started to roll out a 10-count mini lozenge in selected stores. ZONNIC is available in about 33,000 retail outlets. And we look forward to further national expansion over the rest of this year.

Now let's turn to the update on performance at our other operating companies, all of which increased profitability in the second quarter. I'll start with combustibles. We continue to see a backdrop of favorable economic factors benefiting the disposable income of adult tobacco consumers. But changes in wholesale inventory levels had a significant impact to industry cigarette volume in the second quarter, which was down by about 3.9% compared to the prior-year quarter.

You may recall that in the second quarter of last year, wholesalers took its industry inventory levels up significantly at the time of the Lorillard acquisition. That, coupled with a decrease in inventories in the second quarter of this year, led to an unfavorable year-over-year comparison for the industry. When adjusted for these wholesale inventory changes, industry volume was down about 1.7% for the quarter, and was down about 1% for the first half.

As we have previously discussed, over time, we would expect cigarette volume declines to return to their historical range of down 2% to 4%. However, we continue to expect the positive macro trends will benefit the cigarette industry throughout 2016, and our current view continues to be that cigarette volumes will be down closer to the 2% end of the range for the full year.

For RAI's operating companies, total second quarter volume on a pro forma basis was down by about 2.4% from the prior-year quarter, and when adjusted for wholesale inventory changes, was down by about 1.2%. Total second quarter retail cigarette market share for RAI's operating companies increased 0.4 percentage point from the prior-year quarter, to 34.5%. With their combined drive brand adding 0.6 percentage point, to just over 32%. These drive brands currently make up 93% of our operating companies' total cigarette market share.

At R.J. Reynolds, the higher volume's driven by the addition of Newport, as well as higher pricing, again generated strong operating performance. The company's second quarter cigarette shipments fell 3.2% from the prior-year quarter, and again, that is on a pro forma basis.

Turning to share of market, total cigarette market share at R.J. Reynolds was up slightly in the second quarter, at 32.2%. The company's expanded portfolio of drive brands, Newport, Camel and Pall Mall, added 0.3 percentage point in combined market share, bringing that to a 29.8% for the quarter.

As I said earlier, Newport, the nation's number one menthol brand, is demonstrating outstanding momentum, and its inclusion in R.J. Reynolds' new retail contracts has added greater national visibility to the brand. Newport's pro forma volume in the second quarter was down about 0.5% versus the prior year, and was up about 2% when adjusting for wholesale inventory changes. Newport increased its second quarter retail market share by 0.5 percentage point from the prior-year quarter, to 13.9%.

I would note that Newport's market share growth came from both its core menthol styles as well as its non-menthol styles. Newport's accelerated market share growth since it was acquired by R.J. Reynolds has been broad-based across geographies, with growth in both its core markets as well as in its opportunity markets.

R.J. Reynolds' Camel brand is also benefiting from an improved national presence as a result of the expanded retail contracts. In the second quarter, Camel's retail cigarette market share was in line with the prior-year quarter at 8.3%, overcoming the share loss impact from the removal of Camel styles associated with the FDA's not substantially equivalent ruling in the fourth quarter of last year. Additionally, Camel share was up 0.1 percentage point when compared with the first quarter of 2016.

Pall Mall, the nation's number one value brand, continues to play an integral and profitable role in the company's total portfolio strategy. With many adult smokers trading up into premium brands in the current economic environment, the brand's second quarter retail market share was down 0.2 percentage point versus the prior year, at 7.7%.

At Santa Fe, Natural American Spirit's distinctive super premium brand increased retail market share to 2.2%, which is 0.4 percentage point increase from the prior-year quarter; just another great quarter from the fastest-growing premium brand in the industry.

And we expect Natural American Spirit momentum will continue to grow to increase consumer engagement and increased awareness of the brand's unique value. At American Snuff, Grizzly continues to be the clear leader in the growing pouch category, which now makes up almost 20% of the moist-snuff industry, and in wintergreen, which is the largest flavor segment.

During the second quarter, Grizzly's marketplace and performance was impacted by two factors. First, Grizzly Dark styles were expanded nationally in the second quarter of last year. And second, we saw the national expansion of competitive line extensions in the second quarter of this year. As a result, Grizzly's retail market share declined 0.7 percentage point in the second quarter to 30.6%.

Despite the unfavorable compares in dynamics in the quarter, we continue to be very confident in Grizzly's strong underlying trend; it's truly unique product proposition, its highly-loyal consumer base, and its ability to deliver sustainable profitable growth over both the near and long-term.

Looking forward to the third quarter of this year, Grizzly will be expanding a successful Grizzly Dark product line with the roll-out of Grizzly Dark Mint, which combines the differentiated richer and bolder taste of its dark styles with the popular mint flavor.

So, that's a quick look at our operating companies' achievement in the latest quarter, and over the first half of the year. We started the year with a robust plan for growth and a focus on strengthening our premium portfolio of drive brands, and we are clearly delivering on those objectives.

And I'm especially pleased by the successful completion of Newport's integration, and of course, by the way the brand is driving business performance. We have exciting plans in place for the back half of the year, and we are confident that our businesses will continue to deliver on our objectives for future growth.

Thank you. And now, I'll turn the call over to, Andrew.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Thank you, Susan, and good morning everyone. Reynolds American and its operating companies had a very successful second quarter and first half, and that has allowed us to announce significant steps to enhance shareholder value. I'll be discussing those positive developments in more detail shortly, but first, I'll cover our financial results for both periods.

RAI's second quarter reported EPS declined by about 67% from the prior-year quarter to $0.56. As you know, this comparison was driven by the substantial gain on divestiture, following the Lorillard acquisition last year. On an adjusted basis, second quarter EPS was $0.58, up 13.7% from the prior-year quarter, benefiting from the addition of the Newport brand, as well as higher net pricing in both cigarettes and smokeless. This adjusted EPS excludes a charge of $0.02 related to Engle progeny lawsuits.

For the first half, reported EPS was $3.05, up just over 45% from the prior-year period. First half adjusted EPS was $1.08, which was up by almost 15%. These adjusted results also reflect the Engle progeny lawsuits charge, as well as the gain of $2.11 per share related to the sale of Natural American Spirit's International business, and charges of $0.12 per share for debt and financing costs and implementation cost.

RAI's second quarter adjusted operating margin continued to grow, increasing 3.8 percentage points to 45.9%, and that brought first half adjusted operating margin to 45.6%, up 5.8 percentage points from last year's first half.

Now, let's take a look at our operating companies' performance, where I'll discuss adjusted results where applicable. Please refer to Schedules 2 and 3 at the end of our earnings release for a detailed reconciliation of our reported to adjusted results.

R.J. Reynolds continued to perform extremely well in the second quarter with reported operating income up by 67.3% at just over $1.2 billion. Of course, Newport's contribution was a major driver of performance, but the company also benefited from solid net price realization compared to the prior-year quarter.

On an adjusted basis, the company's second quarter operating income increased by 52.1% from the prior-year quarter to $1.3 billion. This reflects a charge of $48 million for Engle progeny lawsuits and $3 million for implementation costs. For the first half, reported operating income was $2.3 billion, and that was up 76.7% from this time last year. First half adjusted operating income came in at $2.4 billion, a 61.6% increase from last year.

R.J. Reynolds also continued to strengthen its adjusted operating margin, which grew by 3.4 percentage points from the prior-year quarter to 47.8%. The company's strong margin improvement was largely driven by the increased mix of premium cigarette volume in addition to strong net pricing and the company's continued focus on operating efficiencies and productivity improvement. Newport's addition also drove R.J. Reynolds' cigarette shipments higher in the second quarter, increasing 25.7% from the prior-year quarter.

As Susan mentioned, wholesale inventory levels for the industry experienced significant changes compared to the second quarter of last year. Wholesale inventories for the industry were approximately 6.9 billion units at the end of second quarter this year, which we believe is close to a normalized level. This compares to industry inventories of 7.6 billion units at the end of second quarter last year. At R.J. Reynolds, inventories of approximately 2.3 billion at the end of second quarter remained relatively stable versus the second quarter of last year, as well as over the past four quarters since the completion of the Lorillard acquisition.

Given the impact on the quarter, I want to be clear. Wholesale inventories for the industry over the course of second quarter 2016 declined by 400 million units, while in last year's second quarter, wholesale inventories increased by 1.1 billion units. Obviously, this dynamic had a positive quarterly impact last year, and a negative impact in this year's second quarter, resulting in an exaggerated headline decline of 3.9% for industry volumes.

Now, moving on to Santa Fe, where solid performance was supported by higher pricing and volume growth of 10.8%. Santa Fe increased its second quarter operating income by just over 7% to $133 million, and that brought first half operating income to $256 million. The company experienced higher marketing costs due to timing in the second quarter of 2016 compared to the prior year, and this resulted in operating margin of 54.1% for the quarter.

American Snuff reported another good quarter despite volume declining approximately 0.5% due to the unfavorable comparison, which Susan mentioned earlier. The company's second quarter operating income of $138 million was up 7.4% from the prior-year quarter, and that resulted in first half operating income of $271 million, which was up by 9.5% from the prior-year period. American Snuff's second quarter operating margin came in very strong at 60%, which was up 0.6 percentage point from the prior-year quarter.

So, that wraps up the summary of our company's performance. Now, I'll turn to the additional steps we're taking to return value to our shareholders.

First, an update on our long-term debt position. RAI ended the quarter with $1.9 billion in cash balances, which takes into account R.J. Reynolds' MSA payment of $2.3 billion in April. In line with our previously-stated commitment to deleverage as quickly and efficiently as possible, we plan to repay the company's outstanding $500 million bond that matures on August 4 with available cash on hand.

We expect this further reduction in RAI's total outstanding debt, along with the continued growth in our businesses to now bring the company within the top end of its long-term target leverage range of 1.5 times to 2.5 times total debt to EBITDA in this year's third quarter.

The timing of this return to our target range is well-ahead of our expectations following the Lorillard transaction and provides us the opportunity to consider additional measures for increasing shareholder value.

With our improved balance sheet metrics, and in line with our previously-stated priorities for the use of excess cash, RAI's board of directors has approved an increase in our target dividend payout ratio from 75% to 80% of adjusted net income. As a result of this new payout policy, our board also approved an increase in our quarterly cash dividend of 9.5% to $0.46 per share or an annualized $1.84 per share. The dividend will be payable on October 3 to shareholders registered on September 12.

As you know, a strong and growing dividend is an integral part of our commitment to capital returns, and we are proud of the great track record we have established in this regard. Today's announced dividend increase follows the 16.7% increase announced in February, and is the third dividend increase since completing the Lorillard acquisition last June. This is also the 12th consecutive year of increased dividend payments since RAI was formed in 2004, and represents growth of more than 280% since that time. RAI's board has also approved a $2 billion share repurchase program that's scheduled to be completed by the end of 2018.

All of these actions clearly demonstrate our commitment to returning tangible value to our shareholders, as well as the confidence that RAI's management and board have in our operating companies' business strategies and performance going forward. And we remain focused on finding opportunities to further enhance shareholder value in a consistent and disciplined manner.

Now that we've successfully reached the half-year mark, we're narrowing the range of RAI's 2016 adjusted EPS guidance by $0.02 to a new range of $2.26 to $2.34, which is up 14.1% to 18.2% over last year's adjusted EPS. Thank you.

Now, we'll turn to the Q&A portion of the call. Operator, would you remind our callers how to get into the queue?

Question-and-Answer Session

Operator

Certainly. And your first question comes from the line of Nik Modi with RBC Capital Markets. Your line is open.

Nik Modi - RBC Capital Markets LLC

Thanks. Good morning, everyone. So, just...

Susan M. Cameron - President, Chief Executive Officer & Director

Good morning, Nik.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning.

Nik Modi - RBC Capital Markets LLC

Good morning. Two quick questions from me; just on the smokeless, just wanted to get some thoughts from you guys on the category growth rate, I mean, is this kind of the new normal in terms of the category growth rate? You think demographics are kind of catching up to the category, just given as we diversify more in terms of the demographic standpoint, those consumers kind of index lower to smokeless tobacco?

And then the second question is, just as we've been out there in the field, it's evident to us that we're seeing a little bit more promotional activity on some core styles for Altria, as well as maybe some more discount brands coming in to the marketplace, just wanted to get your thoughts on that if you're seeing any implications or any impact on the business.

Susan M. Cameron - President, Chief Executive Officer & Director

Okay. Sure, Nik. I think, the moist category growth, we would continue to call that like 2% to 4%, up. We're – as you saw in the materials, we lap a launch that we did last second quarter – this second quarter there were significant competitive launches.

And so, we continue to see growth in that category. And we continue to be happy with Grizzly's performance. I think as we noted, we're going to launch a Grizzly Dark Mint style in the back half and we continue to be confident in Grizzly. But the growth of the category, I think, is on a pretty stable trend, and it's actually ticked up a little bit versus the past couple of years. And your other question was -?

Nik Modi - RBC Capital Markets LLC

On just some of the competitive activity in the marketplace; (26:17).

Susan M. Cameron - President, Chief Executive Officer & Director

Yes. Yeah. I think, I mean, it continues to remain very competitive. We've seen several launches in the combustible category. There's a lot of promotional activity going on. But as you can see from the net price realization, we continue to perform well. All of our operating companies' margins are up with the exception being Santa Fe Natural, and that really is a timing issue.

So, we continue to believe that, while it is very competitive and there's been a lot activity out there that we'll continue to perform well. Newport's doing fantastic, Natural American Spirit's doing fantastic and Camel's even up sequentially. And we're happy after lapping that NSE removal in the fourth quarter of last year.

Nik Modi - RBC Capital Markets LLC

Great. Thanks so much.

Susan M. Cameron - President, Chief Executive Officer & Director

Thanks, Nik.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Thank you.

Operator

Your next question comes from the line of Matthew Grainger with Morgan Stanley. Your line is open.

Matthew C. Grainger - Morgan Stanley & Co. LLC

Hi. Good morning, everyone. Thanks.

Susan M. Cameron - President, Chief Executive Officer & Director

Hey, Matt.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning.

Matthew C. Grainger - Morgan Stanley & Co. LLC

Hi. Two questions; one, I just want to delve a little deeper into the 1.7% underlying volume decline during the quarter, which is still quite good by historical standards, but obviously a little slower than the flattish trend in Q1. So, I guess just curious, Susan, whether you think that's really a reflection of the fact that the industry is now facing tougher comps, or were there any other mitigating factors during the quarter that you'd point to like the phase-in of SET increases or this doesn't often come up, but it seems like it was sort of an issue in scanner, maybe adverse weather conditions during quarter, they would have may be amplified the deceleration?

Susan M. Cameron - President, Chief Executive Officer & Director

I would say, it's much more regarding the tough compare, Matt. In the first quarter, you may have had a little bit of volume going out to reset these racks, that's certainly plausible, but generally speaking, we see positive macroeconomic indicators for the adult tobacco consumer, and that sort of carrying through 2016. Although of course, we lapped those circumstances. But I don't really think there was any – anything else material that we would point to on the difference.

Year-to-date, it's 1% down. As we said, we are calling the year closer to that 2%. And of course, these inventories shift in the second quarter compare, these will eventually kind of wash through the system.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. Matt, I would just add, when you go back and you look at the second quarter of 2015, obviously, you saw volumes were up on unadjusted basis. So, that compare obviously with the challenge in second quarter, a lot of that driven by inventories, but we're comparing to a quarter in 2015 that was actually up closer to 1.9%.

Matthew C. Grainger - Morgan Stanley & Co. LLC

Right. Okay. Thank you both. And Andrew, just two quick questions on RJR. One, I guess, revenues were essentially in line with our expectations, but costs were a bit higher and still seem a little elevated relative to what I would have expected at this point in the integration, so I guess, can you just remind me what the key remaining milestones are in fully achieving that $300 million run rate on savings? And although, Newport's now fully integrated into your manufacturing footprint, was the TSA still a headwind for margins during the quarter?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. So, I think today, we can certainly say that we are going to achieve the $800 million of cost synergies, so the $300 million is going to come through. The manufacturing integration has been completed. But I would note that the full impact will not be seen in the P&L until we sell through the inventory from the reciprocal manufacturing agreement.

We expect that really to be in fourth quarter to be fully reflective in fourth quarter. And obviously, we're still focused on opportunities above and beyond that $800 million of synergies. But those will be areas that we just – I think going forward, we're going to bake into our productivity improvement initiatives, and certainly fold that into a lot of the ongoing work that we're doing here to try and get as efficient as we possibly can.

So, all of that is very positive news for us. We feel very good about the synergies. And I think, today, we can certainly say, the $300 million that we've talked about are there. From a cost standpoint, certainly across the business, we have somewhat higher cost in second quarter. A lot of that was due to timing, Matt. And I think, when you look at our costs for the first half, they were very reflective of costs for the first half of 2015. But certainly, timing plays a role in that, and certainly had an impact, in some cases, on our comps for second quarter.

Matthew C. Grainger - Morgan Stanley & Co. LLC

Okay. Thanks, Andrew. And then last, really quick one, housekeeping. What was the like-for-like pricing number for the quarter?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

You're talking about net price realization?

Matthew C. Grainger - Morgan Stanley & Co. LLC

Yeah. Out of the $12.5 million (31:40), how much was net price?

Susan M. Cameron - President, Chief Executive Officer & Director

That's as real (31:43).

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Okay. Yeah, about half. So, about half of that was mix, and about half of it was actually pricing benefit, on a like-for-like basis.

Matthew C. Grainger - Morgan Stanley & Co. LLC

Okay. Thanks again, I appreciate it.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Thank you.

Susan M. Cameron - President, Chief Executive Officer & Director

Thanks, Matt.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Thank you.

Operator

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

Judy E. Hong - Goldman Sachs & Co.

Thank you. Good morning.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning.

Susan M. Cameron - President, Chief Executive Officer & Director

Hey, Judy.

Judy E. Hong - Goldman Sachs & Co.

Andrew, I wanted to just get your views on the updated guidance, obviously, just $0.01 tightening at each end. If you kind of think about the – how the year is shaping up, the industry volume trend, even with a little bit softer trend in 2Q, seems like it's coming in a little bit better versus sort of the low-end of the 2% to 4% guidance. You now have the share buyback that's starting earlier than expected, pricing seems pretty healthy. So, just wondering what sort of kept you from taking the guidance maybe to the high-end of the range?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. It's a good question. I think, as we look at the back half of the year, we are still looking at an industry that we believe is going to be close to that 2% down on a year-over-year basis. So, when you start looking at second quarter, we think, on an adjusted basis, that's probably pretty good, in terms of reflecting where we think the back half of the year is going to be, and where the year in total will come out.

I would also say, certainly part of our consideration on this is, some costs will be going up in the second half. You're all aware of the deeming regulations and the costs associated with compliance, and future innovation under those new rules will certainly be a consideration for us as we go forward. And there are other regulatory issues that obviously, we're going to need to deal with in the back half of the year as well, that will have some additional higher cost.

So, all of that has played into our view. We're very pleased with where we are, obviously the integration being completed earlier, the synergies coming through, really, fully from beginning of Q4 and the share repurchase, obviously, will have some impact as well. But I would say the share repurchase will probably be – we're going to initiate that in third quarter; that will start in third quarter, but will probably have the bigger impact in fourth quarter going forward.

Judy E. Hong - Goldman Sachs & Co.

Got it. Okay. And then, maybe just some color on sort of the -post the deeming regs; what are you seeing in terms of how the industry is maybe reacting or kind of changing any of the strategy to the deeming regulation? And from your perspective, some color on how VUSE is tracking with some of the innovative products in the marketplace, and any changes to how you think about the broader – the reduced-risk product strategy in light of the deeming?

Susan M. Cameron - President, Chief Executive Officer & Director

Sure, Judy. I think, as I said in my remarks, we're looking forward to working with the Agency in terms of actually how this will unfold. We are certainly investing and preparing numerous VUSE format that will be – are in the market now, and certainly we will be able to evaluate those as we come to this August 8 deadline, to ensure that we have choices to work with the Agency on potentially rolling those out.

I would say, there's lots of lawsuits that the Agency is facing. We remain confident that we can participate, and that we can work through the regulatory process, however that unfolds. And as we've said, we support any sort of reduced risk policy, and we are looking forward to giving adult tobacco consumers additional choices in this smoke-free vapor area.

So, I think we all have to stay tuned. As Andrew mentioned there, there is some increased investment to prepare for this, but it is part of our vision and mission in transforming this industry. And so, we're actually very excited about it. Oh, in VUSE, you asked about?

Judy E. Hong - Goldman Sachs & Co.

Yeah.

Susan M. Cameron - President, Chief Executive Officer & Director

We're delighted that VUSE actually continues to grow. It's over 30% in the track channels, and our volume is actually significantly up, and while that's in that other financial category, and there's other investment, we're very pleased with VUSE performance.

Judy E. Hong - Goldman Sachs & Co.

Okay. So, just in terms of – if we think about the revenue in that others category, I mean, it's still kind of down year-over-year. I know there are other stuff in it, but can you just give us the clean VUSE number within others? Is that possible?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. Judy, we don't report that. But certainly, as Susan said, we continue to see very strong unit growth on VUSE, but we don't break that out.

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

And Judy, remember, Santa Fe International used to be in that. So when you're looking at that year-over-year comparison, that comes into play as well.

Judy E. Hong - Goldman Sachs & Co.

Okay. All right. Thank you.

Susan M. Cameron - President, Chief Executive Officer & Director

Thank you.

Operator

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

Bonnie L. Herzog - Wells Fargo Securities LLC

Thank you. Good morning.

Susan M. Cameron - President, Chief Executive Officer & Director

Hey, Bonnie.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning, Bonnie.

Bonnie L. Herzog - Wells Fargo Securities LLC

Hi, I was hoping you could drill down a little further on key reasons behind the pressures seen on Santa Fe's margins, do you think this is maybe more of a one-time impact or do you anticipate continued pressure on margins? Also, is there anything you could do to cut costs further at Santa Fe, especially given you still operate this business separately from R.J. Reynolds. There are possible opportunities to combine functions between these two businesses, for instance.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. I'll start with that. I think we're very pleased with Santa Fe performance. We're up 0.4 share point. The demand for that business has never been stronger. Consumers certainly are switching to that brand. I think that brand is – I got great momentum in the marketplace.

When you look at the margins, as you said, we were down three percentage points. That is off of an unusually high number last second quarter of 57.2%. If you go back to second quarter of last year, we were actually up 7.6 percentage points. The 54.1% is actually more in line with where we've been historically. And I think, there is unusual compare there.

Some of that certainly was driven by the inventory dynamics that Susan spoke about, where volumes were up last year 25% in second quarter, and operating income was up almost 50%. So, that compare is certainly a component. The other side of that is, we also had some additional marketing expense that was really just a matter of timing. I don't think it – from a full-year basis, I don't think we're seeing anything unique or different there. It's pretty consistent. But certainly from a quarter-to-quarter basis, we had some timing elements that certainly played into the margin there as well.

Bonnie L. Herzog - Wells Fargo Securities LLC

Okay. That helps. And then, I have a – go ahead.

Susan M. Cameron - President, Chief Executive Officer & Director

Sorry. No. I think you asked the question about costs. I have to say, I'm not disappointed with 54% margin to be fair, but I think, we pride ourselves on productivity. We are very proud of that Natural American Spirit brand and Santa Fe Natural

Tobacco Company, and how they have managed that business. And we will continue to do what is right for that business, but there is no pressure at all on the cost basis.

Bonnie L. Herzog - Wells Fargo Securities LLC

Okay. Fair point. And then, I might have missed this, but did you guys give an update to your $800 million lower cost guidance? And I'm thinking about it, especially given that the integration was completed ahead of schedule. Could you guys maybe give us a sense of possible further upside to the cost savings target over the long term?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. So, as I said, the $800 million is the number that we still are on. That is a number that we feel good about, and we – as I said earlier, we feel we can comfortably say that, we're going to achieve that, and that will start coming through the P&L fully in fourth quarter.

We've continued to work on opportunities, I think, to get more efficient. We've talked about these in the past, whether it's procurement, some of the leaf synergies as well. Those are things that will play out over time, and quite honestly, will be pulled into ongoing and existing programs that we already have to try and optimize our cost base and our structures and so on, all the way through.

So, that is something that will come in over time. It's probably not something that will come in at a single quarter, for example. But we've got the organization focused on that. They've got significant incentives to continue to drive – to continue to try and drive those efficiencies. And I think, going forward, that will just essentially come through the P&L, and the margin improvement that we have in the company.

Bonnie L. Herzog - Wells Fargo Securities LLC

Okay. And then, Susan, I was hoping you could update us on your succession planning now that you've completed the integration of Newport ahead of schedule. Anything you can share with us about this process and when we might expect an announcement would be helpful?

Susan M. Cameron - President, Chief Executive Officer & Director

I think, the board is very satisfied with the process, and I think we filed an 8-K or something. The board has extended me through the end of next April, latest. And so, everything is on track. And while we have completed the manufacturing integration, that is there. And as you notice, the other major component is on succession, and we're feeling very good about that.

Bonnie L. Herzog - Wells Fargo Securities LLC

Okay. Thank you.

Susan M. Cameron - President, Chief Executive Officer & Director

Thanks, Bonnie.

Operator

Your next comes from the line of Vivien Azer with Cowen. Your line is open.

Vivien Azer - Cowen & Co. LLC

Hi, good morning.

Susan M. Cameron - President, Chief Executive Officer & Director

Good morning, Vivien.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning.

Vivien Azer - Cowen & Co. LLC

So, I just wanted to circle back on Santa Fe. I apologize if I missed it. But did you call out specifically, if there was a volume impact from trade inventory changes on that brand. If so, what was the impact to volumes?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

There certainly was. So, our shipments were up 10.8% when you adjust for inventories. We would have been up closer to 14%.

Vivien Azer - Cowen & Co. LLC

That's helpful. Thank you very much. And then in terms of the other segment, I totally appreciate the Sante Fe International impact. But it's a kind of – look at the cadence of the operating loss which almost doubled sequentially, should we think about that loss kind of persisting at that level, given the expectation for expansion on the ZONNIC or should that normalize a little bit?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

We would expect that to continue to improve. But, Vivien, that will be largely dependent on the compliance and investment required for the innovation. So, our existing businesses, we continue to see very good progress on the underlying profitability and the financials really across everything that is in market today.

But obviously, as we dive into deeming regs, and really understand what is required to get some of these new products to market and to make sure that they are able to stay in the market going forward, you know, that obviously will play some role. But as Susan said, this is a category that we feel very positive about. We have the leading brand in the category, and we're going to continue to invest appropriately to maintain that leadership going forward.

Vivien Azer - Cowen & Co. LLC

That's helpful. Thank you very much. My last question is on American Snuff. Given the pressure that you saw to volumes, it's pretty impressive. The profit growth that you guys were able to realize, but as we kind of think about an intensified competitive landscape, is there a need for more promotional investment? Is the level of profit growth sustainable given the volume slowdown that we saw?

Susan M. Cameron - President, Chief Executive Officer & Director

I mean, I would say, you know, in the second quarter, we saw this significant competitive launch, and we were still able to grow our profitability. Grizzly did suffer a bit in shipments to retail on a market share basis. And we lap big activity on our part from second quarter last year. So, you'll see in the back half as I mentioned, we're going to launch Grizzly Dark Mint, and we expect there will be continued competitive activity in that space. But, our competition has had a launch, and now we will have a launch, and we continue to be confident in Grizzly's performance.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

And, Vivien, I'd just add, for first half we're up almost 10% on ASC. And I think that, we obviously have to look at this over a period of time, not just because of the competitors, but because of some of the initiatives that we have in terms of growth.

We've got a lot of elements going on at retail even to enhance the presence and the merchandising of Grizzly, going forward. We have some expansion of some styles going on in the back half of the year. And certainly, I would expect the back half to be better than second quarter. And we feel very good about continuing at pace where we've seen Grizzly historically in terms of profit growth.

Vivien Azer - Cowen & Co. LLC

Thank you very much.

Operator

Your next question comes from the line of Chris Growe with Stifel. Your line is open.

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

Hi. Good morning.

Susan M. Cameron - President, Chief Executive Officer & Director

Good morning.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning, Chris.

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

Hi. I just had two questions, if I could. The first one in relation to the Newport brand and the continued strong performance for that brand and the market share growth; is there any way you can help just frame, like, how much is the brand benefiting from, say, distribution, penetration of new customers, that kind of thing, versus kind of the core market still growing here. Is there any way to flush that out here or better speak to that?

Susan M. Cameron - President, Chief Executive Officer & Director

Sure. I'll speak to it, I don't think I'll carve it out to your satisfaction. But let's say that, we are seeing Newport grow in all of its existing markets, strongholds as well as in all its opportunity markets, and we are seeing growth in both its menthol and its non-menthol styles.

So I would say, obviously, the incorporation into the Reynolds contract has given the brand higher visibility, while our marketing support for Newport is actually split across the year, which is different than how Lorillard handled the significant investment in the brand in the front half. But in addition to that, our consumer engagement out there talking about the brand to adult tobacco consumers, I believe that, that is also driving the momentum of Newport. And so, we continue to be very bullish about that continuing.

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

So, should the brand accelerate in terms of its market share growth as you get more resources behind? I know, you only probably give a number here. But is that an expectation that as you have more resources and more marketing, the more sales support that we could see an improved performance from Newport brand?

Susan M. Cameron - President, Chief Executive Officer & Director

No. I think we're seeing growth on the brand that hasn't been (47:40) and we've owned the brand about a year and two weeks. So, it is exceeding our expectations, certainly, from the original business case of the transaction. But how high it's high and how fast we can accelerate is still an unknown. But we are very enthusiastic, and our consumer research on the brand shows true opportunity.

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

Okay. And maybe it's a question for, Andrew. In relation to the synergies that are coming through from the combination of the two companies, can you say how much you generally expect in 2016 now that you've got a lot of the manufacturing activity in place? Do you expect the majority of that sort of remaining kind $300 million in synergies to come through in 2016 or some also in 2017?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Well, as I've said, so, the $300 million will be fully baked starting beginning of fourth quarter is our expectation. So, the full $800 million will be running through the P&L starting in fourth quarter so, you'll have it all in 2017, but obviously, it will have taken us three quarters to fully realize the full run rate here in 2016. So, there will be some residual benefit as we get into 2017.

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

Okay. And then, just a quick one, I guess, a follow-up. Was there an equal number of shipping days this quarter for the RJR division?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

That's a good question. I'm not sure. Do you have it, Bob?

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

Yeah. I think for RJR, we did have one additional shipping day in the second quarter of this year compared to last year, Chris.

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

Okay. And then, I think, is there one less in the fourth quarter this year, just to be clear on that?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

That's right. Yeah. So, for the full year it's an equal number. Correct.

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

Okay. That sounds great. Thanks so much for your time.

Susan M. Cameron - President, Chief Executive Officer & Director

Thank you.

Operator

Your next question comes from the line of Michael Lavery with CLSA. Your line is open.

Michael Lavery - CLSA Americas LLC

Good morning.

Susan M. Cameron - President, Chief Executive Officer & Director

Good morning, Michael.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Good morning.

Michael Lavery - CLSA Americas LLC

Just coming back to Natural American Spirit that – its volumes are typically a bit lumpy, but the adjusted number helps, but could you also give a sense of what the sell-through for that was at retail? Was that any different, versus the 10% and 14%?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. So, as we've said, Michael, the shipments for retail – our retail market share was up 0.4 share point, and the volume to retail was actually up closer to 19%.

Michael Lavery - CLSA Americas LLC

Okay. Thanks. That's helpful. And then, just clarifying on the inventory moves, you mentioned how the second quarter was down 400 million units, and 2Q 2015 was up to 1.1 billion units, was the 400 million units down versus 1Q, or versus last year?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

That was versus the end of first quarter; to the end of first quarter to the end of second quarter was down 400 million units.

Michael Lavery - CLSA Americas LLC

Okay. So, can you give a sense how the end of 2Q compares versus normal? Is it still low, or has it adjusted to come in the right level, or what would you expect for 3Q? Would that maybe restore some volume on a little bit of reloading?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah, on an industry basis, we think it's relatively normalized, so that is, as we look at the $6.9 billion, that's a relatively normalized level at the end of second quarter through this year.

Michael Lavery - CLSA Americas LLC

Okay. Thanks. And then, just looking at the last couple of weeks of the quarter, after you had fully lapped the anniversary of the integration or the deal, can you just give a sense of what the pace looked like as far as organic growth? I mean, you've given some color on the price lift and everything else. But, just to the extent that that's been hard to tease out, can you give a sense of what your momentum looked like coming into the third quarter?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

You're talking about Newport specifically?

Michael Lavery - CLSA Americas LLC

Well, that would be interesting; or I guess, more just the whole cigarette portfolio just because, with the acquisition, that hasn't been as easy to get as clean of a read. So now, with just those couple weeks, do you have a view of maybe just kind of how that looks now, coming into 3Q?

Susan M. Cameron - President, Chief Executive Officer & Director

Well, I think, we continue to look at that – at the market share growth, and when you look at this quarter-over-quarter, or you look at the first quarter and second quarter, and Newport is here at 13.9%. And as you say, we have lapped us owning it and us shipping it. So, we are very pleased with that result.

Michael Lavery - CLSA Americas LLC

That's very (52:10) helpful.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. Michael, I don't think we're going to get into third quarter at this point in time.

Michael Lavery - CLSA Americas LLC

No problem. And then just on ZONNIC, you've talked about that a little more than, I think, than typical, but what's the right way to think about some of the earnings trajectory there? Are there big investments behind that, that would be comparable to something like VUSE, or is that something that's a little bit more low maintenance or – what's kind of the outlook for what the spend would be on that business, and how we think about the impact on the national expansion?

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Yeah. I would say, certainly not – from a cost or marketing expense basis, anywhere near what we've done with VUSE at this point, that is more of an extended expansion. So that is carrying over a number of different quarters. And most of the expense, obviously, is related to the merchandising and the sell-in of the product itself.

So, that is something that will be spread over time. It will be at lower levels than VUSE, but obviously, from an opportunity standpoint, we still feel very good about that. We think that can be a very profitable business for us. It certainly adds to our portfolio in a very significant way. And we feel very good about the future of ZONNIC.

Michael Lavery - CLSA Americas LLC

Thank you very much.

Susan M. Cameron - President, Chief Executive Officer & Director

Thanks, Michael.

Andrew D. Gilchrist - Chief Financial Officer & Executive Vice President

Thank you.

Operator

And your next question comes from the line of Adam Spielman with Citi. Your line is open.

Adam J. Spielman - Citigroup Global Markets Ltd.

Thank you for the – accepting the question. I have a couple of things, and forgive me for my ignorance, but can you explain to me the process of launching Grizzly Dark Mint? And in particular, I'm thinking do you need FDA approval for it? And I suppose that is one question. The other question is also related to the FDA. I know it's really early after the deeming regs, and I know they haven't really come into effect yet. But have you been able to get any sense about – when you speak to the FDA – about how that attitude to (54:22) or premarket approvals (54:27-54:32).

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

You there, Adam?

Operator

Adam's line did disconnect.

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

Okay. Maybe we can go ahead and answer the question, at least the first question on Grizzly Dark that he asked.

Susan M. Cameron - President, Chief Executive Officer & Director

Sure. On Grizzly Dark Mint, it is an existing product that has been in the marketplace. And basically, this is a roll-out. And so, that will progress in the third quarter. And, as he was inquiring about deeming regs, we can also say, really as in my prepared remarks, we look forward to working with the Agency, because there have – a lot of the regs actually read like the combustible. On the other hand, there's been a lot of signaling that this will be a more straightforward process, which is more in line with sort of a risk continuum, risk reduction product arena. So, we will continue to work with the agency on clarification of that process.

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

So, do we have any further...

Operator

No, there are no further questions at this time. Mr. Bannon, I'll turn the call back over to you.

Robert W. Bannon - Vice President, Investor Relations, Reynolds American, Inc.

Great. Thanks, Sally. So, thank you again, everyone, for joining our call today. If you do have any further questions, please feel free to contact us and Investor Relations and have a good day.

Operator

Thank you, ladies and gentlemen. This concludes today's conference call. You may now disconnect.

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