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November, 2006

U.S. Tobacco Cooperative

Reynolds American Rolls Forward

By Joseph Finora

The tobacco giant overcomes the challenges of the industry through the strength of its brands and an innovative marketing approach — as well as a highly touted entry into the smokeless category.

Despite a challenging business environment, Reynolds American Inc. (RAI) continues to move forward thanks to its creative acquisitions and savvy management. But are litigation, smoking bans, tax increases and intensifying competition taking a toll on the second-largest U.S. cigarette manufacturer — or does it all boil down to just another day at the office for the tobacco giant?

RAI had about $8 billion in annual sales and holds 30% of the U.S. market. Its third-quarter profit rose 45%, with continued strong performance by R.J. Reynolds Tobacco Co.’s Camel and Kool cigarettes, as well as Grizzly moist-snuff, which came as part of RAI’s May acquisition of Conwood Company, the nation’s second-largest smokeless tobacco company. Third-quarter revenue climbed nearly 2 percent to $2.19 billion from $2.15 billion last year.

While the external business environment has become considerably more favorable than it was several years ago, non-traditional business factors — mostly lawsuits, smoking bans, and tax increases — continue to challenge Reynolds American, as well as the entire industry. Nevertheless, Reynolds American keeps rolling along.

Brand StrengthIn 2005 RAI’s largest subsidiary, R.J. Reynolds, launched a new portfolio strategy aimed at improving profitability. A key part of this was to create three brand categories for its products. Camel and Kool were selected as “investment products” and as such receive the majority of marketing support. Winston, Salem, Doral, and Pall Mall are “selective support” brands and receive limited resources as the company tries to get greater efficiencies out of them. The remaining brands fall into RAI’s “non-support” category.

With this strategy, R.J. Reynolds intends to accelerate growth of its two investment brands — Camel and Kool — so their growth exceeds declines on the company’s other brands. In this way, the company plans to reverse its declining share-of-market trend and generate total company share growth between 2010 and 2012. Since the new portfolio strategy was introduced, Camel and Kool have grown more than a full share point on a combined basis, and R.J. Reynolds has cut its rate of total decline in half.

The introduction of the new brand strategy came on the heels of highly publicized merger-and-acquisition activity that included a merger with the U.S. operations of No. 3 U.S. cigarette maker Brown & Williamson (2004) and acquisitions of Lane Limited (2004) and Santa Fe Tobacco Co. (2002). Synergies from the B&W merger have already provided Reynolds American with some $600 million in annual savings.

“Reynolds American’s year-to-date results underscore the power of our business model and our operating companies’ inherent strength,” said Susan M. Ivey, RAI’s chairman and c.e.o. “Nine-month profit gains from each of our operating units contributed to continued growth momentum. Our performance continues to validate that our strategy is solid, and is driving results.”

Ivey said that continued total share-trend improvements at R.J. Reynolds are in line with those expected from the brand-portfolio strategy it put in place in early 2005. She also said that the third quarter was marked by the continued strong growth momentum of Conwood.

“Our performance is on track for RAI to again deliver strong full-year results,” Ivey said. “We are increasing our full-year forecast based on additional gains at R.J. Reynolds and Conwood.”

“Reynolds American has offered investors an extraordinary level of wealth creation. Even though it hasn’t been smooth sailing as of late, the stock has returned better than 26% annually over the last five years,” said Peter Gore, CFP of financial advisory firm Gore & Golub LLC in Williamsburg, Va. “Lately, management has been prone to surprise against estimated earnings, besting the overhanging litigation cloud. There still is a compelling story for RAI. That’s not to say there is no risk associated with it but the tobacco industry is still a considerable force to be reckoned with.”

“We expect revenues to rise about 6%,” said Standard & Poor’s (S&P) analyst Raymond Mathis. “We see a likely rise in volumes for focus brands Camel and Kool but anticipate continued volume declines for select-support and non-support brands as marketing efforts are reduced or eliminated. Further, we see increased competitive pressures in the menthol category, limiting growth for RAI’s menthol brands.”

S&P’s RAI outlook has improved, noting a new marketing strategy and secure price increases as two key positive elements bolstering RAI’s short-term prospects. The fact that Camel and Kool have continued to grow market share in a dynamic and challenging marketplace is another encouraging sign. S&P also cites “synergies” generated from recent mergers and acquisitions to begin favorably contributing to RAI’s bottom line.

During the third quarter, R.J. Reynolds’ “investment brands” Camel and Kool, continued to post strong share gains, with a combined increase of 1.07 share points compared with the year-ago quarter. On a nine-month combined basis, the company’s two investment brands were up 0.91 share points compared with the prior-year period, contributing to the continued moderation of its overall share declines.

“Reynolds still needs to see an even more significant improvement in the operating margins for its cigarette operations before it can produce the same level of profitability reported by most of its peers,” noted Greggory Warren, CFA, a Morningstar analyst. “The company’s heavier focus on discount brands has left it well behind Altria and Carolina Group, both of which have stronger portfolios of premium brands and generate operating margins in excess of 30% annually.”

Part of RAI’s strategy was its $40 million “investment” to fight state-ballot initiatives on cigarette excise-tax increases and smoking restrictions, much of it in California. Other smoking-ban and tax fights were on the ballot in Arizona, Nevada, Ohio, South Dakota and Missouri. These types of opposition strategies are becoming part of every giant tobacco company’s long-range plans.

“The company isn’t letting up to defeat this [California] initiative until it is in the hands of the voters,” Ivey said, adding that it is investing more than half of its opposition budget in California alone. “Voters have to make a good decision on Nov. 7, whatever that decision is.” Reynolds derives some 6% of its sales in California.

(Editor’s Note: The results of that investment, post-Election Day, were mixed for Reynolds and the other big U.S. tobacco companies: While voters shot down the huge tax hike proposed in the crucial state of California, as well as Missouri, they approved ballot measures in Arizona, Nevada and Ohio to require smoke-free workplaces and public places, and to increase tobacco taxes in South Dakota and Arizona.)

RAI’s total retail market share for the nine-month period was 29.87%, down 0.35 points. Spending to combat state ballot initiatives and an 8% volume decline that was partially driven by trade-inventory movements weakened RAI’s results.

Smokeless: The New Frontier?Conwood, acquired for $3.5 billion, delivered strong growth for the third quarter and the first nine months with adjusted operating income rising 7.4% to $73 million. The formerly privately held company is a large player in the moist-snuff category largely thanks to Grizzly, a price-value brand that holds 20% of the market. It nabbed a 3.7 share-point gain for the first nine months compared with the same period of 2005.

Conwood manufactures and sells in every smokeless category, including moist and dry snuff, loose leaf, plug and twist tobaccos. It is the growth leader in moist snuff, and Grizzly is the leading value brand. Conwood’s net sales for 2005 were more than $450 million with annual sales growth over 8% during the last five years. Conwood’s president and c.e.o. Bill Rosson reports to RAI group president Jeff Eckmann, who also leads the company’s Lane, Santa Fe and Global Products subsidiaries.

“We’re excited about Conwood’s growth prospects,” said Ivey. “Conwood’s strong, well-positioned brands are gaining share in the growing moist snuff market, and its high margins will enhance our ability to continue to provide an excellent return to our shareholders.”

Conwood brands include H.B. Scotts, Morgan’s, and Levi Garrett in the loose leaf category; Kentucky King and Moore’s Red Leaf in the Twists group; Dental Mild and Sweet, and Levi Garrett snuff; Taylor’s Pride, Cannon Ball, and Black Maria in plugs; Grizzly and Cougar in the moist price-value segment; and Kodiak and Hawken in the moist-premium group. It is the only company to compete in all five smokeless categories, holding the No. 1 or No. 2 position in each. It’s more than doubled its total share of the moist-snuff market during the last six years.

Reynolds American will combine its Lane Limited subsidiary, currently headquartered in Tucker, Ga., with Conwood in order to drive growth in the companies’ portfolio of other tobacco products (OTP). The headquarters of the combined companies will be in Memphis, Tenn., and full integration of the two is expected to be completed by year-end 2007.

Lane Limited has the leading roll-your-own brand in Bugler. Launched in the United States in 1932, it accounts for 24.5% of U.S. sales volume. Midnight Special, a value brand that has undergone rapid growth over recent years, has 7.6% of retail volume. Kite, launched in 1934, is the leading menthol RYO in the United States, with 5.2% of retail sales volume. Four other RYO brands — Samson, Roll Rich, Jester, and Gauloises (marketed on behalf of the European tobacco company Altadis) — account for a further 1.4%, giving Lane 38.8% of total U.S. RYO sales volume before affiliating with Conwood.

Additionally, Lane markets Winchester little cigars, the biggest little-cigar brand, with 15.9% of U.S. little-cigar sales while Captain Black accounts for 4.4% of the category. Lane also markets the Dunhill Aged and the Dunhill Signed ranges of premium cigars in the United States under an agreement with British American Tobacco, plus 20 styles of Holland’s Schimmelpenninck cigars, and produces bulk pipe-tobaccos for smoke shops. Lane’s Captain Black is one of America’s leading pipe-tobacco brands, accounting for 12.1% of pipe tobacco sold in the country. It’s followed by Sir Walter Raleigh, with 5.1%. Lane exports many of its products, with the leading recipient countries being Japan, Nigeria, Turkey, and Russia.

Earlier this year Lane sold its Dr. Grabow line of pipes and pipe filters, and Dill’s pipe cleaners to International Pipes & Accessories LLC for $4.3 million. The sale includes the transfer of ownership of the Dr. Grabow manufacturing facility in Sparta, N.C., as well as a contract for services related to the distribution of Lane products for one year. Dr. Grabow is the best-selling brand of pipes in the United States, annually producing some 250,000 pipes.

“This sale allows Lane to more fully focus on its core business and growth strategy,” said Nick Bumbacco, Lane president and c.e.o. “Selling the Dr. Grabow business is the best fit for Lane and Dr. Grabow while Lane continues to focus on manufacturing and marketing premium tobacco products.”

“Reynolds management has continued to craft and successfully implement a business model focused on identification with and development of its extensive brand portfolio,” said Gore. “Since 2004, they’ve shown their prowess to acquire and merge significant and relevant brands, and adding them to the stable of strong category performers, as witnessed by the Conwood acquisition. These efforts have created substantial shareholder value and are certainly contributing to the continued strong stock performance.”

On a competitive front, Swedish Match announced in October that it will partner its North American unit with Lorillard Tobacco Co., the parent of Carolina Group, to develop and sell smokeless tobacco products in the United States. An official launch date has not been set, but according to a company statement it will be “in the not-too-distant future.”

Separately, Altria Group Inc.’s Philip Morris USA launched Taboka, a smoke-free, spit-free tobacco pouch product, in a test market in July. Reynolds American’s R.J. Reynolds subsidiary is currently conducting a two-market test of its own “spitless” smokeless tobacco product, called Camel Snus.

“There are other companies interested in the smokeless tobacco category,” said Dianne M. Neal, RAI e.v.p. and chief financial officer. “The competitive environment will be what it will be.”

Having Its Days in CourtIn mid-October, R.J. Reynolds and a multi-state group of attorneys general announced a collective agreement on the future marketing of specialty flavored cigarettes to adult smokers.

“This agreement codifies R.J. Reynolds’ practice for some time of not using language describing fruit or candy flavors in magazine and newspaper advertising, or point-of-sale communications in non-age-restricted venues,” said Lynn J. Beasley, R.J. Reynolds’ president and chief operating officer.

In addition to the conditions of the agreement, which are specific to the company’s specialty blends, R.J. Reynolds announced it will voluntarily extend comparable guidelines to all of its brands. Under the agreement, other than in adult-only venues and communications, R.J. Reynolds’ specialty blends will not use the name of a fruit, candy, or alcoholic beverage in the future naming of its cigarette brand styles.

Most of R.J. Reynolds’ specialty flavored cigarettes were marketed as part of the Camel Exotic Blend family of styles, which were originally introduced in 1999 as a superpremium-priced product. In total, these styles represented less than 1/10th of 1% of the company’s annual cigarette volume. In May, R.J. Reynolds ceased manufacturing the last three of its remaining Camel Exotic Blends.

In November, a U.S. federal appellate court granted a permanent stay of the proceedings in the Schwab case. The court also granted the tobacco company defendants their requested appeal of a lower court’s decision, which granted class-action status to the suit. Plaintiffs are arguing that smokers of so-called “light” cigarettes were defrauded into thinking that they were safer than regular ones. Should they be allowed to proceed, they are seeking more than $200 billion in damages to be paid collectively from the nation’s largest cigarette manufacturers. It remains to be seen if the positive momentum generated by dismissals in the Price and Engle cases will carry into the Schwab case and deliver a favorable outcome for the tobacco companies.

Reynolds American continues to face challenges, some unique to the company, others impacting the entire industry. But the company continues to show considerable strength, and no matter what the outcomes, its future will be interesting.

Tobacco International - November, 2006

SMOKE Magazine - Cigars, Pipes, and life's other desires

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