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November, 2007

Reynolds American Rolls Forward

By Joseph Finora

With a diversified product line in an uncertain market, Reynolds American is looking not just to survive, but to thrive.

Reynolds American Inc., (RAI), the second-largest US tobacco-products company sells about a third of all cigarettes sold in the US. Its mid-year 2007 results were in line with the company’s expectations but below those of Wall Street. Results suffered due to unusually high undiscounted wholesale volume and tax gains during the prior-year periods. Adjusted earnings-per-share (EPS) was down for the second-quarter as adjusted net earnings fell 10% during the quarter, but edged up nearly 2% overall for the first half. A second-quarter charge of approximately $20 mn related to debt refinancing was included. RAI remains bullish when forecasting its outlook for the full year and expects to deliver year-over-year growth in reported EPS of 9–12%. To put conviction behind its outlook, the company at midyear, also announced a dividend increase greater than 13%.

RAI’s operating companies posted higher margins and market share gains for some premium cigarette and smokeless tobacco lines. Second-quarter revenue came in at $2.35 bn, a gain of 2.5% from the same period a year earlier, as market share for growth brands Camel, Kool, and Pall Mall hit 12.99%, an increase of 0.63 share points. Reported net income fell to $325 mn from $376 mn vs. the second quarter of 2006.

Founded in 1875, the Winston-Salem-based RAI has a dominant presence through such powerhouse brands as Camel, Kool, Pall Mall, Salem, Winston, Doral, American Spirit, and Eclipse (a cigarette that primarily heats rather than burns tobacco in an effort to reduce second-hand smoke). Highly diversified in the US retail tobacco market, it is the parent company of Conwood Company, LLC, the nation’s second-largest manufacturer of smokeless tobacco products and Santa Fe Natural Tobacco Company, Inc., a leading producer of natural and 100% certified-organic tobacco products and manufacturer of Natural American Spirit cigarettes and other additive-free tobacco products. R.J. Reynolds Global Products, Inc. manufactures, sells and distributes American-blend cigarettes and other tobacco products to customers worldwide. RAI also markets Captain Black, a leading pipe-tobacco brand, accounting for 12.1% of pipe tobacco sold in the US. In addition, the company markets Dunhill luxury cigarettes and Winchester little cigars.

“Reynolds American’s first-half results position us well to deliver strong earnings growth for the full year,” said Susan M. Ivey, RAI’s Chairman, President, and CEO in a statement. “We’re solidly on track.”

“Compared with our full-year 2006 performance, R.J. Reynolds delivered higher operating margins and total growth-brand share gains during the second quarter and first half of 2007,” said Daniel M. Delen, R.J. Reynolds President and CEO. “Those gains are the result of our continued focus on profitable growth.” Delen noted that R.J. Reynolds’ operating margin of 24.1% in the second quarter of 2007 keeps the company on track for year-over-year margin growth. The company’s second-quarter premium-to-value price mix was 62.6%, up more than a percentage point from the prior-year period. “We’re on track to increase operating profit for the full year,” Delen said.

Other notable gains were recorded by Conwood’s Grizzly line, the leading moist-snuff value brand and category growth leader. Grizzly gained 1.90 share points during the second quarter compared with the prior-year period. It is the third-largest moist-snuff brand in the US, and earned a 20.64% second-quarter market share. Conwood’s operating income jumped nearly 14%, boosted by higher volume, pricing and margins. Its second quarter operating margin hit 52.1%, up more than a percentage point from a year ago.

“Grizzly’s growing strength is built on the brand’s powerful position as a premium product with an attractive price,” said William M. Rosson, Conwood’s President and CEO. “Grizzly’s strong brand equity is continuing to fuel growth in the increasingly competitive moist-snuff market.” Conwood also markets Kodiak and Levi Garrett, and sells and distributes tobacco products manufactured by RAI’s Lane, Limited, subsidiary, including Winchester and Captain Black little cigars, and Bugler roll-your-own tobacco. RAI bought Conwood in 2006. Responsibility for sales, marketing and distribution of Lane brands was transferred into Conwood on Jan. 1. Conwood marked its first anniversary as a member of the Reynolds American family during the second quarter.

“Despite Conwood’s solid second-quarter results, we question whether it can continue to generate double-digit growth on a sustainable basis,” noted Citigroup analyst Bonnie Herzog who added that although Conwood turned in 11% growth its overall growth rate is declining. She also added that while Camel Snus “could provide a nice spark for RAI’s earnings,” competition from Philip Morris’ anticipated Marlboro Snus could take share from each.

Herzog also noted that while this quarter’s results were not nearly as “negative at first blush,” and she is still waiting for a “positive catalyst,” to propel RAI, she remains bullish on the company’s 2008 prospects.

Raymond Mathis, tobacco analyst at rating agency Standard & Poor’s (S&P) expects 2007 revenue for RAI to grow by 4% citing a “favorable product mix, price increases, new product introductions and acquisitions,” as the forces behind such forward momentum. Mathis notes that as 2006 inventory is cleared out of warehouses volume should rise for RAI’s foundation brands including Camel, Kool, Pall Mall, and American Spirit, but he anticipates that other brands will experience sales declines. He attributes such declines to lessening marketing support coming from the parent company, which had announced a cigarette marketing plan focusing on the above-mentioned brands last year. Another long-term positive force on the horizon for RAI is continued productivity improvements, which are expected to be in the $75–100 mn range this year and should prove their worth when the books are closed for 2007.

“Our first-half results fully met our expectations and reflect a difficult prior-year comparison,” said Dianne M. Neal, RAI’s CFO. “Each of our businesses are producing solid results, we continue to see growth on key brands and we’re on track to generate full-year productivity gains.” Neal noted that the latest dividend increase keeps RAI consistent with its policy to return about 75% of annual net income to shareholders in the form of dividends.

What’s Ahead?
While unusual dynamics that included artificially high shipment volume in the prior-year period led to RAI’s comparatively weak second-quarter earnings, credit-ratings agency Moody’s Investors Service reported that if cigarette-shipment volume continues to decline, it will replace litigation risk as the biggest threat to cigarette-company credit ratings. Moody’s reported in September that shipment volume was down 5% for major tobacco companies over the previous six months, a steeper drop than anticipated.

“Should shipment volumes decline without an offsetting ability to raise prices, ratings could come under pressure,” said Janice Hofferber, Moody’s Vice President, Senior Analyst. A drop in ratings could make it more expensive for cigarette companies to borrow capital. Cigarette volume is dropping, mostly in developed countries, as smoking bans, tax increases, and smoking-cessation drugs begin to make their presence felt. Additional regulation and tobacco taxation continue to dog the entire industry’s near-term profits. Overall, the industry remains robust if not spectacular and each of its players are scrambling for ways to keep the profits percolating in the face of numerous threats. Moody is maintaining a “stable outlook” for the industry, citing “ample liquidity, strong cash flows, and high margins.” As a case-in-point for the industry, Reynolds stands to finish 2007 on a high note as earnings for the year come in. Standard & Poor’s upgraded RAI’s outlook from “stable” to “positive.”

Consumption in the US cigarette industry continues to decline at a steady level and further excise tax increases may be in the future. There is also continued competition from Altria and other rivals such as Imperial, which acquired Commonwealth Brands in April. The payment included $561.2 mn deposited into an escrow account pending resolution of whether the company is due a credit for its 2004 payment.

Last August numerous women’s and public-health organizations demanded that R.J. Reynolds Tobacco Company immediately eliminate its Camel No. 9 cigarettes. The groups charged that the brand’s aim is to induce young, style-conscious women and girls to begin smoking cigarettes.

Camel No. 9 went retail in early 2007 and its avant-garde packaging immediately became the target of criticism by anti-smoking groups. The shiny, sleek black boxes with fuchsia and teal trim and their accompanying ads feature florals, lace and carry the slogan “Light and Luscious.” One such ad in the series promises a longer cigarette that’s “Now available in stiletto.” Critics have charged the ads to be potentially misleading, among other things. Ironically, newspaper reports noted that a congressional group said it had been rebuffed by major women’s and fashion magazines in their effort to get the magazines to stop publishing the Camel No. 9 ads. Perhaps the magazine publishers’ reaction is a barometer of the public’s patience wearing thin with the seemingly endless anti-cigarette campaign as the world grapples with other more substantive issues.

In a letter from the American Legacy Foundation, a group formed after the 1998 settlement between the states and the tobacco industry, to R.J. Reynolds Chairman Susan Ivey, the foundation demanded that the company “remove Camel No. 9 today.” In sympathy, a group of more than 40 US Congress members, led by Representative Lois Capps expressed disappointment that 11 women’s magazines continue accepting the ads.

In response, Vogue’s publisher wrote in a letter that Congress should create legal guidelines, and that “any other pressure or coercion...is at odds with the basic fabric of our country’s legal system.” Similarly, Glamour responded that it appreciated the health concerns, but “the Camel ads in question do comply with the Master Tobacco Settlement Agreement.” W magazine agreed to further discuss this issue but did not disclose whether it would continue or stop running the ads. Four of RAI’s eight top executives are women.

R.J. Reynolds maintains that the brand is directed to adult smokers of competing brands. “Interest from adult male smokers has been stronger than expected,” said a spokesperson. “The colors and packaging simply accentuate the style and the brand’s premium nature.” He said the company is pleased with initial sales, saying the brand had achieved an average share for the second quarter of almost 0.5%. “Adult smokers are trying it and like it,” he said.

Also in August, R.J. Reynolds Tobacco Company, along with other major US tobacco companies, received a favorable decision from the California State Supreme Court, which affirmed a lower court’s dismissal of a class-action lawsuit against cigarette manufacturers and overruled a 1994 California Supreme Court decision regarding marketing and advertising activities in the state during the 1990s. The State Supreme Court noted that the free speech guarantee of the First Amendment applied as “…cigarette advertising concerns lawful activity because it is addressed to adults who can legally purchase and use cigarettes.”

Earlier in 2007 R.J. Reynolds Tobacco Company won a patent-infringement lawsuit brought by Star Scientific, Inc. (Star). The Court ruled Star engaged in inequitable conduct before the US Patent Office in obtaining patents involving a method of treating tobacco to substantially prevent the formation of tobacco-specific nitrosamines (TSNAs).

Star filed the suit in 2001, and had sought hundreds of millions of dollars in damages. In February R.J. Reynolds again succeeded in court when the 6th Circuit Court of Appeals upheld a lower court’s ruling to dismiss an antitrust lawsuit brought by Smith Wholesale Co., Inc. of Tennessee and 18 other wholesalers claiming that R.J. Reynolds’ Wholesale Partners Program (WPP) is discriminatory. The court ruled that the company has the right to select its own distributors. The plaintiffs had sought unspecified damages. During the first half the company received the return of $100 mn appeal bond in the Engle case.

Boardroom Bulletin
In the boardroom John J. Zillmer, 51, Chairman and Chief Executive officer of Allied Waste Industries, Inc., was elected to the board of directors of Reynolds American Inc., last July. He is serving on the board’s compensation committee. Prior to joining Allied Waste, Zillmer spent 18 years in the food-service industry, holding managerial positions with Saga Food Service Corporation, Szabo Foodservice Corporation and ARAMARK Corporation. He retired as president of ARAMARK’s Food and Support Services division in 2004. Allied Waste, headquartered in Phoenix, is the nation’s second-largest waste-management company. Zillmer had served as Allied Waste’s chairman and CEO since May 2005.

Declining consumption, an increasing tax burden, continued litigation, advertising restrictions and a negative public image are the main liabilities confronting tobacco companies such as RAI on a daily basis. But RAI’s operating companies keep rolling forward. While 2007 may one day be looked upon as a “transition year” for RAI, its foundation is solid and no obstacle appears permanent.

Tobacco International - November, 2007

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