UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

 

                                (Mark One)

þ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2009

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

 

Commission file number: 1-32258

Reynolds American Inc.

(Exact name of registrant as specified in its charter)

 

 

401 North Main Street

Winston-Salem, NC 27101

(Address of principal executive offices) (Zip Code)

(336) 741-2000

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act: None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Exchange Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.  Yes o     No þ

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes þ     No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes þ     No o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

The aggregate market value of common stock held by non-affiliates of Reynolds American Inc. on June 30, 2009, was approximately $6.5 billion, based on the closing price of $38.62. Directors, executive officers and a significant shareholder of Reynolds American Inc. are considered affiliates for purposes of this calculation, but should not necessarily be deemed affiliates for any other purpose.

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: January 29, 2010: 291,441,336 shares of common stock, par value $.0001 per share.

 

Documents Incorporated by Reference:

 

Portions of the Definitive Proxy Statement of Reynolds American Inc. to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934 on or about March 22, 2010, are incorporated by reference into Part III of this report.

 

 

INDEX

 

 

 

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 Internet Web site address is www.reynoldsamerican.com. RAI’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, insider trading reports on Forms 3, 4 and 5 and all amendments to those reports are available free of charge through RAI’s Web site, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. RAI’s Internet Web site and the information contained therein or connected thereto are not intended to be incorporated into this Annual Report on Form 10-K. Effective January 1, 2010, RAI’s Web site is the primary source of publicly disclosed news about RAI and its operating companies.

 

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 Strategy

 

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.

 

RJR Tobacco

 

Overview

 

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.

 

Competition

 

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.

 

Marketing

 

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.

 

Raw Materials

 

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.

 

Conwood

 

Overview

 

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.

 

Competition

 

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.

 

Marketing

 

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.

 

Raw Materials

 

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.

 

Consolidated RAI

 

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.

 

Customers

 

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.

 

Raw Materials

 

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.

 

Intellectual Property

 

RAI’s operating subsidiaries own or have the right to use numerous trademarks, including the brand names of their tobacco products and the distinctive elements of their packaging and displays. RAI’s operating subsidiaries’ material trademarks are registered with the U.S. Patent and Trademark Office. Rights in these trademarks in the United States will last as long as RAI’s subsidiaries continue to use the trademarks. The operating subsidiaries consider the distinctive blends and recipes used to make each of their brands to be trade secrets. These trade secrets are not patented, but RAI’s operating subsidiaries take appropriate measures to protect the unauthorized disclosure of such information.

 

In 1999, RJR Tobacco sold most of its trademarks and patents outside the United States in connection with the sale of the international tobacco business to JTI. The sale agreement granted JTI the right to use certain of RJR Tobacco’s trade secrets outside the United States, but details of the ingredients or formulas for flavors and the blends of tobacco may not be provided to any sub-licensees or sub-contractors. The agreement also generally prohibits JTI and its licensees and sub-licensees from the sale or distribution of tobacco products of any description employing the purchased trademarks and other intellectual property rights in the United States. In 2005, the U.S. duty-free and U.S. overseas military businesses relating to certain brands were acquired from JTI. These rights had been sold to JTI in 1999 as a part of the sale of RJR Tobacco’s international tobacco business.

 

In addition to intellectual property rights it directly owns, RJR Tobacco has certain rights with respect to BAT intellectual property that were available for use by B&W prior to the completion of the B&W business combination.

 

On December 9, 2009, through an indirect subsidiary, RAI acquired Niconovum AB. Substantially all of the value of the acquired assets was determined to be a technology-based, indefinite-lived other intangible asset. For additional information on the acquisition of Niconovum AB, see Item 8, note 3 to consolidated financial statements.

 

Legislation and Other Matters Affecting the Tobacco Industry

 

The tobacco industry is subject to a wide range of laws and regulations regarding the marketing, sale, taxation and use of tobacco products imposed by local, state, federal and foreign governments. Various state governments have adopted or are considering, among other things, legislation and regulations that would:

 

 

In addition, during 2009, the U.S. Congress adopted legislation increasing the federal excise tax on cigarettes and other tobacco products, and granting the FDA broad authority over the manufacture, sale, marketing and packaging of tobacco products. During 2010, the U.S. Congress also may consider legislation regarding:

 

 

Together with manufacturers’ price increases in recent years and substantial increases in state and federal taxes on tobacco products, these developments have had and will likely continue to have an adverse effect on the sale of tobacco products. For further discussion of the regulatory and legislative environment applicable to the tobacco industry, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Governmental Activity.”

 

Litigation and Settlements

 

Various legal proceedings or claims, including litigation claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RAI’s operating subsidiaries’ products, and seeking damages in amounts ranging into the hundreds of millions or even billions of dollars, are pending or may be instituted against RJR Tobacco, the Conwood companies or their affiliates, including RAI or RJR, or indemnitees, including B&W. In particular, in Engle v. R. J. Reynolds Tobacco Co., et al., the Florida Supreme Court issued a ruling that, among other things, determined that the case could not proceed further as a class action. The ruling also permitted members of the Engle class to file individual claims, including claims for punitive damages, through January 11, 2008. RJR Tobacco refers to these cases as the Engle Progeny Cases. RJR Tobacco has been served as of January 29, 2010 in 7,711 cases on behalf of approximately 9,246 plaintiffs. The Engle Progeny Cases have resulted and will continue to result in increased litigation and trial activity and increased expenses. For a more complete description of the Engle Progeny cases, see “— Engle Progeny Cases” in Item 8, note 14 to consolidated financial statements. Also, the consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases, is pending in West Virginia, against both RJR Tobacco and B&W. The case consists of over 600 plaintiffs and will be tried in a single proceeding. Trial began February 1, 2010, but a mistrial was declared February 3, 2010. A new trial is scheduled to begin June 1, 2010. For a more complete description of this case, see “— West Virginia IPIC” in Item 8, note 14 to consolidated financial statements.

 

RAI’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable. RAI and its subsidiaries believe that they have valid basis for appeal of adverse verdicts against them and have valid defenses to all actions and intend to defend all actions vigorously. Nonetheless, the possibility of material losses related to tobacco litigation is more than remote. Litigation is subject to many uncertainties, and generally it is not possible to predict the outcome of the litigation pending against RJR Tobacco, the Conwood companies or their affiliates or indemnitees, or to reasonably estimate the amount or range of any possible loss. Moreover, notwithstanding the quality of defenses available to it and its affiliates in tobacco-related litigation matters, it is possible that RAI’s consolidated results of operations, cash flows or financial position could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 14 to consolidated financial statements.

 

In November 1998, RJR Tobacco, B&W and the other major U.S. cigarette manufacturers entered into the MSA with attorneys general representing most U.S. states, territories and possessions. As described in Item 8, note 14 to consolidated financial statements, the State Settlement Agreements impose a perpetual stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers, and place significant restrictions on their ability to market and sell tobacco products in the future. For more information related to

historical and expected settlement expenses and payments under 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. The State Settlement Agreements have materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial position of RAI and RJR Tobacco in future periods.

 

RJR Tobacco and certain of the other participating manufacturers under the MSA are currently involved in litigation with the settling states with respect to the availability for certain market years of a downward adjustment to the annual MSA settlement payment obligation, known as the Non-Participating Manufacturer Adjustment. RJR Tobacco has disputed a total of $2.9 billion for the years 2003 through 2008. For more information related to this litigation, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements— Enforcement and Validity” in Item 8, note 14 to consolidated financial statements.

 

Employees

 

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.

 

 

RAI and its subsidiaries operate with certain known risks and uncertainties that could have a material adverse effect on their results of operations, cash flows and financial position. The risks below are not the only ones RAI and its subsidiaries face. Additional risks not currently known or currently considered immaterial also could affect RAI’s business. You should carefully consider the following risk factors in connection with other information included in this Annual Report on Form 10-K.

 

RAI’s operating subsidiaries could be subject to substantial liabilities and bonding difficulties from litigation related to cigarette products or smokeless tobacco products, thereby reducing operating margins and cash flows from operations. Adverse litigation outcomes could have a negative impact on RAI’s ability to continue to operate due to their impact on cash flows.

 

RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, including B&W, have been named in a large number of tobacco-related legal actions, proceedings or claims. The claimants seek recovery on a variety of legal theories, including negligence, strict liability in tort, design defect, fraud, misrepresentation, unfair trade practices and violations of state and federal antitrust laws. Various forms of relief are sought, including compensatory and, where available, punitive damages in amounts ranging in some cases into the hundreds of millions or even billions of dollars.

 

The tobacco-related legal actions range from individual lawsuits to class-actions and other aggregate claim lawsuits. In particular, class-action suits have been filed in a number of states against individual cigarette manufacturers, including RJR Tobacco, and their parents, including RAI, alleging that the use of the terms “lights” and “ultra lights” constitutes unfair and deceptive trade practices. In December 2008, the U.S. Supreme Court ruled that neither the Federal Cigarette Labeling and Advertising Act nor the Federal Trade Commission’s regulation of “tar” and nicotine disclosures preempts (or bars) such claims. This ruling limits certain defenses available to RJR Tobacco and other cigarette manufacturers and has led to the filing of additional lawsuits. In the event RJR Tobacco and its affiliates and indemnitees lose one or more of the pending “lights” class-action suits, RJR Tobacco, depending upon the amount of any damages ordered, could face difficulties in obtaining the bond required to stay execution of the judgment. For a more complete description of these cases, see “— Class-Action Suits — ‘Lights’ Cases” in Item 8, note 14 to consolidated financial statements.

 

In Engle v. R. J. Reynolds Tobacco Co., et al., the Florida Supreme Court issued a ruling that, among other things, determined that the case could not proceed further as a class action. The ruling also permitted members of the Engle class to file individual claims, including claims for punitive damages, through January 11, 2008. RJR Tobacco has been served as of January 29, 2010 in 7,711 cases on behalf of approximately 9,246 plaintiffs. The Engle Progeny Cases have resulted in increased litigation and trial activity, including an increased number of

adverse verdicts, and increased expenses. For a more complete description of the Engle Progeny cases, see “— Engle Progeny Cases” in Item 8, note 14 to consolidated financial statements.

 

Also, the consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases, is pending in West Virginia, against both RJR Tobacco and B&W. The case consists of over 600 plaintiffs and will be tried in a single proceeding. Trial began February 1, 2010, but a mistrial was declared February 3, 2010. A new trial is scheduled to begin June 1, 2010. For a more complete description of this case, see “— West Virginia IPIC” in Item 8, note 14 to consolidated financial statements.

 

It is likely that similar legal actions, proceedings and claims arising out of the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of cigarettes and smokeless tobacco products will continue to be filed against RJR Tobacco, the Conwood companies, or their affiliates and indemnitees and other tobacco companies for the foreseeable future.

 

Victories by plaintiffs in highly publicized cases against RJR Tobacco and other tobacco companies regarding the health effects of smoking may stimulate further claims. A material increase in the number of pending claims could significantly increase defense costs. In addition, adverse outcomes in pending cases could have adverse effects on the ability of RJR Tobacco and its indemnitees, including B&W, to prevail in other smoking and health litigation.

 

For a more complete description of the litigation involving RAI and its operating subsidiaries, including RJR Tobacco and the Conwood companies, see “— Litigation Affecting the Cigarette Industry” and “— Smokeless Tobacco Litigation” in Item 8, note 14 to consolidated financial statements.

 

The verdict and order in the case brought by the U.S. Department of Justice, while not final, could subject RJR Tobacco to additional, substantial marketing restrictions as well as significant financial burdens, which would negatively impact the results of operations, cash flows and the financial position of RJR Tobacco and, consequently, of RAI.

 

In September 1999, the U.S. Department of Justice brought an action against RJR Tobacco, B&W and other tobacco companies. The government sought, in addition to other remedies, pursuant to the civil provisions of RICO, disgorgement of profits in an amount of approximately $280 billion, the government contends have been earned as a consequence of a RICO racketeering “enterprise.” In August 2006, the court found certain defendants, including RJR Tobacco, liable for the RICO claims, but did not impose any direct financial penalties. Instead, the court, among other things, enjoined the defendants from committing future racketeering acts, participating in certain trade organizations, making misrepresentations concerning smoking and health and youth marketing, and using certain brand descriptors such as “low tar,” “light,” “ultra light,” “mild” and “natural,” and ordered the defendants to issue “corrective communications” on five subjects, including smoking and health, and addiction.

 

Both sides have appealed. In October 2006, the U.S. Court of Appeals granted the defendants’ motion to stay pending the outcome of the defendants’ appeal. On May 22, 2009, the Court of Appeals affirmed in part the trial court’s order and remanded for further proceedings. The parties’ petitions for writ of certiorari from the U.S. Supreme Court are due February 19, 2010. If the order is affirmed without modification, then RJR Tobacco believes that certain provisions of the order would have adverse business effects on the marketing of RJR Tobacco’s current product portfolio and that such effects could be material. Also, if the order is affirmed, then RJR Tobacco would incur costs in connection with complying with the order, such as the costs of corrective communications. In addition, the DOJ has preserved its right to seek review of the district court’s denial of the government’s request for disgorgement of profits and other remedies, which could have a material adverse impact on the results of operations, cash flows and financial position of RJR Tobacco and, consequently, of RAI.

 

For a more complete description of this case, see “— Health-Care Cost Recovery Cases — Department of Justice Case” in Item 8, note 14 to consolidated financial statements.

RJR Tobacco’s overall retail market share of cigarettes has declined in recent years and may continue to decline; if RJR Tobacco is not able to continue to grow market share of its growth brands, or develop, produce or market new alternative tobacco products profitably, results of operations, cash flows and financial position of RJR Tobacco and, consequently, of RAI could be adversely impacted.

 

RJR Tobacco’s U.S. retail market share of cigarettes has been declining for a number of years, and may continue to decline. According to data from IRI/Capstone, RJR Tobacco’s share of the U.S. cigarette retail market declined slightly to 28.3% in 2009 from 28.4% in 2008, continuing a trend in effect for several years. If RJR Tobacco’s growth brands do not continue to grow combined market share, results of operations, cash flows and financial position will be adversely affected. In addition, consumer health concerns, changes in adult consumer preferences and changes in regulations have prompted RJR Tobacco to introduce new alternative tobacco products. Consumer acceptance of these new products, such as CAMEL Snus or CAMEL Dissolvables, may fall below expectations. Furthermore, RJR Tobacco may not find vendors willing to produce alternative tobacco products resulting in additional capital expenditures for RJR Tobacco.

 

RJR Tobacco is dependent on the U.S. cigarette market, which it expects to continue to decline, negatively impacting revenue.

 

The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to JTI and no international rights were acquired in connection with the B&W business combination. Therefore, RJR Tobacco is dependent on the U.S. cigarette market. Price increases, restrictions on advertising and promotions, funding of smoking prevention campaigns, increases in regulation and excise taxes, health concerns, a decline in the social acceptability of smoking, increased pressure from anti-tobacco groups and other factors have reduced U.S. cigarette consumption. U.S. cigarette consumption is expected to continue to decline. In addition, RJR Tobacco believes its consumers are more price-sensitive than consumers of competing brands, which may result in some consumers switching to a lower priced brand.

 

RJR Tobacco is RAI’s largest operating segment. As such, it is the primary source of RAI’s revenue, operating income and cash flows.

 

RJR Tobacco’s contract manufacturing agreements with BAT may end in 2014.

 

RJR Tobacco’s contract manufacturing for BAT accounted for 5% of total RAI sales and approximately 22% of total RJR Tobacco cigarette production in 2009. These contract manufacturing agreements may expire at the end of 2014. If BAT’s contracts are not renewed or extended or if sales under these contracts decline, RJR Tobacco’s revenue, operating income and cash flows will be unfavorably impacted.

 

In the U.S., tobacco products are subject to substantial and increasing regulation and taxation, which has a negative effect on revenue and profitability.

 

Tobacco products are subject to substantial federal and state excise taxes in the United States. On February 4, 2009, President Obama signed into law, effective April 1, 2009, an increase of $0.62 in the federal excise tax per pack of cigarettes, and significant increases on other tobacco products, to fund expansion of 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.

 

In addition to federal and state excise taxes, certain city and county governments also impose substantial excise taxes on tobacco products sold. Increased excise taxes are likely to result in declines in overall sales volume and shifts by consumers to less expensive brands.

 

A wide variety of federal, state and local laws limit the advertising, sale and use of cigarettes, and these laws have proliferated in recent years. For example, many local laws prohibit smoking in restaurants and other public places. Private businesses also have adopted regulations that prohibit or restrict, or are intended to discourage, smoking. Such laws and regulations also are likely to result in a decline in the overall sales volume of cigarettes. For additional information on the issues described above, see “— Governmental Activity” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

RAI’s operating subsidiaries are subject to significant limitations on advertising and marketing of tobacco products, which could harm the value of their existing brands or their ability to launch new brands, thus negatively impacting revenue.

 

In the United States, television and radio advertisements of cigarettes have been prohibited since 1971, and television and radio advertisements of smokeless tobacco products have been prohibited since 1986. Under the MSA, certain of RAI’s operating subsidiaries, including RJR Tobacco, cannot use billboard advertising, cartoon characters, sponsorship of certain events, non-tobacco merchandise bearing their brand names and various other advertising and marketing techniques. In addition, the MSA prohibits targeting of youth in advertising, promotion or marketing of tobacco products, including the smokeless tobacco products of RJR Tobacco. The Conwood companies are not participants in the MSA. Although these restrictions were intended to ensure that tobacco advertising was not aimed at young people, some of the restrictions also may limit the ability of RAI’s operating subsidiaries to communicate with adult tobacco users. Additional restrictions, such as the FDA regulations discussed below, may be imposed legislatively or agreed to in the future.

 

The regulation of tobacco products by the Food and Drug Administration may adversely affect RAI’s sales and operating profit.

 

On June 22, 2009, President Obama signed into law the FDA Tobacco Act, which granted the FDA 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, resulting in a material adverse effect on RAI’s financial condition, results of operations and cash flows. RAI believes that such regulation may adversely affect the ability of its operating subsidiaries to compete against their larger competitor, Altria Group Inc., which may be able to more quickly and cost-effectively comply with these new rules and regulations. The FDA has yet to issue guidance with respect to many provisions of the FDA Tobacco Act, which may result in less efficient compliance efforts. Finally, the ability of RAI’s operating companies to gain efficient market clearance for new tobacco products could be affected by FDA rules and regulations.

 

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.

 

RJR Tobacco’s and Conwood’s volumes, market share and profitability may be adversely affected by competitive actions and pricing pressures in the marketplace.

 

The tobacco industry is highly competitive. Among the major manufacturers, brands primarily compete on product quality, price, brand recognition, brand imagery and packaging. Substantial marketing support, merchandising display, discounting, promotions and other financial incentives generally are required to maintain or improve a brand’s market position or introduce a new brand.

 

In addition, substantial payment obligations under the State Settlement Agreements adversely affect RJR Tobacco’s ability to compete with manufacturers of deep-discount cigarettes that are not subject to such substantial obligations. For a more complete description of the State Settlement Agreements, see “— Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 14 to consolidated financial statements.

 

Conwood’s largest competitor, USSTC, was acquired by the parent company of Philip Morris USA, Inc. in January 2009. This acquisition of USSTC has changed the competitive dynamics with heavy promotions and competitive pricing. In addition, the possibility of combining pricing and merchandising display for cigarettes and smokeless tobacco products could adversely affect Conwood’s and RJR Tobacco’s market share, which would adversely affect RAI’s profitability and revenues.

 

Increases in commodity prices will increase costs and may reduce profitability.

 

Increases in the cost of tobacco leaf, other raw materials and other commodities used in RAI’s operating subsidiaries’ products could cause profits to decline.

Certain of RAI’s operating subsidiaries may be required to write-down intangible assets, including goodwill, due to impairment, thus reducing operating profit.

 

Intangible assets include goodwill, trademarks and other intangibles. The determination of fair value involves considerable estimates and judgment. For goodwill, the determination of fair value of a reporting unit involves, among other things, RAI’s market capitalization, and application of the income approach, which includes developing forecasts of future cash flows and determining an appropriate discount rate. If goodwill impairment is implied, the fair values of individual assets and liabilities, including unrecorded intangibles, must be determined. RAI believes it has based its goodwill impairment testing on reasonable estimates and assumptions, and during the annual testing in the fourth quarter of 2009, the estimated fair value of each of RAI’s reporting units was substantially in excess of its respective carrying value.

 

Trademarks and other intangible assets with indefinite lives also are tested for impairment annually, in the fourth quarter. The aggregate fair value of RAI’s operating units’ trademarks and other intangible assets was substantially in excess of their aggregate carrying value. However, the individual fair value of six indefinite-lived trademarks was less than 15% in excess of their respective carrying values. The aggregate carrying value of these six trademarks was $561 million at December 31, 2009.

 

The methodology used to determine the fair value of trademarks includes assumptions with inherent uncertainty, including projected sales volumes and related projected revenues, long-term growth rates, royalty rates that a market participant might assume and judgments regarding the factors to develop an applied discount rate.

 

The carrying value of these six trademarks are at risk of impairment if future projected revenues or long-term growth rates are lower than those currently projected, or if factors used in the development of a discount rate result in the application of a higher discount rate.

 

Goodwill, all trademarks and other intangible assets are tested more frequently if events and circumstances indicate that the asset might be impaired. The carrying value of these intangible assets could be impaired if a significant adverse change in the use, life, or brand strategy of the asset is determined, or if a significant adverse change in the legal and regulatory environment, business or competitive climate occurs that would adversely impact the asset. See Item 8, note 3 to consolidated financial statements for a discussion of the impairment charges.

 

Changes in financial market conditions could result in higher costs and decreased profitability.

 

Changes in financial market conditions could negatively impact RAI’s interest rate risk, foreign currency exchange rate risk and the return on corporate cash, thus increasing costs and reducing profitability. Due to the adverse conditions in the financial markets during 2009, RAI invested excess cash in either low interest funds or near zero interest funds, thereby lowering interest income.

 

Adverse changes in liquidity in the financial markets could result in additional realized or unrealized losses on investments.

 

Adverse changes in the liquidity in the financial markets could result in additional realized or unrealized losses associated with the value of RAI’s investments, which would negatively impact RAI’s consolidated results of operations, cash flows and financial position. As of December 31, 2009, $80 million of unrealized losses remain in other comprehensive loss. For more information on investment losses, see Item 8, note 7 to consolidated financial statements.

 

RAI’s access to cash could be impacted by adverse changes in the financial markets and bankruptcy of financial institutions.

 

Effective July 3, 2009, the revolving loan commitment of Lehman Commercial Paper Inc., which filed for protection under Chapter 11 of the federal Bankruptcy Code in 2008, was terminated, thereby reducing the total revolving loan commitments under RAI’s credit facility from $550 million to $498 million. For more information on participants in RAI’s credit facility, see “— Liquidity and Financial Condition” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

Increases in pension expense or pension funding may reduce RAI’s profitability and cash flow.

 

RAI’s profitability is affected by the costs of pension benefits available to employees generally hired prior to January 1, 2004. Adverse changes in investment returns earned on pension assets and discount rates used to calculate pension and related liabilities or changes in required pension funding levels may have an unfavorable impact on pension expense and cash flows. During 2009, RAI contributed $295 million to its pension plans and expects to contribute $309 million to its pension plans in 2010. RAI actively seeks to control increases in pension expense, but there can be no assurance that profitability will not be adversely affected. In addition, changes to pension legislation or changes in pension accounting may adversely affect profitability and cash flow.

 

RJR Tobacco relies on outside suppliers to manage certain non-core business processes. Any interruption in these services could negatively affect the operations of RJR Tobacco and harm its reputation and consequently the operations and reputation of RAI.

 

In an effort to gain cost efficiencies, RJR Tobacco has substantially completed the outsourcing of many of its non-core business processes. Non-core business processes include, but are not limited to, certain processes relating to information technology, human resources, trucking and facilities. If any of the suppliers fail to perform their obligations in a timely manner or at a satisfactory quality level, RJR Tobacco may fail to operate effectively and fail to meet shipment demand.

 

RAI’s operating subsidiaries rely on a limited number of suppliers for direct materials. An interruption in service from any of these suppliers could adversely affect the results of operations, cash flows and financial position of RAI.

 

RAI’s operating subsidiaries rely on a limited number of suppliers for direct materials. If a supplier fails to meet any of RAI’s operating subsidiary’s demand for direct materials, the operating subsidiary may fail to operate effectively and may fail to meet shipment demand, adversely impacting RAI’s results of operations.

 

Certain of RAI’s operating subsidiaries face a customer concentration risk. The loss of this customer would result in a decline in revenue and have an adverse effect on cash flows.

 

Revenues from McLane Company, Inc., a distributor, comprised 27% of RAI’s consolidated revenues in 2009. The loss of this customer, or a significant decline in its purchases, could have a material adverse effect on revenue of RAI.

 

Fire, violent weather conditions and other disasters may adversely affect the operations of RAI’s operating subsidiaries.

 

A major fire, violent weather conditions or other disasters that affect manufacturing and other facilities of RAI’s operating subsidiaries, or of their suppliers and vendors, could have a material adverse effect on the operations of RAI’s operating subsidiaries. Despite RAI’s insurance coverage for some of these events, a prolonged interruption in the manufacturing operations of RAI’s operating subsidiaries could have a material adverse effect on the ability of its operating subsidiaries to effectively operate their businesses.

 

The agreement relating to RAI’s credit facility contains restrictive covenants that limit the flexibility of RAI and its subsidiaries. Breach of those covenants will result in a default under the agreement relating to the facility.

 

Restrictions in the agreement relating to RAI’s credit facility limit the ability of RAI and its subsidiaries to obtain future financing, and could impact the ability to withstand a future downturn in their businesses or the economy in general, conduct operations or otherwise take advantage of business opportunities that may arise. In addition, if RAI does not comply with these covenants, any indebtedness outstanding under the credit facility could become immediately due and payable. The lenders under RAI’s credit facility could refuse to lend funds if RAI is not in compliance with the covenants or could terminate the credit facility. If RAI were unable to repay accelerated amounts, the lenders under RAI’s credit facility could initiate a bankruptcy proceeding or liquidation proceeding.

 

For more information on the restrictive covenants in RAI’s credit facility, see Item 8, note 11 to consolidated financial statements.

RAI has substantial long-term debt, which could adversely affect its financial position and its ability to obtain financing in the future and react to changes in its business.

 

Because RAI and RJR have principal outstanding long-term notes of $4.2 billion:

 

 

It is likely that RAI will refinance, or attempt to refinance, a significant portion of its indebtedness prior to maturity through the incurrence of new indebtedness. There can be no assurance that RAI’s available cash or access to financing on acceptable terms will be sufficient to satisfy such indebtedness.

 

The ability of RAI to access the debt capital markets could be impaired if the credit rating of its debt securities falls below investment grade.

 

The outstanding notes issued by RAI and RJR are rated investment grade. In certain cases, if RAI’s credit rating falls below investment grade, RAI and certain of RAI’s subsidiaries, including its material domestic subsidiaries, referred to as the Guarantors, will be required to provide collateral to secure RAI’s credit facility and senior notes. In such event, RAI may not be able to sell additional debt securities or borrow money in such amounts, at the times, at the lower interest rates or upon the more favorable terms and conditions that might be available if its debt was rated investment grade. In addition, future debt security issuances or other borrowings may be subject to further negative terms, including limitations on indebtedness or similar restrictive covenants.

 

RAI’s credit ratings are influenced by some important factors not entirely within the control of RAI or its affiliates, such as tobacco litigation, the regulatory environment and the performance of suppliers and vendors to RAI’s operating subsidiaries. Moreover, because the kinds of events and contingencies that may impair RAI’s credit ratings and the ability of RAI and its affiliates to access the debt capital markets are often the same kinds of events and contingencies that could cause RAI and its affiliates to seek to raise additional capital on an urgent basis, RAI and its affiliates may not be able to issue debt securities or borrow money upon acceptable terms, or at all, at the times at which they may most need additional capital.

 

For more complete information on RAI’s borrowing arrangements, see Item 8, note 11 to consolidated financial statements.

 

B&W’s significant equity interest in RAI could be determinative in matters submitted to a vote by RAI shareholders, resulting in RAI taking actions that RAI’s other shareholders do not support. B&W also has influence over RAI by virtue of the governance agreement, which requires B&W’s approval before RAI takes certain actions.

 

B&W owns approximately 42% of the outstanding shares of RAI common stock. Only one other stockholder owns more than 10% of the outstanding shares of RAI common stock. Unless substantially all of RAI’s public shareholders vote together on matters presented to RAI shareholders, B&W would have the power to determine the outcome of matters submitted to a shareholder vote.

Moreover, in connection with the B&W business combination, RAI, B&W and BAT entered into an agreement, referred to as the governance agreement, relating to various aspects of RAI’s corporate governance. Under the governance agreement, the approval of B&W, as a RAI shareholder, is required in connection with, among other things, the following matters:

 

 

Such influence could result in RAI taking actions that RAI’s other shareholders do not support.

 

Under the governance agreement, B&W is entitled to nominate certain persons to RAI’s Board, and the approvals of the majority of such persons is required before certain actions may be taken, even though such persons represent less than a majority of the entire Board. In addition, certain provisions of RAI’s articles of incorporation may create conflicts of interest between RAI and certain of these persons.

 

Under the governance agreement, B&W, based upon its current equity stake in RAI, is entitled to nominate five directors to RAI’s Board, at least three of whom are required to be independent directors and two of whom may be executive officers of BAT or any of its subsidiaries. RAI’s Board currently is comprised of 12 persons, including B&W’s five designees. Matters requiring the approval of RAI’s Board generally require the affirmative vote of a majority of the directors present at a meeting. Under the governance agreement, however, the approval of a majority of B&W’s designees on RAI’s Board is required in connection with the following matters:

 

 

As a result, B&W’s designees on RAI’s Board may prevent the foregoing transactions from being effected, notwithstanding a majority of the entire Board may have voted to approve such transactions.

 

Under RAI’s articles of incorporation, a B&W designated director who is affiliated with, or employed by, BAT or its subsidiaries and affiliates is not required to present a transaction, relationship, arrangement or other opportunity, all of which are collectively referred to as a business opportunity, to RAI if that business opportunity does not relate primarily to the United States.

 

B&W’s significant ownership interest in RAI, and RAI’s shareholder rights plan, classified board of directors and other anti-takeover defenses could deter acquisition proposals and make it difficult for a third party to acquire control of RAI without the cooperation of B&W. This could have a negative effect on the price of RAI common stock.

 

As RAI’s largest shareholder, B&W could vote its shares of RAI common stock against any takeover proposal submitted for shareholder approval or refuse to accept any tender offer for shares of RAI common stock. This right would make it very difficult for a third party to acquire RAI without B&W consent. In addition, RAI has a shareholder rights plan, a classified board of directors and other takeover defenses in its articles of incorporation and bylaws. B&W’s ownership interest in RAI and these defenses could discourage potential acquisition proposals and could delay or prevent a change in control of RAI. These deterrents could adversely affect the price of RAI common stock and make it very difficult to remove or replace members of the board of directors or management of RAI without cooperation of B&W.

RAI shareholders may be adversely affected by the expiration of the standstill and transfer restrictions in the governance agreement, which would enable B&W to, among other things, transfer all or a significant percentage of its RAI shares to a third party, seek additional representation on the RAI board of directors, replace existing RAI directors, solicit proxies or otherwise acquire effective control of RAI.

 

The standstill provisions contained in the governance agreement generally restrict B&W from acquiring additional shares of RAI common stock and taking other specified actions as a shareholder of RAI. These restrictions generally will expire upon the earlier of ten years from the date of the B&W business combination and the date on which a significant transaction, as defined in the governance agreement, is consummated or occurs.

 

Subject to the terms of the RAI shareholder rights plan, B&W will be free after expiration of the standstill period to increase its ownership interest in RAI to more than 50% and may use this controlling vote to elect any number of or all the members of RAI’s board of directors.

 

In addition, if the transfer restrictions in the governance agreement are terminated, subject to the terms of the RAI shareholder rights plan, there will be no contractual restrictions on B&W’s ability to sell or transfer its shares of RAI common stock on the open market, in privately negotiated transactions or otherwise. These sales or transfers could create a substantial decline in the price of shares of RAI common stock or, if these sales or transfers were made to a single buyer or group of buyers that own RAI shares, could result in a third party acquiring effective control of RAI.

 

 

None.

 

 

The executive offices of RAI and RJR Tobacco are located in Winston-Salem, North Carolina, and the executive offices of the Conwood companies are located in Memphis, Tennessee. RJR Tobacco’s manufacturing facilities are located in the Winston-Salem, North Carolina area, and Conwood’s primary manufacturing facilities are located in Memphis, Tennessee; Clarksville, Tennessee and Winston-Salem, North Carolina. Other Conwood facilities are located in Bowling Green, Kentucky and Springfield, Tennessee. 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. Included in the Conwood segment is Lane’s manufacturing facility, which is located in Tucker, Georgia. Santa Fe’s primary manufacturing facility is located in Oxford, North Carolina. An indirect subsidiary of RAI has a manufacturing facility located in Puerto Rico. All of RAI’s operating subsidiaries’ executive offices and manufacturing facilities are owned. RAI’s operating subsidiaries continue to evaluate capacity rationalization, which may result in the consolidation or closure of some facilities.

 

 

See Item 8, note 14 to consolidated financial statements for disclosure of legal proceedings involving RAI and its operating subsidiaries.

 

 

None.

 

Executive Officers and Certain Significant Employees of the Registrant

 

The executive officers of RAI are set forth below:

 

Susan M. Ivey.  Ms. Ivey, 51, has been President and Chief Executive Officer of RAI since January 2004, and was elected the Chairman of the Board of RAI effective January 1, 2006. Ms. Ivey also became President of RAI Services Company in January 2010. She served as Chairman of the Board of RJR Tobacco from July 2004 to May

2008. From July 2004 to December 2006, she also served as Chief Executive Officer of RJR Tobacco. She served as President and Chief Executive Officer of B&W from 2001 to 2004. Ms. Ivey also served as a director of B&W from 2000 to 2004 and Chairman of the Board of B&W from January 2003 to 2004. Ms. Ivey commenced serving on the Board of RAI as of January 2004. She also is a member of the board of directors of R. R. Donnelley & Sons Company. In addition, Ms. Ivey is a member of the boards of directors of the United Way of Forsyth County, the Winston-Salem YWCA and the University of Florida Foundation; and she serves on the boards of trustees of Wake Forest University, Senior Services, Inc. and Salem College.

 

Thomas R. Adams.  Mr. Adams, 59, has been Executive Vice President and Chief Financial Officer of RAI since January 2008 and Executive Vice President and Chief Financial Officer of RAI Services Company since January 2010. In addition, he has served on the board of directors for RAI Services Company since January 2010. Mr. Adams previously served as Senior Vice President and Chief Accounting Officer of RAI from March 2007 to December 2007. He served as Senior Vice President-Business Processes of RAI from September 2006 to March 2007 and of RJR Tobacco from May 2005 to November 2006. Mr. Adams also served as Senior Vice President and Chief Accounting Officer of both RAI and RJR Tobacco from July 2004 to April 2005. From June 1999 to July 2004, he served as Senior Vice President and Controller of both RJR Tobacco and RJR. Mr. Adams is a member of the boards of directors of Allegacy Federal Credit Union and the Old Hickory Council of the Boy Scouts of America and the board of commissioners of the Housing Authority of Winston-Salem.

 

Lisa J. Caldwell.  Ms. Caldwell, 49, has been Executive Vice President and Chief Human Resources Officer of RAI since May 2009 and RAI Services Company since January 2010. Ms. Caldwell has served on the board of directors of RAI Services Company since January 2010. She was previously Executive Vice President and Chief Human Resources Officer for RJR Tobacco from May 2009 to January 2010. Ms. Caldwell served as Executive Vice President — Human Resources of RAI and RJR Tobacco since June 2008. She served as Senior Vice President — Human Resources of RAI from November 2006 to June 2008, after having served as Vice President — Human Resources of RAI from September 2004 to November 2006. She also served as Senior Vice President — Human Resources of RJR Tobacco from July 2007 to June 2008, after having served as Vice President — Human Resources of RJR Tobacco from January 2002 to November 2006. Prior to 2002, Ms. Caldwell held numerous human resources positions with RJR Tobacco since joining RJR Tobacco in 1991. Ms. Caldwell serves on the University of North Carolina Board of Visitors.

 

Daniel (Daan) M. Delen.  Mr. Delen, 44, joined RJR Tobacco as President and Chief Executive Officer in January 2007, and was elected Chairman of the Board of RJR Tobacco in May 2008. Prior to joining RJR Tobacco, Mr. Delen was President of BAT Ltd. — Japan from August 2004 to December 2006 and Senior Vice President of Marketing and Sales for B&W from 2001 to July 2004. He held various other positions with BAT after joining BAT in 1989. Mr. Delen is a member of the board of directors of Winston-Salem Alliance.

 

Daniel A. Fawley.  Mr. Fawley, 52, has served as Senior Vice President and Treasurer of RAI, RJR Tobacco and RJR since September 2004 and Senior Vice President and Treasurer of RAI Services Company since January 2010. He was previously Vice President and Assistant Treasurer of RJR from 1999 until July 2004 and of RAI from July 2004 until September 2004. Mr. Fawley is a member of the board of directors of the Reynolds American Foundation, the Board of Trustees of the Arts Council Endowment Fund, Inc. and the Finance Advisory Board for the Finance Academy.

 

McDara P. Folan, III.  Mr. Folan, 51, has been Senior Vice President, Deputy General Counsel and Secretary of RAI since July 2004 and Senior Vice President, Deputy General Counsel and Secretary of RAI Services Company since January 2010. Mr. Folan served as Vice President, Deputy General Counsel and Secretary of RJR from June 1999 to July 2004, and has been Senior Vice President and Secretary and Director of RJR since July 2004. He also was Vice President, Deputy General Counsel and Secretary of RJR Tobacco from June 1999 to March 2000, and currently serves as Assistant Secretary of RJR Tobacco. Mr. Folan serves on the advisory board for Brenner Children’s Hospital, the National Advisory Council of Reynolda House Museum of American Art and the board of advisors of Salem College and Academy and is a member of the board of trustees of the Arts Council of Winston-Salem and Forsyth County and the Arts Council Endowment Fund, Inc.

Jeffery S. Gentry, PhD.  Dr. Gentry, 52, became Executive Vice President — Operations and Chief Scientific Officer of RJR Tobacco on January 1, 2010, after having served as RAI Group Executive Vice President since April 1, 2008. Dr. Gentry has served on the board of directors of RJR Tobacco since January 2010. He was previously Executive Vice President — Research and Development of RJR Tobacco from December 2004, after serving as Vice President — Product Development since 2000. Dr. Gentry joined RJR Tobacco in 1986 as a research and development chemist. He is the co-founder of No Limits II, a non-profit organization providing social opportunities for disabled adults in the Winston-Salem area.

 

Andrew D. Gilchrist.  Mr. Gilchrist, 37, became Executive Vice President and Chief Financial Officer of RJR Tobacco and Executive Vice President and Chief Information Officer of RAI Services Company on January 1, 2010, after having served as Executive Vice President, Chief Financial Officer and Chief Information Officer of RJR Tobacco from July 2008 until January 2010. Mr. Gilchrist has served on the board of directors of RJR Tobacco since May 2008. He also served as Senior Vice President and Chief Financial Officer of RJR Tobacco from November 2006 to July 2008, after having served as Vice President — Integrated Business Management of RJR Tobacco from January 2006 to November 2006. Prior to 2006, Mr. Gilchrist served as Senior Director — Business Development since joining RAI in 2004. Prior to July 2004, Mr. Gilchrist held various positions with B&W and its parent company, BAT. Mr. Gilchrist is a member of the board of trustees of the Arts Council of Winston-Salem and Forsyth County.

 

E. Julia (Judy) Lambeth.  Ms. Lambeth, 58, joined RAI as Executive Vice President — Corporate Affairs, General Counsel and Assistant Secretary in September 2006 and also became Executive Vice President — Corporate Affairs, General Counsel and Assistant Secretary of RAI Services Company in January 2010. She has served on the board of directors of RAI Services Company since January 2010. Prior to joining RAI, Ms. Lambeth served as Corporate Secretary and Deputy General Counsel, Corporate Services for ConocoPhillips from 2002 to 2006. Ms. Lambeth is a member of the Wake Forest Law School Board of Visitors and serves on the board of directors of Reynolds American Foundation, the Winston-Salem Symphony and Southeastern Center for Contemporary Art.

 

J. Brice O’Brien.  Mr. O’Brien, 41, was named Executive Vice President — Consumer Marketing of RJR Tobacco on January 1, 2010, after having served as President of Reynolds Innovations Inc. since January 2009. He served as Senior Vice President — Consumer Marketing of RJR Tobacco from January 2006 until January 2009, after serving as Vice President — Marketing since October 2004. Prior to 2004, he held various positions with RJR Tobacco after joining RJR Tobacco in 1995.

 

Tommy J. Payne.  Mr. Payne, 52, was named President of Niconovum USA, Inc. on January 1, 2010, after having served as Executive Vice President — Public Affairs of RAI from November 2006 to January 2010 and RJR Tobacco from May 2008 to January 2010. Mr. Payne previously served as Executive Vice President — External Relations of RAI from July 2004 to November 2006, and RJR Tobacco from September 1999 to November 2006. Mr. Payne served as Executive Vice President — External Relations at RJR from July 1999 to July 2004. Prior to that time, he held various positions after joining RJR in 1988. Mr. Payne serves on the board of directors and executive committee of the North Carolina Chamber and the board of directors of the Tobacco Manufacturers Association.

 

Frederick W. Smothers.  Mr. Smothers, 46, has served as Senior Vice President and Chief Accounting Officer of RAI since January 2008 and RAI Services Company since January 2010. Mr. Smothers served as Vice President and Corporate Controller of RAI from October 2007 to December 2007. Prior to joining RAI, Mr. Smothers was an independent management consultant from 2002 until 2007, serving as Chief Executive Officer of ATRS Consulting from 2005 until October 2007, providing general management consulting to consumer products and manufacturing clients, including RAI. From 1986 until 2002, Mr. Smothers was employed by the accounting firm of Deloitte & Touche LLP, including four years as partner.

 

Robert D. Stowe.  Mr. Stowe, 52, was named Executive Vice President — Trade Marketing of RJR Tobacco on January 1, 2010, after having served as Senior Vice President — Trade Marketing of RJR Tobacco from January 2006 to January 2010. He also served as an Area Vice President of RJR Tobacco from July 2004 to January 2006. Prior to July 2004, Mr. Stowe held various positions with B&W.

E. Kenan Whitehurst.  Mr. Whitehurst, 53, has been Senior Vice President — Strategy and Business Development of RAI since November 2006. He was previously Vice President — Investor Relations of RAI from July 2004 until November 2006. From January 2001 to July 2004, Mr. Whitehurst served as Vice President — Corporate Business Development for RJR Tobacco, after serving as its Vice President — Marketing from 2000 to 2001. Prior to 2000, he held various positions with RJR Tobacco after joining RJR Tobacco in 1988.

 

The chief executive officers of RAI’s other principal operating subsidiaries are set forth below:

 

Nicholas Bumbacco.  Mr. Bumbacco, 45, was named President and Chief Executive Officer of Santa Fe on March 1, 2009. Previously he served as President of GPI from September 2007 until February 2009. Mr. Bumbacco served as Vice President — Strategy Development for RJR Tobacco from January 2007 until September 2007. He served as President and Chief Executive Officer of Lane from October 2005 until January 2007 after being promoted from Vice President — Trade Marketing of Lane. Prior to October 2005, he held various positions with B&W since joining B&W in 1999.

 

Bryan K. Stockdale.  Mr. Stockdale, 51, was named President and Chief Executive Officer of American Snuff Company, LLC on February 1, 2009. He previously served as Senior Vice President — Marketing Operations for RJR Tobacco from January 2006 until February 2009 and Vice President — Trade Marketing from September 1996 through December 2005.

 

 

RAI common stock, par value $.0001 per share, is listed on the NYSE under the trading symbol “RAI.” On January 29, 2010, there were approximately 17,100 holders of record of RAI common stock. Shareholders whose shares are held of record by a broker or clearing agency are not included in this amount; however, each of those brokers or clearing agencies is included as one holder of record. The closing price of RAI common stock on January 29, 2010, was $53.20 per share.

 

The cash dividends declared, and high and low sales prices per share for RAI common stock on the NYSE Composite Tape, as reported by the NYSE, were as follows:

 

 

On October 6, 2009, RAI’s board of directors raised the quarterly cash dividend to $0.90 per common share. On February 2, 2010, the board of directors of RAI declared a quarterly cash dividend of $0.90, or $3.60 on an annualized basis, per common share. The dividends will be paid on April 1, 2010, to shareholders of record as of March 10, 2010. The current dividend reflects RAI’s policy of paying dividends to the holders of RAI common stock in an aggregate amount that is approximately 75% of RAI’s annual consolidated net income.

 

RAI repurchases and cancels shares of its common stock forfeited with respect to the tax liability associated with vesting of restricted stock grants under the RAI Long-Term Incentive Plan, referred to as the LTIP. During 2009, at a cost of $5 million, RAI purchased 154,441 shares that were forfeited with respect to tax liabilities associated with restricted stock vesting under its LTIP.

 

On April 29, 2008, RAI’s board of directors authorized RAI’s repurchase, from time to time on or before April 30, 2009, of up to $350 million of outstanding shares of RAI common stock in open-market or privately negotiated transactions. RAI and B&W entered into an agreement, pursuant to which B&W agreed to participate in the repurchase program on a basis approximately proportionate with B&W’s 42% ownership of RAI common stock. RAI repurchased and cancelled 3,817,095 shares of RAI common stock for $207 million under the above share repurchase programs in 2008. RAI did not repurchase any RAI common stock under this program in 2009.

 

For equity-based benefit plan information, see Item 8, note 16 to consolidated financial statements.

Performance Graph

 

Set forth below is a line graph comparing, for the period which commenced on December 31, 2004, and ended on December 31, 2009, the cumulative shareholder return of $100 invested in RAI common stock with the cumulative return of $100 invested in the Standard & Poor’s 500 Index and the Standard & Poor’s Tobacco Index.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN⁽¹⁾

Among Reynolds American Inc., The S&P 500 Index

and The S&P Tobacco Index

 

 

 

 

 

The selected historical consolidated financial data as of December 31, 2009 and 2008, and for each of the years in the three-year period ended December 31, 2009, are derived from the consolidated financial statements and accompanying notes, which have been audited by RAI’s independent registered public accounting firm. The selected historical consolidated financial data as of December 31, 2007, 2006 and 2005, and for the years ended December 31, 2006 and 2005, are derived from audited consolidated financial statements not presented or incorporated by reference. The consolidated financial statements of RAI include the results of the Conwood companies subsequent to May 31, 2006. For further information, including the impact of new accounting developments, restructuring and impairment charges, you should read this table in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and the consolidated financial statements.

 

 

 

 

 

 

The following is a discussion and analysis of RAI’s business, initiatives, critical accounting policies and its consolidated results of operations and financial position. Following the overview and discussion of business initiatives, the critical accounting policies disclose certain accounting policies that are material to RAI’s results of operations and financial position for the periods presented in this report. The discussion and analysis of RAI’s results of operations is presented in two comparative sections, 2009 compared with 2008, and 2008 compared with 2007. Disclosures related to liquidity and financial position complete management’s discussion and analysis. You should read this discussion and analysis of RAI’s consolidated financial position and results of operations in conjunction with the consolidated financial statements and the related notes as of December 31, 2009 and 2008, and for each of the years in the three-year period ended December 31, 2009.

 

Overview and Business Initiatives

 

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 and Niconovum AB, among others, are included in All Other. 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.

 

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 cigarettes and tobacco products through arrangements with BAT affiliates.

 

RAI’s other reportable operating segment, Conwood, is the second largest smokeless tobacco products manufacturer in the United States. Conwood’s primary brands 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. Conwood also distributes a variety of other tobacco products, including WINCHESTER and CAPTAIN BLACK little cigars, and BUGLER roll-your-own tobacco.

 

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 sold 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.

 

RJR Tobacco

 

RJR Tobacco primarily conducts business in the highly competitive U.S. cigarette market, which has a few large manufacturers and many smaller participants. The U.S. cigarette market is a mature market in which overall consumer demand has declined since 1981 and is expected to continue to decline. Profitability of the U.S. cigarette industry and RJR Tobacco continues to be adversely impacted by decreases in consumption, increases in state excise taxes and governmental regulations and restrictions, such as marketing limitations, product standards and ingredients legislation.

The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to JTI and no international rights were acquired in connection with the B&W business combination. In addition, in connection with the B&W business combination in 2004, RAI entered into a non-competition agreement with BAT under which RAI’s operating subsidiaries generally were prohibited, subject to certain exceptions, from manufacturing and marketing certain tobacco products outside the United States from the date of the B&W business combination until July 2009.

 

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 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 to ensure 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.

 

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 style.

 

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.

 

Conwood

 

Conwood offers a range of differentiated smokeless and other tobacco products to adult consumers. The moist snuff category is divided into premium and price-value brands. The moist snuff category has developed many of the characteristics of the larger, cigarette market, including multiple pricing tiers with intense competition, focused marketing programs and significant product innovation.

 

In contrast to the declining U.S. cigarette market, 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 have slowed the growth of the price-value brands.

 

Conwood faces significant competition in the smokeless tobacco categories. 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. The parent company of RJR Tobacco’s largest

competitor in the cigarette market, Philip Morris USA, Inc., completed its acquisition of Conwood’s largest competitor, USSTC, in January 2009.

 

Critical Accounting Policies and Estimates

 

Accounting principles generally accepted in the United States, referred to as GAAP, require estimates and assumptions to be made that affect the reported amounts in RAI’s consolidated financial statements and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain, and as a result, actual results could differ from those estimates. Due to the estimation processes involved, the following summarized accounting policies and their application are considered to be critical to understanding the business operations, financial position and results of operations of RAI and its subsidiaries. For information related to these and other significant accounting policies, see Item 8, note 1 to consolidated financial statements.

 

Litigation

 

RAI discloses information concerning litigation for which an unfavorable outcome is more than remote. RAI and its subsidiaries record their legal expenses and other litigation costs and related administrative costs as selling, general and administrative expenses as those costs are incurred. RAI and its subsidiaries will record any loss related to litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. When the reasonable estimate is a range, the recorded loss will be the best estimate within the range. If no amount in the range is a better estimate than any other amount, the minimum amount of the range will be recorded.

 

As discussed in Item 8, note 14 to consolidated financial statements, RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of January 29, 2010, RJR Tobacco had paid approximately $12 million since January 1, 2007, related to unfavorable judgments.

 

RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts against them and have valid defenses to all actions and they intend to defend all actions vigorously. RAI’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, including B&W, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable or estimable. As of December 31, 2009, RJR Tobacco had $2 million accrued for an unfavorable judgment in the Whiteley v R. J. Reynolds Tobacco Co. case and $2 million accrued for non-smoking and health litigation. In addition, as of December 31, 2009, RJR, including its subsidiary RJR Tobacco, had liabilities totaling $94 million that were recorded in connection with certain non-smoking and health indemnification claims asserted by JTI relating to certain activities of Northern Brands and related litigation.

 

Litigation is subject to many uncertainties, and it is possible that some of the tobacco-related legal actions, proceedings or claims could ultimately be decided against RJR Tobacco, the Conwood companies or their affiliates, including RAI, and indemnitees. Any unfavorable outcome of such actions could have a material adverse effect on the consolidated results of operations, cash flows or financial position of RAI or its subsidiaries. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 14 to consolidated financial statements.

 

Settlement Agreements

 

RJR Tobacco, Santa Fe and Lane are participants in the MSA, and RJR Tobacco is a participant in other state settlement agreements related to governmental health-care cost recovery actions. Their obligations and the related expense charges under the State Settlement Agreements are subject to adjustments based upon, among other things, the volume of cigarettes sold by the operating subsidiaries, their relative market share and inflation. Since relative market share is based on cigarette shipments, the best estimate of the allocation of charges to RJR Tobacco under these agreements is recorded in cost of products sold as the products are shipped. Adjustments to these estimates are recorded in the period that the change becomes probable and the amount can be reasonably estimated. The

Conwood companies are not participants in the State Settlement Agreements. For more information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry— Health-Care Cost Recovery Cases — State Settlement Agreements” and “— State Settlement Agreements — Enforcement and Validity” in Item 8, note 14 to consolidated financial statements.

 

Intangible Assets

 

Intangible assets include goodwill, trademarks and other intangibles. The determination of fair value involves considerable estimates and judgment. For goodwill, the determination of fair value of a reporting unit involves, among other things, RAI’s market capitalization, and application of the income approach, which includes developing forecasts of future cash flows and determining an appropriate discount rate. If goodwill impairment is implied, the fair values of individual assets and liabilities, including unrecorded intangibles, must be determined. RAI believes it has based its goodwill impairment testing on reasonable estimates and assumptions, and during the annual testing in the fourth quarter of 2009, the estimated fair value of each of RAI’s reporting units was substantially in excess of its respective carrying value.

 

Trademarks and other intangible assets with indefinite lives also are tested for impairment annually, in the fourth quarter. The aggregate fair value of RAI’s operating units’ trademarks and other intangible assets was substantially in excess of their aggregate carrying value. However, the individual fair value of six indefinite-lived trademarks was less than 15% in excess of their respective carrying values. The aggregate carrying value of these six trademarks was $561 million at December 31, 2009.

 

The methodology used to determine the fair value of trademarks includes assumptions with inherent uncertainty, including projected sales volumes and related projected revenues, long-term growth rates, royalty rates that a market participant might assume and judgments regarding the factors to develop an applied discount rate.

 

The carrying value of these six trademarks are at risk of impairment if future projected revenues or long-term growth rates are lower than those currently projected, or if factors used in the development of a discount rate result in the application of a higher discount rate.

 

Goodwill, all trademarks and other intangible assets are tested more frequently if events and circumstances indicate that the asset might be impaired. The carrying value of these intangible assets could be impaired if a significant adverse change in the use, life, or brand strategy of the asset is determined, or if a significant adverse change in the legal and regulatory environment, business or competitive climate occurs that would adversely impact the asset. See Item 8, note 3 to consolidated financial statements for a discussion of the impairment charges.

 

Fair Value Measurement

 

RAI determines fair value of assets and liabilities using a fair value hierarchy that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity, and the reporting entity’s own assumptions about market participant assumptions developed based on the best information available in the circumstances.

 

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, essentially an exit price. The levels of the fair value hierarchy are:

 

Level 1: inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.

 

Level 2: inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability.

 

Level 3: inputs are unobservable and reflect the reporting entity’s own assumptions about the assumptions that market participants would use in pricing the asset or liability.

Investments

 

Marketable securities are classified as available-for-sale and are carried at fair value, with related unrealized gains and losses deemed temporarily impaired reported, net of tax, as accumulated other comprehensive loss. All losses deemed to be other than temporarily impaired are recorded in earnings. As of December 31, 2009, RAI held investments primarily in money market funds, auction rate securities, a mortgage-backed security and a marketable equity security. Certain money market funds are classified as short-term investments due to the liquidity restrictions by the fund managers preventing immediate withdrawal.

 

Adverse changes in financial markets caused the auction rate securities and the mortgage-backed security to revalue lower than carrying value and become less liquid. The funds associated with the auction rate securities and the mortgage-backed security will not be accessible until a successful auction occurs or a buyer is found. These investments are evaluated on a quarterly basis to determine if a credit loss has been incurred and the investment is other than temporarily impaired. For these investments, RAI uses assumptions about future cash flows and risk-adjusted discount rates to determine fair value. To assess credit losses, RAI uses historical default rates, debt ratings, credit default swap spreads and recovery rates to determine if credit losses have been incurred. RAI has the intent and ability to hold these investments for a period of time sufficient to allow for the recovery in market value.

 

Pension and Postretirement Benefits

 

RAI and certain of its subsidiaries sponsor a number of non-contributory defined benefit pension plans covering most of their employees, and also provide certain health and life insurance benefits for most of their retired employees and their dependents. These benefits are generally no longer provided to employees hired on or after January 1, 2004. For additional information relating to pension and postretirement benefits, see Item 8, note 17 to consolidated financial statements.

 

Because pension and other postretirement obligations ultimately will be settled in future periods, the determination of annual expense and liabilities is subject to estimates and assumptions. RAI reviews these assumptions annually based on historic experience and expected future trends or coincidental with a major event and modifies them as needed. Demographic assumptions such as termination of employment, mortality or retirement are reviewed periodically as expectations change.

 

Gains or losses are annual changes in the amount of either the benefit obligation or the market-related value of plan assets resulting from experience different from that assumed or from changes in assumptions. The minimum amortization of unrecognized gains or losses, is included in pension expense. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

 

The minimum amortization of unrecognized gains or losses is also included in the postretirement benefit expense. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the service to expected full eligibility age for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

 

Differences between actual results and actuarial assumptions are accumulated and amortized over future periods. In recent years, actual results have varied significantly from actuarial assumptions. In particular, pension and postretirement assets have decreased due to significant decreases in fair value. These changes, especially during 2008, have resulted in an increase in charges to other comprehensive loss and increased pension expense. These changes are expected to result in an increase in pension and postretirement expense in future years. The Pension Protection Act may require additional cash funding of the pension obligations in the future.

The most critical assumptions and their sensitivity to change are presented below:

 

Assumed asset return and discount rates have a significant effect on the amounts reported for the benefit plans. A one-percentage-point change in assumed discount rate for the pension plans and other postretirement plans would have had the following effects:

 

 

A one-percentage point change in assumed asset return would have had the following effects:

 

 

Income Taxes

 

Tax law requires certain items to be excluded or included in taxable income at different times than is required for book reporting purposes. These differences may be permanent or temporary in nature.

 

RAI determines its annual effective income tax rate based on forecasted pre-tax book income and forecasted permanent book and tax differences. The rate is established at the beginning of the year and is evaluated on a quarterly basis. Any changes to the forecasted information may cause the effective rate to be adjusted. Additional tax, interest and penalties associated with uncertain tax positions are recognized in tax expense on a quarterly basis.

 

To the extent that any book and tax differences are temporary in nature, that is, the book realization will occur in a different period than the tax realization, a deferred tax asset or liability is established. To the extent that a deferred tax asset is created, management evaluates RAI’s ability to realize this asset. Management currently believes it is more likely than not that the deferred tax assets recorded in RAI’s consolidated balance sheet will be realized. To the extent a deferred tax liability is established, it is recorded, tracked and, once it becomes currently due and payable, paid to the taxing authorities.

 

The financial statements reflect management’s best estimate of RAI’s current and deferred tax liabilities and assets. Future events, including but not limited to, additional resolutions with taxing authorities could have an impact on RAI’s current estimate of tax liabilities, realization of tax assets and upon RAI’s effective income tax rate.

 

Recently Adopted Accounting Pronouncements

 

For information relating to recently adopted accounting guidance, see Item 8, note 1 to consolidated financial statements.

 

Results of Operations

 

2009 Compared with 2008

 

 

 

 

RJR Tobacco

 

Net Sales

 

Domestic cigarette shipment volume, in billions of units for RJR Tobacco and the industry, were as follows⁽¹⁾:

 

 

 

 

RJR Tobacco’s net sales are dependent upon its cigarette shipment volume in a declining market, premium versus value-brand mix and list pricing, offset by promotional spending, trade incentives and federal excise taxes. RJR Tobacco believes the federal excise tax increase, effective April 1, 2009, has had, and will continue to have, a significant and adverse impact on cigarette sales volume. RJR Tobacco also believes its consumers are more price-sensitive than consumers of competing brands and, therefore, are more negatively affected by an increase in the federal excise tax and by the current adverse economic environment.

 

RJR Tobacco’s net sales for the year ended December 31, 2009, decreased $421 million, or 5.4%, from the year ended December 31, 2008, driven by $566 million attributable to lower cigarette volume. RJR Tobacco’s decreases in net sales and cigarette shipment volume primarily reflect a continued decline in consumption, partially offset by the recent price increase resulting from the increase in federal excise tax. RJR Tobacco’s total domestic cigarette shipment volume decreased 8.7% in 2009 compared with 2008. Industry cigarette shipment volume for 2009 was down 8.6% compared with 2008. RJR Tobacco’s and industry cigarette shipment volume declines for 2009 are higher than prior years as a result of the increase in the federal excise tax.

The shares of RJR Tobacco’s brands as a percentage of total share of U.S. retail cigarette sales according to data⁽¹⁾ from IRI/Capstone, were as follows⁽²⁾⁽³⁾:

 

 

 

 

The retail share of market of CAMEL’s filtered styles decreased 0.1 share points in 2009 compared with 2008. CAMEL Crush has captured 0.7 share points as of December 31, 2009, as the success of this style continues to be a key driver in the growing menthol category. RJR Tobacco expanded the use of the capsule technology found in CAMEL Crush to CAMEL’s core menthol styles beginning in third quarter of 2009, giving adult smokers the choice between two levels of menthol. In the first quarter of 2010, RJR Tobacco will introduce new packaging for these styles to raise consumer awareness and trial and to strengthen growth in the menthol category.

 

CAMEL Snus was expanded nationally in the first quarter of 2009, and as of December 31, 2009, gained market share of 0.3 percent on a cigarette equivalent basis that assumes a can of snus is equal to a pack of cigarettes. Two new styles of CAMEL Snus were launched in limited markets in the third quarter of 2009.

 

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 in the third quarter of 2009. RJR Tobacco continues to gain insight on ways to improve the products and the packaging of the products.

 

PALL MALL’s market share increased 2.1 share points in 2009 compared with 2008. PALL MALL’s growth is believed to be the result of adult consumers switching brands seeking greater value. PALL MALL, positioned as a product that offers a longer-lasting cigarette at a value price, has retained a high percentage of adult smokers who try the brand.

 

The combined share of market of RJR Tobacco’s growth brands during 2009 showed improvement over 2008.

 

Operating Income

 

RJR Tobacco’s operating income for the year ended December 31, 2009, decreased $318 million to $1,487 million from $1,805 million for the year ended December 31, 2008. A trademark impairment charge of $377 million was recorded in the first quarter of 2009 as the result of impairment testing to reflect the forecasted sales impact due to the increase in the federal excise tax. An additional trademark impairment charge of $114 million was recorded in the fourth quarter of 2009 as the result of annual impairment testing of brand

trademarks. During 2008, RJR Tobacco recorded trademark impairment charges of $176 million. The impairment charges were based on the excess of each brand’s carrying value over its fair value using the present value of estimated future cash flows assuming a discount rate of 10.5%.

 

RJR Tobacco’s operating income was unfavorably impacted by lower cigarette volume, higher pension expense and higher legal expense. Higher pricing, lower promotional spending and productivity gains resulting from the 2008 restructuring partially offset the unfavorability.

 

In December 2009, RJR Tobacco announced the elimination of approximately 400 full-time production positions. These positions were selected from employees who volunteered to be considered for job elimination. The job eliminations are expected to be substantially completed by December 31, 2010.

 

Under existing benefit plans, $48 million of severance-related cash benefits and $8 million of non-cash pension-related benefits comprised a restructuring charge of $56 million. None of the cash portion of the charge was paid during 2009. The cash benefits are expected to be substantially paid by December 31, 2011. Cost savings related to the restructuring are expected to be $17 million in 2010 and increasing to approximately $30 million in 2011 and each year thereafter.

 

RJR Tobacco’s State Settlement Agreements and federal tobacco buyout expenses, included in cost of products sold, are detailed in the schedule below:

 

 

Expenses under the State Settlement Agreements are expected to be approximately $2.5 billion in 2010, subject to adjustment for changes in volume and other factors, and expense for the federal tobacco quota buyout is expected to be approximately $230 million to $260 million in 2010. For additional information, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 14 to consolidated financial statements.

 

Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. For the years ended December 31, 2009 and 2008, RJR Tobacco’s product liability defense costs were $123 million and $96 million, respectively. The increase in product liability defense costs in 2009 compared with 2008 is due primarily to the increase in Engle Progeny cases. For more information, see “— Individual Smoking and Health Cases — Engle Progeny Cases” in Item 8, note 14 to consolidated financial statements.

 

“Product liability” cases generally include the following types of smoking and health related cases:

 

 

“Product liability defense costs” include the following items:

 

 

 

Numerous factors affect product liability defense costs. The most important factors are the number of cases pending and the number of cases in trial or in preparation for trial, that is, with active discovery and motions practice. See “— Litigation Affecting the Cigarette Industry — Overview” in Item 8, note 14 to consolidated financial statements for detailed information regarding the number and type of cases pending, and “— Litigation Affecting the Cigarette Industry — Scheduled Trials” in Item 8, note 14 to consolidated financial statements for detailed information regarding the number and nature of cases in trial and scheduled for trial through December 31, 2010.

 

RJR Tobacco expects that the factors described above will continue to have the primary impact on its product liability defense costs in the future. Given the increased level of activity in RJR Tobacco’s pending cases and possible new cases, including the increased number of cases in trial and scheduled for trial, particularly with respect to the Engle Progeny cases, RJR Tobacco’s product liability defense costs have increased in 2009 compared with the most recent years. See “— Litigation Affecting the Cigarette Industry — Engle Progeny Cases” and “— Litigation Affecting the Cigarette Industry — Class Action Suits — Engle Case” in Item 8, note 14 to consolidated financial statements for additional information. In addition, it is possible that adverse developments in the factors discussed above, as well as other circumstances beyond the control of RJR Tobacco, could have a material adverse effect on the consolidated results of operations, cash flows or financial position of RAI or its subsidiaries. Those other circumstances beyond the control of RJR Tobacco include the results of present and future trials and appeals, and the development of possible new theories of liability by plaintiffs and their counsel.

 

Conwood

 

Net Sales

 

The moist snuff shipment volume, in millions of cans, for Conwood was as follows⁽¹⁾:

 

 

 

 

Conwood’s net sales for the year ended December 31, 2009, were $673 million compared with $723 million for the year ended December 31, 2008. GRIZZLY, Conwood’s leading price-value moist snuff brand, continues to grow moist snuff sales and was the leading moist snuff brand in the United States as of December 31, 2009. KODIAK, Conwood’s leading premium moist snuff brand, reduced pricing at the end of the first quarter of 2009 to remain competitive. This price reduction and volume decline on KODIAK, and a delay in the price increase on GRIZZLY to cover the additional federal excise tax, were the primary drivers of the decrease in sales during 2009 compared with 2008. During 2009, in addition to aggressive promotional spending, pricing was significantly reduced by a competitor on its premium and certain price-value brands.

The Conwood shares of the moist snuff category as a percentage of total share of U.S. shipments of moist snuff, according to distributor reported data⁽¹⁾ processed by MSAi, were as follows⁽²⁾:

 

 

 

 

Moist snuff has been the key driver to Conwood’s overall growth and profitability within the U.S. smokeless tobacco market. Moist snuff accounted for approximately 71% of Conwood’s revenue in 2009 and approximately 66% in 2008. While industry 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. Continuing with innovation and brand building, Conwood will feature embossed metal lids on KODIAK and GRIZZLY brands in 2010.

 

GRIZZLY had a 25.3% share of moist snuff shipments in 2009, an increase of 2.0 share points from 2008, due in part to the success of new GRIZZLY styles. GRIZZLY launched mint and straight pouch styles in the first quarter of 2009 and GRIZZLY snuff pouches in the fourth quarter of 2009. Pouches, in the industry, have grown over 25% in 2009 and now account for nearly 8% of moist snuff sales. GRIZZLY’s pouch styles generated approximately 60% of the pouch growth in the industry during 2009. Also being launched in the first quarter of 2010 is GRIZZLY 1900 Long Cut, a natural product with a traditional long cut.

 

The shipment share of KODIAK declined 0.2 share points in 2009 compared with 2008 due to competitive promotional activity and the brand’s core markets being burdened by high tobacco taxes and the current economic recession. KODIAK’s price reduction during the first quarter of 2009 aligned KODIAK with other premium brands, making it more competitive.

 

Conwood launched CAMEL Dip, a premium moist snuff, in two styles, Wintergreen Wide Cut and Dark Milled, in lead markets during the second quarter of 2009. CAMEL Dip will be launched in ten additional markets in the first quarter of 2010. CAMEL Wintergreen pouches will be launched in the first quarter of 2010.

 

Operating Income

 

Conwood’s operating income for the year ended December 31, 2009, increased to $276 million from $232 million, primarily impacted by a trademark impairment charge of $76 million in 2009 compared with a trademark impairment charge of $142 million in 2008. Additionally, lower margins on KODIAK and higher promotional spending due to product introductions, tax increases and competitive activity were partially offset by increases in volume and pricing by GRIZZLY.

 

The 2009 impairment charge was the result of impairment testing triggered by certain price reductions and the anticipated sales impact due to the increase in the federal excise tax effective April 1, 2009. This impairment occurred on several of Conwood’s brands, including KODIAK, driven by the decrease in its list price to meet competition, as well as the federal excise tax impact on other brands. The impairment charge was based on the excess of each brand’s carrying value over its fair value using the present value of estimated future cash flows assuming a discount rate of 10.5%.

All Other

 

All Other sales for the year ended December 31, 2009, were favorably impacted by the growth of Santa Fe’s NATURAL AMERICAN SPIRIT brand. Operating income for the 2009 year increased as a result of higher sales in 2009 as compared with 2008.

 

RAI Consolidated

 

Interest and debt expense was $251 million for the year ended December 31, 2009, a decrease of $24 million over the comparable prior year. This decrease was primarily due to lower effective interest rates in 2009 as compared with 2008 coupled with lower debt balances during 2009.

 

Interest income was $19 million for the year ended December 31, 2009, a decrease of $41 million compared with the year ended December 31, 2008. This decrease was the result of investing at lower interest rates in 2009.

 

Gain on termination of joint venture of $328 million in 2008 resulted from the termination of the Reynolds-Gallaher International Sarl joint venture. See Item 8, note 5 to consolidated financial statements for additional information related to the joint venture termination.

 

Other expense net was $9 million for the year ended December 31, 2009, a decrease of $28 million compared with the year ended December 31, 2008. Impairments on investments deemed other-than-temporary of $35 million were expensed in 2008.

 

Provision for income taxes was $572 million, or an effective rate of 37.3%, for the year ended December 31, 2009, compared with $790 million, or an effective rate of 37.1%, for the year ended December 31, 2008. The effective tax rate for 2009 was unfavorably impacted by the increases in unrecognized income tax benefits and increases in tax attributable to accumulated and undistributed foreign earnings. The 2008 effective rate was favorably impacted by a lower tax rate related to the gain on the termination of the Reynolds-Gallaher International Sarl joint venture, but was offset by unfavorability related to tax reserves and U.S. taxes recorded on foreign earnings. The effective tax rates exceeded the federal statutory rate of 35% primarily due to the impact of state taxes and certain non-deductible items, offset by the domestic production activities deduction of the American Jobs Creation Act, enacted on October 22, 2004.

 

RAI expects its effective tax rate to be approximately 38% in 2010.

2008 Compared with 2007

 

 

 

 

 

 

In 2008, RAI and RJR Tobacco announced changes in their organizational structures to streamline non-core business processes and programs in order to allocate additional resources to strategic growth initiatives. The reorganizations resulted in the elimination of approximately 600 full-time jobs, which were substantially completed by December 31, 2009.

 

Under existing benefit plans, $83 million of severance-related cash benefits and $7 million of non-cash pension-related benefits comprised a restructuring charge of $90 million. Of this charge, $81 million was recorded in the RJR Tobacco segment. Of the cash portion of the charge, $5 million was paid as of December 31, 2008. The cash benefits are expected to be substantially paid by December 31, 2010.

RJR Tobacco

 

Net Sales

 

Domestic cigarette shipment volume, in billions of units for RJR Tobacco and the industry, were as follows⁽¹⁾:

 

 

 

 

During 2008, RJR Tobacco selectively reduced the number of products sold by discontinuing a number of low-margin and non-core brands and styles to reduce complexity and improve efficiency.

 

RJR Tobacco’s net sales for the year ended December 31, 2008, decreased $267 million, or 3.3%, from the year ended December 31, 2007, driven by $339 million attributable to lower volume, partially offset by improved pricing, net of promotional spending. RJR Tobacco’s decreases in net sales and shipment volume reflect intensified competitive activity in the first half of 2008, a decrease in consumption, wholesale inventory reductions, and the impact of RJR Tobacco’s selective brand and style reduction. In addition, RJR Tobacco’s consumers are believed to be more price-sensitive than consumers of competing brands and, therefore, are more negatively affected by the current adverse economic pressures. RJR Tobacco’s total domestic shipment volume decreased 8.4% in 2008 compared with 2007. Industry shipment volume for 2008 was down 3.3% compared with 2007.

 

The shares of RJR Tobacco’s brands as a percentage of total share of U.S. retail cigarette sales according to data⁽¹⁾ from IRI/Capstone, were as follows⁽²⁾⁽³⁾:

 

 

 

The retail share of market of CAMEL’s filtered styles increased 0.3 share points in 2008 compared with 2007. During the first half of 2008, CAMEL launched updated packaging and smoother blends for its core styles. CAMEL also introduced CAMEL Crush in lead markets during the first quarter of 2008. CAMEL Crush was expanded nationally during the third quarter of 2008 and had a market share of 0.7 share points in the fourth quarter of 2008.

 

CAMEL Snus expanded into a total of 17 markets in 2008. Additionally, in October 2008, RJR Tobacco introduced CAMEL Dissolvables that include CAMEL Orbs, Sticks and Strips.

 

PALL MALL’s market share increased 0.5 share points in 2008 compared with 2007. PALL MALL’s growth is believed to be the result of the brand’s position as a product that offers a longer-lasting cigarette at a value price. PALL MALL introduced more stylish, round-corner packs in the second quarter of 2008.

 

The combined share of market of RJR Tobacco’s growth brands during 2008 showed improvement over 2007. However, the decline in share of support and non-support brands more than offset the gains on the growth brands.

 

Operating Income

 

RJR Tobacco’s operating income for the year ended December 31, 2008, decreased $183 million to $1,805 million from $1,988 million for the year ended December 31, 2007. In addition to a restructuring charge of $81 million in the second half of 2008, the reclassification of KOOL to a support brand from a growth brand in the third quarter of 2008 triggered a non-cash trademark impairment of $173 million. An additional impairment charge of $3 million was recorded in the fourth quarter of 2008 as the result of annual impairment testing of brand trademarks. In 2007, RJR Tobacco recorded a trademark impairment charge of $33 million.

 

The trademark impairment charge and restructuring charge were partially offset by higher pricing and improvements in productivity. RJR Tobacco’s operating income was also negatively impacted by decreases in shipment volume due to intensified competitive activity in the first half of 2008, a decrease in consumption, wholesale inventory reductions, as well as RJR Tobacco’s selective style and brand reduction.

 

RJR Tobacco’s State Settlement Agreements and federal tobacco buyout expenses, included in cost of products sold, are detailed in the schedule below:

 

 

Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. For the years ended December 31, 2008 and 2007, RJR Tobacco’s product liability defense costs were $96 million and $88 million, respectively.

Conwood

 

Net Sales

 

The moist snuff shipment volume, in millions of cans, for Conwood was as follows⁽¹⁾:

 

 

 

 

Conwood’s net sales for the year ended December 31, 2008, were $723 million compared with $670 million for the year ended December 31, 2007. Moist snuff sales generated the increase over the prior-year period, led by GRIZZLY.

 

The Conwood shares of the moist snuff category as a percentage of total share of U.S. shipments of moist snuff, according to distributor reported data⁽¹⁾ processed by MSAi, were as follows⁽²⁾:

 

 

 

 

Moist snuff accounted for approximately 66% of Conwood’s revenue in 2008 and approximately 60% in 2007. Conwood’s key brands include KODIAK in the premium brand category and GRIZZLY in the price-value brand category. Conwood’s U.S. moist snuff market share was 27.6% in 2008 and 26.0% in 2007 based on distributor-reported data processed by MSAi, for distributor shipments to retail. Although moist snuff volume grew over 7% in 2008, Conwood’s moist snuff volume grew over 13% in 2008, attributable to its innovation, product development and brand building.

 

GRIZZLY had a 23.2% share of moist snuff shipments in 2008, an increase of 2.2 share points from 2007, despite further narrowing of the price gap between premium brands and value brands, such as GRIZZLY. In 2008, Conwood expanded nationally the launch of two new GRIZZLY styles, GRIZZLY Wintergreen Pouches and GRIZZLY Snuff, to build on the brand’s momentum and aid in its share growth.

 

The shipment share of KODIAK declined 0.4 share points in 2008 compared with 2007 due to competitive promotional activity and the brand’s core markets being burdened by high tobacco taxes and the current economic recession.

Operating Income

 

Conwood’s operating income for the year ended December 31, 2008, decreased to $232 million from $312 million for 2007. This change is due to increased price-value volume and higher pricing offset primarily by trademark impairment. The annual impairment testing of trademarks in the fourth quarter of 2008 resulted in a charge of $142 million compared with $32 million in 2007. The 2008 impairment occurred primarily on KODIAK, which reflected the demand shift from premium to price-value brands.

 

All Other

 

All Other sales for the year ended December 31, 2008, were favorably impacted by the growth of Santa Fe’s NATURAL AMERICAN SPIRIT brand. Operating income for the 2008 year increased as a result of lower marketing expenses in 2008 as compared with 2007.

 

RAI Consolidated

 

Gain on termination of joint venture of $328 million in 2008 resulted from the termination of the Reynolds-Gallaher International Sarl joint venture. See Item 8, note 5 to consolidated financial statements for additional information related to the joint venture termination.

 

Interest and debt expense was $275 million for the year ended December 31, 2008, a decrease of $63 million over the comparable prior year. This decrease was primarily due to lower effective interest rates and lower outstanding debt in 2008 as compared with 2007.

 

Interest income was $60 million for the year ended December 31, 2008, a decrease of $74 million compared with the year ended December 31, 2007. This decrease was the result of investing available cash at lower interest rates in 2008.

 

Other expense net was expense of $37 million for the year ended December 31, 2008, an increase of $26 million compared with the year ended December 31, 2007. Impairments on investments deemed other-than-temporary of $35 million were expensed in 2008.

 

Provision for income taxes was $790 million, or an effective rate of 37.1%, for the year ended December 31, 2008, compared with $766 million, or an effective rate of 37.0%, for the year ended December 31, 2007. The 2008 provision was favorably impacted by a lower tax rate related to the gain on the termination of the Reynolds-Gallaher International Sarl joint venture, but was offset by unfavorability related to tax reserves and U.S. taxes recorded on foreign earnings. The effective tax rates exceeded the federal statutory rate of 35% primarily due to the impact of state taxes and certain non-deductible items, offset by the domestic production activities deduction of the American Jobs Creation Act, enacted on October 22, 2004.

 

Liquidity and Financial Condition

 

Liquidity

 

At present, the principal sources of liquidity for RAI’s operating subsidiaries’ businesses and operating needs are internally generated funds from their operations and intercompany loans and advances, mainly from RAI and RJR. The principal capital resources and sources of liquidity for RAI and RJR, in turn, are proceeds from issuances of debt securities by RAI and RJR and the RAI credit facility described below under “— Borrowing Arrangements.” Cash flows from operating activities are believed to be sufficient for the foreseeable future to enable the operating subsidiaries to meet their obligations under the State Settlement Agreements, to fund their capital expenditures and to make payments to RAI and RJR that, when combined with RAI’s and RJR’s cash balances, will enable RAI and RJR to make their required debt-service payments, and enable RAI to pay dividends to its shareholders.

 

The negative impact, if any, on the sources of liquidity that could result from a decrease in demand for products due to short-term inventory adjustments by wholesale and retail distributors, changes in competitive pricing, accelerated declines in consumption, particularly from increases in regulation or excise taxes, or adverse impacts from financial markets, cannot be predicted. RAI cannot predict its cash requirements or those of its subsidiaries

related to any future settlements or judgments, including cash required to be held in escrow or to bond any appeals, if necessary, and RAI makes no assurance that it or its subsidiaries will be able to meet all of those requirements.

 

RAI evaluated the liquidity of key suppliers and significant customers throughout 2009. Where there were liquidity concerns identified with key suppliers, contingency plans were developed. To date, no business interruptions have occurred caused by key supplier liquidity. No liquidity issues were identified regarding significant customers.

 

As of December 31, 2009, RAI held investments primarily in money market funds, auction rate securities, a mortgage-backed security and a marketable equity security. Certain money market funds are classified as short-term investments due to liquidity restrictions by the fund managers preventing immediate withdrawal. Given such restrictions, these funds will not be available until the underlying investments mature or are sold. Adverse changes in financial markets caused the auction rate securities and the mortgage-backed security to revalue lower than carrying value and become less liquid. The auction rate securities and the mortgage-backed security will not become liquid until a successful auction occurs or a buyer is found. RAI intends, and has the ability, to hold these money market funds, auction rate securities and the mortgage-backed security for a period of time sufficient to allow for sale, redemption or anticipated recovery in fair value. At December 31, 2009, RAI considered the mortgage-backed security and the auction rate securities to be temporarily impaired.

 

Contractual obligations as of December 31, 2009 were as follows:

 

 

 

 

Commitments as of December 31, 2009 were as follows:

 

 

Cash Flows

 

2009 Compared with 2008

 

Net cash flows from operating activities were $1,454 million in 2009, compared with $1,315 million in 2008. This change was driven by the partial retention of the 2009 MSA payment and lower taxes paid, partially offset by higher pension payments, higher bonds posted and lower interest received in 2009.

 

Net cash flows used in investing activities was $123 million in 2009, compared with net cash flows from investing activities of $278 million for the prior year. This change was primarily driven by lower proceeds from short-term investments as well as higher capital expenditures and an acquisition in 2009 compared with the 2008 proceeds from the termination of the joint venture.

 

Net cash flows used in financing activities were $1,192 million in 2009, compared with $1,206 million in 2008. Lower common stock purchases in 2009 were nearly offset by long-term debt repaid in 2009.

 

2008 Compared with 2007

 

Net cash flows from operating activities were $1,315 million in 2008, compared with $1,331 million in 2007. This change was driven primarily by higher State Settlement Agreement and tax payments, partially offset by lower pension funding in 2008.

 

Net cash flows from investing activities were $278 million in 2008, compared with $763 million for the prior year. This change was primarily driven by higher short-term investing net proceeds in 2007 that more than offset the proceeds received in 2008 as a result of the termination of the joint venture.

Net cash flows used in financing activities were $1,206 million in 2008, compared with $1,312 million in 2007. This change was due to prior-year repayment of long-term debt, offset by higher stock repurchases and higher dividends per share in 2008.

 

Borrowing Arrangements

 

As of December 31, 2009, RAI’s total consolidated debt consisted of RAI notes in the aggregate principal amount of $4.1 billion, with maturity dates ranging from 2010 to 2037, and RJR notes in the aggregate principal amount of $118 million, with maturity dates ranging from 2012 to 2015. See Item 8, note 12 to consolidated financial statements for more information on these notes.

 

RAI and RJR use interest rate swaps to manage interest rate risk on a portion of their debt obligations. On December 31, 2008, interest rate swaps existed on $1.6 billion of fixed-rate notes. When entered into, these swaps were designated as hedges of underlying exposures. On January 6, 2009, RAI and RJR entered into offsetting interest rate swap agreements in the notional amount of $1.5 billion with maturity dates ranging from June 1, 2012 to June 15, 2017. These swaps were entered into with the same financial institution that holds a notional amount of $1.5 billion of current swaps and have a technical right of offset. The future cash flows, established as a result of entering into the January 6, 2009, swaps, total $321 million, and will be amortized and effectively reduce net interest costs over the remaining life of the notes. Concurrent with entering the swap agreements on January 6, 2009, RAI de-designated the current swaps as fair value hedges.

 

On January 7, 2009, RAI and RJR terminated an interest rate swap agreement in the notional amount of $100 million with a maturity date of June 1, 2012. The resulting gain of approximately $12 million will be amortized to effectively reduce interest expense over the remaining life of the notes.

 

As a result of these actions, RAI and RJR have effectively converted $1.6 billion of fixed-rate notes swapped to a variable rate of interest, to a fixed rate of interest of approximately 4.0%.

 

At their option, RAI and RJR, as applicable, may redeem any or all of their outstanding fixed-rate notes, in whole or in part at any time, subject to the payment of a make-whole premium. RAI’s floating rate notes are redeemable at par on any interest payment date after December 15, 2008.

 

Effective July 3, 2009, RAI entered into a Second Amendment to Credit Agreement, referred to as the Second Amendment, amending RAI’s credit facility. The Second Amendment amends the credit facility by, among other things:

 

 

Effective with the Second Amendment, RAI’s credit facility of $498 million may be increased up to $848 million at the discretion of the lenders upon the request of RAI.

Lenders and their respective commitments in the credit facility, which are several, not joint, commitments, are listed below:

 

 

At December 31, 2009, RAI had $15 million in letters of credit outstanding under the credit facility. At such date, no borrowings were outstanding, and the remaining $483 million of the credit facility was available for borrowing.

 

Certain of RAI’s subsidiaries, including the Guarantors, have guaranteed RAI’s obligations under the credit facility and under RAI’s outstanding senior notes, referred to as the Notes. The collateral for the credit facility, Notes and related guarantees (which was released during 2008) will be reinstated if RAI’s corporate credit rating issued by each of S&P and Moody’s is lowered to at least one level below the lowest rating level established as investment grade, or if RAI’s corporate credit rating issued by either S&P or Moody’s is lowered to at least two levels below the lowest rating level established as investment grade.

 

Concerns about, or lowering of, RAI’s ratings by S&P or Moody’s could have an adverse impact on RAI’s ability to access the debt markets and could increase borrowing costs. However, given the cash balances and operating performance of RAI and its subsidiaries, RAI’s management believes that such concerns about, or lowering of, such ratings would not have a material adverse impact on RAI’s cash flows.

 

RAI, RJR and their affiliates were in compliance with all covenants and restrictions imposed by their indebtedness at December 31, 2009.

 

Dividends

 

On February 2, 2010, RAI’s board of directors declared a quarterly cash dividend of $0.90 per common share. The dividend will be paid on April 1, 2010, to shareholders of record as of March 10, 2010. On an annualized basis, the dividend rate is $3.60 per common share. The current dividend reflects RAI’s policy of paying dividends to the holders of RAI common stock in an aggregate amount that is approximately 75% of RAI’s annual consolidated net income.

 

Stock Repurchases

 

On April 29, 2008, RAI’s board of directors authorized RAI’s repurchase, prior to April 30, 2009, of up to $350 million of outstanding shares of RAI common stock in open market or privately negotiated transactions. Due to RAI’s incorporation in North Carolina, which does not recognize treasury shares, the shares repurchased are cancelled at the time of repurchase. RAI had repurchased and cancelled 3,817,095 shares of RAI common stock for

$207 million under the above share repurchase program during 2008. RAI did not repurchase any shares of RAI common stock under this program in 2009.

 

Additionally during 2009, at a cost of $5 million, RAI purchased 154,441 shares that were forfeited with respect to tax liabilities associated with restricted stock vesting under its LTIP.

 

Capital Expenditures

 

RAI’s operating subsidiaries’ recorded cash capital expenditures of $141 million, $113 million and $142 million in 2009, 2008 and 2007, respectively. Of the 2009 amount, $55 million related to RJR Tobacco and $75 million related to Conwood. RJR Tobacco plans to spend $50 million to $60 million for capital expenditures during 2010, primarily on non-discretionary business requirements, and Conwood plans to spend $165 million to $175 million in 2010, primarily on non-discretionary capacity projects for the Memphis, Tennessee and Clarksville, Tennessee facilities. Capital expenditures are funded primarily by cash flows from operations. RAI’s operating subsidiaries’ capital expenditure programs are expected to continue at a level sufficient to support their strategic and operating needs. There were no material long-term commitments for capital expenditures as of December 31, 2009.

 

Retirement Benefits

 

Due primarily to the adverse changes in the financial markets, RAI’s pension assets have been negatively impacted. In 2008, the overall rate of return on the investments for the pension assets was negative approximately 30.1%. RAI assessed the asset allocation and investment strategy and will phase in appropriate changes to balance funded status, interest rate risk and asset returns. Once fully implemented, these changes will reduce the pension fund’s exposure to equities and increase exposure to fixed income and alternatives. As a result of changes to the asset allocation and investment strategy, RAI lowered the expected long-term return on pension assets, referred to as the ELTRA, to 8.25%, in 2009, from 8.74%. The ELTRA, asset allocation, current asset performance and the discount rate may impact the funded status of RAI’s pension plans. As a result, to improve the funded status, RAI contributed $295 million to the pension assets in 2009 and pension expense increased approximately $187 million in 2009 to $125 million.

 

In 2009, the overall rate of return on the investments for the pension assets was approximately 24.8%. In 2010, RAI plans to contribute $309 million to the pension assets, of which $300 million was contributed in January 2010, and the pension expense is expected to be $115 million.

 

Income Taxes

 

At December 31, 2009, RAI had a net deferred tax asset of $515 million. RAI has determined that no valuation allowance is required to be recorded against this deferred tax asset as RAI believes it is more likely than not that all of the deferred tax asset will be realized. This determination is due largely to RAI’s historical and projected reporting pretax earnings and taxable income.

 

Litigation and Settlements

 

As discussed in Item 8, note 14 to consolidated financial statements, RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, including B&W, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of January 29, 2010, RJR Tobacco has paid approximately $12 million since January 1, 2007, related to unfavorable judgments. RJR, including its subsidiary RJR Tobacco, have liabilities totaling $94 million that were recorded in connection with certain indemnification claims, not related to smoking and health, asserted by JTI against RJR and RJR Tobacco, relating to the activities of Northern Brands and related litigation.

 

RAI’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable. RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts against them and have valid defenses to all actions and intend to defend all actions vigorously. Nonetheless, the possibility of material losses related to

tobacco litigation is more than remote. Litigation is subject to many uncertainties, and generally it is not possible to predict the outcome of the litigation pending against RJR Tobacco, the Conwood companies or their affiliates or indemnitees, or to reasonably estimate the amount or range of any possible loss. Moreover, notwithstanding the quality of defenses available to it and its affiliates in tobacco-related litigation matters, it is possible that RAI’s consolidated results of operations, cash flows or financial position could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters.

 

In November 1998, RJR Tobacco, B&W and the other major U.S. cigarette manufacturers entered into the MSA with attorneys general representing most U.S. states, territories and possessions. As described in Item 8, note 14 to consolidated financial statements, the State Settlement Agreements impose a perpetual stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers and place significant restrictions on their ability to market and sell cigarettes in the future. For more information related to historical and expected settlement expenses and payments under 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. The State Settlement Agreements have materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial position of RAI and RJR Tobacco in future periods. The degree of the adverse impact will depend, among other things, on the rate of decline in U.S. cigarette sales in the premium and value categories, RJR Tobacco’s share of the domestic premium and value cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the State Settlement Agreements.

 

RJR Tobacco and certain of the other participating manufacturers under the State Settlement Agreements are currently involved in litigation with the settling states with respect to the availability for certain market years of a downward adjustment to the annual State Settlement Agreements’ payment obligation, known as the Non-Participating Manufacturer Adjustment. Pending the resolution of these disputes, RJR Tobacco and certain of the other participating manufacturers have placed the disputed portions of their 2006, 2007 and 2008 annual payments into the MSA disputed funds account. In February 2009, approximately $431 million was released, without waiving claim, to the settling states. Accordingly, RJR Tobacco had approximately $1.2 billion deposited in the MSA disputed funds account as of December 31, 2009. In April 2009, RJR Tobacco retained approximately $406.5 million of its 2009 MSA payment to reflect its share of the 2006 NPM Adjustment as calculated by the independent auditor. For more information related to this litigation, see “— Litigation Affecting the Cigarette Industry — State Settlement Agreements — Enforcement and Validity and — Other NPM Adjustment Claims” in Item 8, note 14 to consolidated financial statements.

 

Governmental Activity

 

The marketing, sale, taxation and use of tobacco products have been subject to substantial regulation by government and health officials for many years. Various state governments have adopted or are considering, among other things, legislation and regulations that would:

 

 

In addition, as discussed in greater detail below, during 2009, the U.S. Congress adopted legislation increasing the federal excise tax on cigarettes and other tobacco products, and granting the FDA broad authority over the manufacture, sale, marketing and packaging of tobacco products. During 2010, the U.S. Congress also may consider legislation regarding:

 

 

Together with manufacturers’ price increases in recent years and substantial increases in state and federal taxes on tobacco products, these developments have had and will likely continue to have an adverse effect on the sale of tobacco products.

 

Cigarettes and other tobacco products are subject to substantial taxes in the United States. 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 SCHIP.

 

Under these federal tax increases:

 

 

All states and the District of Columbia currently impose cigarette excise taxes at levels ranging from $0.07 per pack in South Carolina to $3.46 per pack in Rhode Island. As of December 31, 2009, the weighted average state cigarette excise tax per pack, calculated on a 12-month rolling average basis, was approximately $1.16, compared with the 12-month rolling average of $1.00 as of December 31, 2008. During 2009, 14 states and the District of Columbia passed cigarette excise tax increases, and a number of other states are considering an increase in their cigarette excise taxes for 2010. Certain city and county governments, such as New York and Chicago, also impose substantial excise taxes on cigarettes sold in those jurisdictions.

 

Cigars generally are taxed by states on an ad valorem basis, ranging from 5% in South Carolina to 80% in Rhode Island. Other states have unit-based tax schemes for cigars or tax little cigars the same as cigarettes.

 

Forty-nine states and the District of Columbia also subject smokeless tobacco to excise taxes, and the Commonwealth of Pennsylvania, the singular exception, may enact such a tax during its 2010 legislative session. As of December 31, 2009, 32 states taxed moist snuff, and 44 states taxed chewing tobacco, on an ad valorem basis at rates that range from 5% in South Carolina to 100% in Wisconsin. Other states have a unit tax or a weight-based tax. During 2009, four states and the District of Columbia enacted legislation changing from an ad valorem to a weight-based taxation system on moist snuff. In addition, Oregon also passed a weight-based tax on moist snuff, which took effect on January 1, 2010, and Wisconsin switched the method of taxing moist snuff from a weight-based tax back to an ad valorem tax. Legislation to convert from an ad valorem to a weight-based tax is expected to be introduced in several states in 2010. In total, during 2009, 17 states passed tax increases on other tobacco products, and a number of other states are considering an increase in their taxes on other tobacco products for 2010.

On July 16, 2009, Oregon enacted a statute including a requirement that smokeless tobacco manufacturers who are not signatories to the Smokeless Tobacco Master Settlement Agreement, referred to as the STMSA, either certify compliance with certain requirements imposed by the STMSA or place into escrow $0.40 for every unit of smokeless tobacco sold in the state as security against certain types of claims that might be brought by Oregon or other “Releasing Parties” under the STMSA. On September 4, 2009, Conwood Company, LLC, among others, brought suit in Circuit Court, Madison County, Oregon (Conwood Company, LLC v. Kroger) to enjoin the enforcement of this Oregon statute contending the statute violates the constitutions of Oregon and the United States. For further information regarding this case, see Item 8, note 14, to consolidated financial statements.

 

Oregon also is considering legislation that would require smokeless tobacco manufacturers to join the STMSA and make payments thereunder or place into escrow an amount equivalent to what a manufacturer would have paid had it joined the STMSA. The legislation also would change the tax on chewing tobacco from ad valorem to a weight-based tax of $1.78 per ounce.

 

In 1964, the Report of the Advisory Committee to the Surgeon General of the U.S. Public Health Service concluded that cigarette smoking was a health hazard of sufficient importance to warrant appropriate remedial action. Since 1966, federal law has required a warning statement on cigarette packaging, and cigarette advertising in other media also is required to contain a warning statement. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States.

 

During the past four decades, various laws affecting the cigarette industry have been enacted. In 1984, Congress enacted the Comprehensive Smoking Education Act. Among other things, this act:

 

 

The warnings currently required on cigarette packages and advertisements are:

 

 

Since the initial report in 1964, the Secretary of Health, Education and Welfare, now the Secretary of Health and Human Services, and the Surgeon General have issued a number of other reports which purport to find the nicotine in cigarettes addictive and to link cigarette smoking and exposure to cigarette smoke with certain health hazards, including various types of cancer, coronary heart disease and chronic obstructive lung disease. These reports have recommended various governmental measures to reduce the incidence of smoking. In 1992, the federal Alcohol, Drug Abuse and Mental Health Act was signed into law. This act required states to adopt a minimum age of 18 for purchase of tobacco products and to establish a system to monitor, report and reduce the illegal sale of tobacco products to minors in order to continue receiving federal funding for mental health and drug abuse programs. In 1996, the U.S. Department of Health and Human Services announced regulations implementing this legislation. And in 2006, the Surgeon General released a report entitled “The Health Consequences of Involuntary Exposure to Tobacco Smoke.” Among its conclusions, the report found the following: exposure of adults to secondhand smoke causes coronary heart disease and lung cancer, exposure of children to secondhand smoke

results in an increased risk of sudden infant death syndrome, acute respiratory infections, ear problems and more severe asthma; and that there is no risk-free level of exposure to secondhand smoke.

 

In 1986, Congress enacted the Comprehensive Smokeless Tobacco Health Education Act of 1986, which, among other things, required health warning notices on smokeless tobacco packages and advertising and prohibited the advertising of smokeless tobacco products on any medium of electronic communications subject to the jurisdiction of the Federal Communications Commission. The warnings currently required on smokeless tobacco packages and advertising, which appear on a rotating basis, are:

 

 

In 2000, the seven largest U.S. cigar companies, including Lane, entered into agreements with the FTC, to clearly and conspicuously display on virtually every cigar package and advertisement one of the following warnings, which appear on a rotating basis:

 

 

On June 22, 2009, President Obama signed into law the FDA Tobacco Act, which grants the FDA broad authority over the manufacture, sale, marketing and packaging of tobacco products.

 

The following provisions of the FDA Tobacco Act took effect upon passage:

 

 

In addition, as of September 20, 2009, tobacco manufacturers are banned from selling cigarettes with characterizing flavors (other than menthol, which under the FDA Tobacco Act is specifically exempt as a characterizing flavor, but the impact of which on public health will be studied as discussed below).

 

Over the course of the next three years, various provisions under the FDA Tobacco Act and regulations to be issued under the FDA Tobacco Act will become effective and will:

 

 

 

The U.S. Congress did limit the FDA’s authority in two areas, prohibiting it from:

 

 

A “Center for Tobacco Products” has been established within the FDA, funded through quarterly user fees that will be assessed against tobacco product manufacturers and importers based on market share. The total amount of user fees to be collected over the first ten years will be approximately $5.4 billion. The expense related to the FDA user fees of RAI’s operating companies was $22 million in 2009, and the expense for 2010 will be approximately $75 million to $85 million.

 

Within the Center, a Tobacco Products Scientific Advisory Committee will provide advice, information and recommendations with respect to the safety, dependence or health issues related to tobacco products, including:

 

 

In February 2010, RJR Tobacco received a letter from the Center for Tobacco Products (which letter is available on the FDA’s web site) requesting, in connection with the Tobacco Products Scientific Advisory Committee’s study of dissolvable tobacco products, certain information regarding the perception and use of CAMEL Dissolvables. RJR Tobacco, which markets its tobacco products only to adult tobacco users, intends to respond to FDA’s information request.

 

On August 31, 2009, RJR Tobacco and Conwood joined other tobacco manufacturers and a tobacco retailer in filing a lawsuit in the U.S. District Court for the Western District of Kentucky (Commonwealth Brands, Inc. v. United States of America), challenging certain provisions of the FDA Tobacco Act that severely restrict the few remaining channels available to communicate with adult tobacco consumers. RAI believes these provisions cannot be justified on any basis consistent with the demands of the First Amendment. The suit does not challenge the U.S. Congress’s decision to give the FDA regulatory authority over tobacco products, nor does it challenge the vast majority of the provisions of the new law. For further information regarding this case, see Item 8, note 14 to consolidated financial statements.

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. RAI believes that such regulation may adversely affect the ability of its operating subsidiaries to compete against their larger competitor, which may be able to more quickly and cost-effectively comply with these new rules and regulations. The FDA has yet to issue guidance with respect to many provisions of the FDA Tobacco Act, which may result in less efficient compliance efforts. Finally, the ability of RAI’s operating companies to gain efficient market clearance for new tobacco products could be affected by FDA rules and regulations.

 

Legislation imposing various restrictions on public smoking also has been enacted by 49 states and many local jurisdictions, and many employers have initiated programs restricting or eliminating smoking in the workplace. A number of states have enacted legislation designating a portion of increased cigarette excise taxes to fund either anti-smoking programs, health-care programs or cancer research. In addition, educational and research programs addressing health-care issues related to smoking are being funded from industry payments made or to be made under settlements with state attorneys general. Federal law prohibits smoking in scheduled passenger aircraft, and the U.S. Interstate Commerce Commission has banned smoking on buses transporting passengers interstate. Certain common carriers have imposed additional restrictions on passenger smoking.

 

In 2003, the California Environmental Protection Agency Air Resources Board issued a “Proposed Identification of Environmental Tobacco Smoke as a Toxic Air Contaminant” for public review. In 2006, the Air Resources Board identified environmental tobacco smoke as a Toxic Air Contaminant, following a three-year administrative process. The Air Resources Board is now required to prepare a report assessing the need and appropriate degree of control of environmental tobacco smoke. RJR Tobacco cannot predict the form any future California regulation may take.

 

In 2003, the New York Office of Fire Prevention and Control issued a final standard with accompanying regulations that requires all cigarettes offered for sale in New York State after June 28, 2004, to achieve specified test results when placed on ten layers of filter paper in controlled laboratory conditions. As of December 31, 2009, 48 states in addition to New York, as well as Washington, D.C., had enacted fire standards compliance legislation of their own, adopting the same testing standard set forth in the OFPC regulations described above. The cigarettes that RAI’s operating companies sell in these jurisdictions comply with this standard. Wyoming remains the only state to not have enacted this type of legislation. Recognizing these legislative trends in conjunction with its effort to increase productivity and reduce complexity, RJR Tobacco voluntarily converted all of its brands to fire standard compliance paper by the end of 2009.

 

In July 2007, the State of Maine became the first state to enact a statute that prohibits the sale of cigarettes and cigars that have a characterizing flavor. The legislation defines characterizing flavor as “a distinguishable taste or aroma that is imparted to tobacco or tobacco smoke either prior to or during consumption, other than a taste or aroma from tobacco, menthol, clove, coffee, nuts or peppers.” In October 2008, the State of New Jersey passed a similar ban on flavored cigarettes with a similar definition of characterizing flavor but excluding only tobacco, menthol or clove. Additionally, New Jersey extended the ban not only to whether the product itself has a characterizing flavor as part of the aroma of the product or smoke, but also if the product was marketed or advertised as producing such a flavor, taste or aroma. During 2009, New York City passed legislation that would ban characterizing flavors in tobacco products other than cigarettes beginning on February 25, 2010. An exemption applies if the characterizing flavor is tobacco, menthol, mint or wintergreen. U.S. Smokeless Tobacco Manufacturing Co. LLC and U.S. Smokeless Tobacco Brands, Inc. filed suit in federal court on January 7, 2010, claiming that the local law is preempted by the FDA Tobacco Act and violates the Commerce Clause of the U.S. Constitution. Similar bills banning characterizing flavors in tobacco products are pending in other states.

 

Effective October 1, 2008, the San Francisco Board of Supervisors adopted a ban on the sale of tobacco products in some pharmacies. During 2009, the Boston Public Health Commission and the Massachusetts communities of Uxbridge and Needham instituted similar bans.

A price differential exists between cigarettes manufactured for sale abroad and cigarettes manufactured for sale in the United States. Consequently, a domestic gray market has developed in cigarettes manufactured for sale abroad, but instead diverted for domestic sales that compete with cigarettes that RJR Tobacco manufactures for domestic sale. The U.S. federal government and all states, except Massachusetts, have enacted legislation prohibiting the sale and distribution of gray market cigarettes. In addition, RJR Tobacco has taken legal action against distributors and retailers who engage in such practices.

 

RJR Tobacco expects to benefit from certain state legislative activity aimed at leveling the playing field between “original participating manufacturers” under the MSA and “nonparticipating manufacturers” under the MSA, referred to as NPMs. Forty-six states have passed legislation to ensure NPMs are making required escrow payments. Under this legislation, a state would only permit distribution of brands by manufacturers who are deemed by the states to be MSA-compliant. Failure to make escrow payments could result in the loss of an NPM’s ability to sell tobacco products in a respective state.

 

Additionally, 44 states have enacted legislation that closes a loophole in the MSA. The loophole allows NPMs that concentrate their sales in a single state, or a limited number of states, to recover most of the funds from their escrow accounts. To obtain the refunds, the manufacturers must establish that their escrow deposit was greater than the amount the state would have received had the manufacturer been a “subsequent participating manufacturer” under the MSA, that is, the state’s “allocable share.” The National Association of Attorneys General, referred to as NAAG, has endorsed adoption of the allocable share legislation needed to eliminate this loophole. Following a challenge by NPMs, the U.S. District Court for the Southern District of New York has issued an order enjoining New York from enforcing allocable share legislation. It is possible that NPMs will challenge allocable share legislation passed in other states.

 

Finally, four states, Alaska, Michigan, Minnesota and Utah, have enacted “equity assessments” on NPMs’ products. This legislative initiative has not been endorsed by NAAG, and one NPM has filed a challenge to the equity assessment in Michigan.

 

Forty-two states by statute or court rule have limited, and several additional states are considering limiting, the amount of the bonds required to file an appeal of an adverse judgment in state court. The limitation on the amount of such bonds generally ranges from $1 million to $150 million. Bonding statutes in 37 states allow defendants that are subject to large adverse judgments, such as cigarette manufacturers, to reasonably bond such judgments and pursue the appellate process. In five other states and Puerto Rico, the filing of a notice of appeal automatically stays the judgment of the trial court.

 

In 2003, the World Health Organization adopted a broad tobacco-control treaty. The treaty recommends and requires enactment of legislation establishing specific actions to prevent youth smoking, restrict and gradually eliminate tobacco products marketing, provide greater regulation and disclosure of ingredients, increase the size and scope of package warning labels to cover at least 30% of each package and include graphic pictures on packages. The treaty entered into force on February 27, 2005 — 90 days after ratification by the 40th country. In February 2006, the first session of the Conference of the Parties, referred to as the COP, occurred in Geneva, Switzerland. The COP, among other actions taken, established a permanent secretariat, adopted a budget, and created working groups to begin to develop protocols on cross-border advertising and illegal trade and guidelines on establishing smoke-free places and regulating tobacco products. Among the decisions taken at the COP’s second session, in July 2007, the COP adopted guidelines from the working group on the protection from exposure to tobacco smoke and called for an intergovernmental negotiating body to negotiate a protocol on illicit trade. At the COP’s third conference, in November 2008, the parties adopted guidelines with respect to various provisions of the tobacco control treaty, including the packaging and labeling of tobacco products. The fourth COP session is scheduled to be held in Uruguay in late 2010. Although the U.S. delegate to the World Health Organization voted for the treaty in May 2003, and the Secretary for Health and Human Services signed the document in May 2004, the Bush Administration did not send the treaty to the U.S. Senate for ratification. Ratification by the United States could lead to broader regulation of the industry.

It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict the effect of new legislation or regulations on RJR Tobacco or the cigarette industry in general, but any new legislation or regulations could have an adverse effect on RJR Tobacco or the cigarette industry in general. Similarly, it is not possible to determine what additional federal, state or local legislation or regulations relating to smokeless tobacco products will be enacted or to predict the effect of new regulation on Conwood or smokeless tobacco products in general, but any new legislation or regulations could have an adverse effect on Conwood or smokeless tobacco products in general.

 

Tobacco Buyout Legislation

 

For information relating to tobacco buyout legislation, see “— Tobacco Buyout Legislation and Related Litigation” in Item 8, note 14 to consolidated financial statements.

 

Other Contingencies

 

For information relating to other contingencies of RAI, RJR, RJR Tobacco and Conwood, see “— Other Contingencies” in Item 8, note 14 to consolidated financial statements.

 

Off-Balance Sheet Arrangements

 

RAI has no off-balance sheet arrangements that have or are reasonably likely to have a current or future material effect on its financial position, results of operations, liquidity, capital expenditures or capital resources.

 

Cautionary Information Regarding Forward-Looking Statements

 

Statements included in this report that are not historical in nature are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements regarding future events or the future performance or results of RAI and its subsidiaries inherently are subject to a variety of risks and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. These risks and uncertainties include:

 

 

 

Due to these uncertainties and risks, you are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. Except as provided by federal securities laws, RAI is not required to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

 

 

Market risk represents the risk of loss that may impact the consolidated results of operations, cash flows and financial position due to adverse changes in financial market prices and rates. RAI and its subsidiaries are exposed to interest rate risk directly related to their normal investing and funding activities. In addition, RAI and its subsidiaries have immaterial exposure to foreign currency exchange rate risk concerning investments in, or obligations for, and service agreements related to, foreign operations denominated in euros, British pounds, Swiss francs, Swedish krona, Chinese renminbi and Japanese yen. RAI and its subsidiaries have established policies and procedures to manage their exposure to market risks and use major institutions as counterparties to minimize their investment and credit risk. Frequently, these institutions are also members of the bank group that provide RAI credit, and management believes this further minimizes the risk of nonperformance. Derivative financial instruments are not used for trading or speculative purposes.

The table below provides information about RAI’s financial instruments, as of December 31, 2009, that are sensitive to changes in interest rates. The table presents notional amounts and weighted average interest rates by contractual maturity dates for the years ending December 31: