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, 2008

OR

c 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 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, 2008, was approximately $7.9 billion, based on the closing price of $46.67. 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: February 13, 2009: 291,458,868 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 23, 2009, are incorporated by reference into Part III of this report.

 

 

INDEX

 

 

 

Reynolds American Inc., referred to as RAI, is a holding company for 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, 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., formerly known as Brown & Williamson Tobacco Corporation and 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, and previous RJR stockholders exchanged their shares of RJR common stock for approximately 58% 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 after being acquired through an indirect subsidiary of BAT.

 

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.

 

On May 31, 2006, RAI, through its newly formed subsidiary, Conwood Holdings, Inc., completed its $3.5 billion acquisition of a group of smokeless tobacco companies collectively referred to as the Conwood companies. The acquisition was funded by RAI borrowings, new debt securities issued by RAI and available cash. The acquisition of the Conwood companies was treated as a purchase of the Conwood companies’ net assets by RAI for financial accounting purposes.

 

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.

 

Pursuant to requirements of the NYSE, in May 2008, the chief executive officer of RAI filed a form of Annual CEO Certification with the NYSE regarding RAI’s compliance with the NYSE’s corporate governance listing standards. In addition, RAI’s chief executive officer and chief financial officer have signed certifications required by the SEC regarding RAI’s public disclosures. These SEC certifications have been included as Exhibits 31.1 and 31.2 to this Form 10-K for the year ended December 31, 2008.

 

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. RAI’s wholly owned subsidiaries, Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe, and R. J. Reynolds Global Products, Inc., referred to as GPI, 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. Some of 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 20 to consolidated financial statements.

RAI Strategy

 

RAI’s strategy is focused on responding to a shift in consumer preferences by becoming a total tobacco company and competing through its operating subsidiaries in almost every category of tobacco products. RAI is also 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 certain 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, KOOL, PALL MALL, DORAL and WINSTON, were five of the ten best-selling brands of cigarettes in the United States as of December 31, 2008. 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, 2008, the contract manufacturing business of GPI was transferred to RJR Tobacco. 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 GPI.

 

RJR Tobacco primarily conducts its 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. Management Science Associates, Inc., referred to as MSAi, reported that U.S. cigarette shipments declined 3.3% in 2008, to 345.3 billion cigarettes, 5.0% in 2007 and 2.4% in 2006. From year to year, shipments are impacted by various factors including price 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.

 

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 are prohibited, subject to certain exceptions, from manufacturing and marketing certain tobacco products outside the United States until July 2009. The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to Japan Tobacco Inc., referred to as JTI. Therefore, RJR Tobacco is dependent on the U.S. cigarette market.

 

Expanding beyond the cigarette market as an innovative tobacco company, in 2006, RJR Tobacco entered into a category of smokeless, spitless, tobacco known as snus. CAMEL Snus is pasteurized tobacco that is sold in a small pouch that provides convenient tobacco consumption. CAMEL Snus was launched in lead markets beginning in 2006, and is being expanded nationally during the first quarter of 2009. In addition, during 2008, RJR Tobacco announced a new line of smoke-free tobacco products called CAMEL Dissolvables. CAMEL Dissolvables include CAMEL Orbs, Sticks and Strips, all of which are made of finely milled tobacco and dissolve completely in the mouth. CAMEL Dissolvables will be launched in lead markets beginning in the first half of 2009.

 

Competition

 

RJR Tobacco’s primary competitors include Philip Morris USA Inc. and Lorillard Tobacco Company, 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, which with other state settlement agreements are collectively referred to as the MSA, and accordingly, do not have cost structures burdened with MSA-related payments to the same extent as the original participating manufacturers. For further discussion of the MSA, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA” in note 16 to

consolidated financial statements in Item 8 and “— Critical Accounting Policies and Estimates” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

 

Based on data collected by Information Resources Inc./Capstone Research, Inc., referred to as IRI, during 2008, 2007 and 2006, Philip Morris USA Inc. had an overall retail share of the U.S. cigarette market of 51.2%, 51.1% and 50.8%, respectively. During these same years, RJR Tobacco had an overall share of 28.1%, 29.0% and 29.8%, respectively.

 

Domestic shipment volume and retail share of market data that appear in this document have been obtained from MSAi and IRI, 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 as being precise measurements of actual market share because IRI is not able to effectively track the volume of all cigarette brands. RJR Tobacco believes that deep-discount brands made by small manufacturers have combined shipments of approximately 14% of total U.S. industry shipments. Accordingly, the retail share of market of RJR Tobacco and its brands as reported by IRI 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 merchandising 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 new smokeless tobacco categories, such as moist snuff and snus, as well as finding efficient and effective means of balancing market share and profit growth. For example, in January 2009, Altria Group Inc., the parent company of Phillip Morris USA Inc., completed its acquisition of UST Inc., the largest smokeless tobacco products manufacturer in the United States.

 

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 buydowns, periodic price reductions, 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. Free product promotions include offers such as “Buy 2 packs, Get 1 pack free.” The cost of free product promotions, including federal excise tax, is recorded in cost of goods sold.

 

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 brand portfolio strategy is based upon three brand categories: growth, support and non-support. During 2008, RJR Tobacco refined its brand portfolio and reclassified KOOL from a growth brand to a support brand. As a result, 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, KOOL, WINSTON, 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.

Anti-tobacco groups have attempted to restrict cigarette sales, cigarette advertising, and the testing and introduction of new tobacco products, and have encouraged smoking bans. The MSA and federal, state and local laws restrict or prohibit utilization of television, radio or billboard advertising or certain other marketing and promotional tools for cigarettes and smokeless tobacco products. RJR Tobacco continues to use direct mailings and other means to market its brands and enhance their appeal among age-verified adult smokers. RJR Tobacco continues to advertise and promote at retail cigarette locations and in adult venues where permitted. RJR Tobacco suspended the use of print advertising for cigarettes in newspapers and consumer magazines in the U.S. during 2008, and is not planning to resume this type of advertising for cigarettes during 2009. RJR Tobacco is planning to use print advertising for CAMEL Snus and CAMEL Dissolvables in 2009.

 

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 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, 2008 or 2007.

 

Sales made by RJR Tobacco to McLane Company, Inc., a distributor, comprised 31%, 30% and 29% of RJR Tobacco’s revenue in 2008, 2007 and 2006, respectively. No other customer accounted for 10% or more of RAI’s consolidated revenue during those years. RJR Tobacco believes that its relationship with McLane is good. RJR Tobacco’s sales to McLane are not governed by any written supply contract; however, McLane and RJR Tobacco are parties to an arrangement, whereby RJR Tobacco observes and manages its supply and level of McLane’s inventory.

 

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 to BAT affiliates, primarily cigarettes, represented approximately 5.0% of RAI’s total net sales in 2008 and approximately 6.0% in each of 2007 and 2006.

 

Raw Materials

 

In its production of tobacco products, RJR Tobacco uses U.S. and foreign, primarily Brazilian and Thai, burley and flue-cured leaf tobaccos, as well as Oriental tobaccos grown primarily in Turkey 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 brands include its largest selling moist snuff brands, GRIZZLY and KODIAK, two of the seven best-selling brands of moist snuff in the United States as of December 31, 2008. Conwood’s other products include loose leaf chewing tobacco, dry snuff, plug and twist tobacco products, which held the first or second position in market share in each category as of December 31, 2008. In addition, 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.

 

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 product innovation.

 

In contrast to the declining U.S. cigarette market, U.S. moist snuff volumes grew over 7% in 2008 and have grown at an average rate of approximately 6% per year over the last four years, 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.

 

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 66% of Conwood’s revenue in 2008 and approximately 60% in 2007. Conwood offers KODIAK in the premium brand category and GRIZZLY in the price-value brand category. Conwood’s U.S. moist snuff market share was 27.7% in 2008, 26.0% in 2007 and 25.1% in 2006 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 brand moist snuff had a 23.3% market share in 2008, 21.1% market share in 2007 and 19.4% market share in 2006.

 

Competition

 

Conwood is dependent on the U.S. smokeless tobacco market, where competition is significant. Conwood’s largest competitor is UST Inc., which had approximately 58.1% of the moist snuff market share in 2008, 60.6% in 2007 and 62.8% in 2006. The parent company of RJR Tobacco’s largest competitor in the cigarette market, Philip Morris USA Inc., completed its acquisition of UST Inc. in January 2009. Conwood also competes in the U.S. smokeless tobacco market with other domestic and international companies.

 

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.

 

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 Wintergreen Pouches, moist snuff in a fleece pouch, and GRIZZLY Snuff, a traditional moist snuff style with an ultra-fine cut. GRIZZLY Pouches provide pre-measured portions that are more convenient than traditional, loose moist snuff. Pouches represented approximately 6% of the total moist snuff market as of December 31, 2008, and demand continues to grow.

 

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 foil pouch for chewing tobacco and a plastic can for moist snuff.

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; Sanford, North Carolina; and Springfield, Tennessee. Conwood owns all of its facilities. Conwood sells its products primarily to distributors, wholesalers and other direct customers, some of which are retail chains.

 

Sales made by Conwood to McLane Company, Inc. comprised 17% of Conwood’s consolidated revenue for 2008, 16% in 2007 and 17% in 2006. No other customer accounted for 10% or more of RAI’s consolidated revenue during those periods. Conwood believes that its relationship with McLane is good. Conwood’s sales to McLane are not governed by any written supply contract. No significant backlog of orders existed at December 31, 2008 or 2007.

 

Raw Materials

 

In its production of moist snuff and chewing tobacco, 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. flue-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

 

RAI’s wholly owned operating subsidiary, Santa Fe, manufactures and markets cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand. On January 1, 2008, the management of RJR Tobacco’s super premium brands, including those licensed from BAT, including DUNHILL and STATE EXPRESS 555, was transferred to Santa Fe.

 

During 2005, GPI acquired from JTI, its U.S. duty-free and U.S. overseas military businesses relating to certain brands. These rights were sold to JTI in 1999 as a part of the sale of RJR’s international tobacco business. During 2008, GPI sold NATURAL AMERICAN SPIRIT in Europe and Japan, as well as exported tobacco products to U.S. territories, U.S. duty-free shops and U.S. overseas military bases. 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 other indirect subsidiaries of RAI began selling NATURAL AMERICAN SPIRIT in Europe and Japan.

 

Sales to Foreign Countries

 

RAI’s operating subsidiaries’ sales to foreign countries, primarily to related parties, for the years ended December 31, 2008, 2007 and 2006 were $602 million, $600 million and $578 million, respectively.

 

Raw Materials

 

In 2004, the President signed legislation 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 $2.4 billion to $2.8 billion prior to the deduction of permitted offsets under the MSA.

Research and Development

 

RAI’s operating subsidiaries’ research and development expense for the years ended December 31, 2008, 2007 and 2006, was $59 million, $57 million and $58 million, respectively. The primary research and development activities of the operating subsidiaries are conducted at RJR Tobacco’s Whitaker Park complex. Scientists and engineers at this facility continue to work to create more efficient methods of preparing tobacco blends, as well as develop product enhancements, new products and packaging innovations. A focus for research and development activity is the development of potentially reduced exposure products, which ultimately may be recognized as products that present reduced risks to health.

 

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.

 

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 likely will consider legislation regarding the regulation of the manufacture and sale of tobacco products by the FDA. 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 likely will 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. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 16 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.

 

Employees

 

At December 31, 2008, RAI and its subsidiaries had approximately 6,600 full-time employees and approximately 300 part-time employees. The 6,600 full-time employees include approximately 4,800 RJR Tobacco employees and 1,100 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 of 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, alleging that the use of the terms “lights” and “ultra lights” constitutes unfair and deceptive trade practices. Many of these “lights” cases were stayed pending review of the Good v. Altria Group, Inc. case by the U.S. Supreme Court. On December 15, 2008, the U.S. Supreme Court decided that these claims are not preempted by the Federal Cigarette Labeling and Advertising Act or by the U.S. Federal Trade Commission’s, referred to as FTC, historic regulation of the industry. In light of this decision, it is likely that the stayed cases will be activated, additional cases may go to trial, new cases will be filed and defense costs will increase. 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 16 to consolidated financial statements.

 

In addition, in Engle v. R.J. Reynolds Tobacco Co., et al. (Circuit Court, Dade County, Florida, filed May 5, 1994), 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. Although the final number of Engle Progeny Cases is not yet known, RJR Tobacco has been served in 3,156 cases on behalf of approximately 8,808 plaintiffs. The Engle Progeny Cases will result in increased litigation activity, including an increased number of trials in 2009, and increased expenses. For a more complete description of the Engle Progeny cases, see “— Engle Progeny Cases” in Item 8, note 16 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 16 to consolidated financial statements.

 

As a result of the order issued in a case brought by the U.S. Department of Justice, RJR Tobacco could be subject to additional, substantial marketing restrictions, which would negatively impact revenue, increase related compliance costs and reduce operating margins 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 the government contends were 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. Oral argument occurred on October 14, 2008. A decision is pending. RJR Tobacco does not know the timing of an appellate decision or, if the order is affirmed, the compliance deadlines that will be imposed. 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.

 

For a more complete description of this case, see “— Health-Care Cost Recovery Cases — Department of Justice Case” in Item 8, note 16 to consolidated financial statements.

 

RJR Tobacco’s overall retail market share of cigarettes has declined in recent years and is expected to 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 RJR Tobacco expects this market share to continue to decline. According to data from IRI, RJR Tobacco’s share of the U.S. cigarette retail market declined to 28.1% in 2008 from 29.0% in 2007, continuing a trend in effect for several years. If RJR Tobacco’s growth brands do not continue to grow 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 require or cause RJR Tobacco to introduce new alternative tobacco products. Consumer acceptance of new products, such as CAMEL Snus or CAMEL Dissolvables, may not be achieved. 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. 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 are prohibited, subject to certain exceptions, from manufacturing and marketing certain tobacco products outside the United States until July 2009. 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.

 

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 24% of total RJR Tobacco cigarette production in 2008. These contract manufacturing agreements may expire at the end of 2014. If BAT’s contracts are not renewed or extended, RJR Tobacco’s revenue, operating income and cash flows will be unfavorably impacted.

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 may be imposed legislatively or agreed to in the future. Recent proposals have included limiting tobacco advertising to black-and-white, text-only advertisements. Similar to the potential U.S. Food and Drug Administration, referred to as the FDA, restrictions described below, these limitations may make it difficult to maintain the value of existing brands or brand styles, and could significantly impair the ability of RAI’s operating subsidiaries to launch new brand styles.

 

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 an increase of $0.62 in the federal excise tax per pack of cigarettes, for a total of $1.01 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. These tax increases are effective on April 1, 2009.

 

Under the SCHIP, the tax rate for chewing tobacco will increase $0.3083 per pound to $0.5033 per pound and will increase $0.925 per pound to $1.51 per pound for snuff. The federal tax on small cigars, defined as those weighing three pounds or less per thousand, will increase $48.502 per thousand to $50.33 per thousand. Large cigars currently are taxed at a rate of 20.719% of the manufacturer’s price, with a cap of $48.75 per thousand. Under the SCHIP, the rate on large cigars will increase to 52.75% of the manufacturer’s price with a maximum rate of $0.4026 per cigar. In addition, the tax rate for roll-your-own tobacco will increase from $1.097 per pound to $24.78 per pound.

 

The increases in federal excise tax under the SCHIP are substantial, and, as a result, RAI expects its operating subsidiaries’ volume will be adversely impacted beginning in the second quarter of 2009.

 

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.

 

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

 

A bill that would grant the FDA, authority to regulate tobacco products was introduced in Congress in February 2007. On July 30, 2008, the U.S. House of Representatives passed the bill by a vote of 326-102. The U.S. Senate Health, Education, Labor and Pensions Committee approved the FDA regulation bill on August 1, 2007, but the Senate adjourned in 2008 without any further action on the bill. In 2009, it is likely that Congress will again take up the issue of FDA regulation of tobacco products.

It is anticipated that any proposed FDA regulation bill most likely would:

 

 

It is possible that such additional regulation 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 which may have a material adverse effect on RAI’s results of operations, cash flows and financial condition. RAI believes that such regulation may adversely affect the ability of its operating subsidiaries to compete against its larger competitors, including Philip Morris USA, Inc., who may be able to more quickly and cost-effectively comply with these new rules and regulations.

 

Over the years, various state and local governments have continued to regulate tobacco products, including smokeless tobacco products. These regulations relate to, among other things, the imposition of significantly higher taxes, increases in the minimum age to purchase tobacco products, sampling and advertising bans or restrictions, ingredient and constituent disclosure requirements and significant tobacco control media campaigns. Additional state and local legislative and regulatory actions will likely be considered in the future, including, among other things, restrictions on the use of flavorings.

 

Additional federal or state regulation relating to the manufacture, sale, distribution, advertising, labeling, mandatory ingredients disclosure and nicotine yield information disclosure of tobacco products could reduce sales, increase costs and have a material adverse effect on the business of the operating subsidiaries of RAI.

 

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.

 

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 MSA 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 MSA, see “— Health-Care Recovery Cases — MSA” in Item 8, note 16 to consolidated financial statements.

 

Conwood’s largest competitor, UST Inc., was acquired by the parent company of Philip Morris USA, Inc. in January 2009. This acquisition of UST Inc. may change the competitive dynamics by combining pricing and merchandising display for cigarettes and smokeless tobacco products. Pricing pressure and limited merchandising

display 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 or goodwill due to impairment, thus reducing operating profit.

 

RAI conducts an impairment review of goodwill and intangible assets at least once a year, or more often if events or changes in circumstances indicate that the carrying value of the goodwill or intangible asset may not be recoverable. During 2008, RJR Tobacco repositioned its KOOL brand as a support brand from a growth brand, which resulted in an impairment charge of $173 million and an additional $3 million impairment charge was incurred during the annual testing of RJR Tobacco’s brands. Conwood recorded an impairment of $142 million related to KODIAK, as well as multiple loose leaf and little cigar brands, as a result of annual impairment testing. For more information on intangible asset impairment, see Item 8, note 3 to consolidated financial statements.

 

In addition, the recent passage of the SCHIP increases the federal excise tax on cigarettes by $0.62 per pack and significantly increases the federal tax on other tobacco products. These tax increases are effective April 1, 2009, and RAI’s operating subsidiaries expect the tax increases to significantly and adversely impact sales volume. RAI’s operating subsidiaries believe that the federal excise tax increase is an event that will require that their goodwill and trademarks be tested for impairment during the first quarter of 2009, and the resulting fair value of certain of their trademarks could be less than their carrying value. In particular, RJR Tobacco believes that impairment charges related to support and non-support cigarette brands are possible, and Conwood also believes that impairment charges related to certain brands are possible. No reasonable estimate of trademark impairment charges can be made at this time by RAI’s operating subsidiaries.

 

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

 

Changes in financial market conditions could negatively impact RAI’s foreign currency exchange rate risk, interest rate risk and the return on corporate cash, thus increasing costs and reducing profitability. During 2008, adverse conditions in the financial markets forced RAI to invest 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.

 

Continued 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. During 2008, RAI recorded $35 million of impairment losses from declines in the value of short-term and long-term investments. As of December 31, 2008, $69 million of unrealized losses remain in other comprehensive income (loss). For more information on investment losses, see Item 8, note 9 to consolidated financial statements.

 

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

 

During 2008, Lehman Commercial Paper Inc., referred to as LCPI, filed for protection under Chapter 11 of the federal Bankruptcy Code. LCPI is a lender in RAI’s Fifth Amended and Restated Credit Agreement, which as subsequently amended, is referred to as the Credit Facility. There can be no assurance that LCPI would loan LCPI’s pro rata share of any borrowing requests made by RAI. 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.

 

In addition, the adverse conditions in the financial markets during 2008, caused RAI to invest primarily in Treasury money market funds. If there were a high demand for cash from the Treasury money market funds, restrictions could be placed on the funds, preventing immediate withdrawal and RAI’s access to needed cash.

Increases in the cost of pension benefits 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. Due to adverse changes in the financial markets, RAI’s rate of return in 2008 on pension assets was negative 30.1%. This unfavorable return, along with an unfavorable discount rate, will increase RAI’s required pension funding for 2009 to a minimum of $50 million and increase pension expense approximately $180 million in 2009. RAI actively seeks to control increases in pension costs, 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.

 

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 either outsourced or is in the process of outsourcing many of its non-core business processes. Non-core business process functions include, but are not limited 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 29% of RAI’s consolidated revenues in 2008. 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 13 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 has debt of $4.5 billion:

 

 

It is likely that RAI will refinance, or attempt to refinance, a significant portion of this indebtedness prior to its 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 13 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 13 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’s 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 the Conwood companies’ manufacturing facilities are located in Memphis, Tennessee; Clarksville, Tennessee; Winston-Salem, North Carolina; Bowling Green, Kentucky; Sanford, North Carolina; and Springfield, Tennessee. 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.

 

 

See Item 8, note 16 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, 50, 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. 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. of Winston-Salem and Salem College.

 

Thomas R. Adams.  Mr. Adams, 58, was named Executive Vice President and Chief Financial Officer of RAI in January 2008, after having served as Senior Vice President and Chief Accounting Officer of RAI since March 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 Technology Concepts & Design, Inc., 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, 48, was named Executive Vice President — Human Resources of RAI and RJR Tobacco in 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 board of trustees of Winston-Salem State University and the University of North Carolina Board of Visitors.

 

Daniel (Daan) M. Delen.  Mr. Delen, 43, 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.

 

Daniel A. Fawley.  Mr. Fawley, 51, has served as Senior Vice President and Treasurer of RAI, RJR Tobacco and RJR since September 2004. 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 Trustees of the Arts Council Endowment Fund, Inc.

 

McDara P. Folan, III.  Mr. Folan, 50, has been Senior Vice President, Deputy General Counsel and Secretary of RAI since July 2004. 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 Chairman of the board of trustees of the Arts Council of Winston-Salem and Forsyth County and a member of the board of trustees of the Arts Council Endowment Fund, Inc.

 

Jeffery S. Gentry.  Dr. Gentry, 51, was named RAI Group Executive Vice President in April 1, 2008. 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.

 

E. Julia (Judy) Lambeth.  Ms. Lambeth, 57, joined RAI as Executive Vice President — Corporate Affairs, General Counsel and Assistant Secretary in September 2006. 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 the Winston-Salem Symphony.

 

Tommy J. Payne.  Mr. Payne, 51, has been Executive Vice President — Public Affairs of RAI, after having been 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. 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, 45, was named Senior Vice President and Chief Accounting Officer of RAI in January 2008, after having 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 CEO 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.

 

E. Kenan Whitehurst.  Mr. Whitehurst, 52, 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 and other key employees are set forth below:

 

Nicholas Bumbacco.  Mr. Bumbacco, 44, will become President and Chief Executive Officer of Santa Fe effective March 1, 2009. Previously he served as President of GPI from September 2007 until March 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.

 

William M. Rosson.  Mr. Rosson, 60, was President and Chief Executive Officer of Conwood Company, LLC from January 2005 until February 1, 2009. Mr. Rosson will remain an employee of Conwood Company, LLC in an advisory capacity until his retirement later in 2009. From 2001 until January 2005, Mr. Rosson served as Vice President of Administration of Conwood Company, LLC. Prior to 2001, Mr. Rosson held a number of positions at the Conwood companies since joining them in 1975.

 

Richard M. Sanders.  Mr. Sanders, 55, has been President and Chief Executive Officer of Santa Fe since RJR’s acquisition of Santa Fe in January 2002, and plans to resign from this position on March 1, 2009. Mr. Sanders will remain an employee of Santa Fe in an advisory capacity until his retirement later in 2009. From December 1999 until January 2002, he served as Senior Vice President — Marketing of RJR Tobacco while continuing his role as President — Sports Marketing Enterprises, a former division of RJR Tobacco. He is Chairman of the board of directors of the Santa Fe Natural Tobacco Company Foundation, Vice-Chair of the board of directors of Santa Fe Economic Development, Inc., Chair of Santa Fe Future and a board member of Minnesota Resources.

 

Bryan K. Stockdale.  Mr. Stockdale, 50, was named President and Chief Executive Officer of Conwood Company, LLC effective February 1, 2009. He was previously 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’s common stock, par value $.0001 per share, is listed on the NYSE under the trading symbol “RAI.” On February 13, 2009, there were approximately 18,100 holders of record of RAI’s 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’s common stock on February 13, 2009, was $37.76 per share.

 

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

 

 

On February 3, 2009, the board of directors of RAI declared a quarterly cash dividend of $0.85, or $3.40 on an annualized basis, per common share. The dividends will be paid on April 1, 2009, to shareholders of record as of March 10, 2009.

 

The dividends reflect the stated policy of paying dividends to the holders of RAI’s 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 certain option exercises and vesting of restricted stock grants under the RAI Long-Term Incentive Plan, referred to as the LTIP. On February 5, 2008, the board of directors of RAI authorized the repurchase of up to $30 million of outstanding shares of RAI common stock to offset the dilution from shares issued under certain equity-based benefit plans. This $30 million repurchase program was superseded on April 29, 2008, when 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. The repurchases are subject to prevailing market and business conditions, and the program may be terminated or suspended at any time. In connection with the share repurchase program, RAI and B&W entered into an agreement, pursuant to which B&W has agreed to participate in the repurchase program on a basis approximately proportionate with B&W’s 42% ownership of RAI’s common stock.

 

During 2008, RAI repurchased and cancelled 3,817,095 shares of RAI common stock for $207 million under the above share repurchase programs. To preserve liquidity, RAI did not make any stock purchases under the repurchase program in the fourth quarter of 2008.

Additionally during 2008, at a cost of $3 million, RAI purchased 57,223 shares that were forfeited with respect to tax liabilities associated with restricted stock vesting under its LTIP.

 

The following table summarizes RAI’s purchases of its common stock during the fourth quarter of 2008:

 

 

For equity-based benefit plan information, see Item 8, note 18 to consolidated financial statements.

Performance Graph

 

Set forth below is a line graph comparing, for the period which commenced on July 30, 2004, and ended on December 31, 2008, 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 53 MONTH CUMULATIVE TOTAL RETURN(1)

Among Reynolds American Inc. Common Stock, the S&P 500 Index

and the S&P Tobacco Index

 

 

 

 

 

 

The selected historical consolidated financial data as of December 31, 2008 and 2007, and for each of the years in the three-year period ended December 31, 2008, 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, 2006, 2005 and 2004, and for the years ended December 31, 2005 and 2004, are derived from audited consolidated financial statements not presented or incorporated by reference. The consolidated financial statements of RAI include the results of RJR through July 30, 2004, and of RAI from July 30, 2004 through December 31, 2008, including the acquired operations of B&W and Lane subsequent to July 30, 2004, and 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, 2008 compared with 2007, and 2007 compared with 2006. 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, 2008 and 2007, and for each of the years in the three-year period ended December 31, 2008.

 

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. RAI’s wholly owned subsidiaries, Santa Fe and GPI, among others, are included in All Other. Some of 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, KOOL, PALL MALL, DORAL and WINSTON, were five of the ten best-selling brands of cigarettes in the United States as of December 31, 2008. 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. As of January 1, 2008, the contract manufacturing business of GPI was transferred to RJR Tobacco.

 

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 and KODIAK, two of the seven best-selling brands of moist snuff in the United States as of December 31, 2008. Conwood’s other products include loose leaf chewing tobacco, dry snuff, plug and twist tobacco products. Conwood’s products held the first or second position in market share in each category as of December 31, 2008. As a result of combining certain operations of Lane with the Conwood companies in 2007, Conwood began distributing 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. On January 1, 2008, the management of RJR Tobacco’s super premium brands, including those licensed from BAT, including DUNHILL and STATE EXPRESS 555, was transferred to Santa Fe. During 2008, GPI sold NATURAL AMERICAN SPIRIT in Europe and Japan, as well as exported tobacco products to U.S. territories, U.S. duty-free shops and U.S. overseas military bases. 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 other indirect subsidiaries of RAI began selling NATURAL AMERICAN SPIRIT in Europe and Japan.

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. Trade inventory adjustments may result in short-term changes in demand for RJR Tobacco’s products when wholesale and retail tobacco distributors adjust the timing of their purchases of product to manage their inventory levels. RJR Tobacco believes it is not appropriate for it to speculate on other external factors that may impact the purchasing decisions of the wholesale and retail tobacco distributors.

 

RJR Tobacco’s brand portfolio strategy is based upon three brand categories: growth, support and non-support. During 2008, RJR Tobacco refined its brand portfolio strategy and reclassified KOOL from a growth brand to a support brand. As a result, 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, KOOL, WINSTON, 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.

 

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. Expanding beyond the cigarette market as an innovative tobacco company, in 2006, RJR Tobacco entered into a category of smokeless, spitless tobacco, known as snus. CAMEL Snus is pasteurized tobacco that is sold in a small pouch that provides convenient tobacco consumption. CAMEL Snus was launched in lead markets beginning in 2006, and is being expanded nationally during the first quarter of 2009. In addition, during 2008, RJR Tobacco announced new smoke-free tobacco products called CAMEL Dissolvables. CAMEL Dissolvables include CAMEL Orbs, Sticks and Strips, all of which are made of finely milled tobacco and dissolve completely in the mouth. CAMEL Dissolvables will be launched in lead markets beginning in the first half of 2009.

 

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 buydowns, periodic price reductions, 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. Free product promotions include offers such as “Buy 2 packs, Get 1 pack free.” The cost of free product promotions, including federal excise tax, is recorded in cost of goods sold.

 

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 7% in 2008 and have grown at an average rate of approximately 6% per year over the last four years, 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.

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, UST, 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 16 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 February 6, 2009, RJR Tobacco had paid approximately $12 million since January 1, 2006, 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. 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.

 

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 16 to consolidated financial statements.

 

Settlement Agreements

 

RJR Tobacco, Santa Fe and Lane are participants in the Master Settlement Agreement, 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 MSA 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 MSA. For more information related to historical and expected settlement expenses and payments under the MSA, see “— Litigation Affecting the Cigarette Industry— Health-Care Cost Recovery Cases — MSA” and “— MSA — Enforcement and Validity” in Item 8, note 16 to consolidated financial statements.

 

Intangible Assets

 

Intangible assets include goodwill, trademarks and other intangibles and are accounted for under Statement of Financial Accounting Standards, referred to as SFAS, No. 142, “Goodwill and Other Intangible Assets.” The determination of fair value involves considerable estimates and judgment. In particular, the fair value of a reporting unit involves, among other things, developing forecasts of future cash flows, determining an appropriate discount rate, and when goodwill impairment is implied, determining the fair values of individual assets and liabilities, including unrecorded intangibles. Although RAI believes it has based its impairment testing and impairment charges on reasonable estimates and assumptions, the use of different estimates and assumptions could result in materially different results. Generally, if the current competitive or regulatory environment worsens or RAI’s operating companies’ strategic initiatives adversely affect their financial performance, the fair value of goodwill, trademarks and other intangibles could be impaired in future periods. See Item 8, note 3 to consolidated financial statements for a discussion of the impairment charges in connection with RAI’s ongoing application of SFAS No. 142.

 

Fair Value Measurement

 

On January 1, 2008, RAI adopted SFAS No. 157, “Fair Value Measurements,” for financial assets and financial liabilities. SFAS No. 157 provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 establishes 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.

 

On October 10, 2008, the Financial Accounting Standards Board, referred to as FASB, issued FASB Staff Position, referred to as FSP, No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” FSP No. FAS 157-3 clarifies the application of SFAS No. 157, “Fair Value Measurements,” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active.

 

SFAS No. 157 defines fair value as 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 established by SFAS No. 157 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

 

As of December 31, 2008, RAI held investments primarily in money market funds, auction rate securities and mortgage-backed securities. During 2008, certain money market funds were reclassified to short-term investments from cash equivalents due to the liquidity restrictions by the fund managers preventing immediate withdrawal. Adverse changes in financial markets caused certain auction rate securities and mortgage-backed securities to

revalue lower than carrying value and become less liquid. Auction rate securities and mortgage-backed securities will not become liquid until a successful auction occurs or a buyer is found. These investments will be evaluated on a quarterly basis to determine if it is probable that RAI will realize some portion of the unrealized loss.

 

RAI reviews impairments associated with the above in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” FSP No. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” and FSP No. EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20,” to determine the classification of the impairment as temporary or other-than-temporary. For additional information relating to these investments, see Item 8, note 9 to consolidated financial statements.

 

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 19 to consolidated financial statements.

 

Pension and postretirement expenses and reporting are determined in accordance with the provisions of SFAS No. 87, “Employers’ Accounting for Pensions,” SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions” and SFAS No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans-an amendment of FASB Statements No. 87, 88, 106, and 132(R).” 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, as described in SFAS No. 87, 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, as described in SFAS No. 106, 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 have resulted in an increase in charges to other comprehensive income (loss). 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 under SFAS No. 109, “Accounting for Income Taxes.” These differences may be permanent or temporary in nature. FASB Interpretation, referred to as FIN, No. 48, “Accounting for Uncertainty in Income Taxes,” clarifies SFAS No. 109 by providing guidance for consistent reporting of uncertain income tax positions recognized in a company’s financial statements.

 

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 as required under SFAS No. 109. 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 sheets will be realized. To the extent a deferred tax liability is established under SFAS No. 109, 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

 

Effective January 1, 2008, RAI adopted SFAS No. 157, “Fair Value Measurements,” for financial assets and financial liabilities. SFAS No. 157 does not require any new fair value measurements but provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. SFAS No. 157 also establishes a fair value hierarchy that distinguishes between independent and observable inputs and unobservable inputs based on the best information available. The adoption of SFAS No. 157 on financial assets and financial liabilities did not have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

 

In February 2008, the FASB issued FSP No. 157-2, “Effective Date of FASB Statement No. 157,” to allow entities to electively defer the effective date of SFAS No. 157 for nonfinancial assets and liabilities, except for those items recognized or disclosed at fair value on an annual or more frequently recurring basis, until fiscal years

beginning after November 15, 2008. RAI elected to defer SFAS No. 157 for nonfinancial assets and nonfinancial liabilities to be effective as of January 1, 2009. For RAI, the deferral primarily applies to (1) nonfinancial assets and liabilities initially measured at fair value in business combinations; (2) reporting units or nonfinancial assets and liabilities measured at fair value in conjunction with goodwill, trademark and other intangible impairment testing; (3) other nonfinancial assets measured at fair value in conjunction with impairment assessments; and (4) asset retirement obligations initially measured at fair value. RAI believes that the fair value measurements made in these circumstances would not necessarily be different from those that would be made had the provision of SFAS No. 157 been applied, and therefore the impact of the adoption of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities is not expected to have a material impact on RAI’s consolidated results of operations, cash flows or financial position.

 

On October 10, 2008, the FASB, issued FSP No. FAS 157-3, “Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active.” FSP No. FAS 157-3 clarifies the application of SFAS No. 157, “Fair Value Measurements,” in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP No. FAS 157-3 is effective immediately, including prior periods for which financial statements had not been issued. RAI adopted FSP No. FAS 157-3 effective with the financial statements ended September 30, 2008. The adoption of FSP No. FAS 157-3 had no impact on RAI’s consolidated results of operations, cash flows or financial position.

 

On January 13, 2009, the FASB issued FSP No. EITF 99-20-1, “Amendments to the Impairment Guidance of EITF Issue No. 99-20.” FSP No. EITF 99-20-1 provides a more consistent determination of whether an other-than-temporary impairment, referred to as OTTI, has occurred and retains and emphasizes the OTTI guidance and required disclosures in SFAS No. 115, and FSP No. FAS 115-1 and FAS 124-1. RAI adopted FSP No. EITF 99-20-1 effective for periods ending after December 15, 2008.

 

Recently Issued Accounting Pronouncements

 

In March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133.” SFAS No. 161 seeks qualitative disclosures about the objectives and strategies for using derivatives, quantitative data about the fair value of and gains and losses on derivative contracts, and details of credit-risk-related contingent features in hedged positions. SFAS No. 161 also seeks enhanced disclosure around derivative instruments in financial statements, accounted for under SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” and how hedges affect an entity’s financial position, financial performance and cash flows. SFAS No. 161 is effective for RAI as of January 1, 2009, and is not expected to impact results of operations, cash flows or financial position.

 

In April 2008, the FASB issued FSP No. FAS 142-3, “Determination of the Useful Life of Intangible Assets.” FSP No. FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, “Goodwill and Other Intangible Assets.” The objective of FSP No. FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) and GAAP. FSP No. FAS 142-3 is effective for financial statements issued for years beginning after December 15, 2008, and interim periods within those years and is applied prospectively to intangible assets acquired after the effective date. The adoption of FSP No. FAS 142-3 will require additional disclosure regarding renewal or extension assumptions and will not have a material impact on RAI’s results of operations, cash flows or financial position.

 

On December 30, 2008, the FASB issued FSP No. FAS 132(R)-1, “Employers’ Disclosures about Postretirement Benefit Plan Assets.” FSP No. FAS 132(R)-1 amends SFAS No. 132(R), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” to provide guidance on an employer’s disclosures about plan assets of a defined benefit pension or other postretirement plan. The disclosures about plan assets required by FSP No. FAS 132(R)-1 are to be provided for fiscal years ending after December 15, 2009. The adoption of FSP No. FAS 132(R)-1 in 2009 will not have an impact on RAI’s results of operations, cash flows or financial position.

Results of Operations

 

2008 Compared with 2007

 

 

 

 

 

 

In the third quarter of 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 will result in the elimination of approximately 600 full-time jobs, expected to be 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. Cost savings related to the restructuring are expected to be $42 million in 2009, $53 million in 2010 and $55 million on an annualized basis thereafter.

RJR Tobacco

 

Net Sales

 

Domestic 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 shipment volume in a declining market, premium versus value-brand mix and list pricing, offset by promotional spending, trade incentives and federal excise taxes. 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 3.4%, 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, 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 is an innovative cigarette that uses RJR Tobacco’s technology to provide adult smokers the option of changing each cigarette from regular to menthol by crushing a capsule in the filter. CAMEL Crush was expanded nationally during the third quarter of 2008 and had a market share of 0.74 share points in the fourth quarter of 2008. As a result of repositioning KOOL to a support brand, RJR Tobacco is shifting focus to CAMEL’s menthol styles as the key driver in the growing menthol category.

 

CAMEL Snus expanded into a total of 17 markets in 2008 and is planning to expand nationally in the first quarter of 2009. Additionally, in October 2008, RJR Tobacco introduced new smoke-free tobacco products called CAMEL Dissolvables that include CAMEL Orbs, Sticks and Strips. CAMEL Dissolvables are made of finely milled tobacco, and dissolve completely in the mouth. They are designed to provide current adult smokers and smokeless tobacco users with additional, convenient, alternative ways to enjoy tobacco products. CAMEL Dissolvables are being launched in three lead markets beginning in the first half of 2009.

 

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 $184 million to $1,756 million, or 22.9% of net sales, from $1,940 million, or 24.4% of net sales, for the year ended December 31, 2007. 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 all brand trademarks. 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%. The discount rate was determined by adjusting the enterprise discount rate by an appropriate risk premium to reflect an asset group risk.

 

In addition, RJR Tobacco incurred a restructuring charge of $81 million in the second half of 2008 as a result of streamlining non-core business processes and programs and eliminating approximately 540 full-time positions. 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 MSA settlement and federal tobacco buyout expenses, included in cost of products sold, are detailed in the schedule below:

 

 

MSA settlement expenses are expected to be approximately $2.6 billion in 2009, 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 $240 million in 2009. For additional information, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA” in Item 8, note 16 to consolidated financial statements and “— Governmental Activity” 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.

 

“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 16 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 16 to consolidated financial statements for

detailed information regarding the number and nature of cases in trial and scheduled for trial through December 31, 2009.

 

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 RJR Tobacco’s experience in defending its product liability cases and the reasonably anticipated level of activity in RJR Tobacco’s pending cases and possible new cases, RJR Tobacco anticipates that its product liability defense costs will increase 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 16 to consolidated financial statements for additional information. However, 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⁾:

 

 

 

 

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 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 27.7% 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.

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⁾:

 

 

 

 

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, Conwood’s leading price-value moist snuff brand.

 

GRIZZLY had a 23.3% 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. Building on its pouch success, GRIZZLY is launching mint and straight styles in the first quarter of 2009.

 

The shipment share of KODIAK, Conwood’s leading premium moist snuff brand, 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, or 32.1% of net sales, from $312 million, or 46.5% of net sales 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 on several of Conwood’s brands, including KODIAK, which reflected the demand shift from premium to price-value brands, as well as multiple loose leaf and little cigar brands. 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%. The discount rate was determined by adjusting the enterprise discount rate by an appropriate risk premium to reflect an asset group risk.

 

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 (income) 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.

 

RAI expects its effective tax rate to be approximately 38% in 2009.

 

2007 Compared with 2006

 

 

 

 

 

RJR Tobacco

 

Net Sales

 

RJR Tobacco’s net sales for the year ended December 31, 2007, increased $238 million from the prior year, primarily due to higher pricing coupled with lower discounting, partially offset by the impact of total volume decrease of $479 million.

 

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

 

 

 

 

RJR Tobacco’s total domestic shipment volume decreased 6.2% in 2007 compared with the prior year, reflecting both a decline in total cigarette consumption and a decline in market share.

 

RJR Tobacco’s premium shipments as a percentage of total shipments increased during 2007 compared with the prior year, driven by CAMEL. CAMEL provided innovation with CAMEL No. 9 and CAMEL Signature

Blends, which were introduced during the first half of 2007, and the expansion to national distribution of two new CAMEL No. 9 styles in the third quarter of 2007. CAMEL’s menthol styles increased in popularity in 2007 as well. CAMEL Snus pioneered the development of a new category of smokeless, spitless tobacco products in the U.S. RJR Tobacco expanded the introduction of CAMEL Snus from two lead markets into six additional markets in 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, were as follows⁽²⁾:

 

 

 

 

The retail share of market of CAMEL’s filtered styles increased 0.4 share points in 2007 from 2006. CAMEL’s focus remained on brand innovation in 2007. In the first half of 2007, CAMEL introduced CAMEL Signature Blends, a collaborative effort with adult smokers. Also in the first half of 2007, CAMEL introduced CAMEL No. 9 in regular and menthol styles designed to appeal to adult female smokers. CAMEL No. 9, 100mm styles, were introduced during the third quarter of 2007. PALL MALL’s market share continued to grow, gaining 0.3 share points in 2007 over 2006. PALL MALL offers a longer-lasting cigarette with a premium heritage at a less-than-premium price.

 

The combined share of market of RJR Tobacco’s growth brands during 2007 showed improvement over the prior year. 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, 2007 increased $258 million to $1,940 million, or 24.4% of net sales, from $1,682 million, or 21.8% of net sales for the year ended December 31, 2006. Improvements in pricing, product mix, productivity and pension expense were partially offset by volume declines and increased MSA settlement payments during 2007.

 

In connection with the annual impairment testing of goodwill and certain intangible assets in the fourth quarter of 2007, impairment of $33 million occurred on RJR Tobacco’s non-growth brand, WINSTON. The impairment primarily reflects lower projected net sales compared with that assumed in the 2006 annual impairment test. The impairment charge was based on the excess of the 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 MSA settlement and federal tobacco buyout expenses, included in cost of products sold, are detailed in the schedule below:

 

 

For additional information, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA” in Item 8, note 16 to consolidated financial statements and “— Governmental Activity” 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, 2007 and 2006, RJR Tobacco’s product liability defense costs were $88 million and $105 million, respectively. An improved litigation environment and efficient and effective management of cost contributed to the decline in product liability cost in 2007.

 

Conwood

 

Net Sales

 

Conwood’s net sales for the year ended December 31, 2007, were $670 million compared with $409 million for the year ended December 31, 2006. The acquisition of the Conwood companies occurred on May 31, 2006, and consequently, the RAI consolidated statements of income include only the results of operations of the Conwood companies subsequent to May 31, 2006. Additionally, prior year comparative results of Lane operations that were transferred to Conwood on January 1, 2007, have been reclassified.

 

The shares of Conwood’s moist snuff products and volume discussion presented below include periods prior to the acquisition by RAI for enhanced analysis. The shipment volume, in millions of cans, for Conwood was as follows⁽¹⁾:

 

 

 

 

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⁾:

 

 

 

 

GRIZZLY, Conwood’s leading price-value moist snuff brand, had a market share of 21.1% of moist snuff shipments for 2007, an increase of 1.7 points from the prior year. Conwood completed its national roll-out of GRIZZLY Long-Cut Natural in the second quarter of 2007 and began testing two new GRIZZLY styles, GRIZZLY Wintergreen Pouches and GRIZZLY Snuff, to build on the brand’s momentum. GRIZZLY Wintergreen Pouches are moist snuff in a fleece pouch, and GRIZZLY Snuff is a traditional moist snuff style with an ultra-fine cut. The shipment share of KODIAK, Conwood’s leading premium moist snuff brand, was adversely impacted compared with the prior year due to competitive discounting and promotions.

 

Operating Income

 

Conwood’s operating income for the year ended December 31, 2007, increased to $312 million, or 46.5% of net sales, from $181 million, or 44.4% of net sales, for the year ended December 31, 2006. A full year of the Conwood companies’ activities is the primary driver of the year over year increase. In addition, Conwood also benefited from higher volume and higher prices in 2007.

 

In connection with the annual impairment testing of goodwill and certain intangible assets in the fourth quarter of 2007, impairment occurred on five of Conwood’s non-investment brands. The impairment primarily reflects a shift in the level of support among loose leaf product brands and for little cigar brands. In 2007, Conwood recorded impairment charges of $32 million based on the excess of certain brands’ carrying values over their fair values, 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, 2007, were favorably impacted by the growth of Santa Fe’s NATURAL AMERICAN SPIRIT brand. Operating income for 2007 was unfavorably impacted by an increase in corporate expenses as well as an increase in selling expenses associated with an increase in Santa Fe’s sales force.

RAI Consolidated

 

Interest and debt expense was $338 million for the year ended December 31, 2007, an increase of $68 million over the prior year. This increase was primarily due to a full year of interest on the debt incurred by RAI to fund the acquisition of the Conwood companies in May 2006.

 

Other expense (income) net was expense of $11 million for the year ended December 31, 2007. Year-to-date foreign exchange gains and equity income were more than offset by the expensing of unamortized debt fees associated with the term loan that RAI pre-paid in full in June 2007 and the loss on the sale of investment securities. For the year ended December 31, 2006, other income was $13 million consisting primarily of foreign exchange gain and equity income.

 

Provision for income taxes was $766 million, or an effective rate of 37.0%, for the year ended December 31, 2007, compared with $673 million, or an effective rate of 37.2%, for the year ended December 31, 2006. The 2007 provision was favorably impacted by a decrease in nondeductible items and an increase in the Qualified Production Activity Income deduction. The 2006 provision was adversely impacted by nondeductible items, including certain expenditures related to ballot initiatives, offset by the resolution of certain prior years’ tax matters that resulted in a reduction of income tax expense of $17 million.

 

Extraordinary item included a gain of $1 million for the year ended December 31, 2007, and $74 million for the year ended December 31, 2006, related to the 2000 acquisition of RJR’s former parent, Nabisco Group Holdings Corp., referred to as NGH, primarily from settlement of tax matters. Including these adjustments, the net after-tax gain on the acquisition of NGH was $1.8 billion.

 

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 MSA, 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 has evaluated the liquidity of key suppliers and significant customers in 2008. Where there were liquidity concerns identified with key suppliers, contingency plans are being 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, 2008, RAI held investments primarily in money market funds, auction rate securities and mortgage-backed securities. During 2008, certain money market funds were reclassified to short-term investments from cash equivalents 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. During 2008, the auction rate securities and mortgage-backed security were reclassified to long-term investments from short-term investments as liquidation of these securities was not expected to occur within one year. The auction rate securities and 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 mortgage-backed security for a period of time sufficient to allow for sale, redemption or anticipated recovery in fair value. At December 31, 2008, RAI considered the mortgage-backed security, the auction rate securities linked to corporate credit risk and one of the auction rate securities related to financial insurance companies to be temporarily impaired. The remaining auction rate securities related to financial insurance companies were considered other-than-temporarily impaired by RAI at December 31, 2008.

 

Contractual obligations as of December 31, 2008 were as follows:

 

 

 

 

 

Commitments as of December 31, 2008 were as follows:

 

 

Cash Flows

 

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 MSA 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 as a result of the termination of the joint venture in 2008.

 

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.

 

2007 Compared with 2006

 

Net cash flows from operating activities were $1,331 million in 2007, compared with net cash flows from operating activities of $1,457 million in 2006. This decrease was the result of higher income tax and interest payments in 2007, partially offset by increased net income in 2007.

 

Net cash flows from investing activities were $763 million in 2007, compared with net cash flows used in investing activities of $3,531 million in 2006. This change was primarily driven by the acquisition of the Conwood companies in 2006 and higher net proceeds from the sale of short-term investments in 2007.

 

Net cash flows used in financing activities were $1,312 million in 2007, compared with net cash flows provided by financing activities of $2,174 million in 2006. This change reflects prior year RAI debt issuances related to the acquisition of the Conwood companies, as well as increased dividend payments, long-term debt repayment and repurchase of RAI common stock in 2007.

 

Borrowing Arrangements

 

As of December 31, 2008, RAI’s total consolidated debt consisted of RAI notes in the aggregate principal amount of $4.3 billion, with maturity dates ranging from 2009 to 2037, and RJR notes in the aggregate principal amount of $129 million, with maturity dates ranging from 2009 to 2015. See Item 8, note 14 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. Under certain conditions, any fair value that results in a liability position of certain interest rate swaps may require full collateralization with cash or securities. 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 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, totals $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.

 

On June 28, 2007, RAI entered into the Credit Facility, which provides for a five-year, $550 million revolving credit facility, which may be increased to $900 million at the discretion of the lenders upon the request of RAI. The Credit Facility’s maturity date of June 28, 2012, may be extended by one year, at the discretion of the lenders upon RAI’s request.

 

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

 

 

At December 31, 2008, RAI had $12 million in letters of credit outstanding under the Credit Facility. At such date, no borrowings were outstanding, and the remaining $538 million of the Credit Facility was available for borrowing.

 

On December 31, 2008, Wells Fargo & Company completed its merger with Wachovia Corporation, the parent company of Wachovia Bank, National Association, pursuant to which Wells Fargo acquired all of Wachovia Corporation and all its businesses and its obligations.