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, 2007

OR

 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(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, 2007, was approximately $11.1 billion, based on the closing price of $65.20. 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 15, 2008: 295,005,762 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 24, 2008, are incorporated by reference into Part III of this report.

 

 

INDEX

 

 

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 2007, 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, 2007.

 

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 the Conwood companies and Lane. RAI’s wholly owned operating subsidiaries Santa Fe and 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. For net sales, operating income and total assets attributable to each segment, see Item 8, note 18 to consolidated financial statements.

 

RAI Strategy

 

RAI will focus 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 RJR Tobacco’s base business, growth and innovation in smokeless tobacco products, super-premium 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, are currently five of the ten best-selling brands of cigarettes in the United States. Those brands, and its other brands, including SALEM, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States to meet a range of adult smoker preferences. RJR Tobacco also manages contract manufacturing of cigarettes and tobacco products through arrangements with BAT affiliates. On January 1, 2007, the management and distribution of DUNHILL and STATE EXPRESS 555 cigarette brands were transferred from Lane to RJR Tobacco. On January 1, 2008, the management of RJR Tobacco’s super premium brands, including DUNHILL and STATE EXPRESS 555, was transferred to Santa Fe. Also on January 1, 2008, the contract manufacturing business of GPI was transferred to RJR Tobacco.

 

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. U.S. cigarette shipments as tracked by Management Science Associates, Inc., referred to as MSAi, report that shipments declined 5.0% in 2007, to 357.2 billion cigarettes, 2.4% in 2006 and 3.4% in 2005. 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 state excise taxes and governmental regulations and restrictions, such as marketing limitations, product standards and ingredients legislation.

 

The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to JTI. 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. As a result of these limitations, RJR Tobacco is dependent on the U.S. cigarette market.

Expanding beyond the cigarette market as an innovative tobacco company, RJR Tobacco is utilizing eight test markets for a new category of smokeless, spitless, tobacco known as snus. Snus is pasteurized tobacco that is currently sold in a small pouch that provides discreet and convenient tobacco consumption. Other cigarette manufacturers and smokeless tobacco manufacturers are also testing products in this new U.S. category. RJR Tobacco is expanding snus into additional markets in the first half of 2008.

 

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, see “— Litigation Affecting the Cigarette Industry-Health-Care Cost Recovery Cases-MSA” in note 14 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 2007, 2006 and 2005, Philip Morris USA Inc. had an overall retail share of the U.S. cigarette market of 51.1%, 50.8% and 50.6%, respectively. During these same years, RJR Tobacco had an overall share of 29.0%, 29.8% and 30.3%, 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 13% 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 pricing, promotions, product attributes and packaging, 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. Most recently, competition among the major manufacturers has begun shifting to product innovation and expansion into new smokeless tobacco categories, as well as finding efficient and effective means of balancing market share and profit growth.

 

Marketing

 

RJR Tobacco is committed to building and maintaining a portfolio of profitable brands. RJR Tobacco’s marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokers of competing brands to RJR Tobacco brands. In addition to building strong brand equity, RJR Tobacco’s marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend certain brands’ shares of market against competitive pricing pressure. RJR Tobacco’s competitive pricing methods include list price changes, on-going 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 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.

At the beginning of 2007, RJR Tobacco refined its brand portfolio strategy and modified its then existing brand categories to growth, support and non-support categories. The growth brands consist of two premium brands, CAMEL and KOOL, and a value brand, PALL MALL. Although all of these brands are managed for long-term market share and profit growth, CAMEL and KOOL will continue to receive the most significant levels of investment support. The support brands include three premium brands, WINSTON, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The remaining non-support brands are managed to maximize near-term profitability. RJR Tobacco expects this focused portfolio strategy will result in growth in total RJR Tobacco share, as gains on growth brands more than offset declines among other brands.

 

Anti-smoking groups have attempted to restrict cigarette sales, cigarette advertising, and the testing and introduction of new cigarette products, as well as encourage smoking bans. The MSA and other federal, state and local laws restrict or prohibit utilization of television, radio or billboard advertising or certain other marketing and promotional tools for cigarettes. 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. However, in November 2007, RJR Tobacco decided to suspend the use of print advertising for cigarettes in newspapers and consumer magazines during 2008. See Item 8, note 1 to consolidated financial statements for further information on advertising expense.

 

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, an R&D facility, RJR Tobacco’s Central Distribution Center and a pilot plant for trial manufacturing of new products. RJR Tobacco has a combined 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, 2007 or 2006.

 

Sales made by RJR Tobacco to McLane Company, Inc., a distributor, comprised 30%, 29% and 27% of RJR Tobacco’s revenue in 2007, 2006 and 2005, 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 the supply and level of McLane’s inventory.

 

RJR Tobacco has entered into various transactions with affiliates of BAT, the indirect parent of B&W. RJR Tobacco sells contract-manufactured cigarettes and processed strip leaf to BAT affiliates. Net sales to BAT affiliates, primarily cigarettes, represented approximately 6.0% of RAI’s total net sales in 2007, 2006 and 2005.

 

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 Greece. 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 suppliers is good.

 

Under the terms of settlement agreements with flue-cured and burley tobacco growers, and quota holders, RJR Tobacco is required, among other things, to purchase annually a minimum of 90 million pounds of U.S. green leaf flue-cured and burley tobacco combined, subject to adjustment based on its annual total requirements for each type of tobacco, 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 six best-selling brands of moist snuff in the United States. Conwood’s other products include loose leaf chewing tobacco, dry snuff, plug and twist tobacco products, which currently hold the first or second position in market share in each category. On January 1, 2007, as a result of combining certain operations of Lane with the Conwood companies, Conwood began distributing a variety of other tobacco products, including WINCHESTER and CAPTAIN BLACK little cigars, and BUGLER roll-your-own tobacco. The remaining operations of Lane also are included in the Conwood segment.

 

The moist snuff category is divided into premium and price-value brands. The moist snuff category has become increasingly sophisticated in recent years and 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 7% in 2007 and have grown at an average rate of approximately 5% 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 GRIZZLY, in recent years.

 

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 60% of Conwood’s revenue in 2007 and 2006. 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 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 7% in 2007, Conwood’s moist snuff volume grew 11% in 2007, attributable to its innovation, product development and brand building. GRIZZLY brand moist snuff had a 21.1% market share in 2007 and 19.4% market share in 2006.

 

Competition

 

The competition in the smokeless tobacco market is significant. The Conwood companies, collectively, are the second largest smokeless tobacco company in the United States. Conwood’s largest competitor is U.S. Smokeless Tobacco Company, which had approximately 60.6% of the moist snuff market share in 2007 and 62.8% in 2006. RJR Tobacco’s largest competitor in the cigarette market, Philip Morris USA Inc., has recently begun test marketing a moist snuff product. Conwood also competes in the U.S. smokeless tobacco market with both domestic and international companies marketing and selling price-value and sub-price-value smokeless tobacco products.

 

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 selected and limited support brands that include all other brands.

 

Conwood has made significant contributions in the development of the smokeless industry. Conwood completed its national distribution of GRIZZLY Long-Cut Natural in 2007 and began testing two new GRIZZLY styles, GRIZZLY 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 represent approximately 6% of the total moist snuff market and demand continues to grow.

 

GRIZZLY Snuff is a traditional, natural-flavored, fine-cut product. GRIZZLY Snuff was introduced in two states in 2007 and will be expanding nationally in the first half of 2008.

 

Conwood is committed to being an innovative industry leader with high standards in its production operations 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 facility is located in Memphis, Tennessee. Other facilities are located in Winston-Salem, North Carolina; Tucker, Georgia; Bowling Green, Kentucky; Sanford, North Carolina; Springfield, Tennessee; and Clarksville, Tennessee. The Winston-Salem, North Carolina and the Clarksville, Tennessee plants underwent expansion in 2007. 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 16% of Conwood’s consolidated revenue for 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, 2007 or 2006.

 

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 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. GPI manufactures and exports tobacco products to U.S. territories, U.S. duty-free shops and U.S. overseas military bases.

 

GPI also managed RJR’s interest in the R.J. Reynolds-Gallaher International Sarl joint venture. This joint venture terminated on December 31, 2007, and as provided by the joint venture agreement, R.J. Reynolds Tobacco C.V. is entitled to a termination amount. See Item 8, note 23 to consolidated financial statements for joint venture termination details.

 

GPI continues to sell a limited portfolio of American-blend cigarette brands in Italy, France and Spain, the primary markets of the former joint venture. On January 1, 2007, GPI began managing the international businesses of Conwood and Santa Fe. On January 1, 2008, the contract manufacturing business of GPI was transferred to RJR Tobacco.

 

Sales to Foreign Countries

 

RAI’s operating subsidiaries’ net sales to foreign countries for the years ended December 31, 2007, 2006 and 2005 were $638 million, $578 million and $548 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 $2.9 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, 2007, 2006 and 2005, was $57 million, $58 million and $53 million, respectively. The primary research and development activities of the operating subsidiaries are conducted in 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 may ultimately 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, 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 the 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 2008, the U.S. Congress will likely consider regulation of the manufacture and sale of tobacco products by the U.S. Food and Drug Administration, known as the FDA, and a further increase in the federal excise tax on cigarettes and other tobacco products. The U.S. Congress also may consider legislation regarding:

 

 

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

 

Litigation and Settlements

 

Various legal proceedings or claims, including litigation claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RAI’s operating subsidiaries’ products, and seeking damages in amounts ranging into the hundreds of millions or even billions of dollars, are pending or may be instituted against RJR Tobacco, the Conwood companies or their affiliates, including RAI or RJR, or indemnitees, including B&W. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 14 to consolidated financial statements.

 

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

 

Employees

 

At December 31, 2007, RAI and its subsidiaries had approximately 7,100 full-time employees and approximately 200 part-time employees. The 7,100 full-time employees include approximately 5,400 RJR Tobacco employees and 1,000 Conwood employees. No employees of RAI or its subsidiaries are unionized.

 

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.

 

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 — Overview” and “— Smokeless Tobacco Litigation” in Item 8, note 14 to consolidated financial statements.

 

Class-action suits have been filed in a number of states against individual cigarette manufacturers and their parent corporations, alleging that the use of the terms “lights” and “ultra lights” constitutes unfair and deceptive trade practices. In addition, a nation-wide “lights” class-action suit is pending in federal court against cigarette manufacturers, including RJR Tobacco and B&W. In the event RJR Tobacco and its affiliates and indemnitees lose one or more of the pending “lights” class-action suits, RJR Tobacco, depending upon the amount of any damages ordered, could face difficulties in obtaining the bond required to stay execution of the judgment. For a more complete description of these cases, see “— Class-Action Suits — ‘Lights’ Cases” in Item 8, note 14 to consolidated financial statements.

 

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 could 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 defendants’ appeal. Briefing is underway. 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, such as the ban on certain brand style descriptors and the corrective advertising requirements, 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 changing its current packaging to conform to the ban on certain brand descriptors and 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 14 to consolidated financial statements.

 

RJR Tobacco’s retail market share has declined in recent years and is expected to continue to decline over the next several years; any continuation in the decline beyond the next several years could adversely affect the results of operations, cash flows and financial position of RJR Tobacco and consequently, of RAI.

 

RJR Tobacco’s U.S. retail market share has been declining for a number of years and RJR Tobacco expects this market-share to continue to decline over the next several years. According to data from IRI, RJR Tobacco’s share of the U.S. cigarette retail market declined to 29.0% in 2007 from 29.8% in 2006, continuing a trend in effect for several years. If RJR Tobacco’s recently implemented revised brand portfolio is not successful and does not result in growth in total RJR Tobacco market share, or if RJR Tobacco continues to lose market share, results of operations, cash flows and financial position will be adversely affected.

 

RJR Tobacco is dependent on the U.S. cigarette business, 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. As a result of these limitations, 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 segment. As such, it is the primary source of RAI’s revenue, operating income and cash flows.

 

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 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. In addition, 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.

In February 2007, proposed legislation was introduced in the U.S. House of Representatives and the U.S. Senate that would give the FDA broad regulatory authority over tobacco products. The proposals would grant the FDA authority to impose product standards, including standards relating to, among other things, nicotine yields and smoke constituents. Additionally, the proposal would reinstate the FDA’s 1996 proposed regulations related to, among other things, additional warning notices, the disallowance of advertising and promotion expenses as deductions under federal tax law, a ban or further restriction of all advertising and promotion and increased regulation of the manufacturing and marketing of tobacco products by new or existing federal agencies. The proposed legislation also would govern modified-risk products.

 

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.

 

A number of state governments have adopted or are considering adopting legislation establishing fire standards compliance for cigarettes. The cost of complying with standards that vary from state to state would increase production complexity and could have an adverse effect on the results of operations of RJR Tobacco and consequently 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 14 to consolidated financial statements.

 

Conwood not only faces competition from its largest competitor, U.S. Smokeless Tobacco Company, but also from a participant in the cigarette market that has begun test-marketing moist snuff products. Increased competition could strengthen pricing pressure or decrease Conwood’s market share, either of which would adversely affect Conwood’s profitability and revenues.

 

If RJR Tobacco is not able to develop, produce or market new products profitably and with new technologies in response to regulatory changes or changes in adult consumer preferences, revenue and results of operations could be adversely affected.

 

Consumer health concerns and changes in regulations are likely to require or cause RJR Tobacco to introduce new products or make substantial changes to existing products. Similarly, RAI believes that there may be increasing pressure from public health authorities and consumers to develop a conventional cigarette or an alternative cigarette that provides a demonstrable reduced risk of adverse health effects. RJR Tobacco may not be able to develop a potentially reduced risk product that is broadly acceptable to adult consumers in a cost-effective manner. Further, additional marketing restrictions could be imposed legislatively or judicially in the future that could adversely affect RJR Tobacco’s ability to market any potentially reduced risk product it may develop.

If RJR Tobacco and Conwood are not efficient in the production or distribution of tobacco products, profitability could suffer.

 

RJR Tobacco and Conwood must be efficient in the production and distribution of tobacco products in order to be successful in highly competitive markets. RJR Tobacco’s and Conwood’s ability to gain additional efficiencies may become more difficult over time as synergies from the B&W business combination and Conwood acquisition are fully realized. Failure to reduce costs through productivity gains, cost savings projects and outsourcing could have an adverse effect on RAI’s profitability.

 

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 adversely impact the cost of inventory and cause profits to decline.

 

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

 

Changes in 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.

 

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

 

Adverse changes in liquidity in the financial markets could result in additional realized or unrealized losses associated with the value of RAI’s short-term investments, which would negatively impact RAI’s consolidated results of operations, financial position and cash flows.

 

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 with indefinite lives 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 2007, RJR Tobacco recorded an impairment charge of $33 million and Conwood recorded an impairment of $32 million related to the carrying amount of certain trademarks. For more information on asset impairment, see Item 8, note 3 to consolidated financial statements.

 

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 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 costs and cash flows. 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 information technology and other administrative and maintenance functions. 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 is in the process of outsourcing the management of its information technology infrastructure, as well as other administrative and maintenance functions. If 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.

 

RJR Tobacco relies 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 RJR Tobacco, and consequently, of RAI.

 

RJR Tobacco relies on a limited number of suppliers for direct materials. If the suppliers fail to meet RJR Tobacco’s demand for direct materials, RJR Tobacco may fail to operate effectively and may fail to meet shipment demand.

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 28% of RAI’s consolidated revenues in 2007. 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 may limit the flexibility of RAI and its subsidiaries. Breach of those covenants may result in a default under the agreement relating to the facility.

 

Restrictions in the agreement relating to RAI’s credit facility could limit the ability of RAI and its subsidiaries to obtain future financing, 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, or proceed against the collateral securing that indebtedness.

 

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

 

RAI has substantial 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.

An increase in interest rates would increase the cost of servicing RAI’s variable rate indebtedness and could cause its annual debt service obligations to increase significantly and reduce its profitability.

 

Certain of RAI’s outstanding notes bear interest at a variable rate of interest or have been swapped from a fixed rate of interest to a variable rate of interest. Any increase in interest rates would increase the cost of servicing RAI’s variable rate debt and, consequently, RAI’s profitability would decrease. Although RAI currently has no borrowings under its credit facility, borrowings under the credit facility also would bear interest at a variable or floating rate. For a discussion of how RAI manages its exposure to changes in interest rates, see Item 8, note 13 to consolidated financial statements.

 

The ability of RAI to access the debt capital markets could be impaired because of the credit rating of its debt securities.

 

Certain of the outstanding notes issued by RAI, and all of the outstanding notes of RJR, are rated below investment grade. Because of these ratings, 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, particularly if RAI’s debt securities ratings decline further.

 

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 rating and the ability of RAI and its affiliates to access the debt capital markets are often the same kinds of events and contingencies that could cause RAI and its affiliates to seek to raise additional capital on an urgent basis, RAI and its affiliates may not be able to issue debt securities or borrow money upon acceptable terms, or at all, at the times at which they may most need additional capital.

 

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

 

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

 

B&W owns approximately 42% of the outstanding shares of RAI common stock. No other stockholder owns more than 10% of the outstanding shares of RAI common stock. Unless substantially all of RAI’s public shareholders vote together on matters presented to RAI shareholders, B&W would have the power to determine the outcome of matters submitted to a shareholder vote.

 

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

 

 

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

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

 

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

 

 

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

 

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

 

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

 

 

 

Daniel (Daan) M. Delen.   Mr. Delen, 42, joined RJR Tobacco as President and Chief Executive Officer in January 2007. 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.

 

Jeffrey A. Eckmann.   Mr. Eckmann, 55, has been RAI Group President since October 2006. He plans to retire from this position on April 1, 2008, and after a one-month transition period, he will retire from RAI on May 1, 2008. Mr. Eckmann served as an Executive Vice President of both RAI and RJR Tobacco, responsible for, among other things, strategy and business development, from May 2005 until October 2006, for RAI, and November 2006, for RJR Tobacco. He joined RAI in July 2004 as Executive Vice President — Strategy, Planning and Integration. Mr. Eckmann served as Senior Vice President and Chief Financial Officer of B&W from 2001 to July 2004. He held a number of management positions in finance with B&W and BATUS Inc., the former U.S. holding company of B&W from 1991 to 2001. He serves on the board of directors of Soteria Imaging Services and is Non-Executive Chairman of LRSPPP, Inc.

 

Daniel A. Fawley.   Mr. Fawley, 50, 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 until September 2004.

 

McDara P. Folan, III.   Mr. Folan, 49, 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 board of directors of the Piedmont Triad Chapter of the Juvenile Diabetes Research Foundation, the advisory board for Brenner Children’s Hospital 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.

 

Jeffrey S Gentry.   Dr. Gentry, 50, was promoted to RAI Group Executive Vice President effective April 1, 2008, upon the retirement of Mr. Eckmann. He served as Executive Vice President — Research and Development of RJR Tobacco since 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.

 

Ann Johnston.   Ms. Johnston, 54, has been Executive Vice President — Human Resources of RAI since July 2007, and previously from July 2004 to November 2006, and Executive Vice President — Human Resources of RJR Tobacco since January 2002. Ms. Johnston also served as Executive Vice President — Human Resources of RJR from January 2002 to July 2004. Ms. Johnston serves as Chairman of the board of directors of Allegacy Federal Credit Union, is a member of the HR advisory board for the Moore School of Business at the University of South Carolina and serves on the board of visitors for the Babcock Graduate School of Management at Wake Forest University. Ms. Johnston also serves on the boards of directors of the Winston-Salem Symphony, the Winston-Salem Industries for the Blind, the Winston-Salem YWCA and the Deacon Club of Wake Forest University.

 

E. Julia (Judy) Lambeth.   Ms. Lambeth, 56, 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.

 

Tommy J. Payne.   Mr. Payne, 50, 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, 44, 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 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, 51, 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 companies are set forth below:

 

Nicholas Bumbacco.   Mr. Bumbacco, 43, was named President of GPI in September 2007. Mr. Bumbacco served as Vice President — Strategy Development for RJR Tobacco from January 2007 until September 2007. Prior to that time, 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, 59, has been President and Chief Executive Officer of Conwood Company, LLC and Conwood Sales Co., LLC since January 2005. 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, 54, was named President and Chief Executive Officer of Santa Fe in connection with RJR’s acquisition of Santa Fe in January 2002. 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 board member of Minnesota Resources.

 

The following table summarizes RAI’s purchases of its common stock during the fourth quarter of 2007:

 

 

For equity compensation plan information, see Item 8, note 16 to consolidated financial statements.

 

In May 2007, the shareholders of RAI approved an amendment to RAI’s amended and restated articles of incorporation increasing the number of authorized shares of RAI’s common stock, par value $.0001 per share, from 400 million to 800 million. This increase maintains the ratio of authorized but unissued shares of common stock to shares outstanding at approximately the same ratio as existed prior to the two-for-one split in 2006.

Performance Graph

 

Set forth below is a line graph comparing, for the period which commenced on July 30, 2004, and ended on December 31, 2007, 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.

 

 

 

 

 

The selected historical consolidated financial data as of December 31, 2007 and 2006, and for each of the years in the three-year period ended December 31, 2007, 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, 2005, 2004 and 2003, and for the years ended December 31, 2004 and 2003, 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, 2007, 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, acquisitions, 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.

 

 

 

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.

 

At the beginning of 2007, RJR Tobacco refined its brand portfolio strategy and modified its then existing brand categories to growth, support and non-support categories. The growth brands consist of two premium brands, CAMEL and KOOL, and a value brand, PALL MALL. Although all of these brands are managed for long-term market share and profit growth, CAMEL and KOOL will continue to receive the most significant levels of investment support. The support brands include three premium brands, WINSTON, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The remaining non-support brands are managed to maximize near-term profitability. RJR Tobacco expects this focused portfolio strategy will result in growth in total RJR Tobacco share, as gains on growth brands more than offset declines among other brands.

 

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. Most recently, competition among the major manufacturers has broadened to include a new smokeless, spitless category, known as snus. Snus is pasteurized tobacco that is currently sold in a small pouch that provides discreet and convenient tobacco consumption. Other cigarette manufacturers and smokeless tobacco manufacturers also are testing products in this new category. RJR Tobacco is expanding snus into additional markets in the first half of 2008.

 

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 include list price changes, discounting programs, such as retail buydowns, 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 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.”

 

Conwood

 

Conwood offers a range of differentiated smokeless and other tobacco products to adult consumers. Conwood has offerings in the following smokeless tobacco markets: moist snuff, loose leaf, dry snuff, plug and twist tobacco. The moist snuff category is divided into premium and price-value brands. The moist snuff category has become increasingly sophisticated in recent years and 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 7% in 2007 and have grown at an average rate of approximately 5% 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 GRIZZLY, in recent years.

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 60% of Conwood’s revenue in 2007 and 2006. 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 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 7% in 2007, Conwood’s moist snuff volume grew 11% in 2007, attributable to its innovation, product development and brand building. GRIZZLY brand moist snuff had a 21.1% market share in 2007, up from 19.4% market share in 2006.

 

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. Recently, a cigarette manufacturer began testing moist snuff products.

 

In January 2007, certain operations of Lane were combined with the Conwood companies and Conwood began distributing a variety of other tobacco products, including WINCHESTER and CAPTAIN BLACK little cigars and BUGLER roll-your- own tobacco. The remaining operations of Lane also are included in the Conwood segment.

 

Critical Accounting Policies and Estimates

 

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

 

Litigation

 

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

 

As discussed in Item 8, note 14 to consolidated financial statements, RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of February 8, 2008, RJR Tobacco had paid approximately $41 million since January 1, 2005, related to unfavorable judgments, including pre-acquisition contingencies related to the B&W business combination. As discussed in more detail in Item 8, note 14 to consolidated financial statements, in 2007, RJR Tobacco accrued $6 million related to unfavorable judgments in two individual plaintiff’s cases tried in conjunction with the Engle v. R. J. Reynolds Tobacco Co . case. This amount is included in selling, general and administrative expenses in the RAI consolidated statement of income for the year ended December 31, 2007.

 

Subject to the foregoing paragraph, RAI and its subsidiaries believe, however, that they have valid bases for appeal of adverse verdicts against them and have valid defenses to all actions and intend to defend all actions vigorously. Except for the unfavorable judgments described in the preceding paragraph, 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. In addition to the $6 million accrual discussed above, which was paid on February 8, 2008, RJR has liabilities totaling $94 million that were recorded in 1999 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, financial position or cash flows of RAI or its subsidiaries.

 

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 under these agreements is recorded in cost of products sold as the products are shipped. Adjustments to these estimates, which historically have not been significant, 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 14 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 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.

 

Short-Term Investments

 

RAI holds short-term investments in auction rate notes, mortgage-backed securities, federal agency securities and treasury bills and notes. During 2007, adverse changes in financial markets caused certain auction rate notes and mortgage-backed securities to revalue lower than carrying value and become less liquid. Beginning in the third quarter of 2007, the auction rate notes failed to auction due to sell orders exceeding buy orders. The fair values of the auction rate notes and the mortgage-backed securities were determined using pricing, projected future cash flows and credit ratings actions or valuation models that assessed the credit quality of the underlying collateral.

 

The funds associated with these auction rate notes and mortgage-backed securities will not be accessible until a successful auction occurs or a buyer is found. RAI intends, and has the ability, to hold these auction rate notes and mortgage-backed securities for a period of time sufficient to allow for the anticipated recovery in fair value. These investments will be evaluated on a quarterly basis. RAI reviews impairments associated with the above in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and FASB Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments,” to determine the classification of the impairment as temporary or other-than-temporary. RAI considers those investments to be temporarily impaired as of December 31, 2007, with the unrealized loss included in accumulated other comprehensive loss in the consolidated balance sheet as of December 31, 2007. Such unrealized loss did not reduce net income for the year ended December 31, 2007.

Pension and Postretirement Benefits

 

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

 

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 coincidentally 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 liabilities have decreased as a result of the increase in the discount rate. These changes have resulted in a reduction in charges to comprehensive loss. These changes are expected to result in a reduction 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 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. 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 Issued Accounting Pronouncements

 

In 2006, the FASB issued SFAS No. 157, “Fair Value Measurement.” 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 disclosures about fair value measurements. SFAS No. 157 is effective for RAI as of January 1, 2008. In February 2008, the FASB issued FASB Staff Position FAS 157-2, “Effective Date of FASB Statement No. 157,” referred to as FSP 157-2. FSP 157-2 delays the effective date of SFAS 157 for all nonfinancial assets and nonfinancial liabilities, that are not remeasured at fair value on a recurring basis until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. FSP 157-2 is effective for RAI as of January 1, 2009. The adoption of SFAS 157 on financial assets and liabilities will not have a material impact on RAI’s consolidated results of operations, financial position or cash flows.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities.” SFAS No. 159 permits all entities to choose to elect to measure eligible financial instruments at fair value. RAI does not expect to elect to measure any eligible financial instruments at fair value upon adoption of SFAS No. 159 on January 1, 2008.

 

In December 2007, the FASB issued SFAS No. 160, “Noncontrolling Interest in Consolidated Financial Statements.” SFAS No. 160 is an amendment to ARB No. 51 “Consolidated Financial Statements” and clarifies that a noncontrolling interest in a subsidiary is an ownership interest in the consolidated entity that should be reported as equity in the consolidated financial statements. SFAS No. 160 is effective for RAI as of January 1, 2009. RAI has not yet determined the impact of the adoption of SFAS No. 160 on its consolidated results of operations, financial position or cash flows.

 

In December 2007, the FASB issued SFAS No. 141(revised 2007), “Business Combinations.” SFAS No. 141(R) replaces SFAS No. 141, “Business Combinations,” and provides requirements related to an acquiring entity’s recognition and measurement of all assets acquired and liabilities assumed, including any contingent consideration, pre-acquisition contingencies and noncontrolling interests, as well as treatment of acquisition-related transaction and restructuring costs. SFAS No. 141(R) also requires enhanced disclosures regarding the nature and financial effects of the business combination. SFAS No. 141(R) is effective for RAI for business combinations completed on or after January 1, 2009, and its impact will be dependent on its acquisitions, if any, made after that date.

Results of Operations

 

2007 Compared with 2006

 

 

 

 

 

 

RJR Tobacco

 

Net Sales

 

RJR Tobacco’s net sales for the year ended 2007 increased $210 million from the comparable prior year, primarily due to higher pricing coupled with lower discounting, partially offset by the impact of total volume decrease of $479 million. 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.

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 6.0% 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 continues to provide 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 have increased in popularity in 2007 as well. Another innovation, CAMEL Snus, continues to pioneer the development of a new category of smokeless, spitless tobacco products. RJR Tobacco has expanded its initial CAMEL Snus two-market test into six additional markets and is expanding into additional markets in the first half of 2008.

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:

 

 

 

 

The retail share of market of CAMEL’s filtered styles increased 0.4 share points in 2007 from 2006. CAMEL continues to focus on brand innovation. 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. KOOL’s market share in 2007 was stable compared with 2006 despite intense competition in the menthol market and above-average price increases. KOOL has been providing innovative products such as KOOL XL, the smoother and wider cigarette introduced in late 2006 and, most recently, a milder style, KOOL XL Blue. Both KOOL XL and KOOL XL Blue were expanded to national distribution during 2007. PALL MALL’s market share continues 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. During 2007, PALL MALL ultra lights were introduced in a bright, distinctive packaging design.

 

The combined share of market of RJR Tobacco’s growth brands during 2007 showed improvement over the prior year. However, as expected, 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 2007 increased $241 million to $1,934 million, or 24.4% of net sales, from $1,693 million, or 22.0% of net sales for the year ended 2006. Improvements in pricing, product mix, productivity and pension expense were partially offset by increased MSA settlement payments and volume declines 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:

 

 

MSA settlement expenses are expected to be approximately $2.8 billion in 2008, subject to adjustment for changes in volume and other factors, and the federal tobacco quota buyout is expected to be approximately $250 million to $260 million in 2008. For additional information, see “Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA” in Item 8, note 14 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 year 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.

 

“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 the amount of product liability defense costs. The most important factors are the number of cases pending and the number of cases in trial or in preparation for trial (that is, with active discovery and motions practice). See “— Litigation Affecting the Cigarette Industry — Overview” in Item 8, note 14 to consolidated financial statements for detailed information regarding the number and type of cases pending, and “Litigation Affecting the Cigarette Industry — Scheduled Trials” in Item 8, note 14 for detailed information regarding the number and nature of cases in trial and scheduled for trial through December 31, 2008.

 

RJR Tobacco expects that the factors described above will continue to have the primary impact on its product liability defense costs in the future. Given the level of activity in cases in preparation for trial, in trial and on appeal, and the amount of product liability defense costs incurred by RJR Tobacco over the past three years, RJR Tobacco’s recent experiences 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 does not expect that the variances in its product liability defense costs will be significantly different than they have been historically, aside from the assumption of

certain B&W litigation and increased individual case filings in Florida due to the Engle decision. See “Litigation Affecting the Cigarette Industry — Engle Progeny Cases” and “Litigation Affecting the Cigarette Industry — Class Action Suits — Engle Case” in Item 8, note 14 to consolidated financial statements for additional information. 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, financial position or cash flows 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

 

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:

 

 

 

 

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:

 

 

 

 

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 Pouches and GRIZZLY Snuff, to build on the brand’s momentum. GRIZZLY 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 in 2007 were favorably impacted by the growth of Santa Fe’s NATURAL AMERICAN SPIRIT brand. Operating income 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 comparable 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 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.

 

RAI expects its effective tax rate to be approximately 38% in 2008.

 

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, NGH, primarily from settlement of tax matters. Including these adjustments, the net after-tax gain on the acquisition of NGH was $1.8 billion.

 

2006 Compared with 2005

 

 

 

 

 

 

 

 

RJR Tobacco’s total domestic shipment volume decreased 3.2% in 2006 compared with 2005 due to declines in consumption, or retail sales to consumers, and one less shipping day. The overall cigarette industry decline was 1.5%.

 

The industry’s premium shipments increased to 71.9% in 2006 from 71.1% in 2005.

 

The shares of RJR Tobacco as a percentage of total share of U.S. retail cigarette sales according to data ¹ from IRI, were as follows:

 

 

 

 

In 2006 retail share of market of CAMEL’s filtered styles increased 0.7 share points from 2005. In the first quarter of 2006, CAMEL introduced new CAMEL Wides packaging and initiated efforts to enhance the performance of the brand’s menthol styles, including new packaging and introducing the CAMEL Wides Menthol style. Also in 2006, CAMEL introduced CAMEL Snus, a smokeless, spitless tobacco product, in test markets.

 

KOOL continues to maintain its appeal among adult menthol smokers and had an increase in its retail share of market of 0.1 share points in 2006. In the fourth quarter of 2006, KOOL introduced KOOL XL, a wide-gauge cigarette style, which provides another tangible point of difference from competing brands.

 

PALL MALL increased its share of market by 0.3 share points in 2006 and continues to demonstrate its strength in the value category based on its unique product platform of being a longer-lasting cigarette.

 

The combined share of market of RJR Tobacco’s growth brands grew 1.1 share points during 2006. However, the decline in share of support and non-support brands more than offset the gains on the growth brands.

 

RJR Tobacco’s premium share position of 18.8% in 2006 increased 0.3 share points from 2005 due to the increase of its growth brands. RJR Tobacco’s value share position of 11.0% of the market in 2006 declined 0.8 share points from 2005.

Operating Income

 

RJR Tobacco’s operating income for 2006 increased to $1,626 million from $1,346 million in 2005 primarily due to favorable pricing, and lower trademark impairment charges, offset in part by lower volumes and higher MSA and tobacco quota buyout expenses, detailed below.

 

In connection with the annual impairment testing of goodwill and certain intangible assets in the fourth quarter of 2006, impairment occurred on four of RJR Tobacco’s non-growth brands, primarily DORAL and SALEM. The impairment primarily reflects modification, during the fourth quarter of 2006, to the previously anticipated level of support among certain brands, and also results from increased decline rate in projected net sales of certain brands, compared with that assumed in the 2005 annual impairment test, which resulted in $198 million of trademark impairment charges. In 2006, RJR Tobacco recorded impairment charges of $90 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 10.75%. The discount rate was determined by adjusting the RJR Tobacco enterprise discount rate by an appropriate risk premium to reflect an asset group risk.

 

RJR Tobacco’s operating income also was impacted by lower amortization expense of $13 million for the comparable periods, primarily due to certain acquired consumer-related intangibles being fully amortized prior to 2006.

 

RJR Tobacco’s cost of products sold includes the following components for MSA settlements, and federal tobacco buyout expenses for the years ended December 31:

 

 

For additional information, see “Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — MSA” in Item 8, note 14 to consolidated financial statements and “— Governmental Activity” below.

 

Merger and integration costs related to the B&W business combination decreased during 2006 compared with 2005, favorably impacting cost of products sold by $14 million and selling, general and administrative expenses by $60 million. Selling, general and administrative expenses for RJR Tobacco also were impacted by a $48 million decrease in product liability defense costs during 2006 compared with the prior-year period, offset by $46 million of expenditures relating to ballot initiatives in 2006.

 

Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. During 2006 and 2005, RJR Tobacco’s product liability defense costs were $105 million and $153 million, respectively. The decrease in product liability defense costs in 2006 compared with 2005 was primarily due to reduced litigation activity, including a decrease in the number of cases tried or in trial during 2006 (2 cases) compared with 2005 (5 cases, including the U.S. Department of Justice case).

 

Conwood

 

The acquisition of the Conwood companies occurred on May 31, 2006, and consequently, the RAI consolidated statement of income includes only the results of operations of the Conwood companies for June through December 2006 and those of Lane reclassified into the Conwood segment. Conwood’s net sales are dependent upon premium versus price-value brand mix and list pricing, offset by promotional spending, trade incentives and federal excise taxes. Conwood’s operating income of $181 million in 2006 includes $12 million of integration costs.

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

 

 

 

 

GRIZZLY’s growth led Conwood’s share position to 25.1% of the moist snuff market in 2006, an increase of 2.5 share points from 2005. GRIZZLY’s price-value share position was 46.9% of that market in 2006, an increase of 4.2% from 2005. In 2006, Conwood introduced GRIZZLY Long-Cut Natural in 20 states to further enhance GRIZZLY’s growth potential.

 

Conwood’s total moist snuff shipment volume increased 18.4% in 2006 from 2005, including GRIZZLY’s 29.1% volume growth.

 

All Other

 

All Other operating income for 2006 was favorably impacted by the growth of Santa Fe’s NATURAL AMERICAN SPIRIT brand. In addition, 2005 was impacted by the $24 million loss relating to the sale of the packaging operations.

 

RAI Consolidated

 

Interest and debt expense was $270 million for the year ended December 31, 2006, an increase of $157 million from 2005. This increase was primarily due to higher debt balances resulting from the debt incurred by RAI to fund the acquisition of the Conwood companies in May 2006.

 

Interest income was $136 million for the year ended December 31, 2006, an increase of $51 million from 2005. This increase was primarily due to higher interest rates and, to a lesser extent, higher average cash balances.

 

Other (income) expense, net was $13 million income in 2006 compared with $15 million expense in 2005. The change was primarily due to favorable foreign exchange revaluation of $14 million and increased earnings relating to the joint venture, coupled with the 2005 net costs of $7 million related to the extinguishment of the 2006 notes.

Provision for income taxes was a provision of $673 million, or an effective rate of 37.2%, for the year ended December 31, 2006, compared with a provision of $431 million, or an effective rate of 30.4%, in 2005. The 2006 provision was adversely impacted by state taxes and nondeductible items, including certain expenditures relating to ballot initiatives, offset in part by the resolution of certain prior years’ tax matters that resulted in a reduction of income tax expense of $17 million.

 

The 2005 provision was favorably impacted by the resolution of certain prior years’ tax matters that resulted in a reduction of income tax expense of $78 million, offset in part by state taxes and certain nondeductible items.

 

Discontinued operations reflect transactions related to the 1999 sale of the international tobacco business to JTI. During 2005, these transactions included $2 million of after-tax reversals of indemnification accruals. Including these adjustments, the net after-tax gain on the sale of the international tobacco business was $2.5 billion.

 

Extraordinary item included a gain of $74 million and $55 million in 2006 and 2005, respectively, related to the 2000 acquisition of RJR’s former parent, NGH, primarily from settlement of tax matters. Including these adjustments, the net after-tax gain on the acquisition 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 borrowings through RAI and RJR. 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 dividend and other 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. RAI holds short-term investments in auction rate notes, mortgage-backed securities, federal agency securities and treasury bills and notes. During 2007, adverse changes in the financial markets caused certain auction rate notes and mortgage-backed securities to revalue lower than carrying value and become less liquid. Beginning in the third quarter of 2007, the auction rate notes failed to auction due to sell orders exceeding buy orders. The funds associated with these auction rate notes and mortgage-backed securities will not be accessible until a successful auction occurs or a buyer is found. RAI intends, and has the ability, to hold these auction rate notes and mortgage-backed securities for a period of time sufficient to allow for the anticipated recovery in fair value. RAI considers those investments to temporarily impaired as of December 31, 2007.

 

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 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.

Contractual obligations as of December 31, 2007 were as follows:

 

 

 

 

Commitments as of December 31, 2007 were as follows:

 

Cash Flows

 

2007 Compared with 2006

 

Net cash flows from operating activities were $1.3 billion in 2007, compared with net cash flows from operating activities of $1.5 billion 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 $3.5 billion 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 $1.3 billion in 2007, compared with net cash flows provided by financing activities of $2.2 billion 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.

 

2006 Compared with 2005

 

Net cash flows from operating activities were $1.5 billion in 2006, compared with $1.3 billion in 2005. This increase was primarily due to an increase in net income of $98 million, excluding non-cash charges and the receipt of an IRS tax refund in 2006, partially offset by higher pension funding and higher income taxes paid in 2006. Net cash flows for 2006 were also favorably impacted by the $178 million classification of certain book overdrafts as accounts payable compared with the 2005 classification in cash and cash equivalents, resulting from changes in certain banking relationships.

 

Net cash flows used in investing activities were $3.5 billion in 2006, compared with $989 million in 2005. This change was primarily due to the acquisition of the Conwood companies for $3.5 billion, offset in part by lower net purchases of short-term investments of $981 million.

 

Net cash flows from financing activities were $2.2 billion in 2006, compared with net cash flows used in financing activities of $450 million in 2005. This change was primarily due to $3.2 billion in proceeds from RAI’s debt issuances to fund the acquisition of the Conwood companies, and lower debt repayment, offset in part by higher dividends paid per share of common stock.

 

Stock Repurchases

 

On February 6, 2007, the board of directors of RAI authorized the repurchase by RAI of up to $75 million, of its outstanding shares of common stock to offset dilution from restricted stock grants and the exercise of previously granted options under the LTIP. Due to RAI’s incorporation in North Carolina, which does not recognize treasury shares, the shares repurchased are cancelled at the time of repurchase. RAI also 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 LTIP. During 2007, RAI repurchased and cancelled 991,956 shares of its common stock at an aggregate cost of $60 million.

 

On February 5, 2008, the board of directors of RAI authorized the repurchase by RAI of up to $30 million of its outstanding shares of common stock to offset dilution from restricted stock grants and the exercise of previously granted options under the LTIP.

 

RAI continues to explore the potential for a share repurchase program as a way to return value to its shareholders. The decision to implement a share repurchase program, including the timing and amount of any such program, remains subject to B&W’s final agreement to participate on a pro rata basis, overall economic conditions, competitive activity and approval by RAI’s board of directors.

Dividends

 

On February 5, 2008, RAI’s board of directors declared a quarterly cash dividend of $0.85 per common share. The dividend will be paid on April 1, 2008, to shareholders of record as of March 10, 2008. On an annualized basis, the dividend rate is $3.40 per common share. The current dividend reflects RAI’s 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.

 

Capital Expenditures

 

RAI’s operating subsidiaries’ recorded cash capital expenditures of $142 million, $136 million and $105 million in 2007, 2006 and 2005, respectively. Of the 2007 amount, $93 million related to RJR Tobacco and $23 million related to Conwood. RJR Tobacco plans to spend $95 million to $105 million for capital expenditures during 2008, and Conwood plans to spend $40 million to $50 million. Capital expenditures are funded primarily by cash flows from operations. RAI’s operating subsidiaries’ capital expenditure programs are expected to continue at a level sufficient to support their strategic and operating needs. There were no material long-term commitments for capital expenditures as of December 31, 2007.

 

Debt

 

Credit Facility

 

In June 2007, RAI entered into a Fifth Amended and Restated Credit Agreement, referred to as the RAI Credit Facility, which provides for a five-year, $550 million senior secured revolving credit facility, which may be increased to $900 million at the discretion of the lenders upon the request of RAI. The credit agreement amends and restates RAI’s prior agreement dated May 31, 2006.

 

RAI is able to use the RAI Credit Facility for borrowings and issuances of letters of credit, at its option. RAI is required to pay a commitment fee ranging from 0.25% to 1.00% per annum on the unused portion of the facility. Borrowings under the RAI Credit Facility bear interest, at the option of RAI, at a rate equal to an applicable margin plus: the reference rate, which is the higher of the federal funds effective rate plus 0.5% and the prime rate; or the eurodollar rate, which is the rate at which eurodollar deposits for one, two, three or six months are offered in the interbank eurodollar market. At December 31, 2007, RAI had $22 million in letters of credit outstanding under its facility. No borrowings were outstanding, and the remaining $528 million of the RAI Credit Facility was available for borrowing.

 

The RAI Credit Facility contains, among others, the following restrictive covenants that limit, and in some circumstances prohibit, the ability of RAI and its subsidiaries to:

 

 

These covenants in the RAI Credit Facility are subject to a number of qualifications and exceptions. The maturity date of the RAI Credit Facility is June 28, 2012, which date may be extended in two separate one-year increments.

 

RAI’s material domestic subsidiaries guarantee RAI’s obligations under the facility. These guarantors also generally have pledged substantially all of their assets to secure these obligations. RAI has pledged substantially all of its assets, including the stock of its direct subsidiaries, to secure its obligations under the facility. The collateral for the facility generally will be released automatically in certain circumstances, including at such time, if any, as RAI obtains an investment grade corporate credit rating with not worse than stable outlooks by each of Moody’s and S&P. See Item 8, note 11 to consolidated financial statements for additional information related to the RAI Credit Facility.

 

Long-term Debt

 

As of December 31, 2007, RAI’s total debt of $4.5 billion consisted of RAI senior secured notes in the aggregate principal amount of $4.4 billion with maturity dates ranging from 2009 to 2037 and RJR unsecured notes in the aggregate principal amount of $132 million, with maturity dates ranging from 2009 to 2015. For more information regarding RAI’s and RJR’s long-term debt, see Item 8, note 12 to consolidated financial statements.

 

In June 2007, RAI completed the sale of $1.55 billion in aggregate principal amount of senior secured notes, consisting of $400 million of floating rate notes due June 15, 2011, $700 million of 6.75% notes due June 15, 2017, and $450 million of 7.25% notes due June 15, 2037. These notes were sold under RAI’s shelf registration statement filed with the SEC on June 18, 2007. The net proceeds from the offering, together with available cash, were used to prepay in full the principal balance of $1.54 billion of a term loan, together with accrued and unpaid interest, which indebtedness was incurred in connection with the acquisition of the Conwood companies.

 

In June 2007 and July 2007, $46 million and $29 million, respectively, of RJR notes matured and were paid.

 

The guarantors of the RAI Credit Facility also guarantee RAI’s senior secured notes. RAI’s senior secured notes are secured by a pledge of the stock, indebtedness and other obligations of RJR Tobacco owned by or owed to RAI or any restricted subsidiary, as defined in the indenture governing the notes. Such notes also are secured by any principal property of RAI and any guarantor that is a restricted subsidiary. Santa Fe and Lane are excluded from the definition of restricted subsidiary. These assets constitute a portion of the security for the obligations of RAI and the guarantors under the RAI Credit Facility. If these assets are no longer pledged as security for the obligations of RAI and the guarantors under the RAI Credit Facility, or any other indebtedness of RAI, they will be released automatically as security for RAI’s senior secured notes and the related guarantees. Generally, the terms of RAI’s senior secured notes restrict the pledge of collateral, sale/leaseback transactions and the transfer of all or substantially all of the assets of certain of RAI’s subsidiaries.

 

As of December 31, 2007, Moody’s corporate credit rating of RAI was Ba1, positive outlook, and S&P’s rating was BB+, positive outlook. Concerns about, or lowering of, RAI’s corporate ratings by S&P or Moody’s could have an adverse impact on RAI’s ability to access the debt markets and could increase borrowing costs. However, given the cash balances and operating performance of RAI and its subsidiaries, RAI’s management believes that such concerns about, or lowering of, such ratings would not have a material adverse impact on RAI’s cash flows.

 

At its 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. The floating rate notes are redeemable at par beginning 18 months after issuance.

 

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.

 

RAI, RJR and their affiliates were in compliance with all covenants and restrictions imposed by their indebtedness at December 31, 2007.

Litigation and Settlements

 

As discussed in Item 8, note 14 to consolidated financial statements, RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, including B&W, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of February 8, 2008, RJR Tobacco has paid approximately $41 million since January 1, 2005, related to unfavorable judgments, including pre-acquisition contingencies related to the B&W business combination. As discussed in more detail in Item 8, note 14 to consolidated financial statements, in 2007, RJR Tobacco accrued $6 million related to unfavorable judgments in the individual plaintiff’s cases tried in conjunction with the Engle v. R. J. Reynolds Tobacco Co . case. This amount is included in selling, general and administrative expenses in the RAI consolidated statement of income for the year ended December 31, 2007. In addition to the $6 million accrual discussed above, which was paid on February 8, 2008, RJR has liabilities totaling $94 million that were recorded in 1999 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.

 

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

 

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

 

RJR Tobacco and certain of the other participating manufacturers under the MSA are currently involved in litigation with the settling states with respect to the availability for certain market years of a downward adjustment to the annual MSA settlement payment obligation, known as the Non-Participating Manufacturer Adjustment. Pending the resolution of these disputes, RJR Tobacco and certain of the other participating manufacturers have placed the disputed portions of their 2006 and 2007 annual payments into the MSA disputed funds account. RJR Tobacco currently has approximately $1.2 billion deposited in the MSA disputed funds account. For more information related to this litigation, see “Litigation Affecting the Cigarette Industry — MSA — Enforcement and Validity” in Item 8, note 14 to consolidated financial statements.

Governmental Activity

 

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

 

 

In addition, during 2008, the U.S. Congress will likely consider regulation of the manufacture and sale of tobacco products by the FDA, and a further increase in the federal excise tax on cigarettes and other tobacco products. The U.S. Congress also may consider legislation regarding:

 

 

In February 2007, proposed legislation was introduced in the U.S. House of Representatives and the U.S. Senate that would give the FDA broad regulatory authority over tobacco products. The U.S. Senate Health, Education, Labor and Pensions Committee approved the FDA regulation bill on August 1, 2007. The Health Subcommittee of the Energy and Commerce Committee of the U.S. House of Representatives held a hearing on the bill on October 3, 2007, but no further action is scheduled at this time. The proposals would grant the FDA authority to impose product standards, including standards relating to, among other things, nicotine yields and smoke constituents, and would reinstate the FDA’s 1996 proposed legislation that would have restricted marketing. The proposed legislation also would govern modified risk products and would impose new and larger warning labels on tobacco products. At this time, RAI does not know whether FDA regulation over tobacco products will be approved by the balance of Congress or signed into law by the President.

 

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

 

Cigarettes are subject to substantial excise taxes in the United States. The federal excise tax per pack of 20 cigarettes is $0.39. In 2007, the U.S. Senate and U.S. House of Representatives approved an increase of $0.61 in the excise tax per pack of cigarettes, and proportional increases on other tobacco products to fund expansion of the State Children’s Health Insurance Program, referred to as SCHIP. The President vetoed the bill on October 3, 2007. On October 18, 2007, the U.S. House of Representatives failed to override the President’s veto of the bill. Subsequently,

the U.S. Congress passed a slightly revised version of the SCHIP bill, and the President vetoed the bill on December 12, 2007. In January 2008, by a vote of 152-260, the U.S. House of Representatives failed to override the veto. In between the passage of the revised legislation and the override vote, the U.S. Congress passed an extension of SCHIP through March of 2009 without a tax increase. At this time, RAI does not know whether any excise tax bill will be approved to fund SCHIP or any other federal program. The adoption of any such increase could have a material adverse effect on the business or results of operations of RJR Tobacco.

 

All states and the District of Columbia currently impose excise taxes at levels ranging from $0.07 per pack in South Carolina to $2.575 per pack in New Jersey. As of December 31, 2007, the weighted average state cigarette excise tax per pack, calculated on a 12-month rolling average basis, was approximately $0.92, an increase compared to the 12-month rolling average of $0.799 as of December 31, 2006. During 2007, eight states passed excise tax per pack increases. In addition, several states are expected to consider an increase in their excise tax per pack during 2008. Certain city and county governments, such as New York and Chicago, also impose substantial excise taxes on cigarettes sold in those jurisdictions.

 

Cigars are generally taxed by states on an ad valorem basis, ranging from 5% in South Carolina to 75% in Alaska and Washington. Other states have unit-based tax schemes for cigars or tax little cigars the same as cigarettes.

 

The federal excise tax on smokeless tobacco products currently is $0.195 per pound for chewing tobacco, and $0.585 per pound for snuff. The federal tax on small cigars, defined as those weighing three pounds or less per thousand, is $1.828 per thousand. Large cigars are taxed at a rate of 20.719% of the manufacturer’s price, with a cap of $48.75 per thousand.