10-K 1 d448140d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

 

FORM 10-K

 

 

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2012

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From                      to                     

Commission File Number: 001-34097

 

 

Lorillard, Inc.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   13-1911176

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

714 Green Valley Road, Greensboro, North Carolina 27408-7018

(Address of principal executive offices) (Zip Code)

(336) 335-7000

(Registrant’s telephone number, including area code)

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

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.01 par value   New York Stock Exchange

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 Securities Act.    Yes  x    No  ¨

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

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  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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.  x

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.

Large accelerated filer   x    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company   ¨

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

The aggregate market value of voting and non-voting common equity of the registrant held by nonaffiliates of the registrant as of June 30, 2012 was $17.2 billion.

 

Class

 

Outstanding at February 13, 2013

Common Stock, $0.01 par value   379,359,567 shares

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of the definitive proxy statement for the registrant’s 2013 Annual Meeting of Shareholders to be held on May 14, 2013 are incorporated by reference into Part III hereof.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         Page  

PART I

       2   
Item 1.  

BUSINESS

     2   
Item 1A.  

RISK FACTORS

     13   
Item 1B.  

UNRESOLVED STAFF COMMENTS

     26   
Item 2.  

PROPERTIES

     26   
Item 3.  

LEGAL PROCEEDINGS

     27   
Item 4.  

MINE SAFETY DISCLOSURES

     27   

PART II

       28   
Item 5.  

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES.

     28   
Item 6.  

SELECTED FINANCIAL DATA

     30   
Item 7.  

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     32   
Item 7A.  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     49   
Item 8.  

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     50   
Item 9.  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

     106   
Item 9A.  

CONTROLS AND PROCEDURES

     107   
Item 9B.  

OTHER INFORMATION

     109   

PART III

       109   
Item 10.  

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

     109   
Item 11.  

EXECUTIVE COMPENSATION

     109   
Item 12.  

SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

     109   
Item 13.  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

     109   
Item 14.  

PRINCIPAL ACCOUNTANT FEES AND SERVICES

     109   

PART IV

       110   
Item 15.  

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

     110   

SIGNATURES

     115   

 

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Unless otherwise indicated or the context otherwise requires, references to “Lorillard”, “we,” “us” and “our” refer to Lorillard, Inc., a Delaware corporation, and its subsidiaries. “Lorillard, Inc.” refers solely to the parent company and “Lorillard Tobacco” refers solely to Lorillard Tobacco Company, the principal subsidiary of Lorillard, Inc. “LOEC” or “blu eCigs” refers to LOEC, Inc., a subsidiary of Lorillard, Inc.

FORWARD-LOOKING STATEMENTS

Investors are cautioned that certain statements contained in this Annual Report on Form 10-K are “forward-looking” statements. Forward-looking statements include, without limitation, any statement that may project, indicate or imply future results, events, performance or achievements, and may contain the words “expect,” “intend,” “plan,” “anticipate,” “estimate,” “believe,” “will be,” “will continue,” “will likely result” and similar expressions. In addition, any statement concerning future financial performance (including future revenues, earnings or growth rates), ongoing business strategies or prospects, and possible actions taken by us, which may be provided by our management team are also forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995.

Forward-looking statements are based on current expectations and projections about future events and are inherently subject to a variety of risks and uncertainties, many of which are beyond the control of our management team, which could cause actual results to differ materially from those anticipated or projected. These risks and uncertainties include, among others:

 

   

the impact of regulatory initiatives, including the regulation of cigarettes and electronic cigarettes and a possible ban or regulation of the use of menthol in cigarettes by the Food and Drug Administration, and compliance with governmental regulations;

 

   

the outcome of pending or future litigation, including risks associated with adverse jury and judicial determinations, courts reaching conclusions at variance with the general understandings of applicable law, bonding requirements and the absence of adequate appellate remedies to get timely relief from any of the foregoing;

 

   

health concerns, claims, regulations and other restrictions relating to the use of tobacco products and exposure to environmental tobacco smoke;

 

   

the effect on pricing and consumption rates of legislation, including actual and potential federal and state excise tax increases, and tobacco litigation settlements;

 

   

continued intense competition from other cigarette manufacturers, including significant levels of promotional activities and the presence of a sizable deep discount category;

 

   

the continuing decline in volume in the domestic cigarette industry;

 

   

the increasing restrictions on the marketing and use of cigarettes through governmental regulation and privately imposed smoking restrictions;

 

   

general economic and business conditions;

 

   

changes in financial markets (such as interest rate, credit, currency, commodities and equities markets) or in the value of specific investments;

 

   

the availability of financing upon favorable terms, the results of our financing efforts and the impact of any breach of a debt covenant or a credit rating downgrade;

 

   

potential changes in accounting policies by the Financial Accounting Standards Board, the Securities and Exchange Commission (the “SEC”) or regulatory agencies for the industry in which we participate that may cause us to revise our financial accounting and/or disclosures in the future, and which may change the way analysts measure our business or financial performance;

 

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the risk of fire, violent weather or other disasters adversely affecting our production, storage and other facilities;

 

   

changes in the price, quality or quantity of tobacco leaf and other raw materials available for use in our cigarettes;

 

   

reliance on a limited number of suppliers for certain raw materials;

 

   

our ability to attract and retain the best talent to implement our strategies as a result of the decreasing social acceptance of cigarettes; and

 

   

the closing of any contemplated transactions and agreements.

Adverse developments in any of these factors, as well as the risks and uncertainties described in “Item 1. Business,” “Item 1A. Risk Factors,” “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Environment” and elsewhere in this Annual Report on Form 10-K, could cause our results to differ materially from results that have been or may be anticipated or projected. Forward-looking statements speak only as of the date of this Annual Report on Form 10-K and we expressly disclaim any obligation or undertaking to update these statements to reflect any change in expectations or beliefs or any change in events, conditions or circumstances on which any forward-looking statement is or may be based.

INTRODUCTORY NOTE

On November 13, 2012, the Company’s Board of Directors declared a three-for-one split of the Company’s common stock in the form of a 200% stock dividend. The record date of the stock split was December 14, 2012 and the additional shares were distributed January 15, 2013. Treasury shares were treated as shares outstanding in the stock split. All shares and per share amounts in this filing have been adjusted for all periods presented for the stock split.

PART I

 

Item 1. BUSINESS

Overview

Lorillard is the third largest manufacturer of cigarettes in the United States. Founded in 1760, Lorillard is the oldest continuously operating tobacco company in the United States. Newport, our flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette brand overall in the United States based on gross units sold in 2012. The Newport brand, which includes both menthol and non-menthol product offerings, accounted for approximately 87.0% of our consolidated net sales for the fiscal year ended December 31, 2012. In addition to the Newport brand, our product line has four additional brand families marketed under the Kent, True, Maverick, and Old Gold brand names. These five brands include 39 different product offerings which vary in price, taste, flavor, length and packaging. In 2012, we shipped 40.2 billion cigarettes, all of which were sold in the United States and certain U.S. possessions and territories. Lorillard, through its LOEC, Inc. subsidiary, is also a leading electronic cigarette company in the U.S., marketed under the blu eCigs brand following its acquisition of blu eCigs and other assets used in the manufacture, distribution, development, research, marketing, advertising and sale of electronic cigarettes on April 24, 2012. Newport, Kent, True, Maverick, Old Gold and blu eCigs are the registered trademarks of Lorillard and its subsidiaries. We sold our major cigarette trademarks outside of the United States in 1977. We maintain our headquarters and manufacture all of our cigarette products in Greensboro, North Carolina.

We produce cigarettes for both the premium and discount segments of the domestic cigarette market. We do not compete in a subcategory of the discount segment that we identify as the deep discount segment. Premium brands are well known, established brands marketed at higher retail prices. Discount brands are generally less

 

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well recognized brands marketed at lower retail prices. We define the deep discount subcategory to include brands sold at the lowest retail prices. Deep discount cigarettes are typically manufactured by smaller companies, relative to us and other major U.S. manufacturers, many of which have no, or significantly lower, payment obligations under the Master Settlement Agreement among major tobacco manufacturers and 46 states and various other governments and jurisdictions (the “MSA”) and the settlements of similar claims brought by Mississippi, Florida, Texas and Minnesota, collectively the “State Settlement Agreements”.

Advertising and Sales Promotion

The predominant form of promotion in the industry and for us consists of retail price reduction programs, such as discounting or lowering the price of a pack or carton of cigarettes in the retail store. These programs are developed, implemented and executed by our sales force through merchandising or promotional agreements with retail chain accounts and independent retailers.

We focus our retail programs in markets and stores reflecting unique potential for increased menthol cigarette sales. Our direct buying wholesale customers provide us with information as to the quantities of cigarettes shipped to their retail accounts on a weekly basis. This data covers approximately 99% of domestic wholesale units shipped by us and our major competitors, and enables us to analyze, plan and execute retail promotion programs in markets and stores that optimize the most efficient and effective return on our promotional investments.

We employ other promotion methods to communicate with our adult consumers as well as with adult smokers of our competitors’ products. These promotional programs include the use of direct marketing communications, retail coupons, relationship marketing and promotional materials intended to be displayed at retail. Relationship marketing entails the use of various communication techniques to directly reach adult consumers in order to establish a relationship with them for the purpose of advertising and promoting a product or products. We use our proprietary database of adult smokers of our brands and our competitors’ brands to deliver targeted communications about a given brand through age-restricted direct mail and internet programs. We regularly review the results of our promotional spending activities and adjust our promotional spending programs in an effort to maintain our competitive position. Accordingly, sales promotion costs in any particular fiscal period are not necessarily indicative of costs that may be realized in subsequent periods.

Advertising plays a relatively lesser role in our overall marketing strategy for cigarettes. We advertise Newport in a limited number of magazines that meet certain requirements regarding the age and composition of their readership. Newport is our only cigarette brand that receives magazine advertising support.

Advertising of cigarettes through television and radio has been prohibited since 1971. Under the State Settlement Agreements, the participating cigarette manufacturers agreed to severe restrictions on their advertising and promotion activities including, among other things:

 

   

prohibiting the targeting of youth in the advertising, promotion or marketing of cigarettes;

 

   

banning the use of cartoon characters in all cigarette advertising and promotion;

 

   

limiting each cigarette manufacturer to one brand-name event sponsorship during any twelve-month period, which may not include major team sports or events in which the intended audience includes a significant percentage of youth;

 

   

banning all outdoor advertising of cigarettes with the exception of small signs at retail establishments that sell tobacco products;

 

   

banning cigarette manufacturers from offering or selling apparel and other merchandise that bears a cigarette brand name, subject to specified exceptions;

 

   

prohibiting the distribution of free samples of cigarettes except within adult-only facilities;

 

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prohibiting payments for cigarette placement in various media; and

 

   

banning gift offers based on the purchase of cigarettes without sufficient proof that the intended gift recipient is an adult.

In June 2009, the federal Family Smoking Prevention and Tobacco Control Act (the “FSPTCA”) was enacted granting authority over the regulation of certain tobacco products to the FDA, excluding electronic cigarettes. Pursuant to the FSPTCA, the FDA reissued a set of marketing and sales restrictions originally promulgated in 1995 as part of an unsuccessful effort by the agency to assert jurisdiction over certain tobacco products. The FSPTCA also contains other restrictions, some of which may be more stringent than those found in the original 1995 FDA rule, affecting the advertising, marketing and sale of cigarette products. See the section entitled “Legislation and Regulation” below for additional information concerning the marketing and sales provisions of the FSPTCA. In addition, many states, cities and counties have enacted legislation or regulations further restricting cigarette advertising, marketing and sales promotions, and others may do so in the future. We cannot predict the impact of such initiatives on our marketing and sales efforts.

We fund a Youth Smoking Prevention Program, which is designed to discourage youth from smoking by promoting parental involvement and assisting parents in discussing the issue of smoking with their children. We are also a founding member of the Coalition for Responsible Tobacco Retailing which through its “We Card” program trains retailers in how to prevent the purchase of cigarettes by underage persons. In addition, we have adopted guidelines established by the National Association of Attorneys General to restrict advertising in magazines with large readership among people under the age of 18.

Electronic cigarettes are generally less regulated than cigarettes. Accordingly, a wider variety of marketing programs are available. The predominant forms of advertising and promotion in the electronic cigarette industry are television, print advertising, sampling events and web based advertising. LOEC requires all purchasers of its electronic cigarettes to be at least 18 years of age. During 2012, the FDA indicated that it intends to regulate electronic cigarettes under the FSPTCA through the issuance of deeming regulations that would include electronic cigarettes under the definition of a “tobacco product” under the FSPTCA subject to the FDA’s jurisdiction. As of February 11, 2013, the FDA had not taken such action.

Customers and Distribution

Our field sales personnel are based throughout the United States, and we maintain field sales offices throughout the United States. Our sales department is divided into regions based on geography and sales territories. We sell our products primarily to wholesale distributors, who in turn service retail outlets, chain store organizations, and government agencies, including the U.S. Armed Forces. Upon completion of the manufacturing process, we ship cigarettes to public distribution warehouse facilities for rapid order fulfillment to wholesalers and other direct buying customers. We retain a portion of our manufactured cigarettes at our Greensboro central distribution center and Greensboro cold-storage facility for future finished goods replenishment.

As of December 31, 2012, we had approximately 500 direct buying customers servicing more than 400,000 retail accounts for our cigarettes. We do not sell cigarettes directly to consumers. During 2012, 2011 and 2010, sales made by us to the McLane Company, Inc. comprised 29%, 28% and 27%, respectively, of our revenues. No other customer accounted for more than 10% of 2012, 2011 or 2010 cigarette revenues. We do not have any written sales agreements with our customers, including the McLane Company, Inc. that provide for any backlog orders.

Most of our customers buy cigarettes on a next-day-delivery basis. Customer orders are shipped from public distribution warehouses via third party carriers. We do not ship products directly to retail stores. In 2012,

 

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approximately 99% of our customers purchased cigarettes using electronic funds transfer, which provides immediate payment to us.

As of December 31, 2012, we had approximately 400 direct buying customers providing blu eCigs electronic cigarettes to more than 50,000 retail accounts. We also sell electronic cigarettes directly to consumers over the internet. We do not have any written sales agreements with our customers that provide for any backlog orders for electronic cigarettes. Customer orders are shipped primarily from a public distribution warehouse via third party carriers.

Raw Materials and Manufacturing

In our production of cigarettes, we use domestic and foreign grown burley and flue-cured leaf tobaccos, as well as aromatic tobaccos grown primarily in Turkey and other Near Eastern countries. We believe that there is an adequate supply of leaf tobacco of the type and quality we require at competitive prices from a combination of global sources, and that we are not dependent on any one geographic region or country for our requirements. An affiliate of Reynolds American Inc. (“RAI”) manufactures all of our reconstituted tobacco pursuant to our specifications, as set forth in the agreement between us and RAI. Reconstituted tobacco is a form of tobacco material manufactured as a paper-like sheet from small pieces of tobacco that are too small to incorporate into the cigarette directly and may include some tobacco stems, and which is used as a component of cigarette blends.

We purchase our leaf tobacco through tobacco dealers, which contract with leaf growers. Such purchases are made at prevailing market prices in the country of origin. Due to the varying size and quality of annual crops, changes in the value of the U.S. dollar in relation to other foreign currencies and other economic factors, tobacco prices have historically fluctuated. We direct these dealers in the purchase of tobacco according to our specifications for quality, grade, yield, particle size, moisture content, and other characteristics. The dealers purchase and process the whole leaf and then dry and package it for shipment to and storage at our Danville, Virginia facility. We have not experienced any difficulty in purchasing our requirement of leaf tobacco.

We purchased approximately 31.9%, 24.9% and 27.4% of our leaf tobacco from one dealer, Alliance One International, Inc. (“Alliance One”) in 2012, 2011 and 2010. If Alliance One becomes unwilling or unable to supply leaf tobacco to us, we believe that we can readily obtain high quality leaf tobacco from well-established, alternative industry sources. However, we believe that such high quality leaf tobacco may not be available at prices comparable to those we pay to Alliance One.

We store our tobacco in 29 storage warehouses on our 130-acre Danville, Virginia facility. To protect against loss, amounts of all types and grades of tobacco are stored in separate warehouses. Certain types of tobacco used in our blends must be allowed to mature over time to allow natural chemical changes that enhance certain characteristics affecting taste. Because of these aging requirements, we maintain large quantities of leaf tobacco at all times. We believe our current tobacco inventories are sufficient and adequately balanced for our present and expected production requirements. If necessary, we can typically purchase aged tobacco in the open market to supplement existing inventories.

We produce cigarettes at our Greensboro, North Carolina manufacturing plant, which has a production capacity of approximately 200 million cigarettes per day and approximately 50 billion cigarettes per year. Through various automated systems and sensors, we actively monitor all phases of production to promote quality and compliance with applicable regulations.

All raw materials used in the manufacture of our electronic cigarettes, with the exception of the liquid flavorings, are produced by various suppliers located in Asia. The liquid flavorings used in our electronic cigarettes, which have varieties with and without nicotine, are manufactured in the U.S. and exported to Asian based manufacturers. All of our electronic cigarettes are manufactured and assembled in Asia and imported to the US.

 

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Research and Development

We have an experienced research and development team that continuously evaluates new products and line extensions and assesses new technologies and scientific advancements to be able to respond to marketplace demands and developing regulatory requirements. Our research and development efforts focus primarily on:

 

   

developing quality products that appeal to adult consumers;

 

   

studying and developing consumer-acceptable products with the potential for reduced exposure to smoke constituents or reduced health risk;

 

   

improving the quality and consistency of existing electronic cigarette products;

 

   

developing advancements in electronic cigarette technology aimed at improving consumer acceptability and realizing the potential for harm reduction compared to cigarette products;

 

   

identifying and investigating, through the use of internal and external resources, suspect constituents of cigarette products or their components to determine the feasibility of reduction or elimination;

 

   

maintaining state-of-the-art knowledge about public health and scientific issues related to cigarettes and electronic cigarettes;

 

   

developing new, or modifying existing, products and processes to promote quality control and to comply with current and anticipated laws and regulations; and

 

   

collaborating and cooperating with public and private scientific institutions and encouraging independent research relating to cigarettes and electronic cigarettes.

Tobacco-related research activities include: the analysis of cigarette components, including cigarette paper, filters, tobacco and ingredients, including menthol; analysis of mainstream and sidestream smoke; and modification of cigarette design. We employ advanced scientific equipment in our research efforts, including gas chromatographs, mass spectrographs and liquid chromatographs. We use this equipment to structurally identify and measure the amount of chemical compounds found in cigarette smoke and various tobaccos. These measurements allow us to better understand the relationship between the tobacco, cigarette construction, and the smoke yielded from cigarettes. In addition, advanced biological techniques are developed and used to test the biological impact of tobacco smoke on cells and advance our understanding of potential biomarkers for disease risk.

Information Technology

We are committed to the use of information technology throughout the organization to provide operating effectiveness, cost reduction and competitive advantages. We believe our system platform provides the appropriate level of information in a timely fashion to effectively manage the business. We utilize proven technologies while also continuously exploring new technologies consistent with our information technology architecture strategy. Our information technology environment is anchored by an SAP enterprise resource planning (“ERP”) system designed to meet the processing and analysis needs of our core business operations and financial control requirements. The process control and production methods in our manufacturing operation utilize scanning, radio frequency identification, wireless technologies and software products to monitor and control the manufacturing process. Our primary data center is located at our corporate headquarters and is staffed by an in-house team of experienced information technology professionals. A satellite data center, located at our cigarette manufacturing facility, supports our manufacturing environment. In addition, we have a comprehensive redundancy and disaster recovery plan in place.

Employees

As of December 31, 2012, we had approximately 2,900 full-time employees. As of that date, approximately 1,100 of those employees were represented by labor unions covered by two collective bargaining agreements.

 

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Local Union #317T Greensboro of the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union (AFL-CIO-CLC) represents workers at our Greensboro cigarette manufacturing plant. In August 2011, a new collective bargaining agreement covering this Union was approved, which expires in September 2015. Workers at our Danville, Virginia tobacco storage facility are also represented by Local Union #317T Danville of the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union (AFL-CIO-CLC). In March 2012, a new collective bargaining agreement covering Local Union #317T of Danville was approved, which expires in April 2016. We have historically had an amicable relationship with the unions representing our employees.

We provide a retirement plan, a profit sharing plan and other benefits for our hourly paid employees who are represented by unions. In addition, we provide to our salaried employees a retirement plan, group life, disability and health insurance program and a savings plan. We also maintain an incentive compensation plan for certain salaried employees, and an employee stock purchase plan under which certain full-time employees may purchase shares of Lorillard common stock.

Intellectual Property

We believe that our trademarks, including brand names, are important to our business. We own the patents, trade secrets, know-how and trademarks, including our brand names and the distinctive packaging and displays, used by us in our business. All of our material trademarks are registered with the U.S. Patent and Trademark Office. Rights in these trademarks in the United States will continue indefinitely as long as we continue to use the trademarks.

We consider the blends of tobacco and the flavor formulas used to make our brands to be trade secrets. These trade secrets are generally not the subject of patents, though various manufacturing processes are patented.

We sold the international rights to substantially all of our major cigarette brands, including Newport, in 1977.

Competition

The domestic market for cigarettes is highly competitive. Competition is primarily based on a brand’s taste; quality; price, including the level of discounting and other promotional activities; positioning; consumer loyalty; and retail display.

Our principal competitors are the two other major U.S. cigarette manufacturers, Philip Morris USA Inc. (“Philip Morris”), a subsidiary of Altria Group, Inc. and R.J. Reynolds Tobacco Company (“RJR Tobacco”), a subsidiary of RAI. We also compete with numerous other smaller manufacturers and importers of cigarettes. We believe our ability to compete even more effectively has been restrained in some marketing areas as a result of retail merchandising contracts offered by Philip Morris and RJR Tobacco which limit the retail shelf space available to our brands. As a result, in some retail locations we are limited in competitively supporting our promotional programs, which may constrain sales.

The market for electronic cigarettes is evolving at a very fast pace and is very fragmented, with many smaller companies competing with similar product offerings. In the competition for retail presence, blu eCigs has begun the process of differentiating itself from the competition with unique technology, impactful displays and point of sale materials. The method of distribution for many competing companies is predominately over the internet, with only a small number of competitors currently having a significant presence at retail.

Please read the sections entitled “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Environment” and “—Selected Industry and Domestic Cigarette Retail Market Share Data” beginning on pages 32 and 40, respectively, for additional information.

 

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Legislation and Regulation

Our business operations are subject to a variety of federal, state and local laws and regulations governing, among other things, the research, development and manufacture of cigarettes; the development of new tobacco products; the publication of health warnings on cigarette packaging and advertising; the marketing and sale of tobacco products; restrictions on smoking in public places; and fire safety standards. From time to time, new legislation and regulations are proposed and reports are published by government sponsored committees and others recommending additional regulation of tobacco products.

We cannot predict the ultimate outcome of these proposals, reports and recommendations. If they are enacted or implemented, certain of these proposals could have a material adverse effect on our business and our financial condition or results of operations in the future.

Federal Regulation

The Federal Comprehensive Smoking Education Act, which became effective in 1985, requires that cigarette packaging and advertising display one of the following four warning statements, on a rotating basis:

(1) “SURGEON GENERAL’S WARNING: Smoking Causes Lung Cancer, Heart Disease, Emphysema, and May Complicate Pregnancy.”

(2) “SURGEON GENERAL’S WARNING: Quitting Smoking Now Greatly Reduces Serious Risks to Your Health.”

(3) “SURGEON GENERAL’S WARNING: Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, and Low Birth Weight.”

(4) “SURGEON GENERAL’S WARNING: Cigarette Smoke Contains Carbon Monoxide.”

This law also requires that each company that manufactures, packages or imports cigarettes shall annually provide to the Secretary of Health and Human Services a list of the ingredients added to tobacco in the manufacture of cigarettes. This list of ingredients may be submitted in a manner that does not identify the company that uses the ingredients or the brand of cigarettes that contain the ingredients.

In addition, bills have been introduced in Congress, including those that would:

 

   

prohibit all tobacco advertising and promotion;

 

   

authorize the establishment of various anti-smoking education programs;

 

   

provide that current federal law should not be construed to relieve any person of liability under common or state law;

 

   

permit state and local governments to restrict the sale and distribution of cigarettes;

 

   

direct the placement of advertising of tobacco products;

 

   

provide that cigarette advertising not be deductible as a business expense;

 

   

restrict the sale or distribution of cigarettes in retail stores, by mail or over the internet;

 

   

impose additional, or increase existing, excise taxes on cigarettes; and

 

   

require that cigarettes be manufactured in a manner that will cause them, under certain circumstances, to be self-extinguishing.

In June 2009, the Family Smoking Prevention and Tobacco Control Act was enacted granting the Food and Drug Administration (“FDA”) authority to regulate tobacco products. As it relates to cigarettes, the legislation:

 

   

establishes a Tobacco Products Scientific Advisory Committee to, among other things, evaluate the issues surrounding the use of menthol as a flavoring or ingredient in cigarettes and issue a nonbinding recommendation to the FDA regarding menthol;

 

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grants the FDA the regulatory authority to consider and impose broad additional restrictions through a rule making process, including a ban on the use of menthol in cigarettes;

 

   

requires larger and more severe health warnings, including graphic images, on cigarette packs, cartons, and advertising;

 

   

bans the use of descriptors on cigarettes, such as “low tar” and “light”;

 

   

bans the distribution of free samples of cigarettes;

 

   

requires the disclosure of cigarette ingredients and additives to consumers;

 

   

requires pre-market approval by the FDA of all new cigarette products, including substantially equivalent products;

 

   

requires pre-market approval by the FDA for all claims made with respect to reduced risk or reduced exposure products;

 

   

allows the FDA to review existing products to determine whether these products are substantially equivalent to other products in the market;

 

   

allows the FDA to require the reduction of nicotine or any other compound in cigarettes;

 

   

allows the FDA to mandate the use of reduced risk technologies in cigarettes;

 

   

allows the FDA to place more severe restrictions on the advertising, marketing and sales of cigarettes; and

 

   

permits inconsistent state regulation of the advertising or promotion of cigarettes and eliminates the existing federal preemption of such regulation.

The legislation permits the FDA to impose restrictions regarding the use of menthol in cigarettes, including a ban, if those restrictions would be appropriate for the public health. Any ban or material limitation on the use of menthol in cigarettes would materially adversely affect our results of operations, cash flows and financial condition. It is possible that such additional regulation, including regulation of menthol short of a ban thereof, could result in a decrease in cigarette sales in the United States (including sales of our brands), increased costs to us, and/or the development of a significant black market for cigarettes, which may have a material adverse effect on our financial condition, results of operations and cash flows.

During 2012, the FDA indicated that it intends to regulate electronic cigarettes under the FSPTCA through the issuance of deeming regulations that would include electronic cigarettes under the definition of a “tobacco product” under the FSPTCA subject to the FDA’s jurisdiction. As of February 11, 2013, the FDA had not taken such action. We cannot predict the scope of such regulations or the impact they may have on our electronic cigarette business, though if enacted, they could have a material adverse effect on our electronic cigarette business in the future.

Environmental Tobacco Smoke

Various publications and studies by governmental entities have reported that environmental tobacco smoke (“ETS”), also called second-hand smoke, presents health risks. In addition, public health organizations have issued statements on the adverse health effects of ETS, and scientific papers have been published that address the health problems associated with ETS exposure. Various states, cities and municipalities have restricted public smoking in recent years, and these restrictions have been based at least in part on the publications regarding the health risks believed to be associated with ETS exposure.

The governmental entities that have published these reports have included the Surgeon General of the United States, first with a report focused on the health risks of ETS in 1986 and again in 2006. The 2006 report, for instance, concluded that there is no risk-free level of exposure to ETS. In 2000, the Department of Health and Human Services listed ETS as a known human carcinogen. In 1993, the U.S. Environmental Protection Agency concluded that ETS is a human lung carcinogen in adults and causes respiratory effects in children. The Surgeon General also addressed the health risks of ETS in the 2010 Report of the Surgeon General on “How Tobacco

 

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Smoke Causes Disease: The Biology and Behavioral Basis for Smoking-Attributable Disease” (“2010 Surgeon General Report”).

Agencies of state governments also have issued publications regarding ETS, including reports by California entities that were published in 1997, 1999 and 2006. In the 2006 study, the California Air Resources Board determined that ETS is a toxic air contaminant. Based on these or other findings, public health concerns regarding ETS have lead and could continue to lead to the imposition of additional restrictions on public smoking, including bans, which could have a material adverse effect on our business, financial condition, results of operations and cash flows in the future.

State and Local Regulation

Many state, local and municipal governments and agencies, as well as private businesses, have adopted legislation, regulations or policies which prohibit or restrict, or are intended to discourage, smoking, including legislation, regulations or policies prohibiting or restricting smoking in various places such as public buildings and facilities, stores, restaurants and bars and on airline flights and in the workplace. This trend has increased significantly since the release of the EPA’s report regarding ETS in 1993.

Two states, Massachusetts and Texas, have enacted legislation requiring each manufacturer of cigarettes sold in those states to submit an annual report identifying for each brand sold certain “added constituents,” and providing nicotine yield ratings and other information for certain brands. Neither law allows for the public release of trade secret information.

A New York law which became effective in June 2004 requires cigarettes sold in that state to meet a mandated standard for ignition propensity. We developed proprietary technology to comply with the standards and were compliant by the effective date. Since the passage of the New York law, an additional 49 states and the District of Columbia have passed similar laws utilizing the same technical standards. The effective dates of these laws range from May 2006 to January 2011. Beginning November 1, 2009, all of our cigarettes were manufactured using this technology.

Other similar laws and regulations have been enacted or considered by other state and local governments and may include electronic cigarettes as well as cigarettes. We cannot predict the impact which these regulations may have on our business, though if enacted, they could have a material adverse effect on our business, financial condition, results of operations and cash flows in the future.

Excise Taxes and Assessments

Cigarettes are subject to substantial federal, state and local excise taxes in the United States and, in general, such taxes have been increasing. Effective April 1, 2009, the federal excise tax on cigarettes increased to $50.33 per thousand cigarettes (or $1.0066 per pack of 20 cigarettes) from $19.50 per thousand cigarettes (or $0.39 per pack of 20 cigarettes). State excise taxes, which are levied upon and paid by the distributors, are also in effect in the fifty states, the District of Columbia and many municipalities. During 2012 state excise tax increases on cigarette sales were implemented in two states ranging from $0.04 per pack to $1.00 per pack. For the twelve months ended December 31, 2012, the combined state and municipal taxes ranged from $0.17 to $5.85 per pack of cigarettes.

A federal law enacted in October 2004 repealed the federal supply management program for tobacco growers and compensated tobacco quota holders and growers with payments to be funded by an assessment on tobacco manufacturers and importers. Cigarette manufacturers and importers are responsible for paying 91.6% of a $10.14 billion payment to tobacco quota holders and growers over a ten-year period which will expire in 2014. The law provides that payments will be based on shipments for domestic consumption.

Electronic cigarettes are generally not subject to federal, state and local excise taxes. However, one state has imposed an excise tax on electronic cigarettes and certain other jurisdictions are considering imposing excise taxes and other restrictions on electronic cigarettes.

 

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Separation Agreement with Loews Corporation

Prior to June 10, 2008, Lorillard, Inc. was a wholly-owned subsidiary of Loews Corporation (“Loews”), a publicly traded company listed on the New York Stock Exchange (the “NYSE”). Our results of operations and financial condition were included as a separate reporting segment in Loews’s financial statements and filings with the SEC. On June 10, 2008, we began operating as an independent, publicly traded company pursuant to our separation from Loews (the “Separation”). In connection with the Separation, we entered into an agreement with Loews on May 7, 2008 to provide for the separation of our business from Loews as well as providing for indemnification and allocation of taxes between the parties (the “Separation Agreement”). The Separation Agreement sets forth the relationship between Lorillard and Loews following the Separation, including provisions relating to indemnification and tax allocation between the parties.

Indemnification Provisions

We agreed to indemnify Loews and its officers, directors, employees and agents against all costs and expenses arising out of third party claims (including, without limitation, attorneys’ fees, interest, penalties and costs of investigation or preparation for defense), judgments, fines, losses, claims, damages, liabilities, taxes, demands, assessments and amounts paid in settlement based on, arising out of or resulting from:

 

   

the ownership or the operation of our assets and properties, and the operation or conduct of our businesses at any time prior to or following the Separation (including with respect to any smoking and health claims and litigation);

 

   

certain tax matters, as discussed below;

 

   

any other activities in which we may engage;

 

   

any action or omission by us (or any successor entity) that causes the Separation to become taxable to Loews;

 

   

any breach by us of the Separation Agreement;

 

   

any other acts or omissions by us arising out of the performance of our obligations under the Separation Agreement;

 

   

misstatements in or omissions from the registration statement filed with regard to the Separation, other than misstatements or omissions made in reliance on information relating to and furnished by Loews for use in the preparation of such registration statement; and

 

   

any taxes and related losses resulting from the receipt of any such indemnity payment.

Our indemnification obligations, including the tax indemnification obligations described below, are binding on our successors. We are not permitted to merge, consolidate, transfer or convey all or a significant portion of our properties or assets unless the resulting entity, transferee or successor expressly agrees in writing to be bound by these indemnification obligations. Any equity security or equity interest of Lorillard Licensing Company, LLC (“Lorillard Licensing”), an indirect wholly-owned subsidiary and owner of our trademarks, or any interest in the intellectual property owned by Lorillard Licensing, is deemed a “significant portion” for purposes of the foregoing.

We also agreed to release Loews and its shareholders, officers, directors and employees from any liability owed by any of them to us with respect to acts or events occurring on or prior to the Separation date, except with respect to tax matters.

The Separation Agreement also provides that Loews will indemnify us and our officers, directors, employees and agents against losses, including but not limited to, litigation matters, and other claims, based on, arising out of or resulting from:

 

   

any activity that Loews and its subsidiaries (other than us) engage in;

 

   

any breach by Loews of the Separation Agreement;

 

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any other acts or omissions by Loews arising out of the performance of its obligations under the Separation Agreement; and

 

   

misstatements in or omissions from the registration statement filed with regard to the Separation, but only with respect to misstatements or omissions made in reliance on information relating to and furnished by Loews for use in the preparation of such registration statement.

Loews agreed to release us and all of our directors, officers and employees from any liability owed by any of us to Loews with respect to acts or events occurring on or prior to the Separation date, except with respect to tax matters.

Tax Allocation Provisions

Following the Separation, we are no longer included in Loews’s consolidated group for federal income tax purposes. In connection with the Separation, the Separation Agreement provides certain tax allocation arrangements, pursuant to which we will indemnify Loews for tax liabilities that are allocated to us for taxable periods ending on or before the Separation date. The amount of federal income taxes allocated to us for such periods is generally equal to the federal income taxes that would have been payable by us during such periods if we had filed separate consolidated returns. In addition, with respect to periods in which we were included in Loews’s consolidated group, Loews will indemnify us with respect to the tax liability of the members of the Loews consolidated group other than us. After the Separation, we have the right to be notified of and participate in tax matters for which we are financially responsible under the terms of the Separation Agreement, although Loews will generally control such matters.

The Separation Agreement requires us (and any successor entity) to indemnify Loews for any losses resulting from the failure of the Separation to qualify as a tax-free transaction (except if the failure to qualify is solely due to Loews’s fault). This indemnification obligation applies regardless of whether the action is restricted as described above, or whether we or a potential successor obtains a supplemental ruling or an opinion of counsel.

The Separation Agreement further provides for cooperation between us and Loews with respect to additional tax matters, including the exchange of information and the retention of records which may affect the income tax liability of the parties to the Separation Agreement.

Available Information

We are listed on the NYSE under the symbol “LO.” Our principal offices are located at 714 Green Valley Road, Greensboro, North Carolina 27408. Our telephone number is (336) 335-7000. Our corporate website is located at www.lorillard.com, and our filings pursuant to Section 13(a) of the Exchange Act are available free of charge on our website under the tabs “Investor Relations—Financial Reporting—SEC Filings” as soon as reasonably practicable after such filings are electronically filed with the SEC. Our Corporate Governance Guidelines, Code of Business Conduct and Ethics and charters for the audit, compensation and nominating and corporate governance committees of our Board of Directors are also available on our website under the tabs, “Investor Relations—Governance” and printed copies are available upon request. The information contained on our website is not, and shall not be deemed to be, a part of this Annual Report on Form 10-K or incorporated into any other filings we make with the SEC, except to the extent that we specifically incorporate it by reference into such filing.

Investors may also read and copy any materials that we file at the SEC’s Public Reference Room at 100 F Street, N.E., Washington, D.C. 20549. Readers may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC also maintains an internet site at www.sec.gov that contains our reports.

 

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Item 1A. RISK FACTORS

FDA regulation of menthol in cigarettes and concerns that mentholated cigarettes may pose greater health risks could adversely affect our business.

Some plaintiffs in our litigation and constituencies, including the FDA and other public health agencies, have claimed or expressed concerns that mentholated cigarettes may pose greater health risks and may impact public health more than non-mentholated cigarettes, including concerns that mentholated cigarettes may make it easier to start smoking and harder to quit, and may seek restrictions or a ban on the production and sale of mentholated cigarettes. Any ban or material limitation on the use of menthol in cigarettes would materially adversely affect our results of operations, cash flow and financial condition.

Following the passage of the Family Smoking Prevention and Tobacco Control Act (the “Act”) in June 2009, the FDA established the Tobacco Products Scientific Advisory Committee (the “TPSAC”) to evaluate, among other things, “the impact of the use of menthol in cigarettes on the public health, including such use among children, African-Americans, Hispanics, and other racial and ethnic minorities.” In addition, the Act permits the FDA to impose restrictions regarding the use of menthol in cigarettes, including a ban, if those restrictions would be appropriate for the public health. The TPSAC or the Menthol Report Subcommittee held meetings on March 30-31, 2010, July 15-16, 2010, September 27, 2010, October 7, 2010, November 18, 2010, January 10-11, 2011, February 10-11, 2011, March 2, 2011, March 17-18, 2011 and July 21, 2011 to consider the issues surrounding the use of menthol in cigarettes. At the March 18, 2011 meeting, TPSAC presented its report and recommendations on menthol. The report’s findings included that menthol likely increases experimentation and regular smoking, menthol likely increases the likelihood and degree of addiction for youth smokers, non-white menthol smokers (particularly African-Americans) are less likely to quit smoking and are less responsive to certain cessation medications, and that consumers continue to believe that smoking menthol cigarettes is less harmful than smoking nonmenthol cigarettes as a result of the cigarette industry’s historical marketing. TPSAC’s overall recommendation to the FDA was that “[r]emoval of menthol cigarettes from the marketplace would benefit public health in the United States.” At the July 21, 2011 meeting, TPSAC considered revisions to its report, and the voting members unanimously approved the final report for submission to the FDA with no change in its recommendation.

On June 27, 2011, the FDA provided a progress report on its review of the science related to menthol cigarettes. In the June 2011 update, the FDA stated that “[e]xperts within the FDA Center for Tobacco Products are conducting an independent review of the science related to the impact [of menthol] in cigarettes on public health …” The FDA stated that it would submit its draft independent review of menthol science to an external peer review panel in July 2011. On January 26, 2012, the FDA provided a second progress report on its review of the science related to menthol cigarettes. In its January 2012 update, the FDA stated that “FDA submitted its report to external scientists for peer review, and the agency is revising its report based on their feedback.” FDA stated its intent to make the final report, along with the peer review scientists’ feedback and the agency’s response to the feedback, available for public comment in the Federal Register. The FDA did not provide a date for releasing the final report. The FDA also indicated that it would consider any public comments to the final report, which “may provide additional evidence or emerging data.” Based on those comments, together with the agency’s report, the TPSAC report, the industry’s perspective report and prior public comments, the FDA stated that it will consider the collective evidence and “possible actions related to the public health impact of menthol in cigarettes.” If the FDA determines that regulation of menthol is warranted, the FDA could promulgate regulations that, among other things, could result in a ban on or restrictions on the use of menthol in cigarettes.

Since we are the leading manufacturer of mentholated cigarettes in the United States, we could face increased exposure to tobacco-related litigation as a result of such allegations. Even if such claims are unsubstantiated, increased concerns about the health impact of mentholated cigarettes could materially adversely affect our sales, including sales of Newport. A ban or limitation on the use of menthol in cigarettes by the FDA would materially adversely affect our business.

 

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The regulation of cigarettes by the Food and Drug Administration may materially adversely affect our business.

In June 2009, the Family Smoking Prevention and Tobacco Control Act was enacted granting the FDA authority to regulate tobacco products. As it relates to cigarettes, the legislation:

 

   

establishes a Tobacco Products Scientific Advisory Committee to, among other things, evaluate the issues surrounding the use of menthol as a flavoring or ingredient in cigarettes and issue a nonbinding recommendation to the FDA regarding menthol;

 

   

grants the FDA the regulatory authority to consider and impose broad additional restrictions through a rule making process, including a ban on the use of menthol in cigarettes;

 

   

requires larger and more severe health warnings, including graphic images, on cigarette packs, cartons and advertising;

 

   

bans the use of descriptors on cigarettes, such as “low tar” and “light”;

 

   

requires the disclosure of cigarette ingredients and additives to consumers;

 

   

requires pre-market approval by the FDA of all new cigarette products, including substantially equivalent products;

 

   

requires pre-market approval by the FDA for claims made with respect to reduced risk or reduced exposure products;

 

   

allows the FDA to require the reduction of nicotine or any other compound in cigarettes;

 

   

allows the FDA to mandate the use of reduced risk technologies in cigarettes;

 

   

allows the FDA to place more severe restrictions on the advertising, marketing and sales of cigarettes; and

 

   

permits possible inconsistent state and local regulation of the advertising or promotion of cigarettes and eliminates the existing federal preemption of such regulation.

We believe that such regulation could have a material adverse effect on our business. For example, under the Act, we must file a report with the FDA substantiating that any cigarettes introduced or modified after February 15, 2007 are “substantially equivalent” to cigarettes on the market before that date to enable the agency to determine whether the new or modified products are “substantially equivalent” to specific predicate products already being sold. For any products introduced or modified between February 15, 2007 and March 22, 2011, initial reports were required to be filed with the FDA on or before March 22, 2011. The FDA announced that a product introduced or modified before March 22, 2011 may remain on the market pending the FDA’s review, provided a “substantially equivalent” report was filed with the FDA on or before March 22, 2011. We believe, based on the limited guidance issued by the FDA to date, that we were required to file, and have filed, reports for all of our cigarettes on or before March 22, 2011 since modifications had been made to our products since 2007. While all of our cigarettes may remain on the market pending the FDA’s review, they are subject to removal should the FDA determine any are not “substantially equivalent.”

In addition, products introduced on or after March 22, 2011 require pre-market approval by the FDA which may be subject to similar or more restrictive procedures. One component of our strategic plan is the introduction of new cigarette products in adjacent market segments, in which we do not have a significant presence. We have submitted a number of requests for approval of substantially equivalent new products with the FDA. Although we believe that the statutory language of the FSPTCA suggests the pre-market approval process should take 90 days for substantially equivalent new products, the FDA has not approved any substantially equivalent new product applications by us or anyone else in the industry as of February 11, 2013. We believe our ability to execute our strategic plan has been negatively impacted by the delay in the FDA’s new product approval process.

 

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As of February 11, 2013, Lorillard Tobacco is a defendant in approximately 7,203 tobacco-related lawsuits, including approximately 665 cases in which Lorillard, Inc. is a co-defendant. These cases, which are extremely costly to defend, could result in substantial judgments against Lorillard Tobacco and/or Lorillard, Inc.

Numerous legal actions, proceedings and claims arising out of the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of cigarettes are pending against Lorillard Tobacco and Lorillard, Inc., and it is likely that similar claims will continue to be filed for the foreseeable future. In addition, several cases have been filed against Lorillard Tobacco and other tobacco companies challenging certain provisions of the MSA among major tobacco manufacturers and 46 states and various other governments and jurisdictions, and state statutes promulgated to carry out and enforce the MSA.

Punitive damages, often in amounts ranging into the billions of dollars, are specifically pleaded in a number of cases in addition to compensatory and other damages. It is possible that the outcome of these cases, individually or in the aggregate, could result in bankruptcy. It is also possible that Lorillard Tobacco and Lorillard, Inc. may be unable to post a surety bond in an amount sufficient to stay execution of a judgment in jurisdictions that require such bond pending an appeal on the merits of the case. Even if Lorillard Tobacco and Lorillard, Inc. are successful in defending some or all of these actions, these types of cases are very expensive to defend. A material increase in the number of pending claims could significantly increase defense costs and have an adverse effect on our results of operations and financial condition. Further, adverse decisions in litigations against other tobacco companies could have an adverse impact on the industry, including us.

Plaintiffs have been awarded damages, including punitive damages, from Lorillard Tobacco in a Conventional Product Liability Case.

In December 2010, a Massachusetts jury awarded damages, including punitive damages, from Lorillard Tobacco in a Conventional Product Liability Case, Evans v. Lorillard Tobacco Company (Superior Court, Suffolk County, Massachusetts). In September 2011, the court reduced the compensatory damages awarded to the estate of a deceased smoker to $25 million and reduced the award to the deceased smoker’s son to $10 million. The court declined to reduce the jury’s award of $81 million in punitive damages. In September 2011, the court entered a judgment that reflected the jury’s damages awards and the court’s reductions following trial. The judgment awarded plaintiffs interest on each of the three damages awards at the rate of 12% per year from the date the case was filed in 2004. Interest on the three awards will continue to accrue until either the judgment is paid or is vacated on appeal. The judgment permitted plaintiff’s counsel to request an award of attorneys’ fees and costs. In November 2011, the court granted in part plaintiff’s counsel’s application for attorneys’ fees and costs and has awarded approximately $2.4 million in fees and approximately $225,000 in costs. The court entered a final judgment that incorporated the amounts of the verdicts, as reduced by the trial court, the awards of interest, and the awards of attorneys’ fees and costs. Lorillard Tobacco has noticed an appeal from the final judgment to the Massachusetts Appeals Court. In March 2012, plaintiff’s application for direct appellate review was granted, transferring the appeal to the Massachusetts Supreme Judicial Court. The parties’ arguments in this appeal were heard in December 2012. It is possible that the verdict in this case could lead to additional litigation.

The Florida Supreme Court’s ruling in Engle has resulted in additional litigation against cigarette manufacturers, including us.

The case of Engle v. R.J. Reynolds Tobacco Co., et al. (Circuit Court, Dade County, Florida, filed May 5, 1994) was certified as a class action on behalf of Florida residents, and survivors of Florida residents, who were injured or died from medical conditions allegedly caused by addiction to smoking. The case was tried between 1998 and 2000 in a multi-phase trial that resulted in verdicts in favor of the class. In 2006, the Florida Supreme Court issued a ruling that, among other things, determined that the case could not proceed further as a class action. In February 2008, the trial court entered an order on remand from the Florida Supreme Court that formally decertified the class.

 

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The 2006 ruling by the Florida Supreme Court in Engle also permitted members of the Engle class to file individual claims, including claims for punitive damages. The Florida Supreme Court held that these individual plaintiffs are entitled to rely on a number of the jury’s findings in favor of the plaintiffs in the first phase of the Engle trial. These findings included that smoking cigarettes causes a number of diseases; that cigarettes are addictive or dependence-producing; and that the defendants, including Lorillard Tobacco and Lorillard, Inc., were negligent, breached express and implied warranties, placed cigarettes on the market that were defective and unreasonably dangerous, and concealed or conspired to conceal the risks of smoking. Lorillard Tobacco is a defendant in approximately 4,565 cases pending in various state and federal courts in Florida that were filed by members of the Engle class (the “Engle Progeny Cases”), including 662 cases in which Lorillard, Inc. is a co-defendant.

As of February 11, 2013, trial was underway in one Engle Progeny case in which Lorillard Tobacco is a defendant: the case of Evers v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Thirteenth Judicial Circuit, Hillsborough County, Florida). Lorillard, Inc. is not a defendant in this trial. As of February 11, 2013, Lorillard Tobacco and Lorillard, Inc. are defendants in Engle Progeny Cases that have been placed on courts’ 2013 trial calendars or in which specific trial dates have been set. Trial schedules are subject to change and it is not possible to predict how many of the Engle Progeny Cases pending against Lorillard Tobacco or Lorillard, Inc. will be tried in 2013. It also is not possible to predict whether some courts will implement procedures that consolidate multiple Engle Progeny Cases for trial.

Trials of some of the Engle Progeny Cases have resulted in verdicts that have awarded damages from cigarette manufacturers, including us.

As of February 11, 2013, plaintiffs in nine Engle Progeny Cases were awarded compensatory damages from Lorillard Tobacco. In three of the nine cases, plaintiffs were awarded punitive damages from Lorillard Tobacco. In one of the cases, the court awarded damages to the plaintiff from the defendants, including Lorillard Tobacco, following trial. Lorillard, Inc. was not a defendant in any of these nine cases. The nine cases are listed below in the order in which the verdicts were returned:

 

   

In Mrozek v. Lorillard Tobacco Company (Circuit Court, Fourth Judicial Circuit, Duval County, Florida), the jury awarded plaintiffs a total of $6 million in compensatory damages and $11.3 million in punitive damages. The jury apportioned 35% of the fault for the smoker’s injuries to the smoker and 65% to Lorillard Tobacco. The final judgment entered by the trial court reflected the jury’s verdict and awarded plaintiff $3,900,588 in compensatory damages and $11,300,000 in punitive damages plus 6% annual interest. A motion filed by Lorillard Tobacco to disqualify the trial judge based on comments he made in another Engle Progeny trial was denied in July 2012 and a petition filed by Lorillard Tobacco requesting that the Florida First District Court of Appeal review that decision was denied in January 2013. In December 2012, the Florida First District Court of Appeal affirmed the final judgment awarding compensatory and punitive damages. Lorillard Tobacco has filed a motion for rehearing of the appellate court opinion. The appellate court provisionally granted plaintiff’s motion for appellate attorneys’ fees, ruling that the trial court is authorized to award appellate fees if the trial court determines entitlement to attorneys’ fees. As of February 11, 2013, the trial court had not ruled on plaintiff’s motion for costs and attorneys’ fees.

 

   

In Tullo v. R.J. Reynolds, et al. (Circuit Court, Palm Beach County, Florida), the jury awarded plaintiff a total of $4.5 million in compensatory damages. The jury assessed 45% of the fault to the smoker, 5% to Lorillard Tobacco and 50% to other defendants. The jury did not award punitive damages to the plaintiff. The court entered a final judgment that awarded plaintiff $225,000 in compensatory damages from Lorillard Tobacco plus 6% annual interest. Defendants noticed an appeal from the final judgment to the Florida Fourth District Court of Appeal.

 

   

In Sulcer v. Lorillard Tobacco Company, et al. (Circuit Court, Escambia County, Florida), the jury awarded $225,000 in compensatory damages to the plaintiff and it assessed 95% of the fault for the

 

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smoker’s injuries to the smoker with 5% allocated to Lorillard Tobacco. The jury returned a verdict for Lorillard Tobacco as to whether plaintiff is entitled to punitive damages. The court entered a final judgment that incorporated the jury’s determination of the parties’ fault and awarded plaintiff $11,250 in compensatory damages. Lorillard Tobacco paid approximately $246,000 to resolve the damages verdict, costs and fees. Following this payment, Sulcer was concluded.

 

   

In Jewett v. R.J. Reynolds Tobacco Co., et al. (Circuit Court, Duval County, Florida), the jury awarded the estate of the decedent $692,981 in compensatory damages and awarded the plaintiff $400,000 for loss of companionship. The jury assessed 70% of the responsibility for the decedent’s injuries to the decedent, 20% to R.J. Reynolds and 10% to Lorillard Tobacco. The jury determined that no punitive damages were warranted. The final judgment entered by the trial court reflected the jury’s verdict and awarded plaintiff a total of $109,298 from Lorillard Tobacco plus 6% annual interest. In June 2012, an agreement was reached between the parties as to the amount of costs and attorneys’ fees incurred and plaintiff’s motion for costs and attorneys’ fees was withdrawn. In November 2012, the Florida First District Court of Appeal reversed the judgment awarding compensatory damages and ordered the case returned to the trial court for a new trial. In January 2013, the appellate court denied a motion filed by the plaintiff for rehearing of the decision reversing the judgment.

 

   

In Weingart v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Palm Beach County, Florida), the jury determined that the decedent did not sustain any compensatory damages from the defendants, including Lorillard Tobacco, and it returned a verdict for the defendants that punitive damages were not warranted. The jury assessed 91% of the fault for the decedent’s injuries to the decedent, 3% to Lorillard Tobacco and 3% to each of the other two defendants. Following trial, the court granted in part a motion by the plaintiff to award damages, and it tentatively awarded plaintiff $150,000 in compensatory damages. The court entered a final judgment that applied the jury’s comparative fault determinations to the court’s award of compensatory damages. The final judgment awarded plaintiff $4,500 from Lorillard Tobacco. Defendants have noticed an appeal to the Florida Fourth District Court of Appeal from the order that awarded compensatory damages to the plaintiff and have amended their notice of appeal to address the final judgment. In March 2012, the court entered a judgment against the defendants for costs with Lorillard Tobacco’s share amounting to $43,081 plus 4.75% annual interest. Defendants have noticed an appeal from this cost judgment.

 

   

In Sury v. R.J. Reynolds Tobacco Company, et al., (Circuit Court, Duval County, Florida), the jury awarded plaintiff $1,000,000 in compensatory damages and assessed 60% of the responsibility for the decedent’s injuries to the decedent, 20% to Lorillard Tobacco and 20% to R.J. Reynolds. The jury returned a verdict for the defendants regarding whether punitive damages were warranted. In March 2012, the court entered a final judgment against defendants in the amount of $1,000,000 plus 4.75% annual interest, declining to apply the jury’s comparative fault findings to causes of action alleging intentional conduct. Defendants have noticed an appeal to the Florida First District Court of Appeal from the final judgment that awarded compensatory damages to the plaintiff. In December 2012, Lorillard Tobacco reached an agreement with the plaintiff to resolve the trial costs and fees, should the judgment be upheld on appeal.

 

   

In Alexander v. Lorillard Tobacco Company, et al. (Circuit Court, Eleventh Judicial Circuit, Miami-Dade County, Florida) the jury awarded plaintiff $20,000,000 in compensatory damages and $25,000,000 in punitive damages. Lorillard Tobacco is the only defendant in this case. The jury apportioned 20% of the fault for the smoker's injuries to the smoker and 80% to Lorillard Tobacco. In March 2012, the court entered a final judgment that applied the jury’s comparative fault determination to the court’s award of compensatory damages, awarding the plaintiff $16,000,000 in compensatory damages and $25,000,000 in punitive damages from Lorillard Tobacco. In May 2012, the court granted a motion by Lorillard Tobacco to lower the amount of compensatory damages and reduced the amount awarded to $10,000,000 from Lorillard Tobacco. Other post-trial motions challenging the verdict were denied. The court entered an amended final judgment that applied the jury’s comparative fault

 

determination to the court’s award of compensatory damages, awarding the plaintiff $8,000,000 in

 

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compensatory damages and $25,000,000 in punitive damages, plus the statutory rate of interest, should the judgment be upheld on appeal. Lorillard Tobacco has noticed an appeal from the amended final judgment to the Florida Third District Court of Appeal. Plaintiff filed a motion for attorneys’ fees and costs. In September 2012, an agreement was reached between the parties as to the amount of costs and attorneys’ fees incurred.

 

   

In Calloway v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Seventeenth Judicial Circuit, Broward County, Florida), the jury awarded plaintiff and a daughter of the decedent a total of $20,500,000 in compensatory damages. The jury apportioned 20.5% of the fault for the smoker’s injuries to the smoker, 27% to R.J. Reynolds, 25% to Philip Morris, 18% to Lorillard Tobacco, and 9.5% to Liggett. The jury awarded $12,600,000 in punitive damages from Lorillard Tobacco and $42,250,000 from the other defendants, for a total punitive damages award of $54,850,000. In August 2012, the court granted a post-trial motion by the defendants and lowered the compensatory damages award to $16,100,000. The court also ruled that the jury’s finding on the plaintiff’s percentage of comparative fault would not be applied to reduce the compensatory damage award because the jury found in favor of the plaintiff on her claims alleging intentional conduct. In August 2012, the court entered final judgment against defendants in the amount of $16,100,000 in compensatory damages and $54,850,000 in punitive damages, plus the statutory rate of interest, which is currently 4.75%. Lorillard Tobacco is liable for $12,600,000 of the total punitive damages award. The final judgment also granted plaintiff’s application for costs and attorneys’ fees, but as of February 11, 2013, the trial court had not awarded an amount. Defendants have noticed an appeal from the final judgment to the Florida Fourth District Court of Appeal.

 

   

In Evers v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Thirteenth Judicial Circuit, Hillsborough County, Florida), the jury awarded plaintiff and the estate of the decedent a total of $3,230,000 in compensatory damages. The jury apportioned 31% of the fault for the smoker’s injuries to the smoker, 60% to R.J. Reynolds and 9% to Lorillard Tobacco. The jury found that punitive damages against Lorillard Tobacco were not warranted. The jury determined that punitive damages were warranted against R.J. Reynolds Tobacco Company. As of February 11, 2013, the trial had not proceeded to a second phase to determine the amount of punitive damages, if any.

As of February 11, 2013, verdicts have been returned in 71 Engle Progeny Cases in which neither Lorillard Tobacco nor Lorillard, Inc. were defendants since the Florida Supreme Court issued its 2006 ruling. Juries awarded compensatory damages and punitive damages in 24 of these trials. The punitive damages awards have totaled approximately $625 million and have ranged from $20,000 to $244 million. In 20 of the trials, juries awarded only compensatory damages. In the 27 other trials, juries found in favor of the defendants. In some of the trials decided in the defendants’ favor, plaintiffs have filed motions challenging the verdicts. It is not possible to predict the final outcome of this litigation.

Various intermediate state and federal Florida appellate courts have issued rulings that address the scope of the preclusive effect of the findings from the first phase of the Engle trial, including whether those findings relieve plaintiffs from the burden of proving certain legal elements of their claims. In July 2010, the United States Court of Appeals for the Eleventh Circuit reversed the decision of the trial court in the Bernice Brown case, finding that it was premature to address the extent of any preclusive effect of the Engle Phase I findings until the scope of the factual issues decided in Engle Phase I was determined by the trial court. In December 2010, in the Martin case, the Florida First District Court of Appeal disagreed with the Bernice Brown ruling and found that the trial court correctly construed the Florida Supreme Court’s 2006 Engle decision and that it properly instructed the jury on the preclusive effect of certain of the Engle jury’s findings. In September 2011, in the Jimmie Lee Brown case, the Florida Fourth District Court of Appeal had a different interpretation of the effect of the 2006 Engle decision on plaintiff’s claims than both the Bernice Brown and Martin courts. In December 2011, the U.S. District Court for the Middle District of Florida, in the Waggoner case, found that the Florida Supreme Court’s 2006 Engle decision to give the Engle Phase I findings preclusive effect, in conjunction with the Martin and Jimmie Lee Brown cases, was a constitutionally permissible application of Florida law. Since the

 

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Martin and Jimmie Lee Brown decisions, 15 other verdicts awarding damages to plaintiffs have been affirmed in intermediate state Florida appellate courts. The Florida Supreme Court has granted review in one of those cases, the Douglas case, to address the issue of whether a tobacco manufacturer’s due process rights are violated by relying upon the Engle Phase I findings. The Florida Supreme Court heard argument in September 2012. The due process issue is also currently on appeal in the United States Court of Appeals for the Eleventh Circuit in the Duke and Walker cases. The Duke appeal has been stayed pending the Florida Supreme Court’s decision on Douglas. A joint motion to consolidate the Duke and Walker appeals and suspend any further activity on those appeals until after the Florida Supreme court’s decision on Douglas is also pending.

In connection with the Engle Progeny Cases, Lorillard and various other tobacco manufacturing defendants face various legal issues that could materially affect the outcome of the Engle cases. These legal issues include, but are not limited to, the application of the statute of limitations and statute of repose, the ability of an Engle plaintiff to pursue a claim against defendants that did not manufacture or market the cigarettes plaintiff smoked, the constitutionality of a cap on the amount of a bond necessary to obtain an automatic stay of a post-trial judgment, and whether a plaintiff’s representative may continue an existing lawsuit or file a new lawsuit after that the original plaintiff has died. Various intermediate Florida appellate courts and Florida Federal Courts have issued rulings on these issues.

The judgment entered in the federal government’s reimbursement case, while not final in all respects, could restrict or limit our defenses in other litigation.

In August 2006, a final judgment and remedial order was entered in United States of America v. Philip Morris USA, Inc., et al. (U.S. District Court, District of Columbia, filed September 22, 1999). The court based its final judgment and remedial order on the government’s only remaining claims, which were based on the defendants’ alleged violations of the Racketeering Influenced and Corrupt Organizations Act (“RICO”). Lorillard, Inc. is not a party to this matter, but Lorillard Tobacco is one of the defendants in the case. Although the verdict did not award monetary damages to the plaintiff, the final judgment and remedial order imposed a number of requirements on the defendants. Such requirements include, but are not limited to, the publishing of corrective statements by defendants related to the health effects of smoking.

In 2009, a three judge panel of the Court of Appeals upheld substantially all of the District Court’s final judgment and remedial order. In June 2010, the U.S. Supreme Court denied the parties’ petitions seeking review of the case. The case has been returned to the U.S. District Court, District of Columbia for implementation of the Court of Appeals’ directions in its 2009 ruling and for entry of an amended final judgment. As of February 11, 2013, the trial court had not entered the amended final judgment.

The 2006 final judgment and remedial order made many adverse findings regarding the conduct of the defendants. It is possible that the final opinion, final judgment and remedial order entered by the court could form the basis of allegations by the plaintiffs in other matters, or of additional judicial findings by other courts against cigarette manufacturers. It is possible that other courts could apply the findings in the United States of America case to restrict or otherwise limit our defenses in other litigation.

A ruling by the United States Supreme Court could limit the ability of cigarette manufacturers to contend that certain claims asserted against them in product liability litigation are barred. The Supreme Court’s decision also could encourage litigation involving cigarettes labeled as “lights” or “low tar.”

In December 2008, the United States Supreme Court issued a decision that neither the Federal Cigarette Labeling and Advertising Act nor the Federal Trade Commission’s regulation of cigarettes’ tar and nicotine disclosures preempts (or bars) some of plaintiffs’ claims. The decision also more broadly addresses the scope of preemption based on the Federal Cigarette Labeling and Advertising Act, and could significantly limit cigarette manufacturers’ arguments that certain of plaintiffs’ other claims in smoking and health litigation, including claims based on the alleged concealment of information with respect to the hazards of smoking, are preempted.

 

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In addition, the Supreme Court’s ruling could encourage litigation against cigarette manufacturers, including us, regarding the sale of cigarettes labeled as “lights” or “low tar,” and it may limit cigarette manufacturers’ ability to defend such claims. The Supreme Court issued this ruling in a purported “lights” class action, Good v. Altria Group, Inc. We were not a defendant in Good.

The U.S. Surgeon General has issued reports regarding the risks of cigarette smoking to non-smokers that could result in additional litigation against cigarette manufacturers, additional restrictions placed on the use of cigarettes, and additional regulations placed on the manufacture or sale of cigarettes.

In a report entitled “The Health Consequences of Involuntary Exposure to Tobacco Smoke: A Report of the Surgeon General, 2006,” the U.S. Surgeon General summarized conclusions from previous Surgeon General’s reports concerning the health risks to non-smokers from exposure to ETS, also called second-hand smoke. According to this report, scientific evidence supported six major conclusions:

 

   

Second-hand smoke causes premature death and disease in children and in adults who do not smoke.

 

   

Children exposed to second-hand smoke are at an increased risk for sudden infant death syndrome, acute respiratory infections and ear problems.

 

   

Exposure of adults to second-hand smoke has immediate adverse effects on the cardiovascular system and causes heart disease and lung cancer.

 

   

The scientific evidence indicates that there is no risk-free level of exposure to second-hand smoke.

 

   

Many millions of Americans, both children and adults, are exposed to second-hand smoke in their homes and workplaces.

 

   

Eliminating smoking in indoor spaces fully protects non-smokers from exposure to second-hand smoke. Separating smokers from non-smokers, cleaning the air, and ventilating buildings cannot eliminate exposures of non-smokers to second-hand smoke.

The Surgeon General also addressed the health risks to non-smokers from exposure to ETS in the 2010 Surgeon General Report. These reports could form the basis of additional litigation against cigarette manufacturers, including us. The reports have been and in the future could be used to support litigation against us or other cigarette manufacturers. It also is possible that the Surgeon General’s report could result in additional restrictions placed on cigarette smoking or in additional regulations placed on the manufacture or sale of cigarettes. It is possible that such additional restrictions or regulations could result in a decrease in cigarette sales in the United States, including sales of our brands. These developments may have a material adverse effect on our financial condition, results of operations, and cash flows.

We have substantial payment obligations under the State Settlement Agreements which will have a material adverse effect on our cash flows and operating income in future periods.

In 1998, Lorillard Tobacco, Philip Morris, RJR Tobacco and Brown & Williamson Tobacco Corporation (now an affiliate of RJR Tobacco) (the “Original Participating Manufacturers”) entered into the MSA with 46 states and various other governments and jurisdictions to settle asserted and unasserted health care cost recovery and other claims. We and certain other U.S. tobacco product manufacturers had previously settled similar claims brought by Mississippi, Florida, Texas and Minnesota (the “Initial State Settlements” and, together with the MSA, are referred to as the “State Settlement Agreements).”

Under the State Settlement Agreements, we paid $1.348 billion in 2012 and estimate that we will pay between $1.350 billion and $1.400 billion in 2013, primarily based on 2012 estimated industry volume. Annual payments under the State Settlement Agreements are required to be paid in perpetuity and are based, among other things, on our domestic market share and unit volume of domestic shipments, with respect to the MSA, in the year preceding the year in which payment is due, and, with respect to the Initial State Settlements, in the year in which payment is due.

 

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In the fourth quarter 2011, RAI, the parent of RJR Tobacco, announced a change to a mark-to-market pension accounting method. Such method of accounting for pension and postretirement benefits results in the recognition of actuarial gains and losses on pension and postretirement plan assets or benefit obligations in the year it is incurred rather than amortized over the average future service period of the active employees in such plans. Amounts due under the State Settlement Agreements are impacted by a number of factors, including industry volume, market share and industry operating profits. As a result of the change to mark-to-market pension accounting announced by RAI, the industry operating profits as defined in the State Settlement Agreements may be impacted positively or negatively in any given year. For example, in 2012 RAI’s mark-to-market pension adjustment resulted in a $8 million reduction in our obligations under the State Settlement Agreements. It is possible that our State Settlement Agreement obligations, results of operations, cash flows and financial position could be materially adversely affected by RAI’s mark-to-market adjustments in the future.

We are unable to estimate the amount or range of loss that could result from an unfavorable outcome of certain material pending litigation.

We record provisions in the consolidated financial statements for pending litigation when we determine that it is probable that a loss has been incurred and the amount of loss can be reasonably estimated. Except for the impact of the State Settlement Agreements as described above, while it is reasonably possible that a loss has been incurred, (i) management has concluded that it is not probable that a loss has been incurred in any material pending litigation against us, (ii) management is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome in any material pending litigation due to the many variables, uncertainties and complexities surrounding pending litigation, and (iii) accordingly, management has not provided any amounts in the consolidated financial statements for possible losses related to material pending litigation. It is possible that our results of operations or cash flows in a particular quarterly or annual period or its financial position could be materially adversely affected by an unfavorable outcome or settlement of certain pending or future litigation or an inability to secure bonds where required to stay the execution of judgments on appeal.

We may not be able to develop, produce or commercialize competitive new products and technologies required by regulatory changes or changes in consumer preferences.

Consumer health concerns and changes in regulations are likely to require us to introduce new products or make substantial changes to existing products. For example, all 50 states and the District of Columbia require cigarette manufacturers to reduce the ignition propensity of their products. We believe that there may be increasing pressure from public health authorities to develop a conventional cigarette, an alternative cigarette or an alternative tobacco product that provides a demonstrable reduced risk of adverse health effects. Certain of the other major cigarette makers have already developed and marketed alternative cigarette products. We may not be able to develop a reduced risk or reduced exposure product that the FDA allows to be marketed or is acceptable to consumers. In addition, the costs associated with developing any such new products and technologies could be substantial.

We face intense competition and our failure to compete effectively could have a material adverse effect on our profitability and results of operations.

We compete primarily on the basis of product quality, brand recognition, brand loyalty, service, marketing, advertising and price. We are subject to highly competitive conditions in all aspects of our business. The competitive environment and our competitive position can be significantly influenced by weak economic conditions, erosion of consumer confidence, competitors’ introduction of low-priced products or innovative products, increased competitive discounting and other promotional activity, higher excise taxes, higher absolute prices and larger gaps between price categories, and product regulation that diminishes the ability to differentiate cigarette products.

Our principal competitors are the two other major U.S. cigarette manufacturers, Philip Morris and RJR Tobacco. We also compete against numerous other smaller manufacturers or importers of cigarettes. If our major

 

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competitors were to significantly increase the level of price discounts offered to consumers, we could respond by increasing price discounts, which could have a materially adverse effect on our profitability and results of operations.

The market for electronic cigarettes is evolving at a very fast pace and is very fragmented, and we compete with many smaller companies with similar product offerings. The method of distribution for many competing companies is predominately over the internet, with only a small number of competitors currently having a significant presence at retail.

We are subject to important limitations on advertising and marketing cigarettes that could harm our competitive position.

Television and radio advertisements of cigarettes have been prohibited since 1971. Under the State Settlement Agreements, we generally cannot use billboard advertising, cartoon characters, sponsorship of concerts, non-tobacco merchandise bearing Lorillard’s brand names and various other advertising and marketing techniques. In addition, the MSA prohibits the targeting of youth in advertising, promotion or marketing of cigarettes. Accordingly, we have determined not to advertise our cigarettes in magazines with large readership among people under the age of 18. In June 2009, the federal Family Smoking Prevention and Tobacco Control Act was enacted granting authority over the regulation of cigarettes to the FDA. Pursuant to the FSPTCA, the FDA reissued a set of marketing and sales restrictions originally promulgated in 1995 as part of an unsuccessful effort by the agency to assert jurisdiction over cigarettes. The FSPTCA contains other restrictions on the advertising, marketing and sale of cigarette products more stringent than those found in the original FDA rule. In addition, many states, cities and counties have enacted legislation or regulations further restricting tobacco advertising, marketing and sales promotions, and others may do so in the future. Additional restrictions may be imposed or agreed to in the future. These limitations may make it difficult to maintain the value of an existing brand if sales or market share decline for any reason. Moreover, these limitations significantly impair the ability of cigarette manufacturers, including us, to launch new premium brands.

The potential regulation of electronic cigarettes by the Food and Drug Administration may materially adversely affect our electronic cigarette business.

During 2012, the FDA indicated that it intends to regulate electronic cigarettes under the FSPTCA through the issuance of deeming regulations that would include electronic cigarettes under the definition of a “tobacco product” under the FSPTCA subject to the FDA’s jurisdiction. As of February 11, 2013, the FDA had not taken such action. The application of the FSPTCA to electronic cigarettes could impose, among other things, restrictions on the advertising, marketing and sale of electronic cigarettes, the use of certain flavorings and introducing new products. See “The regulation of cigarettes by the Food and Drug Administration may materially adversely affect our business” above for additional information on the FSPTCA restrictions applicable to cigarettes. We cannot predict the scope of such regulations or the impact they may have on our electronic cigarette business, though if enacted, they could have a material adverse effect on our electronic cigarette business in the future.

Changes in laws, regulations and other requirements could adversely affect our business, results of operations or financial condition.

In addition to the regulation of our business by the FDA, our business, results of operations or financial condition could be adversely affected by new or future legal requirements imposed by legislative or regulatory initiatives, including but not limited to those relating to health care reform, climate change and environmental matters. For example, the health care reform legislation, which was signed into law in March 2010, resulted in the repeal of $2 million of future tax deductions for Medicare Part D subsidies for our retiree drug benefits and could impact our accounting for retiree medical benefits, employer-sponsored medical plans and related matters in future periods. However, the extent of that impact, if any, cannot be determined until regulations are promulgated and additional interpretations of the health care law are available. New legislation or regulations may result in increased costs directly for our compliance or indirectly to the extent such requirements increase

 

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the prices of goods and services because of increased costs or reduced availability. We cannot predict whether such legislative or regulatory initiatives will result in significant changes to existing laws and regulations and/or whether any changes in such laws or regulations will have a material adverse effect on our business, results of operations or financial condition.

Sales of cigarettes are subject to substantial federal, state and local excise taxes.

The federal excise tax on cigarettes was last increased on April 1, 2009 from $0.39 per pack to $1.0066 per pack to finance health insurance for children. For the twelve months ended December 31, 2012, combined state and local excise taxes ranged from $0.17 to $5.85 per pack of cigarettes. Various states and localities have raised the excise tax on cigarettes substantially in recent years. During 2012, state excise tax increases on cigarette sales were implemented in two states ranging from $0.04 per pack to $1.00 per pack. It is our expectation that several states will propose further increases in 2013 and in subsequent years. We believe that increases in excise and similar taxes have had an adverse impact on sales of cigarettes. In addition, we believe that the 2009 increase in the federal excise tax, as well as possible future increases, the extent of which cannot be predicted, compounded by poor economic conditions, could result in further volume declines for the cigarette industry, including us, and an increased sales shift toward lower priced discount cigarettes rather than premium brands.

We are dependent on the domestic cigarette business, which we expect to continue to contract.

Although we conduct business in Puerto Rico, Guam and the U.S. Virgin Islands, our cigarette business in the 50 states of the United States (the “domestic cigarette market”) is currently our only significant business and has generally been contracting. We do not have foreign cigarette sales that could offset these effects, as we sold the international rights to substantially all of our cigarette brands, including Newport, in 1977. As a result of price increases, restrictions on advertising and promotions, 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, industry-wide domestic cigarette shipments have decreased at a compound annual rate of approximately 3.7% during the period 2002 through 2012. Industry-wide domestic cigarette shipments decreased by an estimated 2.3% for 2012 compared to 2011, 3.5% for 2011 compared to 2010, 3.8% for 2010 compared to 2009 and 8.6% for 2009 compared to 2008. We expect the domestic cigarette market to continue to contract, which could have a material adverse effect on our results of operation and financial condition.

We derive most of our revenue from one brand.

Our largest selling brand, Newport, accounted for approximately 87.0% of our consolidated net sales for 2012. Our principal strategic plan revolves around the marketing and sales promotion in support of the Newport brand. We cannot ensure that we will continue to successfully implement our strategic plan with respect to Newport or that implementation of our strategic plan will result in the maintenance, growth or profitability of the Newport brand.

The use of significant amounts of promotion expenses and sales incentives in response to competitive actions and market price sensitivity may have a material adverse impact on our business.

Since 1998, the cigarette market has been increasingly price competitive due to the impact of, among other things, higher state and local excise taxes and the market share of deep discount brands. In response to these and other competitor actions and pricing pressures, we have engaged in the significant use of promotional expenses and sales incentives. The cost of these measures could have a material adverse impact on our business. We regularly review the results of our promotional spending activities and adjust our promotional spending programs in an effort to maintain our competitive position. Accordingly, unit sales volume and sales promotion costs in any period are not necessarily indicative of sales and costs that may be realized in subsequent periods.

We rely on a limited number of key executives and may continue to experience difficulty in attracting and hiring qualified new personnel in some areas of our business.

The loss of any of our key employees could adversely affect our business. As a tobacco company, we may experience difficulty in identifying and hiring qualified executives and other personnel in some areas of our business. This difficulty is primarily attributable to the health and social issues associated with the tobacco

 

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industry. The loss of services of any key personnel or our inability to attract and hire personnel with requisite skills could restrict our ability to develop new products, enhance existing products in a timely manner, sell products or manage our business effectively. These factors could have a material adverse effect on our results of operations and financial condition.

Increased restrictions on smoking in public places could adversely affect our sales volume, revenue and profitability.

In recent years, states and many local and municipal governments and agencies, as well as private businesses, have adopted legislation, regulations or policies which prohibit, restrict, or discourage smoking; smoking in public buildings and facilities, stores, restaurants and bars; and smoking on airline flights and in the workplace. Other similar laws and regulations are currently under consideration and may be enacted by state and local governments in the future. Although we have no empirical evidence of the effect of such restrictions, we believe that restrictions on smoking in public and other places may lead to a decrease in the number of people who smoke or a decrease in the number of cigarettes smoked by smokers. Increased restrictions on smoking in public and other places may have caused a decrease, and may continue to cause a decrease in the volume of cigarettes that would otherwise be sold by us absent such restrictions, which may have a material adverse effect on our sales volume, revenue and profits.

We rely on a single manufacturing facility for the production of our cigarettes.

We produce all of our traditional cigarettes at our Greensboro, North Carolina manufacturing facility. If our manufacturing plant is damaged, destroyed or incapacitated or we are otherwise unable to operate our manufacturing facility, we may be unable to produce cigarettes and may be unable to meet customer demand which could have a material adverse effect on our sales volume, revenue and profits.

We rely on a small number of suppliers for certain of our leaf tobacco and reconstituted tobacco.

We purchased approximately 31.9%, 24.9% and 27.4% of our leaf tobacco through one supplier in 2012, 2011 and 2010, Alliance One International, Inc. (“Alliance One”). If Alliance One becomes unwilling or unable to supply leaf tobacco to us, we believe that leaf tobacco may not be available at prices comparable to those we pay to Alliance One, which could have a material adverse effect on our future profits. In addition, we purchase all of our reconstituted tobacco from one supplier, which is an affiliate of RAI, one of our major competitors. Reconstituted tobacco is a form of tobacco material manufactured as a paper-like sheet from small pieces of tobacco that are too small to incorporate into the cigarette directly and may include some tobacco stems, and which is used as a component of cigarette blends. If RAI becomes unwilling or unable to supply us and we are unable to find an alternative supplier on a timely basis, our operations could be disrupted resulting in lower production levels and reduced sales, which could have a material adverse effect on our sales volume, revenue and profits in the future.

The availability of counterfeit cigarettes could adversely affect our sales volume, revenue and profitability.

Sales of counterfeit cigarettes in the United States, including counterfeits of our Newport brand, could adversely impact sales by the manufacturers of the brands that are counterfeited and potentially damage the value and reputation of those brands. Additionally, smokers who mistake counterfeit cigarettes for our cigarettes may attribute quality and taste deficiencies in the counterfeit product to our brands and discontinue purchasing our brands. Although we do not believe that sales of counterfeit Newport cigarettes have had a material adverse effect on our sales volume, revenue and profits to date, the availability of counterfeit Newport cigarettes together with the potential regulation of cigarettes and their ingredients, substantial increases in excise taxes and other potential price increases could result in increased demand for counterfeit product that could have a material adverse effect on our sales volume, revenue and profits in the future.

 

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We may not be able to adequately protect our intellectual property, which could harm the value of our brands and have a material adverse effect on our business.

Our intellectual property is material to the conduct of our business. Our ability to maintain and further build brand recognition is dependent on the continued and exclusive use of our trademarks, service marks, trade dress, trade secrets and other proprietary intellectual property, including our name and logo and the unique features of our tobacco products. If our efforts to protect our intellectual property are ineffective, thereby permitting a third-party to misappropriate or infringe on our intellectual property, the value of our brands may be harmed, which could have a material adverse effect on our business and might prevent our brands from growing or maintaining market share.

Our business could be materially adversely affected by any failure, interruption or security lapse of our information technology systems.

Our ability to effectively manage our business depends significantly on our information systems. The failure of our current systems, or future upgrades, to operate effectively or to integrate with other systems, could result in transaction errors, processing inefficiencies, and the loss of sales and customers, disrupting our business. In addition, cybersecurity threats are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to data, denial of service attacks and other electronic security breaches that could lead to disruptions in critical systems, unauthorized release of confidential or otherwise protected information and corruption of data. Although we have in place various processes, procedures and controls to monitor and mitigate these threats, there can be no assurance that these will be sufficient to prevent a material security threat. If any of these events were to materialize, they could lead to disruption of our operations, loss of sensitive information or damage to our reputation, and could have a material adverse effect on our financial position, results of operations, or cash flows.

Provisions in our certificate of incorporation and by-laws, and of Delaware law, may prevent or delay an acquisition of us, which could decrease the trading price of our Common Stock.

Our certificate of incorporation and by-laws contain provisions that are intended to deter coercive takeover practices and inadequate takeover bids and to encourage prospective acquirers to negotiate with our Board of Directors rather than to attempt a hostile takeover. These provisions include:

 

   

a board of directors that is divided into three classes with staggered terms;

 

   

elimination of the right of our shareholders to act by written consent;

 

   

rules regarding how our shareholders may present proposals or nominate directors for election at shareholder meetings;

 

   

the right of our Board of Directors to issue preferred stock without shareholder approval; and

 

   

limitations on the right of shareholders to remove directors.

Delaware law also imposes some restrictions on mergers and other business combinations between us and any holder of 15% or more of our outstanding Common Stock.

We believe these provisions protect our shareholders from coercive or otherwise unfair takeover tactics by requiring potential acquirers to negotiate with our Board of Directors and by providing our board with time to assess any acquisition proposal. These provisions are not intended to prevent such takeovers. However, these provisions apply even if the offer may be considered beneficial by some shareholders and could delay or prevent an acquisition that our Board of Directors determines is not in our best interests and those of our shareholders.

The Separation Agreement between us and Loews contains provisions that may prevent or discourage other companies from acquiring us.

The tax-free nature of the Separation may be affected by certain transactions undertaken by us. In particular, under Section 355(e) of the Internal Revenue Code, the Separation would become taxable to Loews if it was

 

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determined that 50% or more of the shares of our Common Stock were acquired, directly or indirectly, as part of a plan or series of related transactions that included the Separation. If, as a result of acquisitions of our Common Stock subsequent to the Separation, the Separation becomes taxable pursuant to Section 355(e), Loews would recognize a substantial gain for tax purposes as the Separation would be treated as a sale of Lorillard for federal income tax purposes. The Separation Agreement requires us (and any successor entity) to indemnify Loews for any losses resulting from the failure of the Separation to qualify as a tax free transaction (except if the failure to qualify is solely due to Loews’s fault). This indemnification obligation applies regardless of whether the action is restricted as described above, or whether we or a potential acquirer obtains a supplemental ruling or an opinion of counsel. These restrictions and potential indemnification obligations may prevent or discourage other companies from acquiring us.

We are required to indemnify Loews against losses and other expenses incurred at any time (including with respect to smoking and health claims and litigation) with respect to our assets, properties and businesses.

In the Separation Agreement, we have agreed to indemnify Loews and its officers, directors, employees and agents against costs and expenses (including, but not limited to, litigation matters and other claims) based on, arising out of or resulting from, among other things, the ownership or the operation of us and our assets and properties, and the operation or conduct of us and our businesses at any time prior to or following the Separation (including with respect to smoking and health claims and litigation). If Loews incurs legal or other fees or costs and expenses resulting from the operation of our businesses or otherwise with respect to us, we are required to reimburse Loews for such losses and any legal or other fees related thereto, which could be substantial. These indemnification obligations may discourage third parties from trying to acquire us because our indemnification obligations are binding on our successors and we are prohibited by the Separation Agreement from merging, consolidating or transferring all or a significant portion of our properties or assets unless the resulting entity, transferee or successor agrees to be bound by these indemnification obligations. In addition, we could face substantial charges for indemnification payments to Loews, which could have a material adverse effect on our cash flows, financial condition and results of operations.

We do not believe the Separation has altered or will alter our legal exposure with respect to tobacco-related claims.

 

Item 1B. UNRESOLVED STAFF COMMENTS

None.

 

Item 2. PROPERTIES

Our cigarette manufacturing facility is located on approximately 80 acres in Greensboro, North Carolina. This 854,300 square-foot plant contains modern high-speed cigarette manufacturing machinery. The Greensboro facility also includes a warehouse with shipping and receiving areas totaling 187,300 square feet. In addition, we own tobacco receiving and storage facilities totaling approximately 1,400,000 square feet in Danville, Virginia. Our executive offices are located in a 130,000 square-foot, four-story office building in Greensboro. Our 93,800 square-foot research facility is also located in Greensboro.

Our principal properties are owned in fee and generally we own all of the machinery we use. We believe that our properties and machinery are in generally good condition. We lease sales offices in major cities throughout the United States, a cold-storage facility in Greensboro and warehousing space in 18 public distribution warehouses located throughout the United States.

 

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We lease an office for headquarters, marketing and administrative personnel in our electronic cigarettes business in Charlotte, NC as well as an office for product development in Campbell, CA. We also lease a warehouse with shipping and receiving areas totaling approximately 7,200 square feet in Charlotte, NC that is used for the fulfillment of consumer orders over the internet.

 

Item 3. LEGAL PROCEEDINGS

Information regarding legal proceedings is set forth in Note 22 “Legal Proceedings” to our Consolidated Financial Statements included in Part II, Item 8 of this report, which is incorporated herein by reference.

 

Item 4. MINE SAFETY DISCLOSURES

None.

 

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PART II

 

Item 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES.

Our Common Stock began trading “regular way” on the NYSE under the symbol “LO” on June 10, 2008. There were 77 shareholders of record as of February 13, 2013. This figure excludes any estimate of the indeterminate number of beneficial holders whose shares may be held of record by brokerage firms and clearing agencies. The following table presents the high and low sales prices of our Common Stock on the NYSE as well as cash dividends declared per share during the fiscal quarters indicated:

 

Common Stock Market Price

   Price per Share      Cash
Dividends
Declared

Per Share
 
   High      Low     

2012

        

Fourth Quarter

   $ 41.09       $ 37.23       $ 0.5167   

Third Quarter

     46.55         38.59         0.5167   

Second Quarter

     45.98         39.99         0.5167   

First Quarter

     43.98         35.80         0.5167   

2011

        

Fourth Quarter

   $ 40.00       $ 35.49       $ 0.4333   

Third Quarter

     37.89         32.46         0.4333   

Second Quarter

     38.97         31.48         0.4333   

First Quarter

     32.35         24.13         0.4333   

Dividend Policy

Lorillard’s current policy is to return approximately 70-75% of its earnings to shareholders in the form of dividends over the long term. The declaration and payment of future dividends to holders of our Common Stock will be at the discretion of our Board of Directors and depend upon many factors, including our financial condition, earnings, capital requirements of our business, legal requirements, regulatory constraints, industry practice, and other factors that the Board of Directors may deem relevant. As a holding company with no material liquid assets other than the capital stock of our subsidiaries, our ability to pay dividends is dependent on the receipt of dividends from our operating subsidiaries.

In 2012, we paid cash dividends of $202 million, $203 million, $203 million and $199 million on March 9, 2012, June 11, 2012, September 10, 2012 and December 10, 2012, respectively. In 2011, we paid cash dividends of $188 million, $185 million, $177 million and $173 million on March 11, 2011, June 10, 2011, September 12, 2011 and December 12, 2011, respectively. In 2010, we paid cash dividends of $155 million, $152 million, $171 million and $167 million on March 11, 2010, June 11, 2010, September 10, 2010 and December 13, 2010, respectively. We expect to continue to pay cash dividends on our Common Stock.

Stock Split

In the fourth quarter of 2012, the Board of Directors declared a three-for-one split of the Company’s common stock. The record date of the stock split was December 14, 2012 and the additional shares were distributed January 15, 2013. All shares and per share amounts in this filing have been adjusted for all periods presented for the stock split. For additional information, see Note 1, “Basis of Presentation,” Note 17, “Share-based Compensation” and Note 18, “Share Repurchase Programs.”

 

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Performance Graph

The following graph compares the cumulative total shareholder return on our Common Stock from June 10, 2008, the date our Common Stock commenced trading on a “when issued” basis, to December 31, 2012 with the comparable cumulative return of (i) the S&P 500 Index and (ii) the S&P Tobacco Index. The graph assumes $100 was invested on June 10, 2008 in our Common Stock and in each of the indices and assumes that all cash dividends are reinvested. The table below the graph shows the dollar value of those investments as of the dates in the graph. The comparisons in the graph are required by the SEC and are not intended to forecast or be indicative of future performance of our Common Stock.

 

LOGO

 

    06/10/08     06/30/08     12/31/08     06/30/09     12/31/09     06/30/10     12/31/10     06/30/11     12/31/11     06/30/12     12/31/12  

Lorillard Common Stock

    100.00        90.25        75.59        93.59        113.75        104.84        122.96        167.76        179.85        213.29        193.35   

S&P 500 Index

    100.00        94.32        67.46        69.60        85.32        79.64        98.17        104.08        100.24        109.75        116.28   

S&P 500 Tobacco Index

    100.00        98.68        86.85        92.49        109.09        108.49        139.31        161.60        190.04        218.86        209.85   

The performance graph and related information above shall not be deemed “soliciting material” or to be “filed” with the SEC, nor shall such information be incorporated by reference into any future filing under the Securities Act of 1933, as amended, or the Exchange Act, except to the extent that we specifically incorporate it by reference into such filing.

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

In the fourth quarter of 2012, we repurchased the following number of shares of our Common Stock:

 

(In millions, except for per share amounts)

   Total
Number
of Shares
Purchased
     Average
Price
Paid Per
Share
     Total Number of
Shares Purchased
as Part of
Publicly
Announced
Plans
or Programs
     Approximate
Dollar Value
of
Shares that
May Yet Be
Purchased
Under the
Plans
or Programs
 

October 1, 2012 – October 31, 2012

     2.0       $ 38.66         2.0       $ 337   

November 1, 2012 – November 30, 2012

     3.0         38.96         3.0       $ 220   

December 1, 2012 – December 31, 2012

     2.8         39.51         2.8       $ 109   
  

 

 

    

 

 

    

 

 

    

Total

     7.8       $ 39.08         7.8      
  

 

 

    

 

 

    

 

 

    

 

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The shares repurchased were acquired under the share repurchase program authorized by the Board of Directors on August 21, 2012 for a maximum of $500 million. All repurchases were made in open market transactions. We record the repurchase of shares of Common Stock at cost based on the transaction date of the repurchase. As of December 31, 2012, the maximum dollar value of shares that could yet be purchased under the August 21, 2012 repurchase program was $109 million.

 

Item 6. SELECTED FINANCIAL DATA

The following table includes our selected historical consolidated financial information as of the dates and for the periods indicated. The selected historical consolidated financial information as of and for the years ended December 31, 2008 through 2012 have been derived from our audited financial statements. You should read the following selected historical consolidated financial data in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes appearing herein.

 

     Years Ended December 31,  
(In millions, except per share data)    2012     2011     2010     2009     2008  

Results of Operations:

          

Net sales (1)

   $ 6,623      $ 6,466      $ 5,932      $ 5,233      $ 4,204   

Cost of sales (1)

     4,241        4,123        3,809        3,327        2,434   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     2,382        2,343        2,123        1,906        1,770   

Selling, general and administrative (2)

     504        451        398        365        355   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (3)

     1,878        1,892        1,725        1,541        1,415   

Investment income (4)

     4        3        4        5        20   

Interest expense

     (154     (125     (94     (27     (1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     1,728        1,770        1,635        1,519        1,434   

Income taxes

     629        654        606        571        547   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 1,099      $ 1,116      $ 1,029      $ 948      $ 887   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted weighted average number of shares
outstanding (5)

     390.13        418.06        455.19        493.78        516.26   

Diluted earnings per share (5)

   $ 2.81      $ 2.66      $ 2.25      $ 1.91      $ 1.71   

Dividends per share (5)

   $ 2.07      $ 1.73      $ 1.42      $ 1.28      $ 1.56   

Ratio of earnings to fixed charges

     12.2        15.2        18.4        57.3        N/M   

Segment data:

          

Net sales

          

Cigarettes (1)

   $ 6,562      $ 6,466      $ 5,932      $ 5,233      $ 4,204   

Electronic cigarettes

     61        —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   $ 6,623      $ 6,466      $ 5,932      $ 5,233      $ 4,204   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income

          

Cigarettes

   $ 1,877      $ 1,892      $ 1,725      $ 1,541      $ 1,415   

Electronic cigarettes

     1        —          —          —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   $ 1,878      $ 1,892      $ 1,725      $ 1,541      $ 1,415   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Includes excise taxes of $1,987, $2,014, $1,879, $1,547 and $712 million, respectively.
(2) 2008 included expenses of $18 million related to the Separation of Lorillard from Loews. See “Item 1. Business—Separation from Loews Corporation” for information regarding the Separation.
(3)

2012 includes a $6 million unfavorable impact on administrative expenses resulting from the acquisition of blu eCigs on April 24, 2012. 2012 also includes a $7 million unfavorable impact on tobacco settlement expense resulting from a competitor’s adjustments to its 2001-2005 operating income and restructuring

 

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  charges. See further discussion under Results of Operations in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
(4) Includes interest income of $4, $3, $4, $5 and $21 million.
(5) Share and per share amounts have been adjusted for all periods presented for the three-for-one stock split announced November 13, 2012 and distributed January 15, 2013.

 

     December 31,  

(In millions)

   2012     2011     2010     2009      2008  

Financial Position:

           

Current assets

   $ 2,777      $ 2,564      $ 2,935      $ 2,181       $ 1,962   

Total assets

     3,396        3,008        3,296        2,575         2,321   

Current liabilities

     1,601        1,485        1,426        1,337         1,273   

Long-term debt

     3,111        2,595        1,769        722         —     

Total liabilities

     5,173        4,521        3,521        2,488         1,690   

Shareholders’ equity (deficit)

     (1,777     (1,513     (225     87         631   

 

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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with our consolidated financial statements, the notes related to those financial statements and “Item 6. Selected Financial Data” appearing herein. In addition to historical information, the following discussion contains forward-looking statements based on current expectations that involve risks and uncertainties. Actual results and the timing of certain events may differ significantly from those projected in such forward-looking statements due to a number of factors, including those set forth in the “Forward-Looking Statements,” “Item 1A. Risk Factors,” “Business Environment” and elsewhere in this Annual Report on Form 10-K. Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States (“GAAP”).

Overview

We conduct our business through two operating segments – the Cigarettes segment and the Electronic Cigarettes segment.

The Cigarettes segment consists principally of the operations of Lorillard, Inc., Lorillard Tobacco and related entities. Lorillard Tobacco is the third largest manufacturer of cigarettes in the United States. Founded in 1760, Lorillard Tobacco is the oldest continuously operating tobacco company in the United States. Newport, Lorillard’s flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette overall in the United States based on gross units sold during the years ended December 31, 2012 and 2011. In addition to the Newport brand, the Lorillard product line has four additional brand families marketed under the Kent, True, Maverick and Old Gold brand names. These five cigarette brands include 39 different product offerings which vary in price, taste, flavor, length and packaging.

The Electronic Cigarettes segment consists prinicipally of the operations of LOEC, Inc. and related entities. LOEC, Inc. is a leading electronic cigarette company in the United States, marketed under the blu eCigs brand. Lorillard acquired the blu eCigs brand and other assets used in the manufacture, distribution, development, research, marketing, advertising and sale of electronic cigarettes on April 24, 2012. Certain selling, general and administrative expenses of the Cigarettes segment have been allocated to the Electronic Cigarettes segment.

Critical Accounting Policies and Estimates

The preparation of the consolidated financial statements in conformity with GAAP requires us to make estimates and assumptions that affect the amounts reported in our consolidated financial statements and the related notes. Actual results could differ from those estimates. The financial statements include our subsidiaries after the elimination of intercompany accounts and transactions.

The consolidated financial statements and accompanying notes have been prepared in accordance with GAAP, applied on a consistent basis. We continually evaluate the accounting policies and estimates used to prepare the consolidated financial statements. Significant estimates in the consolidated financial statements and related notes include: (1) accruals for tobacco settlement costs, legal expenses and litigation costs, sales incentive programs, income taxes and share-based compensation, (2) the determination of discount and other rate assumptions for defined benefit pension and other postretirement benefit expenses, (3) the valuation of pension assets and (4) the valuation of goodwill and intangible assets. In general, our estimates are based on historical experience, evaluation of current trends, information from third party professionals and various other assumptions that we believe are reasonable under the known facts and circumstances at the time.

We consider the accounting policies discussed below to be critical to an understanding of our consolidated financial statements as their application places the most significant demands on management’s judgment. Due to the inherent uncertainties involved with this type of judgment, actual results could differ significantly from estimates and may have a material adverse impact on our results of operations and equity.

 

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Goodwill and Intangible Assets

The acquisition of blu eCigs in April of 2012 has resulted in the recording of goodwill, trademarks and other intangible assets. Upon acquisition, the purchase price was first allocated to identifiable assets and liabilities, including trademarks and other intangible assets, and the remainder of the purchase price was recorded as goodwill. Our trademarks and goodwill are considered indefinite lived intangible assets and as such are not amortized. All of our trademarks and recognized intangible assets have been recorded as a part of our Electronic Cigarettes reporting segment. We test indefinite lived intangible assets for impairment as of November 1 of each year and more frequently if indicators of impairment exist.

Goodwill Valuations

Goodwill is evaluated using a two-step impairment test at the reporting unit level. The first step of the goodwill impairment test compares the book value of a reporting unit, including goodwill, with its fair value. If the book value of a reporting unit exceeds its fair value, we perform the second step of the impairment test. In the second step, we estimate an implied fair value of the reporting unit’s goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other than goodwill. The difference between the total fair value of the reporting unit and the fair value of all of the assets and liabilities other than goodwill is the implied fair value of that goodwill. The amount of impairment loss is equal to the excess of the book value of the goodwill over the implied fair value of that goodwill.

In arriving at the fair value of a reporting unit, we utilize a combination of the income and market approaches. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted using a weighted average cost of capital that is determined based on current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in sales, costs and number of units, estimates of future expected changes in operating margins and cash expenditures. Other estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics. Finally, we consider the implied control premium and conclude whether the implied control premium is reasonable based on other recent market transactions. We believe we have based our goodwill impairment testing on reasonable estimates and assumptions, and as a result of our annual testing of goodwill performed as of November 1, 2012, the estimated fair value of the Electronic Cigarettes reporting unit was substantially in excess of its reported carrying value.

Intangible Asset Valuations

The fair value of our acquired trademarks and trade names are estimated utilizing the relief from royalty method, and compared to the carrying value. The main assumptions utilized in the relief from royalty method are projected revenues from our long range plan, assumed royalty rates that could be payable if we did not own the trademarks and a discount rate. We recognize an impairment loss when the estimated fair value of the indefinite lived intangible asset is less than its carrying value.

Based on our impairment testing performed as of November 1, 2012, the estimated fair value of the blu eCigs trademark and trade name was substantially in excess of its carrying value, and, therefore, no impairment was determined to exist.

For additional information about goodwill and intangible asset valuations, see Notes 1 and 6 to our consolidated financial statements beginning on page 57.

Revenue Recognition

Revenue from product sales, net of sales incentives, is recognized at the time ownership of the goods transfers to customers and collectability is reasonably assured. Federal excise taxes are recognized on a gross

 

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basis and are included in both sales and cost of sales. Sales incentives include retail price discounts, coupons and retail display allowances and are recorded as a reduction of revenue based on amounts estimated as due to customers and consumers at the end of a period based primarily on use and redemption rates.

Tobacco Settlement Costs

In 1998, Lorillard Tobacco, Philip Morris, RJR Tobacco and Brown & Williamson Tobacco Corporation (now an affiliate of RJR Tobacco) (the “Original Participating Manufacturers”) entered into the MSA with 46 states and various other governments and jurisdictions to settle asserted and unasserted health care cost recovery and other claims. We and certain other U.S. tobacco product manufacturers had previously settled similar claims brought by Mississippi, Florida, Texas and Minnesota (which are referred to as the “Initial State Settlements”, and together with the MSA, are referred to as the “State Settlement Agreements”). Our portion of ongoing adjusted settlement payments and legal fees is based on our relative share of the settling manufacturers’ domestic cigarette shipments, with respect to the MSA, in the year preceding that in which the payment is due, and, with respect to the Initial State Settlements, in the year in which payment is due. We record our portion of ongoing adjusted settlement payments as part of cost of sales as product is shipped. Please read “State Settlement Agreements” beginning on page 47 for additional information.

Tobacco and Other Litigation

We and other cigarette manufacturers continue to be confronted with substantial litigation. Plaintiffs in most of the cases seek unspecified amounts of compensatory damages and punitive damages, although some seek damages ranging into the billions of dollars. Plaintiffs in some of the cases seek treble damages, statutory damages, return of profits, equitable and injunctive relief, and medical monitoring, among other damages.

We believe that we have valid defenses to the cases pending against us. We also believe we have valid bases for appeal of the adverse verdicts against us. While we intend to defend vigorously all tobacco products liability litigation, it is not possible to predict the outcome of any of this litigation. Litigation is subject to many uncertainties, and it is possible that some of these actions could be decided unfavorably. We may enter into discussions in an attempt to settle particular cases if we believe it is appropriate to do so.

We establish accruals in accordance with Accounting Standards Codification Topic 450, Contingencies (“ASC 450”), when a material litigation liability is both probable and can be reasonably estimated. There are a number of factors impacting our ability to estimate the possible loss or a range of loss, including the specific facts of each matter; the legal theories proffered by plaintiffs and legal defenses available to us; the wide-ranging outcomes reached in similar cases; differing procedural and substantive laws in the various jurisdictions in which lawsuits have been filed, including whether punitive damages may be pursued or are permissible; the degree of specificity in a plaintiff’s complaint; the history of the case and whether discovery has been completed; plaintiffs’ history of use of our cigarettes relative to those of the other defendants; the attribution of damages, if any, among multiple defendants; the application of contributory and/or comparative negligence to the allocation of damage awards among plaintiffs and defendants; the likelihood of settlements for de minimus amounts prior to trial; the likelihood of success at trial; the likelihood of success on appeal; and the impact of current and pending state and federal appellate decisions. It has been our experience and is our continued expectation that the above complexities and uncertainties will not be clarified until the late stages of litigation. For those reasonably possible loss contingencies for which an estimate of the possible loss or range of loss cannot be made, we disclose the nature of the litigation and any developments as appropriate.

We monitor the status of all outstanding litigation on an ongoing basis in order to determine the probability of loss and assess whether an estimate of the possible loss or range of loss can be determined. In evaluating litigation, we consider, among other things, the nature of the claims; the jurisdiction in which the claims have been filed and the law and case law developed in that jurisdiction; the experience of plaintiffs’ counsel in this type of litigation; the parties’ respective litigation strategies; the stage of the proceedings; the outcome of the

 

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matters at trial or on appeal; the type and amount of damages claimed by plaintiffs; the outcomes and damage awards, if any, for similar matters brought against us and/or the tobacco industry; and the possibility and likelihood of success on appeal. Our assessment of a possible loss or range of loss is based on our assessment of the final outcome of the litigation upon the conclusion of all appeals.

We record provisions in the consolidated financial statements for pending litigation when we determine that it is probable that a loss has been incurred and the amount of loss can be reasonably estimated. Except for the impact of the State Settlement Agreements as described above, while it is reasonably possible that a loss has been incurred, (i) we have concluded that it is not probable that a loss has been incurred in any material pending litigation against us, (ii) we are unable to estimate the possible loss or range of loss that could result from an unfavorable outcome in any material pending litigation due to the many variables, uncertainties and complexities described above, and (iii) accordingly, we have not provided any amounts in the consolidated financial statements for possible losses related to material pending litigation. It is possible that our results of operations or cash flows in a particular quarterly or annual period or our financial position could be materially adversely affected by an unfavorable outcome or settlement of certain pending or future litigation or an inability to secure bonds where required to stay the execution of judgments on appeal.

Defense costs associated with product liability claims are a significant component of our selling, general and administrative expenses and are accrued as incurred. Defense costs may increase in future periods, in part, as a result of the Engle Progeny Cases as described in Note 22, “Legal Proceedings,” to our consolidated financial statements beginning on page 91. Numerous factors affect product liability defense costs in any given period. The principal factors are as follows:

 

   

the number and types of cases filed;

 

   

the number of cases tried and appealed;

 

   

the development of the law;

 

   

the application of new or different theories of liability by plaintiffs and their counsel; and

 

   

litigation strategy and tactics.

Please read Note 22 “Legal Proceedings,” to our consolidated financial statements beginning on page 91 for detailed information regarding tobacco litigation affecting us.

Pension and Postretirement Benefit Obligations

We are required to make a significant number of assumptions in order to estimate the liabilities and costs related to our pension and postretirement benefit obligations to employees under our benefit plans. The assumptions that have the most impact on pension costs are the discount rate, the expected return on plan assets and the expected rate of compensation increases. These assumptions are evaluated relative to current market factors such as inflation, interest rates and fiscal and monetary policies. Changes in these assumptions can have a material impact on pension obligations and pension expense.

In determining the discount rate assumption, we utilized current market information and liability information, including a discounted cash flow analysis of our pension and postretirement obligations. In particular, the basis for our discount rate selection was the yield on indices of highly rated fixed income debt securities with durations comparable to that of our plan liabilities. The discount rate was determined by projecting the plan’s expected future benefit payments as defined for the projected benefit obligation, discounting those expected payments using a theoretical zero-coupon spot yield curve derived from a universe of high-quality bonds as of the measurement date, and solving for the single equivalent discount rate that resulted in the same projected benefit obligation.

 

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The salary growth assumption reflects our long-term actual experience and future and near-term outlook. Long-term return on plan assets is determined based on historical portfolio results, asset allocations and management’s expectation of the future economic environment. Our major assumptions are set forth in Note 16 to our Consolidated Financial Statements beginning on page 70.

For 2012, hypothetical changes in the assumptions we used for the pension plans would have had the following impact on our pension expense:

 

   

A decrease of 25 basis points in the long-term rate of return would have increased our pension expense by approximately $1 million;

 

   

A decrease of 25 basis points in the discount rate would have increased our pension expense by approximately $2 million; and

 

   

An increase of 25 basis points in the future salary growth rate would have increased our net pension expense by approximately $1 million.

Income Taxes

We account for income taxes in accordance with Accounting Standard Codification Topic 740—Income Taxes (“ASC 740”). Under ASC 740, deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Judgment is required in determining income tax provisions and in evaluating tax positions. The uncertain tax provisions of ASC 740 prescribe a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Additionally, ASC 740 provides guidance on the measurement, derecognition, classification and disclosure of tax positions, along with accounting for the related interest and penalties.

Inventories

Cigarette inventories (including leaf tobacco, manufactured stock and materials and supplies) are valued at the lower of cost, determined on a last-in, first-out (“LIFO”) basis, or market. The inventory of leaf tobacco is classified as a current asset in accordance with generally recognized trade practice although, due to the duration of the aging processes, a significant portion of the tobacco on hand will not be sold or used within one year. Electronic cigarette inventories are valued at the lower of cost, determined on a first-in, first-out (“FIFO”) basis, or market and are included in manufactured stock.

Recent Accounting Pronouncements

Please read “Recently adopted accounting pronouncements” in Note 1 of the Notes to Consolidated Financial Statements beginning on page 57.

Business Environment

Participants in the U.S. tobacco industry, including us, face a number of issues that have adversely affected their results of operations and financial condition in the past and will continue to do so, including:

 

   

A substantial volume of litigation seeking compensatory and punitive damages ranging into the billions of dollars, as well as equitable and injunctive relief, arising out of allegations of cancer and other health effects resulting from the use of cigarettes, addiction to smoking or exposure to environmental tobacco smoke, including claims for economic damages relating to alleged misrepresentation concerning the use of descriptors such as “lights,” as well as other alleged damages.

 

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Substantial annual payments continuing in perpetuity, and significant restrictions on marketing and advertising have been agreed to and are required under the terms of certain settlement agreements, including the Master Settlement Agreement among major tobacco manufacturers and 46 states and various other governments and jurisdictions (the “MSA”) that we entered into in 1998 along with Philip Morris, RJR Tobacco and Brown & Williamson Tobacco Corporation (now an affiliate of RJR Tobacco) (the other “Original Participating Manufacturers”) to settle asserted and unasserted health care cost recovery and other claims. We and certain other U.S. tobacco product manufacturers previously settled similar claims brought by Mississippi, Florida, Texas and Minnesota (the “Initial State Settlements,” and together with the MSA, the “State Settlement Agreements”). The State Settlement Agreements impose a stream of future payment obligations on us and on the other major U.S. cigarette manufacturers as product is sold and place significant restrictions on our and their ability to market and sell cigarettes.

 

   

The domestic cigarette market, in which we conduct our only significant business, continues to contract. As a result of price increases, restrictions on advertising, promotions and smoking in public and private facilities, 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, domestic cigarette shipments have decreased at a compound rate of approximately 3.7% from 2002 through 2012.

 

   

Increases in cigarette prices since 1998 have led to an increase in the volume of discount and, specifically, deep discount cigarettes. Cigarette price increases have been driven by increases in federal, state and local excise taxes and by manufacturer price increases. Price increases have led, and continue to lead, to high levels of discounting and other promotional activities for premium brands. Deep discount brands have grown from an estimated domestic shipment share in 1998 of less than 2.0% to an estimated share of 13.6% for the twelve months ended December 31, 2012, and continue to be a significant competitive factor in the domestic cigarette market. We do not have sufficient empirical data to determine whether the increased price of cigarettes has deterred consumers from starting to smoke or encouraged them to quit smoking, but it is likely that increased prices may have had an adverse effect on consumption and may continue to do so.

 

   

The tobacco industry is subject to substantial and increasing regulation. In June 2009, the Family Smoking Prevention and Tobacco Control Act (the “FSPTCA”) was enacted granting the FDA authority to regulate tobacco products. Pursuant to the terms of the FSPTCA, the FDA established the Tobacco Products Scientific Advisory Committee (the “TPSAC”) to evaluate, among other things, the impact of the use of menthol in cigarettes on the public health. In March 2011, the TPSAC issued its report to the FDA stating that “removal of menthol cigarettes from the marketplace would benefit public health.” On July 21, 2011, TPSAC considered revisions to its report, and the voting members unanimously approved the final report for submission to the FDA with no change in its recommendation. The FDA could promulgate regulations that, among other things, could result in a ban on or restrict the use of menthol in cigarettes. The law imposes and will impose new restrictions on the manner in which cigarettes can be advertised and marketed, requires larger and more severe health warnings on cigarette packaging, permits restriction of the level of tar and nicotine contained in or yielded by cigarettes and may alter the way cigarette products are developed and manufactured.

 

   

On June 27, 2011, the FDA provided a progress report on its review of the science related to menthol cigarettes. In its Menthol Update, the FDA stated that “[e]xperts within the FDA Center for Tobacco Products are conducting an independent review of the science related to the impact [of menthol] in cigarettes on public health …” The FDA also stated that it will submit its draft independent review of menthol science to an external peer review panel in July 2011, and that following the peer review period (originally announced as three and one-half months), the FDA will make available the results of the peer review and its preliminary scientific assessment for public comment. On January 26, 2012, the FDA stated that its report had been submitted to the peer review panel and comments had been received from the panel on the report. The FDA also indicated that its final report, including the peer review comments, will be released for public comment at a future date.

 

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In August 2009, we, along with RJR Tobacco, other tobacco manufacturers and a tobacco retailer, filed a lawsuit in the U.S. District Court for the Western District of Kentucky against the FDA challenging the constitutionality of certain restrictions on speech included in the FSPTCA. These restrictions on speech include, among others, bans on the use of color and graphics in certain tobacco product advertising, limits on the right to make truthful statements regarding modified risk tobacco products, a prohibition on making certain statements about the FDA’s regulation of tobacco products, restrictions on the placement of outdoor advertising, a ban on certain promotions offering gifts in consideration for the purchase of tobacco products, a ban on brand name sponsorship of events and the sale of brand name merchandise, and a ban on the distribution of product samples. The suit also challenges the law’s requirement for extensive graphic warning labels on all packaging and advertising. The complaint seeks a judgment (i) declaring that such provisions of the law violate the First and/or Fifth Amendments of the U.S. Constitution and (ii) enjoining the FDA from enforcing the unconstitutional provisions of the law. On January 4, 2010, the district court issued an order (a) striking down the provisions of the law that banned the use of color and graphics in certain tobacco product advertising and prohibited tobacco manufacturers from making certain statements about the FDA’s regulation of tobacco products and (b) upholding the remaining challenged advertising provisions. Both sides appealed the district court's ruling to the Sixth Circuit Court of Appeals, and on March 19, 2012 the Sixth Circuit issued an opinion (i) affirming the district court’s decision upholding the FSPTCA’s restrictions on marketing modified-risk tobacco products, bans on event sponsorship, branding nontobacco merchandise, and free sampling; (ii) affirming the district court’s decision upholding the FSPTCA’s requirement that tobacco manufacturers reserve significant packaging space for graphic health warnings; (iii) affirming the district court’s decision striking down the FSPTCA’s restriction of tobacco advertising, in most instances, to black and white text; (iv) reversing the district court’s decision upholding the FSPTCA’s restriction on statements regarding the relative safety of tobacco products based on FDA regulation and its decision upholding the FSPTCA’s ban on tobacco continuity programs in most instances. Plaintiffs motion for rehearing en banc was denied, and Plaintiffs filed a petition for certiorari with the U.S. Supreme Court on October 30, 2012. The Government’s response to the petition for certiorari is due on March 8, 2013. The government did not appeal the part of the Court of Appeal’s ruling striking the FSPTCA’s restriction of tobacco advertising to black and white text. While we believe there is established legal precedent supporting our petition for certiorari and our claims we cannot predict the outcome of that petition or any further appeal. Nor can we make any assurances that our petition or any such appeal will be successful.

 

   

In February 2011, we, along with RJR Tobacco, filed a lawsuit in the U.S. District Court for the District of Columbia against the FDA challenging the composition of the TPSAC because of the FDA’s appointment of certain voting members with significant financial conflicts of interest. We believe these members are financially biased because they regularly testify as expert witnesses against tobacco-product manufacturers, and because they are paid consultants for pharmaceutical companies that develop and market smoking-cessation products. The suit similarly challenges the presence of certain conflicted individuals on the Constituents Subcommittee of the TPSAC. The complaint seeks a judgment (i) declaring that, among other things, the appointment of the conflicted individuals to the TPSAC (and its Constituents Subcommittee) was arbitrary, capricious, an abuse of discretion, and otherwise not in compliance with the law because it prevented the TPSAC from preparing a report that was unbiased and untainted by conflicts of interest, and (ii) enjoining the FDA from, among other things, relying on the TPSAC’s report. The FDA filed a motion to dismiss this action and the parties briefed the issue with a hearing held on February 14, 2012. On August 1, 2012, the court denied the FDA’s motion to dismiss. On October 12, 2012, the FDA filed its answer to the amended complaint and the case will proceed before the U.S. District Court for the District of Columbia.

 

   

In August 2011, we, along with RJR Tobacco and several other tobacco manufacturers, filed a lawsuit in the U.S. District Court for the District of Columbia against the FDA challenging the constitutionality of certain regulations requiring specific graphic warning labels on all packaging and advertising. The Complaint seeks a judgment (i) declaring that the regulations violate the First

 

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Amendment; (ii) declaring that the regulations violate various provisions of the Administrative Procedure Act; (iii) declaring that the textual and graphic warnings required under the FSPTCA shall become effective 15 months after the FDA issues regulations that are permissible under the U.S. Constitution and federal law; and (iv) preliminarily and permanently enjoining enforcement of the regulations. Plaintiffs moved for a preliminary injunction, and after full briefing and oral argument, the district court granted plaintiffs’ motion. Plaintiffs also moved in the district court for summary judgment in their favor and after full briefing and oral argument, the district court granted that motion too. The FDA appealed both decisions to the D.C. Circuit Court of Appeals, which consolidated the appeals and heard oral argument on April 10, 2012. On August 24, 2012, the D.C. Circuit Court of Appeals affirmed the lower court’s judgment that the graphic warnings were unconstitutional, vacated the regulations and remanded them to the FDA. On October 9, 2012, the FDA filed a motion with the Court of Appeals for rehearing or rehearing en banc. That motion was denied on December 5, 2012. The FDA’s deadline for filing a petition for certiorari with the U.S. Supreme Court is March 5, 2013.

 

   

Electronic cigarettes are generally less regulated than cigarettes. However, during 2012, the FDA indicated that it intends to regulate electronic cigarettes under the FSPTCA through the issuance of deeming regulations that would include electronic cigarettes under the definition of a “tobacco product” under the FSPTCA subject to the FDA’s jurisdiction. As of February 11, 2013, the FDA had not taken such action. We cannot predict the scope of such regulations or the impact they may have on our electronic cigarette business, though if enacted, they could have a material adverse effect on our electronic cigarette business in the future.

 

   

The federal government and many state and local governments and agencies, as well as private businesses, have adopted legislation, regulations or policies which prohibit, restrict or discourage smoking, including legislation, regulations or policies prohibiting or restricting smoking in public buildings and facilities, stores, restaurants and bars, on airline flights and in the workplace. Other similar laws and regulations are under consideration and may be enacted by federal, state and local governments in the future.

 

   

Substantial federal, state and local excise taxes are reflected in the retail price of cigarettes. For the twelve months ended December 31, 2012, the federal excise tax was $1.0066 per pack and combined state and local excise taxes ranged from $0.17 to $5.85 per pack. For the twelve months ended December 31, 2012, excise tax increases ranging from $0.04 to $1.00 per pack were implemented in two states. On June 21, 2010, New York state legislature approved a $1.60 per pack state excise tax increase that was implemented on July 1, 2010. The federal excise tax on cigarettes increased by $0.6166 per pack from $0.39 per pack of cigarettes to $1.0066 per pack, effective April 1, 2009, to finance health insurance for children. It is likely that increases in excise and similar taxes have had an adverse impact on sales of cigarettes and that the most recent increase and future increases, the extent of which cannot be predicted, could result in further volume declines for the cigarette industry, including us, and an increased sales shift toward deep discount cigarettes rather than premium brands. In addition, we and other cigarette manufacturers and importers are required to pay an assessment under a federal law designed to fund payments to tobacco quota holders and growers and are required to pay an annual user fee to the FDA.

The domestic market for cigarettes is highly competitive. Competition is primarily based on a brand’s taste; quality; price, including the level of discounting and other promotional activities; positioning; consumer loyalty; and retail display. Our principal competitors are the two other major U.S. cigarette manufacturers, Philip Morris USA and RJR Tobacco. We also compete with numerous other smaller manufacturers and importers of cigarettes, including deep discount cigarette manufacturers. We believe our ability to compete even more effectively has been restrained in some marketing areas as a result of retail merchandising contracts offered by Philip Morris USA and RJR Tobacco which limit the retail shelf space available to our brands. As a result, in some retail locations we are limited in competitively supporting our promotional programs, which may constrain sales.

 

 

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The following table presents selected Lorillard and industry cigarette shipment data for the years ended December 31, 2012, 2011 and 2010:

Selected Industry Data

 

     Year Ended December 31,  
(Volume in billions)    2012      2011      2010  

Lorillard total domestic unit volume (1), (3)

     39.491         40.034         37.433   

Industry total domestic unit volume (1), (3)

     286.468         293.098         303.679   

Lorillard’s premium volume as a percentage of its total volume (2)

     85.0%         85.6%         86.6%   

Newport’s share of Lorillard’s total volume (2)

     84.1%         84.5%         85.2%   

Newport’s share of Lorillard’s Cigarettes Segment net sales (2)

     87.8%         88.4%         88.8%   

 

(1) Source: Management Science Associates, Inc. (“MSAI”), an independent third-party database management organization that collects wholesale shipment data from various cigarette manufacturers. MSAI divides the cigarette market into two price segments, the premium price segment and the discount or reduced price segment. MSAI’s information relating to unit sales volume and market share of certain of the smaller, primarily deep discount, cigarette manufacturers is based on estimates derived by MSAI. Management believes that volume and market share information for deep discount manufacturers may be understated.
(2) Source: Lorillard shipment reports.
(3) Domestic unit volume includes cigarette units sold as well as promotional units and excludes volumes for Puerto Rico and U.S. Possessions.

The following table presents selected Lorillard and industry retail market share data for the years ended December 31, 2012, 2011 and 2010, based on Lorillard’s proprietary retail shipment data, “EXCEL,” which reflects shipments from wholesalers to retailers.

Selected Domestic Cigarette Retail Market Share Data(1)

 

     Year Ended December 31,  
     2012     2011     2010  

Lorillard’s share of the retail market

     14.4     14.1     12.9

Lorillard’s share of the premium market

     16.6     16.5     15.2

Lorillard’s share of the menthol market (2)

     39.3     39.1     38.4

Newport’s share of the retail market

     12.1     11.9     10.9

Newport’s share of the premium market

     16.4     16.3     15.0

Newport’s share of the menthol market (2)

     36.1     36.2     36.0

Total menthol segment market share for the industry (2)

     31.1     30.6     30.0

Total discount segment market share for the industry

     26.7     27.1     27.0

 

(1) Source: Lorillard’s proprietary retail shipment data, EXCEL, which reflect shipments from wholesalers to retailers.
(2) Lorillard has made certain adjustments to its proprietary retail shipment data to reflect management’s judgment as to which brands are included in the menthol segment.

The market for electronic cigarettes is evolving at a very fast pace and is very fragmented, with many smaller companies competing with similar product offerings. In the competition for retail presence, blu eCigs has begun the process of differentiating itself from the competition with unique technology, impactful displays and point of sale materials. According to our proprietary EXCEL database which now includes electronic cigarettes, blu eCigs domestic retail market share of the electronic cigarettes market for the fourth quarter was over 30%.

 

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The method of distribution for many competing companies is predominately over the internet, with only a small number of competitors currently having a significant presence at retail.

Income Statement Captions

Net sales includes revenue from product sales, net of sales incentives, and is recognized at the time that ownership of the goods transfers to customers and collectability is reasonably assured. Federal excise taxes on cigarettes are recognized on a gross basis, and are included in both net sales and cost of sales. Sales incentives include retail price discounts, coupons and retail display allowances, and are recorded as a reduction of revenue based on amounts estimated as due to customers and consumers at the end of a period based primarily on use and redemption rates.

Cost of sales includes federal excise taxes, leaf tobacco cost, wrapping and casing material, manufacturing labor and production salaries, wages and overhead, depreciation related to manufacturing plant and equipment, research and development costs, distribution, other manufacturing costs, State Settlement Agreement expenses, the federal assessment for tobacco growers, Food and Drug Administration fees, promotional product expenses and electronic cigarette raw materials and manufacturing costs. Promotional product expenses include the cost, including all applicable excise taxes, of the free portion of “buy some get some free” promotions.

Selling, general and administrative expenses includes sales force expenses, legal and other costs of litigating and administering product liability claims, administrative expenses and advertising and marketing costs. Advertising and marketing costs include items such as direct mail, advertising, agency fees and point of sale materials.

Investment income includes interest and dividend income, realized gains and losses on sale of investments and equity in the earnings of limited partnership investments.

Interest expense includes interest expense related to debt and income taxes.

Results of Operations

Year ended December 31, 2012 Compared to the Year ended December 31, 2011

Lorillard Consolidated Results

 

     2012     2011  
     (In millions)  

Net sales (including excise taxes of $1,987 and $2,014)

   $ 6,623      $ 6,466   

Cost of sales (including excise taxes of $1,987 and $2,014)

     4,241        4,123   
  

 

 

   

 

 

 

Gross profit

     2,382        2,343   

Selling, general and administrative

     504        451   
  

 

 

   

 

 

 

Operating income

     1,878        1,892   

Investment income

     4        3   

Interest expense

     (154     (125
  

 

 

   

 

 

 

Income before income taxes

     1,728        1,770   

Income taxes

     629        654   
  

 

 

   

 

 

 

Net income

   $ 1,099      $ 1,116   
  

 

 

   

 

 

 

 

 

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Cigarettes Segment Results

 

     2012      2011  
     (In millions)  

Net sales (including excise taxes of $1,987 and $2,014)

   $ 6,562       $ 6,466   

Cost of sales (including excise taxes of $1,987 and $2,014)

     4,201         4,123   
  

 

 

    

 

 

 

Gross profit

     2,361         2,343   

Selling, general and administrative

     484         451   
  

 

 

    

 

 

 

Operating income

   $ 1,877       $ 1,892   
  

 

 

    

 

 

 

Net sales. Cigarette net sales increased by $96 million, or 1.5%, from $6.466 billion in 2011 to $6.562 billion in 2012. Net sales increased $190 million due to higher average unit prices reflecting price increases in July and December 2011 and June and December 2012, partially offset by lower unit sales volume of $94 million (including $27 million of federal excise tax).

Total Lorillard wholesale cigarette unit volume, which includes Puerto Rico and U.S. Possessions, decreased 1.4% for 2012 compared to the corresponding period of 2011. Domestic wholesale cigarette unit volume, which excludes Puerto Rico and U.S. Possessions, also decreased 1.4% for 2012, compared to 2011. Adjusting for the negative impact of changes in wholesale inventory patterns, Lorillard domestic wholesale shipments decreased an estimated 0.8% compared to 2011. Total cigarette industry domestic wholesale shipments decreased an estimated 2.5% for 2012 compared to 2011. Changes in total cigarette industry wholesale inventory patterns had a minimal impact in 2012 as compared to 2011.

Total wholesale unit volume for Newport, the Company’s flagship brand, decreased 1.9% for 2012 compared to 2011. Domestic wholesale cigarette unit volume for Newport, which excludes Puerto Rico and U.S. Possessions decreased 1.8% for 2012 compared to 2011. Adjusting for the negative impact of changes in wholesale inventory patterns, Newport domestic wholesale shipments were down an estimated 1.3%. Domestic wholesale shipments for Maverick, the Company’s leading discount brand, increased 3.5% for 2012 compared to 2011.

Based on Lorillard’s proprietary retail shipment data (“EXCEL”), which measures shipments from wholesale to retail and is unaffected by wholesale inventory changes, Lorillard’s domestic retail market share once again posted solid gains in 2012, increasing 0.3 share points to 14.4%. Newport’s domestic retail market share reached 12.1% for 2012, an increase of 0.2 share points compared to 2011. Lorillard’s domestic retail share of the menthol market reached 39.3% for 2012, an increase of 0.2 share points compared to 2011. Gains in market share were largely attributable to unit volume outperformance of Newport Menthol in our core markets, geographic promotional expansion of Newport Menthol, and continued growth of Maverick, and were achieved despite the heightened level of competitive menthol activity.

Cost of sales. Cost of sales increased by $78 million, or 1.9%, from $4.123 billion in 2011 to $4.201 billion in 2012. The increase in cost of sales is primarily due to higher expenses related to the State Settlement Agreements ($72 million), higher raw material costs, primarily tobacco and wrapping materials ($37 million) and higher Food and Drug Administration fees ($5 million), partially offset by lower unit sales volume ($34 million, including $27 million of federal excise tax) and a lower Federal Assessment for Tobacco Growers ($2 million). We recorded pre-tax charges for our obligations under the State Settlement Agreements of $1.379 billion and $1.307 billion for the years ended December 31, 2012 and 2011, respectively, an increase of $72 million. The $72 million increase is due to the impact of the inflation adjustment ($36 million) and other adjustments ($55 million), partially offset by the impact of lower unit sales ($19 million). Other adjustments include a decrease in the favorable impact of a competitor’s mark-to-market pension accounting adjustment on tobacco settlement expense of $17 million in the fourth quarter of 2011 and the unfavorable impact of RJRT’s adjustments to its 2001 – 2005 operating income on tobacco settlement expense of $7 million in the first quarter of 2012.

Selling, general and administrative. Selling, general and administrative expenses increased $33 million, or 7.3%, from $451 million in 2011 to $484 million in 2012. The increase in 2012 is primarily a result of higher legal costs related to the Engle Progeny litigation and $5 million of expenses incurred with the acquisition of blu eCigs.

 

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Electronic Cigarettes Segment Results

(Since date of acquisition - April 24, 2012)

 

     2012  
     (In millions)  

Net sales

   $ 61   

Cost of sales

     40   
  

 

 

 

Gross profit

     21   

Selling, general and administrative

     20   
  

 

 

 

Operating income

   $ 1   
  

 

 

 

Gross profit was $21 million in 2012, or 34.4% of net sales.

According to our proprietary EXCEL database which now includes electronic cigarettes, blu eCigs domestic retail market share of the electronic cigarettes market for the fourth quarter was over 30%.

Selling, general and administrative costs were $20 million and include marketing and administrative costs associated with the blu eCigs’ national retail roll-out, as well as $1 million of expenses incurred in conjunction with the acquisition of blu eCigs.

Operating income for the Electronic Cigarette segment totaled $1 million in 2012.

Lorillard Consolidated Results

Interest expense. Interest expense increased $29 million in 2012, compared to 2011, and reflects interest on the Senior Notes issued in the third quarters of 2011 and 2012.

Income taxes. Income taxes decreased $25 million or 3.8%, from $654 million in 2011 to $629 million in 2012. The change reflects the decrease in income before income taxes of $42 million in 2012 or 2.4% and a decrease in the effective tax rate from 37.0% to 36.4% for the years ended December 31, 2011 and 2012, respectively. The decrease was primarily driven by an increase in the manufacturers’ deduction and a decrease in state income taxes.

Year ended December 31, 2011 Compared to the Year ended December 31, 2010

Lorillard Consolidated Results

 

     2011     2010  
     (In millions)  

Net sales (including excise taxes of $2,014 and $1,879)

   $ 6,466      $ 5,932   

Cost of sales (including excise taxes of $2,014 and $1,879)

     4,123        3,809   
  

 

 

   

 

 

 

Gross profit

     2,343        2,123   

Selling, general and administrative

     451        398   
  

 

 

   

 

 

 

Operating income

     1,892        1,725   

Investment income

     3        4   

Interest expense

     (125     (94
  

 

 

   

 

 

 

Income before income taxes

     1,770        1,635   

Income taxes

     654        606   
  

 

 

   

 

 

 

Net income

   $ 1,116      $ 1,029   
  

 

 

   

 

 

 

 

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Net sales. Cigarette net sales increased by $534 million, or 9.0%, from $5.932 billion in 2010 to $6.466 billion in 2011. Net sales increased $486 million due to higher unit sales volume (including $135 million of federal excise tax) and $150 million due to higher average unit prices reflecting price increases in February, May and November 2010 and July and December 2011. These increases were partially offset by $102 million of higher sales incentives in 2011. Federal excise taxes are included in net sales and increased $30.83 per thousand units, or $0.62 per pack of 20 units, to $50.33 per thousand cigarettes, or $1.01 per pack of 20 cigarettes, effective April 1, 2009.

Total Lorillard wholesale unit volume, which includes Puerto Rico and U.S. Possessions, increased 6.9% during 2011 compared 2010. Domestic unit volume, which excludes Puerto Rico and U.S. Possessions, also increased 6.9% in 2011 compared to 2010. Unit volume figures in this section are provided on a gross basis. Total unit volume for Newport, the Company’s flagship brand, increased 6.0% in 2011 and domestic Newport unit volume increased 6.1% in 2011 compared to 2010. Domestic wholesale shipments for Maverick, the Company’s leading discount brand, increased 16.0% in 2011 compared to 2010. Total cigarette industry domestic wholesale shipments decreased an estimated 3.5% in 2011 compared to 2010.

Based on our proprietary retail shipment data (“EXCEL”), which measures shipments from wholesale to retail and is unaffected by changes in wholesale inventory patterns, Lorillard’s domestic retail market share increased 1.2 share points in 2011 to 14.1%. Newport’s domestic retail market share reached 11.9% during 2011, an increase of 1.0 share points compared to 2010. The Company’s strategic initiatives including the successful launch of Newport Non-Menthol, geographic expansion initiatives on Newport Menthol and continued retail shipment growth on Maverick accounted for the increase in volume and market share growth.

Cost of sales. Cost of sales increased by $314 million, or 8.2%, from $3.809 billion in 2010 to $4.123 billion in 2011. The increase in cost of sales is primarily due to higher unit sales volume ($166 million, including $135 million of federal excise tax), higher raw material costs, primarily tobacco and wrapping materials ($28 million), higher expenses related to the State Settlement Agreements ($95 million), higher Food and Drug Administration fees ($25 million) and the Federal Assessment for Tobacco Growers ($9 million). We recorded pre-tax charges for our obligations under the State Settlement Agreements of $1.307 billion and $1.212 billion for the years ended December 31, 2011 and 2010, respectively, an increase of $95 million. The $95 million increase is due to the impact of higher unit sales ($93 million), the impact of the inflation adjustment ($36 million), partially offset by other adjustments ($34 million). Other adjustments include a favorable impact on tobacco settlement expense of $25 million resulting from a competitor’s adoption of mark-to-market pension accounting in the fourth quarter of 2011. The reduction in our costs associated with the mark-to-market adjustment reported by Reynolds American amounted to approximately $3 million and was recorded in the fourth quarter of 2011. In addition, industry operating profits reported in prior years were reduced as a result of the restatement arising from Reynolds American’s accounting change, which had the effect of further reducing the amounts due under the State Settlement Agreements by approximately $22 million. Tobacco settlement expenses are impacted by a number of factors including industry profits, which were significantly reduced in the fourth quarter by the competitor’s accounting change.

Selling, general and administrative. Selling, general and administrative expenses increased $53 million, or 13.3%, from $398 million in 2010 to $451 million in 2011. The increase in 2011 is primarily a result of higher legal costs related to the Engle Progeny litigation. In addition, certain other selling, general and administrative costs increased due to higher compensation costs and higher administrative costs incurred in support of strategic initiatives, including market research and advertising costs related to the launch of Newport Non-Menthol, as well as costs incurred in support of the Company’s position and industry reports to the FDA regarding the use of Menthol in cigarettes.

Interest expense. Interest expense increased $31 million in 2011, compared to 2010, and reflects interest on the senior notes issued in the second quarter of 2010 and the third quarter of 2011.

Income taxes. Income taxes increased $48 million or 7.9%, from $606 million in 2010 to $654 million in 2011. The change reflects the increase in income before income taxes of $135 million in 2011 or 8.3%, offset

 

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partially by a decrease in the effective tax rate from 37.1% to 37.0% for the years ended December 31, 2010 and 2011, respectively. The decrease was primarily driven by state tax law changes enacted during the second quarter of 2011 as well as the settlement of certain state and federal tax matters.

Liquidity and Capital Resources

Our cash and cash equivalents of $1.720 billion at December 31, 2012 were invested in prime money market funds.

Cash Flows

Cash flow from operating activities. The principal source of liquidity for our business and operating needs is internally generated funds from our operations. We generated net cash flow from operations of $1.170 billion for 2012 compared to $1.183 billion for 2011. The decreased net cash flow in 2012 primarily reflects the decrease in net income and an increase in cash paid for settlement costs and inventories, partially offset by a decrease in cash paid for income taxes. Net cash flow from operations was $1.183 billion for 2011, compared to $1.091 billion for 2010. The increased cash flow in 2011 primarily reflects an increase in net income.

Cash flow from investing activities. Our cash flow from investing activities used cash of $209 million for the twelve months ended December 31, 2012 compared to $56 million for 2011. The increase in cash used by investing activities in 2012 is due primarily to the acquisition of blu eCigs in April 2012 for $135 million in cash and increased purchases of equipment. Our investing activities used cash of $56 million for the twelve months ended December 31, 2011 compared to $40 million for 2010. The increase in cash used by investing activities in 2011 is due to increased purchases of equipment.

Capital expenditures were $74 million, $56 million and $40 million for 2012, 2011 and 2010, respectively. The expenditures were primarily for the modernization of manufacturing equipment. Our capital expenditures for 2013 are forecast to be between $65 million and $75 million.

Cash flow from financing activities. Our cash flow from operations has exceeded our working capital and capital expenditure requirements in each of the years ended December 31, 2012, 2011 and 2010. In 2010, we paid cash dividends of $155 million, $152 million, $171 million and $167 million on March 11, 2010, June 11, 2010, September 10, 2010 and December 13, 2010, respectively. In 2011, we paid cash dividends of $188 million, $185 million, $177 million and $173 million on March 11, 2011, June 10, 2011, September 12, 2011 and December 12, 2011, respectively. In 2012, we paid cash dividends of $202 million, $203 million, $203 million and $199 million on March 9, 2012, June 11, 2012, September 10, 2012 and December 10, 2012, respectively.

In April 2010, Lorillard Tobacco issued $1 billion of unsecured senior notes in two tranches pursuant to an Indenture, dated June 23, 2009 (the “Indenture”), and the Second Supplemental Indenture, dated April 12, 2010. The first tranche was $750 million aggregate principal amount of 6.875% Notes due May 1, 2020 (the “2020 Notes”), and the second tranche was $250 million aggregate principal amount of 8.125% Notes due May 1, 2040 (the “2040 Notes”). The net proceeds from the issuance were used for the repurchase of our common stock.

In August 2011, Lorillard Tobacco issued $750 million of unsecured senior notes in two tranches pursuant to the Indenture and the Third Supplemental Indenture, dated August 4, 2011. The first tranche was $500 million aggregate principal amount of 3.500% Notes due August 4, 2016 (the “2016 Notes”) and the second tranche was $250 million aggregate principal amount of 7.000% Notes due August 4, 2041 (the “2041 Notes”). The net proceeds from the issuance were used for the repurchase of our common stock.

In August 2012, Lorillard Tobacco issued $500 million aggregate principal amount of 2.300% unsecured senior notes due August 21, 2017 (the “2017 Notes”) pursuant to the Indenture and the Fourth Supplemental Indenture, dated August 21, 2012. The net proceeds from the issuance were used for the repurchase of our common stock.

 

 

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Lorillard Tobacco is the principal, wholly owned operating subsidiary of Lorillard, Inc., and the $750 million aggregate principal amount of 8.125% senior notes issued in June 2009 and due 2019 (the “2019 Notes”), 2016 Notes, 2017 Notes, 2020 Notes, 2040 Notes and 2041 Notes (together, the “Notes”) are unconditionally guaranteed on a senior unsecured basis by Lorillard, Inc.

The interest rate payable on the 2019 Notes is subject to incremental increases from 0.25% to 2.00% in the event either Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”) or both Moody’s and S&P downgrade the 2019 Notes below investment grade (Baa3 and BBB- for Moody’s and S&P, respectively). As of December 31, 2012, our debt ratings were Baa2 and BBB- with Moody’s and S&P, respectively, both of which are investment grade.

Upon the occurrence of a change of control triggering event, Lorillard Tobacco will be required to make an offer to repurchase the Notes at a price equal to 101% of the aggregate principal amount of the Notes, plus accrued interest. A “change of control triggering event” occurs when there is both a “change of control” (as defined in the Second Supplemental Indenture) and the Notes cease to be rated investment grade by both Moody’s and S&P within 60 days of the occurrence of a change of control or public announcement of the intention to effect a change of control. The Notes are not entitled to any sinking fund and are not redeemable prior to maturity. The Notes contain covenants that restrict liens and sale and leaseback transactions, subject to a limited exception.

During 2012, we repurchased approximately 14.8 million shares at a cost of $39.05 per share and totaling $578 million under the $750 million repurchase program announced in August 2011 and the $500 million repurchase program announced in August 2012. As of January 30, 2013, the $500 million repurchase program announced in August, 2012 had been completed.

Purchases under these programs were made from time to time at prevailing market prices in open market purchases, privately negotiated transactions, block purchase techniques or otherwise, as determined by management. The purchases were funded from existing cash balances, including proceeds from the issuance of the Notes. These programs do not obligate us to acquire any particular amount of our common stock. The timing, frequency and amount of repurchase activity will depend on a variety of factors such as levels of cash generation from operations, cash requirements for investment in our business, current stock price, market conditions and other factors.

Liquidity

We believe that cash flow from operating activities will be sufficient for the foreseeable future to enable us to meet our obligations under the State Settlement Agreements and to fund our working capital and capital expenditure requirements. We cannot predict our cash requirements related to any future settlements or judgments, including cash required to bond any appeals, if necessary, and can make no assurance that we will be able to meet all of those requirements.

The rate of return on our pension assets in 2012 was a positive 11.2%. Our pension expense was approximately $30 million in 2012 and we anticipate pension expense of approximately $20 million in 2013. We contributed $31 million to our pension plans in 2012 and anticipate a contribution of $31 million in 2013.

We believe that it is appropriate for a company of our size and financial characteristics to have a prudent level of debt as a component of our capital structure in order to reduce our total cost of capital and improve total shareholder returns. Accordingly, we raised $500 million, $750 million and $1 billion of debt financing in 2012, 2011 and 2010, respectively, and we expect that we will seek to raise additional debt financing in the future, although the structure, timing and amount of such indebtedness has not yet been determined and will depend on a number of factors, including, but not limited to the prevailing credit and interest rate environment, our cash requirements, and other business, financial and tax considerations. The proceeds of any such debt financing may

 

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be used to fund stock repurchases, acquisitions, dividends or for other general corporate purposes. We presently have no commitments or agreements with or from any third party regarding any debt financing transactions and no assurance can be given that we will ultimately pursue any debt financing or, if pursued, that we will be able to obtain debt financing at the suggested levels or on attractive terms.

On July 10, 2012, Lorillard Tobacco, the principal, wholly owned operating subsidiary of Lorillard, Inc., terminated its three year $185 million credit agreement (the “Old Revolver”), dated March 26, 2010, and entered into a $200 million revolving credit facility that expires on July 10, 2017 (the "Revolver") and is guaranteed by Lorillard, Inc. The Revolver may be increased to $300 million upon request. Proceeds from the Revolver may be used for general corporate and working capital purposes. The interest rates on borrowings under the Revolver are based on prevailing interest rates and, in part, upon the credit rating applicable to our senior unsecured long-term debt.

The Revolver requires that we maintain a ratio of debt to net income plus income taxes, interest expense, depreciation and amortization expense, any extraordinary losses, any non-cash expenses or losses and any losses on sales of assets outside of the ordinary course of business (“Adjusted EBITDA”) of not more than 2.25 to 1 and a ratio of Adjusted EBITDA to interest expense of not less than 3.0 to 1. In addition, the Revolver contains customary affirmative and negative covenants, including restrictions on liens and sale and leaseback transactions subject to a limited exception. The Revolver contains customary events of default, including upon a change in control that could result in the acceleration of all amounts and cancellation of all commitments outstanding, if any, under the Revolver.

There were no borrowings under the Revolver during 2010, 2011 or 2012.

State Settlement Agreements

The State Settlement Agreements require us and the other Original Participating Manufacturers (Philip Morris, RJR Tobacco and Brown & Williamson Tobacco Corporation (now an affiliate of RJR Tobacco)) to make aggregate annual payments of $10.4 billion in perpetuity, subject to adjustment for several factors described below. In addition, the Original Participating Manufacturers are required to pay plaintiffs’ attorneys’ fees, subject to an aggregate annual cap of $500 million. These payment obligations are several and not joint obligations of each of the Original Participating Manufacturers. Our obligations under the State Settlement Agreements will materially adversely affect our cash flows and operating income in future years.

Both the aggregate payment obligations of the Original Participating Manufacturers, and our payment obligations, individually, under the State Settlement Agreements are subject to adjustment for several factors which include:

 

   

inflation;

 

   

aggregate volume of Original Participating Manufacturers cigarette shipments;

 

   

other Original Participating Manufacturers and our market share; and

 

   

aggregate Original Participating Manufacturers operating income, allocated to such manufacturers that have operating income increases.

The inflation adjustment increases payments on a compounded annual basis by the greater of 3.0% or the actual total percentage change in the consumer price index for the preceding year. The inflation adjustment is measured starting with inflation for 1999. The volume adjustment increases or decreases payments based on the increase or decrease in the total number of cigarettes shipped in or to the 50 U.S. states, the District of Columbia and Puerto Rico by the Original Participating Manufacturers during the preceding year compared to the 1997 base year shipments. If volume has increased, the volume adjustment would increase the annual payment by the same percentage as the number of cigarettes shipped exceeds the 1997 base number. If volume has decreased, the

 

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volume adjustment would decrease the annual payment by 98.0% of the percentage reduction in volume. In addition, downward adjustments to the annual payments for changes in volume may, subject to specified conditions and exceptions, be reduced in the event of an increase in the Original Participating Manufacturers aggregate operating income from domestic sales of cigarettes over base year levels established in the State Settlement Agreements, adjusted for inflation. Any adjustments resulting from increases in operating income would be allocated among those Original Participating Manufacturers who have had increases.

During 2012, we paid $1.348 billion under the State Settlement Agreements, primarily based on 2011 volume. Included in the above number was $98 million we deposited in an interest-bearing escrow account in accordance with procedures established in the MSA pending resolution of a claim by us and the other Original Participating Manufacturers that they are entitled to reduce their MSA payments based on a loss of market share to non-participating manufacturers. Most of the states that are parties to the MSA are disputing the availability of the reduction and we believe that this dispute will ultimately be resolved by judicial and arbitration proceedings. Our $98 million reduction is based upon the Original Participating Manufacturers collective loss of market share in 2009 that resulted in a reduction of $106 million, partially offset by unfavorable adjustments for years 2008 and 2007 of $3 million and $5 million, respectively. In April of 2011, 2010, 2009, 2008, 2007 and 2006, we had previously deposited $107 million, $88 million, $74 million, $72 million, $111 million and $109 million, respectively, in the same escrow account discussed above, which was based on a loss of market share in 2008, 2007, 2006, 2005, 2004 and 2003 to non-participating manufacturers. In February 2009, we directed the transfer of $72 million from this account to the non-disputed account, related to the loss of market share in 2005, pursuant to an Agreement Concerning Arbitration that we and other Participating Manufacturers entered into with certain MSA states. This amount was then paid to the MSA states. We and other Original Participating Manufacturers have the right to claim additional reductions of MSA payments in subsequent years under provisions of the MSA.

On December 18, 2012, Lorillard Tobacco, along with other participating manufacturers, agreed to a term sheet with 17 states and the District of Columbia and Puerto Rico that resolves disputes under the 1998 Master Settlement Agreement (MSA) involving payment adjustments relating to nonparticipating manufacturers. The settlement would resolve the claims for the years 2003 through 2012 and would put in place a new method for calculating this adjustment beginning in 2013. Under the terms of the agreement, Lorillard Tobacco and other manufacturers will receive credits against their future MSA payments over the next five years, and the signatory states will be entitled to receive their allocable share of the amounts currently being held in escrow resulting from these disputes. The term sheet is subject to approval by the arbitration panel presiding over the arbitration of the dispute for 2003. If the settlement proceeds and is approved, Lorillard Tobacco expects to receive credits over the next five years totaling at least $196 million on its outstanding claims, with the majority of the credits occurring in April 2013 and the remainder over the following four years. As of February 11, 2013, the arbitration panel has not made its ruling with regard to the settlement. No amounts have been included in 2012 results related to the settlement. Certain non-settling states have objected to the request for approval. No assurance can be given that the arbitration panel will issue the order necessary for the agreement to proceed or that the objections or any other such actions by nonsignatory states will be resolved in a manner favorable to Lorillard.

Contractual Cash Payment Obligations

The following table presents the contractual cash payment obligations of Lorillard as of December 31, 2012:

 

     Total      Less
than
1 year
     1-3
years
     3-5
years
     More
than
5 years
 
     (In millions)  

Senior notes

   $ 3,000       $ —         $ —         $ 1,000       $ 2,000   

Interest payments related to notes

     1,941         179         519         320         923   

Contractual purchase obligations

     69         69         —           —           —     

Operating lease obligations

     4         2         2         —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 5,014       $ 250       $ 521       $ 1,320       $ 2,923   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

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As of December 31, 2012, we do not believe that we will make any payments in the next twelve months related to gross unrecognized tax benefits. We cannot make a reasonably reliable estimate of the amount of liabilities for unrecognized tax benefits that may result in cash settlements for periods beyond twelve months.

As previously discussed, we have entered into the State Settlement Agreements which impose a stream of future payment obligations on us and the other major U.S. cigarette manufacturers. Our portion of ongoing adjusted settlement payments, including fees to settling plaintiffs’ attorneys, are based on a number of factors which are described above. Our cash payment under the State Settlement Agreements in 2012 amounted to $1.348 billion and we estimate our cash payments in 2013 under the State Settlement Agreements will be between $1.350 billion and $1.400 billion, primarily based on 2012 estimated industry volume. Payment obligations are not incurred until the related sales occur and therefore are not reflected in the above table. Please see the discussion of the calculation of the Original Participating Manufacturers base payment obligations under the State Settlement Agreements under “State Settlement Agreements” on page 47.

Off-Balance Sheet Arrangements – None.

 

Item 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We invest in financial instruments that involve market risk. Our measure of market risk exposure represents an estimate of the change in fair value of our financial instruments. Market risk exposure is presented below for each class of financial instrument we held at December 31, 2012, assuming immediate adverse market movements of the magnitude described below. We believe that the rate of adverse market movement represents a measure of exposure to loss under hypothetically assumed adverse conditions. The estimated market risk exposure represents the hypothetical loss to future earnings and does not represent the maximum possible loss nor any expected actual loss, even under adverse conditions, because actual adverse fluctuations would likely differ. In addition, since our investment portfolio is subject to change based on our portfolio management strategy as well as in response to changes in the market, these estimates are not necessarily indicative of the actual results which may occur. The market risk exposure represents the potential loss in carrying value and pretax impact to future earnings caused by the hypothetical change in price.

Exposure to market risk is managed and monitored by senior management. Senior management approves our overall investment strategy and has the responsibility to ensure that the investment positions are consistent with that strategy with an acceptable level of risk.

Interest rate risk. Our investments, which are included in cash and cash equivalents, consist of money market funds with financial institutions. Those investments are exposed to fluctuations in interest rates. A sensitivity analysis, based on a hypothetical 1% increase or decrease in interest rates on our average 2012 investments, would cause an increase or decrease in pre-tax income of approximately $17 million.

Our debt is denominated in US Dollars and has been issued at a fixed rate. In September 2009, we entered into interest rate swap agreements for a total notional amount of $750 million to hedge changes in fair value of the Notes due to changes in the designated benchmark interest rate. Changes in the fair value of the derivative are recorded in earnings along with offsetting adjustments to the carrying amount of the hedged debt. A sensitivity analysis, based on a hypothetical 1% change in LIBOR, would cause an increase or decrease in pretax income of approximately $8 million for 2012.

Liquidity risk. We may be forced to cash settle all or a portion of our derivative contracts before the expiration date if our debt rating is downgraded below Ba2 by Moody’s or BB by S&P. This could have a negative impact on our cash position. Early cash settlement would result in the timing of our hedge settlement not being matched to the cash settlement of the debt. As of December 31, 2012 our Moody’s debt rating was Baa2, and our S&P debt rating was BBB-, both of which are above the ratings at which settlement of our derivative contracts would be required. See Note 13 for additional information on derivatives.

 

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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Financial Statements and Supplementary Data are comprised of the following sections:

 

     Page

No.

 

Report of Independent Registered Public Accounting Firm

     51   

Consolidated Balance Sheets

     52   

Consolidated Statements of Income

     53   

Consolidated Statements of Comprehensive Income

     54   

Consolidated Statements of Shareholders’ Equity (Deficit)

     55   

Consolidated Statements of Cash Flows

     56   

Notes to Consolidated Financial Statements

     57   

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Shareholders of Lorillard, Inc.

Greensboro, North Carolina

We have audited the accompanying consolidated balance sheets of Lorillard, Inc. and subsidiaries (the “Company”) as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, shareholders’ equity (deficit), and cash flows for each of the three years in the period ended December 31, 2012. Our audits also included the financial statement schedule listed in the Index at Item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedule based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2012, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2012, based on the criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 19, 2013 expressed an unqualified opinion on the Company’s internal control over financial reporting.

 

LOGO

Charlotte, North Carolina

February 19, 2013

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

     December 31,  
(In millions, except per share data)    2012     2011  
ASSETS:     

Cash and cash equivalents

   $ 1,720     $ 1,634  

Accounts receivable, less allowances of $3 and $2

     18       10  

Other receivables

     52       83  

Inventories

     410       277  

Deferred income taxes

     557       535  

Other current assets

     20       25  
  

 

 

   

 

 

 

Total current assets

     2,777       2,564  

Plant and equipment, net

     298       262  

Goodwill

     64       —    

Intangible assets

     57       —    

Deferred income taxes

     48        54  

Other assets

     152       128  
  

 

 

   

 

 

 

Total assets

   $ 3,396     $ 3,008  
  

 

 

   

 

 

 
LIABILITIES AND SHAREHOLDERS’ DEFICIT:     

Accounts and drafts payable

   $ 39     $ 32  

Accrued liabilities

     356       296  

Settlement costs

     1,183       1,151  

Income taxes

     23       6  
  

 

 

   

 

 

 

Total current liabilities

     1,601       1,485  

Long-term debt

     3,111       2,595  

Postretirement pension, medical and life insurance benefits

     409       388  

Other liabilities

     52       53  
  

 

 

   

 

 

 

Total liabilities

     5,173       4,521  
  

 

 

   

 

 

 

Commitments and Contingent Liabilities

    

Shareholders’ Deficit:

    

Preferred stock, $0.01 par value, authorized 10 million shares

     —          —     

Common stock:

    

Authorized – 600 million shares; par value—$.01 per share

Issued – 525 million and 525 million shares (outstanding 382 million and 396 million shares)

     5       5  

Additional paid-in capital

     298       263  

Retained earnings

     2,351       2,059  

Accumulated other comprehensive loss

     (241     (228

Treasury stock at cost, 143 million and 129 million shares

     (4,190     (3,612
  

 

 

   

 

 

 

Total shareholders’ deficit

     (1,777     (1,513
  

 

 

   

 

 

 

Total liabilities and shareholders’ deficit

   $ 3,396     $ 3,008  
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 

     Year Ended December 31,  
(In millions, except per share data)    2012     2011     2010  

Net sales (including excise taxes of $1,987, $2,014 and $1,879)

   $ 6,623      $ 6,466      $ 5,932   

Cost of sales (including excise taxes of $1,987, $2,014 and $1,879)

     4,241        4,123        3,809   
  

 

 

   

 

 

   

 

 

 

Gross profit

     2,382        2,343        2,123   

Selling, general and administrative

     504        451        398   
  

 

 

   

 

 

   

 

 

 

Operating income

     1,878        1,892        1,725   

Investment income

     4        3        4   

Interest expense

     (154     (125     (94
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     1,728        1,770        1,635   

Income taxes

     629        654        606   
  

 

 

   

 

 

   

 

 

 

Net income

   $ 1,099      $ 1,116      $ 1,029   
  

 

 

   

 

 

   

 

 

 

Earnings per share:

      

Basic

   $ 2.82      $ 2.67      $ 2.26   

Diluted

   $ 2.81      $ 2.66      $ 2.25   

Weighted average number of shares outstanding:

      

Basic

     389.27        417.32        454.76   

Diluted

     390.13        418.06        455.19   

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

     Year Ended December 31,  
(In millions, except per share data)    2012     2011     2010  

Net income

   $ 1,099      $ 1,116      $ 1,029   

Other comprehensive income, net of tax:

      

Defined benefit retirement plans gain (loss), net of tax expense (benefit) of $(4), $(64) and $6

     (13     (119     12   
  

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

     (13     (119     12   
  

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 1,086      $ 997      $ 1,041   
  

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(DEFICIT)

 

     Common
Stock
     Additional
Paid-in
Capital
     Retained
Earnings
    Accum-
ulated
Other
Compre-
hensive
Loss
    Treasury
Stock
    Total
Share-
Holders’
Equity
(Deficit)
 
(In millions)                                       

Balance, December 31, 2009

   $ 5       $ 231       $ 1,282      $ (121   $ (1,310   $ 87   

Net income

           1,029            1,029   

Other comprehensive income, net of tax expense of $6

             12          12   

Dividends paid ($1.42 per share)

           (645         (645

Share repurchases

               (716     (716

Share-based compensation

        8               8   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2010

   $ 5       $ 239       $ 1,666      $ (109   $ (2,026   $ (225 )
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Net income

           1,116            1,116   

Other comprehensive loss, net of tax benefit of ($64)

             (119       (119

Dividends paid ($1.73 per share)

           (723         (723

Share repurchases

               (1,586     (1,586

Share-based compensation

        24               24   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2011

   $ 5       $ 263       $ 2,059      $ (228   $ (3,612   $ (1,513 )
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Net income

           1,099            1,099   

Other comprehensive loss, net of tax benefit of $(4)

             (13       (13

Dividends paid ($2.07 per share)

           (807         (807

Share repurchases

               (578     (578

Share-based compensation

        35               35   
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2012

   $ 5       $ 298       $ 2,351      $ (241   $ (4,190   $ (1,777 )
  

 

 

    

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year Ended December 31,  
     2012     2011     2010  
     (In millions)  

Cash flows from operating activities:

      

Net income

   $ 1,099      $ 1,116      $ 1,029   

Adjustments to reconcile to net cash provided by operating activities:

      

Depreciation and amortization

     39        37        35   

Pension, health and life insurance contributions

     (43     (42     (32

Pension, health and life insurance benefits expense

     44        28        30   

Deferred income taxes

     (11     (15     1   

Share-based compensation

     20        16        8   

Excess tax benefits from share-based arrangements

     (11     (4     (2

Changes in operating assets and liabilities, net of amounts acquired:

      

Accounts and other receivables

     (8     1        5   

Inventories

     (118     —          4   

Accounts payable and accrued liabilities

     64        (33     (46

Settlement costs

     32        91        78   

Income taxes

     59        (6     (34

Other current assets

     5        (10     (2

Other assets

     (1     4        17   
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     1,170        1,183        1,091   
  

 

 

   

 

 

   

 

 

 

Cash flows from investing activities:

      

Business acquisition, net of cash acquired

     (135     —          —     

Additions to plant and equipment

     (74     (56     (40
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (209     (56     (40
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

      

Shares repurchased

     (578     (1,586     (716

Proceeds from issuance of long-term debt

     500        750        1,000   

Dividends paid

     (807     (723     (645

Debt issuance costs

     (5     (9     (13

Proceeds from exercise of stock options

     5        8        —     

Excess tax benefits from share-based arrangements

     10        4        2   
  

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

     (875     (1,556     (372
  

 

 

   

 

 

   

 

 

 

Change in cash and cash equivalents

     86        (429     679   

Cash and cash equivalents, beginning of year

     1,634        2,063        1,384   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of year

   $ 1,720      $ 1,634      $ 2,063   
  

 

 

   

 

 

   

 

 

 

Cash paid for income taxes

   $ 580      $ 671      $ 637   

Cash paid for interest, net of cash received from interest rate swaps of $24 in 2012, $24 in 2011 and $24 in 2010

   $ 144      $ 109      $ 79   

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    Significant Accounting Policies

Basis of presentation—Lorillard, Inc., through its subsidiaries, is engaged in the manufacture and sale of cigarettes and electronic cigarettes. Its principal products are marketed under the brand names of Newport, Kent, True, Maverick and Old Gold with substantially all of its sales in the United States of America. On April 24, 2012 Lorillard acquired blu eCigs, an electronic cigarette brand in the U.S. Newport, Kent, True, Maverick, Old Gold and blu eCigs are the registered trademarks of Lorillard, Inc. and its subsidiaries.

The consolidated financial statements of Lorillard, Inc. (the “Company”), together with its subsidiaries (“Lorillard” or “we” or “us” or “our”), include the accounts of the Company and its subsidiaries after the elimination of intercompany accounts and transactions.

The Company conducts its business through two operating and reporting segments – Cigarettes and Electronic Cigarettes. The Company’s Cigarettes Segment is managed through the Company, Lorillard Tobacco Company (“Lorillard Tobacco” or “Issuer”) and related entities. The Electronic Cigarettes Segment is managed through LOEC, Inc. (“LOEC”).

Stock Split—On November 13, 2012, the Company’s Board of Directors declared a three-for-one split of the Company’s common stock effected in the form of a 200% stock dividend. The record date of the stock split was December 14, 2012 and the additional shares were distributed on January 15, 2013. Treasury shares were treated as shares outstanding in the stock split. All shares and per share amounts in these financial statements have been adjusted for all periods presented for the stock split. For additional information, see Note 17, “Share-based Compensation” and Note 18, “Share Repurchase Programs.”

Use of estimates—The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts in the consolidated financial statements and related notes. Significant estimates in the consolidated financial statements and related notes include: (1) accruals for tobacco settlement costs, litigation, sales incentive programs, income taxes and share-based compensation, (2) the determination of discount and other rate assumptions for defined benefit pension and other postretirement benefit expenses, (3) the valuation of pension assets and (4) the valuation of goodwill and intangible assets. Actual results could differ from those estimates.

Cash equivalents—Cash equivalents consist of short-term liquid investments with a maturity at date of purchase of 90 days or less. Interest and dividend income are included in investment income.

Inventories—Cigarette inventories (including leaf tobacco, manufactured stock and materials and supplies) are valued at the lower of cost, determined on a last-in, first-out (“LIFO”) basis, or market. A significant portion of leaf tobacco on hand will not be sold or used within one year, due to the duration of the aging process. All inventory of leaf tobacco, including the portion that has an operating cycle that exceeds 12 months, is classified as a current asset and is a generally recognized trade practice. Electronic cigarette inventories are valued at the lower of cost, determined on a first-in, first-out (“FIFO”) basis, or market and are included in manufactured stock.

Depreciation—Buildings, machinery and equipment are depreciated for financial reporting purposes on the straight-line method over estimated useful lives of those assets of 40 years for buildings and 3 to 12 years for machinery and equipment.

Derivative agreements—In September 2009, Lorillard Tobacco entered into interest rate swap agreements, which the Company guaranteed, with a total notional amount of $750 million. The interest rate swap agreements qualify for hedge accounting and were designated as fair value hedges. Under the swap agreements, Lorillard Tobacco receives a fixed rate settlement and pays a variable rate settlement with the difference recorded in interest expense. Changes in the fair value of the swap agreements are recorded in other assets or other liabilities with an offsetting adjustment to the carrying amount of the hedged debt. See Notes 10 and 13.

 

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Business Combinations—Lorillard utilizes the acquisition method in accounting for business combinations whereby the amount of purchase price that exceeds the fair value of the acquired assets and assumed liabilities is allocated to goodwill. Lorillard recognizes intangible assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. Assumptions and estimates are used in determining the fair value of assets acquired and liabilities assumed in a business combination. Valuation of intangible assets acquired requires that we use significant judgment in determining fair value, whether such intangibles are amortizable and, if the asset is amortizable, the period and the method by which the intangible asset will be amortized. In April 2012, the Company acquired blu eCigs and other assets used in the manufacture, distribution, development, research, marketing, advertising, and sale of electronic cigarettes. Changes in the initial assumptions could lead to changes in amortization or impairment charges recorded in our consolidated financial statements. See Notes 2 and 6 to the Consolidated Financial Statements for additional disclosure about the acquisition and the purchase price allocation.

Goodwill and Intangible Assets—Goodwill is evaluated using a two-step impairment test at the reporting unit level. The first step of the goodwill impairment test compares the book value of a reporting unit, including goodwill, with its fair value. If the book value of a reporting unit exceeds its fair value, we perform the second step of the impairment test. In the second step, we estimate an implied fair value of the reporting unit’s goodwill by allocating the fair value of the reporting unit to all of the assets and liabilities other than goodwill. The difference between the total fair value of the reporting unit and the fair value of all of the assets and liabilities other than goodwill is the implied fair value of that goodwill. The amount of impairment loss is equal to the excess of the book value of the goodwill over the implied fair value of that goodwill.

The fair value of our trademarks and trade names are estimated utilizing the relief from royalty method, and compared to the carrying value. The main assumptions utilized in the relief from royalty method are projected revenues from our long range plan, assumed royalty rates that could be payable if we did not own the trademarks and a discount rate. We recognize an impairment loss when the estimated fair value of the indefinite lived intangible asset is less than its carrying value.

Accumulated other comprehensive income (loss)—The components of accumulated other comprehensive income (loss) (“AOCI”) are unamortized actuarial gains and losses and prior service costs related to Lorillard’s defined benefit pension and postretirement plans. These unamortized gains and losses and prior service costs are recognized in net periodic benefit costs over the estimated service lives of covered employees.

Revenue recognition—Revenue from product sales, net of sales incentives, is recognized at the time ownership of the goods transfers to customers and collectability is reasonably assured. Federal excise taxes are recognized on a gross basis, and are reflected in both net sales and cost of sales. Sales incentives include retail price discounts, coupons and retail display allowances and are recorded as a reduction of revenue based on amounts estimated as due to customers and consumers at the end of a period based primarily on use and redemption rates. Sales to one customer represented 29%, 28% and 27% of Lorillard’s revenues in 2012, 2011 and 2010, respectively. Our largest selling brand, Newport, accounted for approximately 87.0%, 88.4% and 88.8% of consolidated net sales of Lorillard in 2012, 2011 and 2010, respectively.

Cost of sales—Cost of sales includes federal excise taxes, leaf tobacco cost, wrapping and casing material, manufacturing labor and production salaries, wages and overhead, research and development costs, distribution, other manufacturing costs, State Settlement Agreement expenses, the federal assessment for tobacco growers, Food and Drug Administration fees, promotional product expenses and electronic cigarette raw materials and manufacturing costs. Promotional product expenses include the cost, including excise taxes, of the free portion of “buy some get some free” promotions. We purchased approximately 31.9%, 24.9% and 27.4% of our leaf tobacco from one dealer in 2012, 2011 and 2010, respectively.

 

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Advertising and marketing costs—Advertising costs are recorded as expense in the year incurred. Marketing and advertising costs that include such items as direct mail, advertising, agency fees and point of sale materials are included in selling, general and administrative expenses. Advertising expense was $54 million, $41 million and $35 million for the years ended December 31, 2012, 2011 and 2010, respectively.

Research and development costs—Research and development costs are recorded as expense as incurred, are included in cost of sales and amounted to $20 million, $22 million and $19 million for each of the years ended December 31, 2012, 2011 and 2010, respectively.

Tobacco settlement costs—Lorillard recorded pre-tax charges of $1.379 billion, $1.307 billion and $1.212 billion for the years ended December 31, 2012, 2011 and 2010, respectively, to accrue its obligations under the State Settlement Agreements (see Note 22). Lorillard’s portion of ongoing adjusted settlement payments and legal fees is based on its share of total domestic cigarette shipments in that year. Accordingly, Lorillard records its portion of ongoing adjusted settlement payments as part of cost of sales as the related sales occur. Payments are made annually and are generally due in April of the year following the accrual of costs. The settlement cost liability on the balance sheets represents the unpaid portion of the Company’s obligations under the State Settlement Agreements.

Share-Based compensation costs—Under the 2008 Incentive Compensation Plan, the fair market value of the restricted shares and restricted stock units and the exercise price of stock options is based on the closing price at the date of the grant. Share-based compensation expense is recognized net of an estimated forfeiture rate and for shares expected to vest, using a straight-line basis over the requisite service period of the award.

Legal costs and loss contingencies—Legal costs are expensed as incurred and amounted to $160 million, $140 million and $116 million for the years ended December 31, 2012, 2011 and 2010, respectively. Lorillard establishes accruals in accordance with Accounting Standards Codification Topic 450, Contingencies (“ASC 450”), when a loss contingency is both probable and can be reasonably estimated as a charge to selling, general and administrative expense. There are a number of factors impacting Lorillard’s ability to estimate the possible loss or a range of loss, including the specific facts of each matter; the legal theories proffered by plaintiffs and legal defenses available to Lorillard Tobacco and Lorillard, Inc.; the wide-ranging outcomes reached in similar cases; differing procedural and substantive laws in the various jurisdictions in which lawsuits have been filed, including whether punitive damages may be pursued or are permissible; the degree of specificity in a plaintiff’s complaint; the history of the case and whether discovery has been completed; plaintiffs’ history of use of Lorillard Tobacco’s cigarettes relative to those of the other defendants; the attribution of damages, if any, among multiple defendants; the application of contributory and/or comparative negligence to the allocation of damage awards among plaintiffs and defendants; the likelihood of settlements for de minimus amounts prior to trial; the likelihood of success at trial; the likelihood of success on appeal; and the impact of current and pending state and federal appellate decisions. It has been Lorillard’s experience and is its continued expectation that the above complexities and uncertainties will not be clarified until the late stages of litigation. For those reasonably possible loss contingencies for which an estimate of the possible loss or range of loss cannot be made, Lorillard discloses the nature of the litigation and any developments as appropriate. See Note 22 for a description of loss contingencies.

Income taxes—Deferred tax assets and liabilities are determined based on the differences between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Judgment is required in determining income tax provisions and in evaluating tax positions. For uncertain tax positions to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement. Where applicable, interest related to uncertain tax positions is recognized in interest expense. Penalties, if incurred, are recognized as a component of income tax expense.

 

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Recently adopted accounting pronouncements — Lorillard adopted FASB ASU 2010-09 “Subsequent Events (Topic 855): Amendments to Certain Recognition and Disclosure Requirements.” ASU 2010-09 amends Topic 855 for SEC filers to eliminate the disclosure of the date through which subsequent events have been reviewed. The effective date was February 24, 2010. ASU 2010-09 did not have a material impact on Lorillard’s financial position or results of operations.

Lorillard adopted FASB ASU 2010-06 “Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements.” ASU 2010-06 establishes additional disclosures related to fair value. Transfers in and out of Level 1 and Level 2 and the reasons for the transfers must be disclosed. Level 3 purchases, sales, issuances and settlements should be presented separately rather than net. In addition, the level of disaggregation and input and valuation techniques need to be disclosed. The effective dates are periods beginning after December 15, 2010 for the Level 3 purchases, sales, issuances and settlements disclosure, and periods beginning after December 15, 2009 for all other provisions. ASU 2010-06 did not have a material impact on Lorillard’s financial position or results of operations.

Lorillard adopted ASU 2011-04 “Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS.” ASU 2011-04 clarifies certain areas of the fair value guidance, including application of the highest and best use and valuation premise concepts, measuring the fair value of an instrument classified in a reporting entity’s shareholders’ equity, and quantitative information about unobservable inputs used in a Level 3 fair value measurement. Additionally, ASU 2011-04 contains guidance on measuring the fair value of instruments that are managed within a portfolio, application of premiums and discounts in a fair value measurement, and requires additional disclosures about fair value measurements. The amendments contained in ASU 2011-04 are to be applied prospectively, and ASU 2011-04 is effective for public companies for interim and annual periods beginning after December 15, 2011. ASU 2011-04 did not have a material impact on Lorillard’s financial position or results of operations.

Lorillard adopted ASU 2011-05 “Comprehensive Income (Topic 220): Presentation of Comprehensive Income.” ASU 2011-05 requires presentation of comprehensive income in either a single statement of comprehensive income or two separate but consecutive statements. ASU 2011-05 does not change the definitions or the components of net income and other comprehensive income (OCI), when an item must be reclassified from OCI to net income, or the calculation or presentation of earnings per share. The entity still has the choice to either present OCI components before tax with one line amount for tax, or net of taxes. Disclosure of the tax impact for each OCI component is still required. ASU 2011-05 is effective for public companies for reporting periods beginning after December 15, 2011 and must be applied retrospectively. ASU 2011-05 did not have any impact on Lorillard’s financial position or results of operations, but resulted in the presentation of a separate statement of comprehensive income.

In September 2011, the FASB issued ASU 2011-08 “Intangibles – Goodwill and Other (Topic 350): Testing Goodwill for Impairment.” ASU 2011-08 gives an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value in a reporting unit is less than its carrying amount. If an entity determines that it is not more likely than not, then performing a two-step impairment test of goodwill is not necessary. ASU 2011-08 is effective for public companies for reporting periods beginning after December 15, 2011. The adoption of ASU 2011-08 did not have a material impact on Lorillard’s financial position or results of operations, but may impact the manner in which Lorillard assesses goodwill for impairment.

Accounting pronouncements not yet adopted — In July 2012, the FASB issued ASU 2012-02 “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Assets for Impairment.” ASU 2012-02 gives an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances indicates that it is more likely than not that indefinite-lived intangible assets other than goodwill are impaired, before being required to complete a quantitative impairment test. If an entity concludes, after assessing the totality of qualitative factors, that it is more likely than not that the indefinite-lived intangible assets are not impaired, then it is not required to complete a quantitative impairment test whereby the fair value of the

 

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indefinite-lived intangible asset would be determined and compared with the carrying amount of the intangible asset. The amendments in this update are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, and early adoption is permitted. The adoption of ASU 2012-02 will not have a material impact on Lorillard’s financial position or results of operations, but may impact the manner in which Lorillard assesses indefinite-lived intangible assets for impairment.

In February 2013, the FASB issued ASU 2013-02 “Comprehensive Income (Topic 220) — Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income.” ASU 2013-02 requires an entity to provide information about amounts reclassified out of accumulated other comprehensive income. An entity is also required to present either on the face of the financial statements or in the footnotes, significant items reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the item reclassified is required under U.S. GAAP to be reclassified to net income in its entirety. For other items that are not required under U.S. GAAP to be reclassified to net income in their entirety, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. This standard is effective for public entities prospectively for reporting periods beginning after December 15, 2012. The adoption of ASU 2013-02 will not have a material impact on Lorillard’s financial position or results of operations, but will result in disclosure of additional information about amounts reclassified out of accumulated other comprehensive income.

2.    Acquisition

On April 24, 2012, Lorillard, Inc., through its wholly owned subsidiary, Lorillard Holdings Company, Inc. (“LHCI”), and its subsidiaries acquired blu eCigs and other assets used in the manufacture, distribution, development, research, marketing, advertising and sale of electronic cigarettes (the “Acquisition”) for $135 million in cash. The Acquisition was made pursuant to an asset purchase agreement (the “Agreement”) with BLEC, LLC, Intermark Brands, LLC and QSN Technologies, LLC (the “Sellers”). The Agreement contains customary representations, warranties, covenants and indemnities by the Sellers and LHCI. The Acquisition provided Lorillard with the blu eCigs brand and an electronic cigarette product line.

The results of operations of blu eCigs are included in our consolidated financial statements beginning as of April 24, 2012. Lorillard’s consolidated revenues include $61 million of sales of blu eCigs and Lorillard incurred $6 million of acquisition-related expenses during the year ended December 31, 2012. blu eCigs had operating income of $1 million during the year ended December 31, 2012.

The fair values of the assets acquired and liabilities assumed at the date of acquisition are summarized below (in millions):

 

Assets acquired:

  

Current assets:

  

Accounts receivable

   $ 2   

Inventories

     15   
  

 

 

 

Total current assets

     17   
  

 

 

 

Goodwill

     64   

Intangible assets

     58   
  

 

 

 

Total assets

     139   
  

 

 

 

Liabilities assumed:

  

Current liabilities:

  

Accounts and drafts payable

     4   
  

 

 

 

Purchase price

   $ 135   
  

 

 

 

 

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3.    Inventories

Cigarette inventories (including leaf tobacco, manufactured stock and materials and supplies) are valued at the lower of cost, determined on a last-in, first-out (“LIFO”) basis, or market. Electronic cigarette inventories of $41 million included in manufactured stock as of December 31, 2012 are valued at the lower of cost, determined on a first-in, first-out (“FIFO”) basis, or market. Inventories consisted of the following:

 

     December 31,  
     2012      2011  
     (In millions)  

Leaf tobacco

   $ 311       $ 230   

Manufactured stock

     94         43   

Materials and supplies

     5         4   
  

 

 

    

 

 

 
   $ 410       $ 277   
  

 

 

    

 

 

 

If the average cost method of accounting was used for inventories valued on a LIFO basis, inventories would be greater by approximately $245 million and $223 million at December 31, 2012 and 2011, respectively.

4.    Other Current Assets

Other current assets were as follows:

 

     December 31,  
     2012      2011  
     (In millions)  

Restricted cash

   $ —         $ 13   

Appeal bonds

     7         7   

Deposits

     7         —     

Other current assets

     6         5   
  

 

 

    

 

 

 

Total

   $ 20       $ 25   
  

 

 

    

 

 

 

5.    Plant and Equipment, Net

Plant and equipment is stated at historical cost and consisted of the following:

 

     December 31,  
     2012     2011  
     (In millions)  

Land

   $ 3     $ 3  

Buildings

     95       90  

Equipment

     657       597  
  

 

 

   

 

 

 

Total

     755       690  

Accumulated depreciation

     (457     (428
  

 

 

   

 

 

 

Plant and equipment, net

   $ 298     $ 262  
  

 

 

   

 

 

 

Depreciation and amortization expense was $39 million, $37 million and $35 million for 2012, 2011 and 2010, respectively.

 

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6.    Goodwill and Intangible Assets

On April 24, 2012, Lorillard completed the Acquisition of the net assets of blu eCigs from Sellers (see Note 2). The purchase price allocation includes $64 million of goodwill and $58 million of intangible assets, $57 million of which was an indefinite lived intangible asset consisting of trademarks and trade names. All goodwill and trademarks have been recorded as a part of our Electronic Cigarettes reporting segment.

We evaluated our goodwill and indefinite lived intangible assets for impairment as of November 1, 2012. Based on the results of our impairment analysis, no impairment of goodwill or the blu eCigs trademark or trade name was determined to exist.

Goodwill

Goodwill and the changes in goodwill during the period are as follows:

 

(In millions)    Total  

Balance, December 2011

   $ —     

Purchase of blu eCigs net assets

     64   
  

 

 

 

Balance, December 2012

   $ 64   
  

 

 

 

7.    Other Assets

Other assets were as follows:

 

     December 31,  
     2012      2011  
     (In millions)  

Debt issuance costs

   $ 26       $ 24   

Interest rate swap

     111         95   

Other prepaid assets

     15         9   
  

 

 

    

 

 

 

Total

   $ 152       $ 128   
  

 

 

    

 

 

 

8.    Accrued Liabilities

Accrued liabilities were as follows:

 

     December 31,  
     2012      2011  
     (In millions)  

Legal fees

   $ 23       $ 28   

Salaries and other compensation

     19         20   

Medical and other employee benefit plans

     33         31   

Consumer rebates

     87         60   

Sales promotion

     26         23   

Accrued vendor charges

     19         7   

Excise and other taxes

     63         52   

Accrued interest

     33         27   

Other accrued liabilities

     53         48   
  

 

 

    

 

 

 

Total

   $ 356       $ 296   
  

 

 

    

 

 

 

 

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9. Commitments

Lorillard leases certain real estate and transportation equipment under various operating leases. Listed below are future minimum rental payments required under those operating leases with non-cancelable terms in excess of one year.

 

     December 31, 2012  
     (In millions)  

2013

   $ 1.9   

2014

     1.3   

2015

     0.7   

2016

     0.1   
  

 

 

 

Net Minimum lease payments

   $ 4.0   
  

 

 

 

Rental expense for all operating leases was $4 million, $5 million and $6 million for 2012, 2011 and 2010, respectively.

At December 31, 2012, Lorillard Tobacco had contractual purchase obligations of approximately $69 million. These purchase obligations related primarily to agreements to purchase machinery during 2013.

At December 31, 2012, blu eCigs had contractual purchase obligations of approximately $17 million. These purchase obligations related primarily to agreements to purchase inventory during 2013.

10.    Fair Value

Fair value is the price that would be received upon sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The following fair value hierarchy is used in selecting inputs, with the highest priority given to Level 1, as these are the most transparent or reliable:

 

   

Level 1 — Quoted prices for identical instruments in active markets.

 

   

Level 2 — Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations in which all significant inputs are observable directly or indirectly.

 

   

Level 3 — Valuations derived from valuation techniques in which one or more significant inputs are unobservable.

Lorillard is responsible for the valuation process and as part of this process may use data from outside sources in establishing fair value. Lorillard performs due diligence to understand the inputs used or how the data was calculated or derived, and corroborates the reasonableness of external inputs in the valuation process.

 

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Assets and liabilities measured at fair value on a recurring basis at December 31, 2012 were as follows:

 

(In millions)    Level 1      Level 2      Level 3      Total  

Cash and Cash Equivalents:

           

Prime money market funds

   $ 1,720       $ —         $ —         $ 1,720   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total cash and cash equivalents

   $ 1,720       $ —         $ —         $ 1,720   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative Asset:

           

Interest rate swaps — fixed to floating rate

   $ —         $ 111       $ —         $ 111   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total derivative asset

   $ —         $ 111       $ —         $ 111   
  

 

 

    

 

 

    

 

 

    

 

 

 

Assets and liabilities measured at fair value on a recurring basis at December 31, 2011 were as follows:

 

(In millions)    Level 1      Level 2      Level 3      Total  

Cash and Cash Equivalents:

           

Prime money market funds

   $ 1,634       $ —         $ —         $ 1,634   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total cash and cash equivalents

   $ 1,634       $ —         $ —         $ 1,634   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative Asset:

           

Interest rate swaps — fixed to floating rate

   $ —         $ 95       $ —         $ 95   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total derivative asset

   $ —         $ 95       $ —         $ 95   
  

 

 

    

 

 

    

 

 

    

 

 

 

There were no transfers between levels within the fair value hierarchy or Level 3 purchases, sales, issuances or settlements for the years ended December 31, 2012 and 2011.

The fair value of the money market funds, classified as Level 1, utilized quoted prices in active markets.

The fair value of the interest rate swaps, classified as Level 2, utilized a market approach model using the notional amount of the interest rate swap and observable inputs of time to maturity and market interest rates. See Note 13 for additional information on the interest rate swaps.

11.    Credit Agreement

On July 10, 2012, Lorillard Tobacco, the principal, wholly owned operating subsidiary of the Company, terminated its three year $185 million credit agreement (the “Old Revolver”), dated March 26, 2010, and entered into a $200 million revolving credit facility that expires on July 10, 2017 (the "Revolver") and is guaranteed by the Company. The Revolver may be increased to $300 million upon request. Proceeds from the Revolver may be used for general corporate and working capital purposes. The interest rates on borrowings under the Revolver are based on prevailing interest rates and, in part, upon the credit rating applicable to the Company's senior unsecured long-term debt.

The Revolver requires that the Company maintain a ratio of debt to net income plus income taxes, interest expense, depreciation and amortization expense, any extraordinary losses, any non-cash expenses or losses and any losses on sales of assets outside of the ordinary course of business (“Adjusted EBITDA”) of not more than 2.25 to 1 and a ratio of Adjusted EBITDA to interest expense of not less than 3.0 to 1. In addition, the Revolver contains other affirmative and negative covenants customary for facilities of this type. The Revolver contains customary events of default, including upon a change in control (as defined therein), that could result in the acceleration of all amounts and cancellation of all commitments outstanding under the Revolver.

As of December 31, 2012, Lorillard was in compliance with all financial covenants and there were no borrowings under the Revolver.

 

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12. Long-Term Debt

Long-term debt, net of interest rate swaps, consisted of the following:

 

     December 31,
2012
     December 31,
2011
 
     (In millions)  

2016 Notes—3.500% Notes due 2016

   $ 500       $ 500   

2017 Notes—2.300% Notes due 2017

     500         —     

2019 Notes—8.125% Notes due 2019

     861         845   

2020 Notes—6.875% Notes due 2020

     750         750   

2040 Notes—8.125% Notes due 2040

     250         250   

2041 Notes—7.000% Notes due 2041

     250         250   
  

 

 

    

 

 

 

Total long-term debt

   $ 3,111       $ 2,595   
  

 

 

    

 

 

 

In April 2010, Lorillard Tobacco issued $1 billion of unsecured senior notes in two tranches pursuant to an Indenture, dated June 23, 2009 (the “Indenture”) and the Second Supplemental Indenture, dated April 12, 2010. The first tranche was $750 million aggregate principal amount of 6.875% Notes due May 1, 2020 (the “2020 Notes”), and the second tranche was $250 million aggregate principal amount of 8.125% Notes due May 1, 2040 (the “2040 Notes”). The net proceeds from the issuance were used for the repurchase of the Company’s common stock.

In August 2011, Lorillard Tobacco issued $750 million of unsecured senior notes in two tranches pursuant to the Indenture and the Third Supplemental Indenture, dated August 4, 2011. The first tranche was $500 million aggregate principal amount of 3.500% Notes due August 4, 2016 (the “2016 Notes”), and the second tranche was $250 million aggregate principal amount of 7.000% Notes due August 4, 2041 (the “2041 Notes”). The net proceeds from the issuance were used for the repurchase of the Company’s common stock.

In August 2012, Lorillard Tobacco issued $500 million aggregate principal amount of 2.300% unsecured senior notes due August 21, 2017 (the “2017 Notes”) pursuant to the Indenture and the Fourth Supplemental Indenture, dated August 21, 2012. The net proceeds from the issuance were used for the repurchase of the Company’s common stock.

Lorillard Tobacco is the principal, wholly owned operating subsidiary of the Company and the 2016 Notes, 2017 Notes, 2019 Notes, 2020 Notes, 2040 Notes and 2041 Notes (collectively, the “Notes”) are unconditionally guaranteed on a senior unsecured basis by the Company.

The interest rate payable on the $750 million of 2019 Notes issued in June 2009 is subject to incremental increases from 0.25% to 2.00% in the event either Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”) or both Moody’s and S&P downgrade the 2019 Notes below investment grade (Baa3 and BBB- for Moody’s and S&P, respectively). As of December 31, 2012, our debt ratings were Baa2 and BBB- with Moody’s and S&P, respectively, both of which are investment grade.

Upon the occurrence of a change of control triggering event, Lorillard Tobacco will be required to make an offer to repurchase the Notes at a price equal to 101% of the aggregate principal amount of the Notes, plus accrued interest. A “change of control triggering event” occurs when there is both a “change of control” (as defined in the Supplemental Indenture) and the Notes cease to be rated investment grade by both Moody’s and S&P within 60 days of the occurrence of a change of control or public announcement of the intention to effect a change of control. The Notes are not entitled to any sinking fund and are not redeemable prior to maturity. The Notes contain covenants that restrict liens and sale and leaseback transactions, subject to a limited exception. At December 31, 2012 and 2011, the carrying value of the Notes was $3.111 billion and $2.595 billion, respectively, and the estimated fair value was $3.512 billion and $2.801 billion, respectively. The fair value of the Notes is based on market pricing. The fair value of the Notes, classified as Level 1, utilized quoted prices in active markets.

 

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13.    Derivative Instruments

In September 2009, Lorillard Tobacco entered into interest rate swap agreements, which the Company guaranteed, with a total notional amount of $750 million to modify its exposure to interest rate risk by effectively converting the interest rate payable on the 2019 Notes from a fixed rate to a floating rate. Under the agreements, Lorillard Tobacco receives interest based on a fixed rate of 8.125% and pays interest based on a floating one-month LIBOR rate plus a spread of 4.625%. The variable rates were 4.840% and 4.896% as of December 31, 2012 and 2011, respectively. The agreements expire in June 2019. The interest rate swap agreements qualify for hedge accounting and were designated as fair value hedges. Under the swap agreements, Lorillard Tobacco receives a fixed rate settlement and pays a variable rate settlement with the difference recorded in interest expense. That difference reduced interest expense by $24 million in both 2012 and 2011.

For derivatives designated as fair value hedges, which relate entirely to hedges of long-term debt, changes in the fair value of the derivatives are recorded in other assets or other liabilities with an offsetting adjustment to the carrying amount of the hedged debt. At December 31, 2012 and 2011, the adjusted carrying amounts of the hedged debt were $861 million and $845 million, respectively and the amounts included in other assets were $111 million and $95 million, respectively.

If our debt rating is downgraded below Ba2 by Moody’s or BB by S&P, the swap agreements will terminate and we will be required to settle them in cash before their expiration date. As of December 31, 2012, our debt ratings were Baa2 and BBB- with Moody’s and S&P, respectively, both of which are above the ratings at which settlement of our derivative contracts would be required.

14.    Earnings Per Share

Basic and diluted earnings per share (“EPS”) were calculated using the following:

 

     Year Ended
December 31,
 
     2012     2011     2010  
     (In millions)  

Numerator:

      

Net income, as reported

   $ 1,099      $ 1,116      $ 1,029   

Less: Net income attributable to participating securities

     (3     (3     —     
  

 

 

   

 

 

   

 

 

 

Net income available to common shareholders

   $ 1,096      $ 1,113      $ 1,029   
  

 

 

   

 

 

   

 

 

 

Denominator:

      

Basic EPS – weighted average shares

     389.27        417.32        454.76   

Effect of dilutive securities:

      

Stock Options and SARS

     0.86        0.74        0.43   
  

 

 

   

 

 

   

 

 

 

Diluted EPS – adjusted weighted average shares and assumed conversions

     390.13        418.06        455.19   
  

 

 

   

 

 

   

 

 

 

Earnings Per Share:

      

Basic

   $ 2.82      $ 2.67      $ 2.26   

Diluted

   $ 2.81      $ 2.66      $ 2.25   

Options to purchase 0.1 million shares and 0.2 million shares of common stock were excluded from the diluted earnings per share calculation because their effect would be anti-dilutive for the years ended December 31, 2011 and 2010, respectively.

 

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15.    Income Taxes

Prior to the separation from Loews in 2008 (the “Separation”), Lorillard was included in the Loews consolidated federal income tax return, and federal income tax liabilities were included on the balance sheet of Loews. Under the terms of the pre-Separation Tax Allocation Agreement between Lorillard and Loews, Lorillard made payments to, or was reimbursed by Loews for the tax effects resulting from its inclusion in Loews’ consolidated federal income tax return. As of December 31, 2012, there were no tax obligations between Lorillard and Loews for periods prior to the Separation. Following the Separation, Lorillard and its eligible subsidiaries filed a stand-alone consolidated federal income tax return.

The Separation Agreement with Loews (the “Separation Agreement”) requires Lorillard (and any successor entity) to indemnify Loews for any losses resulting from the failure of the Separation to qualify as a tax-free transaction (except if the failure to qualify is solely due to Loews’ fault). This indemnification obligation applies regardless of whether Lorillard or a potential acquirer obtains a supplemental ruling or an opinion of counsel.

The Separation Agreement further provides for cooperation between Lorillard and Loews with respect to additional tax matters, including the exchange of information and the retention of records which may affect the income tax liability of the parties to the Separation Agreement.

A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:

 

(In millions)    2012     2011     2010  

Balance at January 1,

   $ 42      $ 33      $ 39   

Additions for tax positions of prior years

     4        6        1   

Reductions for tax positions of prior years

     (6     (2     (15

Additions based on tax positions related to the current year

     9        9        9   

Settlements

     (4     (1     —     

Lapse of statute of limitations

     (4     (3     (1
  

 

 

   

 

 

   

 

 

 

Balance at December 31,

   $ 41      $ 42      $ 33   
  

 

 

   

 

 

   

 

 

 

At December 31, 2012, 2011 and 2010, there were $27 million, $28 million and $22 million, respectively, of tax benefits that, if recognized, would affect the effective tax rate.

Lorillard recognizes interest related to unrecognized tax benefits and tax refund claims in interest expense and recognizes penalties (if any) in income tax expense. During the years ended December 31, 2012, 2011 and 2010, Lorillard recognized an expense of approximately $2 million, $2 million and $3 million in interest and penalties. Lorillard had accrued interest and penalties related to unrecognized tax benefits of $16 million and $15 million at December 31, 2012 and 2011, respectively.

Due to the potential for resolution of certain tax examinations and the expiration of various statutes of limitation, it is reasonably possible that Lorillard’s gross unrecognized tax benefits balance may decrease by approximately $6 million in the next twelve months.

Lorillard and/or one or more of its subsidiaries file income tax returns in the U.S. federal jurisdiction and various states and city jurisdictions. Lorillard’s consolidated federal income tax returns for the periods after 2008 are subject to IRS examination. With few exceptions, Lorillard’s state, local or foreign tax returns are subject to examination by taxing authorities for years after 2007.

 

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The provision (benefit) for income taxes consisted of the following:

 

     Year Ended December 31,  
     2012     2011     2010  
     (In millions)  

Current

      

Federal

   $ 530      $ 548      $ 489   

State

     111        120        112   

Deferred

      

Federal

     (10     (10     5   

State

     (2     (4     —     
  

 

 

   

 

 

   

 

 

 

Total

   $ 629      $ 654      $ 606   
  

 

 

   

 

 

   

 

 

 

Deferred tax assets (liabilities) are as follows:

 

     December 31,  
(In millions)    2012     2011  

Deferred tax assets:

    

Employee benefits-

   $ 161     $ 154  

Settlement costs

     511       498  

State and local income taxes

     18       18  

Litigation and legal

     6       7  

Inventory

     4       —    

Other

     2       8   
  

 

 

   

 

 

 

Gross deferred tax assets

     702       685  
  

 

 

   

 

 

 

Deferred tax liabilities:

    

Depreciation

     (63     (57

Inventory

     —         (6

Federal effect of state deferred taxes

     (34     (33
  

 

 

   

 

 

 

Gross deferred tax liabilities

     (97     (96
  

 

 

   

 

 

 

Net deferred tax assets

   $ 605     $ 589  
  

 

 

   

 

 

 

Total income tax expense for the years ended December 31, 2012, 2011 and 2010 was different than the amounts of $605 million, $620 million and $572 million, computed by applying the statutory U.S. federal income tax rate of 35% to income before taxes for each of the years.

 

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A reconciliation between the statutory federal income tax rate and Lorillard’s effective income tax rate as a percentage of income is as follows:

 

     2012     2011     2010  

Statutory rate

     35.0     35.0     35.0

Increase (decrease) in rate resulting from:

      

State taxes

     4.1        4.3        4.5   

Domestic manufacturer’s deduction

     (2.8     (2.4     (2.5

Other

     0.1        0.1        0.1   
  

 

 

   

 

 

   

 

 

 

Effective rate

     36.4     37.0     37.1
  

 

 

   

 

 

   

 

 

 

16.    Retirement Plans

Lorillard has defined benefit pension, postretirement benefits, profit sharing and savings plans for eligible employees.

Pension and postretirement benefits—The Salaried Pension Plan provides benefits based on employees’ compensation and service. The Hourly Pension Plan provides benefits based on fixed amounts for each year of service. Lorillard also provides medical and life insurance benefits to eligible employees. Lorillard uses a December 31 measurement date for its plans.

Lorillard also provides certain senior level management employees with nonqualified, unfunded supplemental retirement plans. While these plans are unfunded, Lorillard has certain assets invested in an executive life insurance policy that are to be used to provide for certain of these benefits.

Weighted-average assumptions used to determine benefit obligations:

 

     Pension Benefits    Other
Postretirement  Benefits
     December 31,    December 31,
     2012    2011    2012    2011

Discount rate

   3.90%-4.25%    4.70%-4.90%    3.90%-4.00%    4.60%-4.80%

Rate of compensation increase

   4.25%    4.75%      

Weighted-average assumptions used to determine net periodic benefit cost:

 

     Pension Benefits    Other Postretirement
Benefits
     Year Ended December 31,    Year Ended December 31,
     2012    2011    2010    2012    2011    2010

Discount rate

   4.70%-4.90%    5.40%-5.75%    6.00%    4.60%-4.80%    5.25%-5.50%    6.00%

Expected long-term return on plan assets

   7.75%    7.50%    7.50%         

Rate of compensation increase

   4.75%    4.75%    4.75%         

The expected long-term rate of return for Plan assets is determined based on widely-accepted capital market principles, long-term return analysis for global fixed income and equity markets and the active total return oriented portfolio management style. The methodology used to derive asset class risk/return estimates varies due to the nature of asset classes, the availability of historical data, implications from currency, and other factors. In many cases, where historical data is available, data is drawn from indices such as Morgan Stanley Capital International (“MSCI”) or G7 country data. For alternative asset classes where historical data may be insufficient

 

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or incomplete, estimates are based on long-term capital market conditions and/or asset class relationships. The expected rate of return for the Plan is based on the target asset allocation and return assumptions for each asset class. The estimated Plan return represents a nominal compound return which captures the effect of estimated asset class and market volatility.

Assumed health care cost trend rates for other postretirement benefits:

 

     Other Postretirement
Benefits
 
     Year Ended
December 31,
 
     2012     2011  

Pre-65 health care cost trend rate assumed for next year

     8.5     9.0

Post-65 health care cost trend rate assumed for next year

     6.0     8.0

Rate to which the cost trend rate is assumed to decline (the ultimate trend rate)

     4.5     5.0

Year that the rate reaches the ultimate trend rate:

    

Pre-65

     2021       2020  

Post-65

     2021       2018  

Assumed health care cost trend rates have a significant effect on the amounts reported for the health care plans. A one-percentage-point change in assumed health care cost trend rates would have the following effects:

 

     One Percentage Point  
     Increase      Decrease  
     (In millions)  

Effect on postretirement benefit obligations

   $ 17       $ 14   

Effect on total of service and interest cost

     1         1   

Net periodic pension and other postretirement benefit costs include the following components:

 

     Pension Benefits     Other Postretirement
Benefits
 
     Year Ended
December 31,
    Year Ended
December 31,
 
     2012     2011     2010     2012     2011     2010  
     (In millions)  

Service cost

   $ 24     $ 18     $ 17     $ 5     $ 4     $ 4  

Interest cost

     55       56       56       10       10       12  

Expected return on plan assets

     (76     (73     (68     —         —         —    

Amortization of unrecognized net loss (gain)

     22       8       7       —         —         (1

Amortization of unrecognized prior service cost

     4       4       5       (1     (1     (1
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net periodic benefit cost

   $ 29     $ 13     $ 17     $ 14     $ 13     $ 14  
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

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The following provides a reconciliation of benefit obligations, plan assets and funded status of the pension and postretirement plans.

 

     Pension Benefits     Other
Postretirement
Benefits
 
     December 31,     December 31,  
     2012     2011     2012     2011  
     (In millions)  

Change in benefit obligation:

        

Benefit obligation at January 1

   $ 1,183      $ 1,023      $ 212     $ 197  

Service cost

     24       18       5       4  

Interest cost

     55       56       10       10  

Plan participants’ contributions

     —         —         5       5  

Amendments

     —         9       2       —    

Actuarial (gain) loss

     66       144       12       15  

Benefits paid

     (63     (67     (18     (21

Other

     —         —         2       2  
  

 

 

   

 

 

   

 

 

   

 

 

 

Benefit obligation at December 31

     1,265       1,183       230       212  
  

 

 

   

 

 

   

 

 

   

 

 

 

Change in plan assets:

        

Fair value of plan assets at January 1

     998       989       —         —    

Actual return on plan assets

     112       48       —         —    

Employer contributions

     31       28       13       16  

Plan participants’ contributions

     —         —         5       5  

Benefits paid from plan assets

     (63     (67     (18     (21
  

 

 

   

 

 

   

 

 

   

 

 

 

Fair value of plan assets at December 31

     1,078       998       —         —    
  

 

 

   

 

 

   

 

 

   

 

 

 

Funded status

   $ (187   $ (185   $ (230   $ (212
  

 

 

   

 

 

   

 

 

   

 

 

 

Amounts recognized in the balance sheets consist of:

        

Current liabilities

   $ —       $ —       $ (14   $ (14

Noncurrent liabilities

     (187     (185     (216     (198
  

 

 

   

 

 

   

 

 

   

 

 

 

Net amount recognized

   $ (187   $ (185   $ (230   $ (212
  

 

 

   

 

 

   

 

 

   

 

 

 

Net actuarial loss

   $ 30      $  168      $ 12      $ 15   

Recognized actuarial gain (loss)

     (22     (7     —         1  

Prior service cost

     —         10        2        —    

Recognized prior service cost

     (4     (4     —         —    
  

 

 

   

 

 

   

 

 

   

 

 

 

Total recognized in other comprehensive (income) loss

   $ 4      $ 167     $ 14      $ 16   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total recognized net periodic benefit cost and other comprehensive (income) loss

   $ 33      $ 180      $ 28      $ 29   
  

 

 

   

 

 

   

 

 

   

 

 

 

Information for pension plans with an accumulated benefit obligation in excess of plan assets consisted of the following:

 

     Pension Benefits  
     December 31,  
     2012      2011  
     (In millions)  

Projected benefit obligation

   $ 1,265       $ 1,183   

Accumulated benefit obligation

     1,189         1,111   

Fair value of plan assets

     1,078         998   

 

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The table below presents the estimated amounts to be recognized from accumulated other comprehensive income into net periodic benefit cost during 2013.

 

     Pension
Benefits
     Other
Postretirement
Benefits
 
     (In millions)  

Amortization of actuarial (gain) loss

   $ 21       $ 1   

Amortization of prior service cost

     4         —     
  

 

 

    

 

 

 

Total estimated amounts to be recognized

   $ 25       $ 1   
  

 

 

    

 

 

 

Lorillard projects expected future minimum benefit payments as follows.

 

Expected future benefit payments

   Pension
Benefits
     Other
Postretirement
Benefit Plans
     Less
Medicare
Drug

Subsidy
     Net  
     (In millions)  

2013

   $ 67       $ 15       $ 1       $ 14   

2014

     70         16         1         15   

2015

     71         16         1         15   

2016

     73         16         1         15   

2017

     75         17         1         16   

2018 – 2022

     396         84         4         80   
  

 

 

    

 

 

    

 

 

    

 

 

 
   $ 752       $ 164       $ 9       $ 155   
  

 

 

    

 

 

    

 

 

    

 

 

 

Lorillard expects to contribute $31 million to its pension plans and $15 million to its other postretirement benefit plans in 2013.

The general principles guiding the investment of the Plan assets are embodied in the Employee Retirement Income Security Act of 1974 (ERISA). These principles include discharging Lorillard’s investment responsibilities for the exclusive benefit of Plan participants and in accordance with the “prudent expert” standards and other ERISA rules and regulations. Investment objectives for Lorillard’s pension Plan assets are to optimize the long-term return on Plan assets while maintaining an acceptable level of risk, to diversify assets among asset classes and investment styles, and to maintain a long-term focus.

In 2009, Lorillard conducted an asset/liability study to determine the optimal strategic asset allocation to meet the Plan’s projected long-term benefit obligations and desired funding status. The Plan is managed using a Liability Driven Investment (“LDI”) framework which focuses on achieving the Plan’s return goals while assuming a reasonable level of funded status volatility.

Based on this LDI framework the asset allocation has two primary components. The first component of the asset allocation is the “hedging portfolio” which uses the Plan’s fixed income portfolio to hedge a portion of the interest rate risk associated with the Plan’s liabilities, thereby reducing the Plan’s expected funded status volatility. The second component is the “growth/equity portfolio” which is designed to enhance portfolio returns. The growth portfolio is broadly diversified across the following asset classes; Global Equities, Long Short Equities, Absolute Return Hedge Funds, Private Equity (including growth equity, buyouts, and other illiquid assets designed to enhance returns), and Private Real Assets. Alternative investments, including hedge funds, are used judiciously to enhance risk adjusted long-term returns while improving portfolio diversification. Overlay derivatives are used to assist in the rebalancing of the total portfolio to the strategic asset allocation. Derivatives may be used to gain market exposure in an efficient and timely manner. Investment risk is measured and monitored on an ongoing basis through annual liability measurements, periodic asset/liability studies, and quarterly investment portfolio reviews.

 

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The pension plans asset allocations were:

 

     Asset Allocation as  of
12/31/12
     Asset Allocation as  of
12/31/11
 
     (%)      (%)  

Asset Class

     

U.S. Equity

     10.6         14.0   

Global ex U.S. Equity

     8.0         10.4   

Global ex Emerging Markets Equity

     3.8         —     

Emerging Markets Equity

     3.7         3.6   

Absolute Return Hedge Funds

     13.9         11.7   

Equity Hedge Funds

     11.4