10-K 1 d449654d10k.htm FORM 10-K Form 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

(Mark One)

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

For the fiscal year ended December 31, 2012

OR

 

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

Commission file number: 1-32258

Reynolds American Inc.

(Exact name of registrant as specified in its charter)

 

North Carolina   20-0546644

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

401 North Main Street

Winston-Salem, NC 27101

(Address of principal executive offices) (Zip Code)

(336) 741-2000

(Registrant’s telephone number, including area code)

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

 

Title of each class

 

Name of each

exchange on which

registered

 

Title of each class

 

Name of each

exchange on which

registered

Common stock, par value $.0001 per share   New York   Rights to Purchase Series A Junior Participating Preferred Stock   New York

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  þ    No  ¨

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

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

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

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.  þ

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

 

Large accelerated filer  þ   Accelerated filer  ¨   Non-accelerated filer  ¨   Smaller reporting company  ¨
    (Do not check if a smaller reporting company)  

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

The aggregate market value of common stock held by non-affiliates of Reynolds American Inc. on June 29, 2012, was approximately $15 billion, based on the closing price of $44.87. Directors, executive officers and a significant shareholder of Reynolds American Inc. are considered affiliates for purposes of this calculation, but should not necessarily be deemed affiliates for any other purpose.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: January 28, 2013: 552,948,192 shares of common stock, par value $.0001 per share.

Documents Incorporated by Reference:

Portions of the Definitive Proxy Statement of Reynolds American Inc. to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934 on or about March 22, 2013, are incorporated by reference into Part III of this report.

 

 

 


Table of Contents

INDEX

 

PART I

    

Item 1.

  Business      2   

Item 1A.

  Risk Factors      14   

Item 1B.

  Unresolved Staff Comments      23   

Item 2.

  Properties      23   

Item 3.

  Legal Proceedings      24   

Item 4.

  Mine Safety Disclosures      24   

PART II

    

Item 5.

  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      25   

Item 6.

  Selected Financial Data      27   

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      28   

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk      60   

Item 8.

  Financial Statements and Supplementary Data      62   

Item 9.

  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      165   

Item 9A.

  Controls and Procedures      165   

Item 9B.

  Other Information      165   

PART III

    

Item 10.

  Directors, Executive Officers and Corporate Governance      166   

Item 11.

  Executive Compensation      166   

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      166   

Item 13.

  Certain Relationships and Related Transactions, and Director Independence      166   

Item 14.

  Principal Accountant Fees and Services      166   

PART IV

    

Item 15.

  Exhibits and Financial Statement Schedules      167   
Signatures      174   

 

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PART I

Item 1. Business

Reynolds American Inc., referred to as RAI, is a holding company whose operating subsidiaries include the second largest cigarette manufacturer in the United States, R. J. Reynolds Tobacco Company; the second largest smokeless tobacco products manufacturer in the United States, American Snuff Company, LLC, referred to as American Snuff Co.; the manufacturer of the fastest growing super-premium cigarette brand, Santa Fe Natural Tobacco Company, Inc., referred to as SFNTC; and Niconovum AB, a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name. RAI was incorporated in the state of North Carolina on January 2, 2004, and its common stock is listed on the NYSE under the symbol “RAI.” RAI’s headquarters are located in Winston-Salem, North Carolina. On July 30, 2004, the U.S. assets, liabilities and operations of Brown & Williamson Tobacco Corporation, now known as Brown & Williamson Holdings, Inc., referred to as B&W, an indirect, wholly owned subsidiary of British American Tobacco p.l.c., referred to as BAT, were combined with R. J. Reynolds Tobacco Company, a wholly owned operating subsidiary of R.J. Reynolds Tobacco Holdings, Inc., a wholly owned subsidiary of RAI, referred to as RJR. These July 30, 2004, transactions generally are referred to as the B&W business combination. As a result of the B&W business combination, B&W owns approximately 42% of RAI’s outstanding common stock.

References to RJR Tobacco prior to July 30, 2004, relate to R. J. Reynolds Tobacco Company, a New Jersey corporation. References to RJR Tobacco on and subsequent to July 30, 2004, relate to the combined U.S. assets, liabilities and operations of B&W and R. J. Reynolds Tobacco Company. Concurrent with the completion of the B&W business combination, RJR Tobacco became a North Carolina corporation.

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

RAI’s reportable operating segments are RJR Tobacco, American Snuff and Santa Fe. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The American Snuff segment consists of the primary operations of American Snuff Co. and, prior to its sale, Lane, Limited, referred to as Lane. The Santa Fe segment consists of the primary operations of SFNTC. Niconovum AB, among other RAI subsidiaries, is included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance. Certain of RAI’s operating subsidiaries have entered into intercompany agreements for products or services with other subsidiaries. As a result, certain activities of an operating subsidiary may be included in a different segment of RAI. For net sales and operating income attributable to each segment, see Item 8, note 17 to consolidated financial statements.

As a result of the B&W business combination, Lane became a wholly owned subsidiary of RAI. On February 28, 2011, RAI completed the sale of all of the capital stock of Lane and certain other assets related to the Lane operations, to an affiliate of Scandinavian Tobacco Group A/S, referred to as STG, for net proceeds of $202 million in cash. The results of operations of the disposal group were included through February 28, 2011, in income from continuing operations in the American Snuff segment.

RAI Strategy

RAI’s strategy is focused on transforming tobacco in anticipation of shifts in consumer preferences to deliver sustainable earnings growth, strong cash flow and enhanced long-term shareholder value. This

 

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transformation strategy includes growing the core cigarette and moist-snuff businesses, focusing on innovation, including modern smoke-free tobacco, and exploring nicotine replacement treatments and other opportunities for adult tobacco consumers while maintaining efficient and effective operations.

RAI’s strategy encourages the migration of adult smokers to smoke-free tobacco products, which we believe aligns consumer preferences for new alternatives to traditional tobacco products in view of societal pressure to reduce public smoking. RAI’s operating companies facilitate this migration through innovation, including the development of CAMEL Snus, tobacco extract products, heat-not-burn cigarettes, tobacco vapor products and nicotine replacement therapy technologies. RAI remains committed to maintaining high standards of corporate governance and business conduct in a high performing culture.

RJR Tobacco

Overview

RAI’s largest reportable operating segment, RJR Tobacco, is the second largest tobacco company in the United States. RJR Tobacco’s brands include many of the best-selling cigarettes in the United States: CAMEL, PALL MALL, WINSTON, KOOL, DORAL and SALEM. Those brands, and its other brands, including MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. RJR Tobacco also manages contract manufacturing of cigarettes and tobacco products through arrangements with BAT affiliates, and manages the export of tobacco products to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases. Effective January 1, 2012, the management of super premium cigarette brands, DUNHILL and STATE EXPRESS 555, was transferred to RJR Tobacco from Santa Fe.

RJR Tobacco primarily conducts business in the highly competitive U.S. cigarette market. The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to Japan Tobacco Inc., referred to as JTI, and no international rights were acquired in connection with the B&W business combination. The U.S. cigarette market, which has a few large manufacturers and many smaller participants, is a mature market in which overall consumer demand has declined since 1981, and is expected to continue to decline. Management Science Associates, Inc., referred to as MSAi, reported that U.S. cigarette shipments declined 2.3% in 2012, to 286.5 billion cigarettes, 3.5% in 2011 and 3.8% in 2010. From year to year, shipments are impacted by various factors including price increases, excise tax increases and wholesale inventory adjustments.

Profitability of the U.S. cigarette industry and RJR Tobacco continues to be adversely impacted by decreases in consumption, increases in state excise taxes and governmental regulations and restrictions, such as marketing limitations, product standards, smoking bans and ingredients legislation.

RJR Tobacco’s portfolio also includes CAMEL Snus, a modern smoke-free tobacco product. CAMEL Snus is heat-treated tobacco in individual pouches that provides convenient tobacco consumption.

Competition

RJR Tobacco’s primary competitors include Philip Morris USA Inc., Lorillard Tobacco Company, Liggett Group and Commonwealth Brands, Inc., as well as manufacturers of deep-discount brands. Deep-discount brands are brands manufactured by companies that are not original participants in the Master Settlement Agreement, referred to as the MSA, and other state settlement agreements with the states of Mississippi, Florida, Texas and Minnesota, together with the MSA collectively referred to as the State Settlement Agreements, and accordingly, do not have cost structures burdened with payments related to State Settlement Agreements to the same extent as the original participating manufacturers referred to as PMs. For further discussion of the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 to consolidated financial statements.

 

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Based on data collected by SymphonyIRI Group and Capstone Research, Inc., collectively referred to as IRI/Capstone, during 2012 and 2011, RJR Tobacco had an overall retail share of the U.S. cigarette market of 26.5% and 27.6%, respectively. During these same years, Philip Morris USA Inc. had an overall retail share of the U.S. cigarette market of 49.3% and 48.1%, respectively.

Domestic shipment volume and retail share of market data that appear in this document have been obtained from MSAi and IRI/Capstone, respectively. These two organizations are the primary sources of volume and market share data relating to the cigarette and tobacco industry. This information is included in this document because it is used by RJR Tobacco primarily as an indicator of the relative performance of industry participants. However, you should not rely on the market share data reported by IRI/Capstone as being precise measurements of actual market share because IRI/Capstone uses a sample and projection methodology that is not able to effectively track all volume. Moreover, you should be aware that in a product market experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes. RJR Tobacco believes that deep-discount brands made by small manufacturers have combined shipments of approximately 15% of total U.S. industry shipments. Accordingly, the retail share of market of RJR Tobacco and its brands as reported by IRI/Capstone may overstate their actual market share.

Competition is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other incentives to maintain or improve market position or to introduce a new brand or brand style. Competition among the major cigarette manufacturers has begun shifting to product innovation and expansion into smoke-free tobacco categories, such as snus, as well as finding efficient and effective means of balancing market share and profit growth.

Marketing

RJR Tobacco is committed to building and maintaining a portfolio of profitable brands. RJR Tobacco’s marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokers of competing brands to RJR Tobacco brands. In addition to building strong brand equity, RJR Tobacco’s marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend certain brands’ shares of market against competitive pricing pressure. RJR Tobacco’s competitive pricing methods may include list price changes, discounting programs, such as retail and wholesale buydowns, periodic price reductions, off-invoice price reductions, dollar-off promotions and consumer coupons. Retail buydowns refer to payments made to the retailer to reduce the price that consumers pay at retail. Consumer coupons generally are distributed by a variety of methods including in, or on, the pack and by direct mail.

RJR Tobacco provides trade incentives through trade terms, wholesale partner programs and retail incentives. Trade discounts are provided to wholesalers based on compliance with certain terms. The wholesale partner programs provide incentives to RJR Tobacco’s direct buying customers based on performance levels. Retail incentives are paid to the retailer based on compliance with RJR Tobacco’s contract terms.

RJR Tobacco’s cigarette brand portfolio strategy is based upon three brand categories: growth, support and non-support. The growth brands consist of a premium brand, CAMEL, and a value brand, PALL MALL. Although both of these brands are managed for long-term market share and profit growth, CAMEL will continue to receive the most significant support. The support brands include four premium brands, WINSTON, KOOL, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The non-support brands, consisting of all other brands, are managed to maximize near-term profitability. The key objectives of the portfolio strategy are to ensure the long-term market share growth of the growth brands while managing the support brands for long-term sustainability and profitability. Consistent with that strategy, RJR Tobacco has discontinued many of its non-core cigarette styles as well as private-label cigarette brands. CAMEL Snus is also focused on long-term growth.

 

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Anti-tobacco groups have attempted to restrict cigarette sales, cigarette advertising, and the testing and introduction of new tobacco products as well as encourage smoking bans. The MSA and federal, state and local laws and regulations, including the Family Smoking Prevention and Tobacco Control Act, referred to as the FDA Tobacco Act, discussed below, and related regulations, restrict or prohibit utilization of television, radio or billboard advertising or certain other marketing and promotional tools for cigarettes and smoke-free tobacco products. RJR Tobacco continues to use direct mailings and other means to market its brands and enhance their appeal among age-verified adults who use tobacco products. RJR Tobacco continues to advertise and promote at retail locations and in adult venues where permitted and also uses print advertising in newspapers and consumer magazines in the United States.

Manufacturing and Distribution

RJR Tobacco owns its manufacturing facilities, located in the Winston-Salem, North Carolina area, known as the Tobaccoville manufacturing facility and the Whitaker Park complex, which includes a cigarette manufacturing facility. During 2010, RJR Tobacco announced plans to close the Whitaker Park cigarette manufacturing facility and transfer production to the Tobaccoville facility, which was completed in early 2012. RJR Tobacco has a total production capacity of approximately 110 billion cigarettes per year.

RJR Tobacco distributes its cigarettes primarily through a combination of direct wholesale deliveries from a local distribution center and public warehouses located throughout the United States.

RJR Tobacco has entered into various transactions with affiliates of BAT. RJR Tobacco sells contract-manufactured cigarettes, tobacco leaf and processed tobacco to BAT affiliates. Net sales, primarily of cigarettes, to BAT affiliates represented approximately 4%, 6% and 4% of RAI’s total net sales in 2012, 2011 and 2010, respectively.

Raw Materials

In its production of tobacco products, RJR Tobacco uses U.S. and foreign, grown primarily in Brazil, burley and flue-cured leaf tobaccos, as well as Oriental tobaccos grown primarily in Turkey, Macedonia and Bulgaria. RJR Tobacco believes there is a sufficient supply of leaf in the worldwide tobacco market to satisfy its current and anticipated production requirements.

RJR Tobacco purchases the majority of its U.S. flue-cured and burley leaf directly through contracts with tobacco growers. These short-term contracts are frequently renegotiated. RJR Tobacco believes the relationship with its leaf suppliers is good.

Under the modified terms of settlement agreements with flue-cured and burley tobacco growers, and quota holders, RJR Tobacco is required, among other things, to purchase annually a minimum amount, in pounds and subject to adjustment based on its annual total requirements, of U.S. green leaf flue-cured and burley tobacco combined, through the 2015 crop year.

RJR Tobacco also uses other raw materials such as filter tow, filter rods and fire standards compliant paper, which are sourced from either one supplier or a few suppliers. RJR Tobacco believes it has reasonable measures in place designed to mitigate the risk posed by the limited number of suppliers of certain raw materials.

American Snuff

Overview

RAI’s reportable operating segment, American Snuff, is the second largest smokeless tobacco products manufacturer in the United States. The American Snuff segment consists of the primary operations of American Snuff Co. and, prior to its sale, Lane. On February 28, 2011, RAI completed the sale of all of the capital stock of

 

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Lane and certain other assets related to the Lane operations to STG. The moist snuff category is divided into premium and price-value brands. American Snuff’s primary products include its largest selling moist snuff brands, GRIZZLY, in the price-value category, and KODIAK, in the premium category.

In contrast to the declining U.S. cigarette market, U.S. moist snuff volumes grew approximately 5% in 2012, 5% in 2011 and 8% in 2010. Moist snuff’s growth is partially attributable to cigarette smokers switching from cigarettes to smokeless tobacco products or using both.

Moist snuff has been the key driver to American Snuff’s overall growth and profitability within the U.S. smokeless tobacco market. Profit margins on moist snuff products are generally higher than on cigarette products. Moist snuff accounted for approximately 86%, 83% and 74% of American Snuff’s revenue in 2012, 2011 and 2010, respectively. The increase in 2012 and 2011 was impacted by the sale of Lane during 2011.

Competition

American Snuff is dependent on the U.S. smokeless tobacco market, where competition is significant. Similar to the cigarette market, competition is based primarily on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Moist snuff has developed many of the characteristics of the larger cigarette market, including multiple pricing tiers with intense competition, focused marketing programs and product innovation.

American Snuff’s largest competitor is U.S. Smokeless Tobacco Company LLC, referred to as USSTC, which had approximately 55.8% and 55.9% of the U.S. moist snuff market share in 2012 and 2011, respectively. American Snuff’s retail share of market of U.S. moist snuff, according to data processed by IRI/Capstone, was 32.4% and 31.0% in 2012 and 2011, respectively. GRIZZLY moist snuff had a market share of 29.0% and 27.3% in 2012 and 2011, respectively. American Snuff also competes in the U.S. smokeless tobacco market with other domestic and international companies.

Marketing

American Snuff is committed to building and maintaining a portfolio of profitable brands. American Snuff’s marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokeless consumers of competing brands to American Snuff brands.

American Snuff’s brand portfolio strategy consists of the investment brand, GRIZZLY, and selective and non-support brands that include all other brands. American Snuff is focusing on growing market share and profits on its GRIZZLY branded products through equity-building initiatives and promotions. American Snuff also offers GRIZZLY pouches, which provide pre-measured portions that are more convenient than traditional, loose moist snuff. Pouches represented approximately 10% of the total U.S. moist snuff market as of December 31, 2012, and during the fourth quarter of 2012, demand continued to grow at more than double the overall category rate. In 2012, American Snuff’s performance continued to benefit from new retail contracts introduced in the first quarter of 2011, and support from RJR Tobacco’s larger field trade-marketing organization, through a services agreement, strengthening product distribution and retail presence.

Manufacturing and Distribution

American Snuff owns its manufacturing facilities located in Memphis, Tennessee; Clarksville, Tennessee; Winston-Salem, North Carolina; and Bowling Green, Kentucky. American Snuff began capacity upgrade and expansion projects during 2009 at newly acquired sites in Memphis, Tennessee and Clarksville, Tennessee, that are both now in production. American Snuff distributes its products primarily through a combination of direct wholesale deliveries from a distribution center in North Carolina and public warehouses located throughout the United States.

 

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Raw Materials

In its production of moist snuff, American Snuff uses U.S. fire-cured and air-cured tobaccos as well as foreign, primarily Brazilian, burley and air-cured leaf tobaccos. American Snuff purchases the majority of its U.S. fire-cured and air-cured leaf directly through contracts with tobacco growers. These short-term contracts are frequently renegotiated. American Snuff believes the relationship with its leaf suppliers is good and there is a sufficient supply of leaf in the worldwide tobacco market to satisfy its current and anticipated production requirements.

Santa Fe

Overview

RAI’s reportable operating segment, Santa Fe, manufactures and markets cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand. Santa Fe managed RJR Tobacco’s super-premium cigarette brands, DUNHILL and STATE EXPRESS 555, which are licensed from BAT, until January 1, 2012, at which time such management was transferred to RJR Tobacco.

Competition

Santa Fe competes in the U.S. cigarette market. Santa Fe’s cigarette brand, NATURAL AMERICAN SPIRIT, is a super-premium brand priced at a higher premium compared with most other competitive brands, and is differentiated from key competitors through its use of all natural, additive-free tobacco. Competition in the cigarette category is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence.

Based upon data collected by IRI/Capstone, during 2012 and 2011, Santa Fe had an overall retail share of the U.S. cigarette market of 1.2% and 1.0%, respectively.

Marketing

Santa Fe has a commitment to its natural tobacco products, the environment and its consumers and uses its marketing programs to promote this commitment. Santa Fe is a subsequent participating manufacturer to the MSA. The MSA and federal, state and local laws and regulations, including the FDA Tobacco Act and related regulations, restrict or prohibit utilization of television, radio or billboard advertising or certain other marketing and promotional tools for cigarettes and smoke-free tobacco products. Santa Fe uses direct mailings and other means to market its brands and enhance their appeal among age-verified adults who use tobacco products. Santa Fe advertises and promotes at retail locations and in adult venues where permitted and also uses print advertising in newspapers and consumer magazines in the United States.

Manufacturing and Distribution

Santa Fe owns its manufacturing facility, which is located in Oxford, North Carolina.

Raw Materials

Santa Fe’s support for sustainable agriculture is part of its commitment to the environment and natural resources. Santa Fe contracts directly with independent farmers and advocates earth-friendly practices through its Purity Residue Clean, referred to as PRC, tobacco program, which utilizes environmentally friendly cultivation

practices. PRC tobacco is grown using only certain fertilizers and pesticides that break down quickly. After the tobacco cures, sample testing is done to ensure that there are no detectable residues of the fertilizers or pesticides.

 

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In its production of tobacco products, Santa Fe relies on sustainable resources, such as purchasing electricity generated from renewable sources, including wind power.

Other

RAI’s subsidiary, Niconovum USA, Inc. has entered its first lead market in the United States with ZONNIC, a nicotine replacement therapy gum, while another subsidiary, R.J. Reynolds Vapor Company, has introduced an electronic cigarette, VUSE, in limited distribution. RAI’s subsdiairy, Niconovum AB, is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name.

Consolidated RAI

Customers

The largest customer of RJR Tobacco, American Snuff and Santa Fe is McLane Company, Inc. Sales to McLane Company, Inc., a distributor, comprised approximately 31% of RAI’s consolidated revenue in 2012, and 27% in each of 2011 and 2010. During 2012, RJR Tobacco, American Snuff and Santa Fe sales to Core-Mark International, Inc., a distributor, represented approximately 10% of RAI’s consolidated revenue. No other customer accounted for 10% or more of RAI’s consolidated revenue during those periods. Sales of RJR Tobacco, American Snuff and Santa Fe to McLane Company, Inc. and Core-Mark International, Inc. are not governed by any written supply contract. RJR Tobacco, American Snuff and Santa Fe believe that their relationship with McLane Company, Inc. and Core-Mark International, Inc. is good. No significant backlog of orders existed at RJR Tobacco, American Snuff or Santa Fe as of December 31, 2012 or 2011.

Sales to Foreign Countries

RAI’s operating subsidiaries’ sales to foreign countries, primarily to BAT affiliates, for the years ended December 31, 2012, 2011 and 2010 were $494 million, $613 million and $525 million, respectively. The increase during 2011 was attributable to higher sales to BAT.

Raw Materials

In 2004, legislation was passed eliminating the U.S. government’s tobacco production controls and price support program. The buyout is funded by a direct quarterly assessment on every tobacco product manufacturer and importer, on a market-share basis measured on volume to which federal excise tax is applied. The aggregate cost of the buyout to the tobacco industry is approximately $9.9 billion, including approximately $9.6 billion payable to quota tobacco holders and growers through industry assessments over ten years and approximately $290 million for the liquidation of quota tobacco stock. RAI’s operating subsidiaries estimate that their overall share will approximate $2.5 billion prior to the deduction of permitted offsets under the MSA.

Research and Development

The research and development activities of RAI’s operating subsidiaries are primarily conducted at RJR Tobacco’s facility in Winston-Salem. Scientists and engineers continue to explore and develop innovative products, packaging and processes, as well as harm reduction technologies, modified risk tobacco products and analytical methodologies. Another key activity for research and development is to ensure RAI’s operating companies remain compliant with regulations of the U.S. Food and Drug Administration, referred to as the FDA, and to adhere to future FDA guidelines and approval processes.

RAI’s operating subsidiaries’ research and development expense for the years ended December 31, 2012, 2011 and 2010, was $62 million, $69 million and $71 million, respectively.

 

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Intellectual Property

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

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

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

Legislation and Other Matters Affecting the Tobacco Industry

The marketing, sale, taxation and use of tobacco products have been subject to substantial regulation by government and health officials for many years. In 2012, President Obama signed into law a provision requiring retailers selling loose tobacco and operating roll-your-own, referred to as RYO, machines to pay the same tax rate as other cigarette manufacturers. In addition, various state governments have adopted or are considering, among other things, legislation and regulations that would:

 

   

significantly increase their taxes on tobacco products;

 

   

restrict displays, advertising and sampling of tobacco products;

 

   

raise the minimum age to possess or purchase tobacco products;

 

   

restrict or ban the use of menthol in cigarettes or prohibit mint or wintergreen as a flavor in smokeless tobacco products;

 

   

require the disclosure of ingredients used in the manufacture of tobacco products;

 

   

require the disclosure of nicotine yield information for cigarettes;

 

   

impose restrictions on smoking in public and private areas; and

 

   

restrict the sale of tobacco products directly to consumers or other unlicensed recipients, including over the Internet.

Together with manufacturers’ price increases in recent years and substantial increases in state and federal taxes on tobacco products, and the granting to the FDA of broad authority over the manufacture, sale, marketing and packaging of tobacco products, these developments have had and will likely continue to have an adverse

 

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effect on the sale of tobacco products, primarily cigarettes. For further discussion of the regulatory and legislative environment applicable to the tobacco industry and FDA-related matters, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Governmental Activity.”

Litigation and Settlements

Various legal proceedings or claims, including litigation claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RAI’s operating subsidiaries’ products, and seeking damages in amounts ranging into the hundreds of millions or even billions of dollars, are pending or may be instituted against RJR Tobacco, American Snuff Co. or their affiliates, including RAI or RJR, or indemnitees, including B&W. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of December 31, 2012, RJR Tobacco had paid approximately $118 million since January 1, 2010, related to unfavorable smoking and health litigation judgments and $139 million related to an unfavorable medical monitoring and smoking cessation case.

In particular, in Engle v. R. J. Reynolds Tobacco Co., the Florida Supreme Court issued a ruling in 2006 that, while determining that the case could not proceed further as a class action, permitted members of the Engle class to file individual claims, including claims for punitive damages, through January 11, 2008. RJR Tobacco refers to these cases as the Engle Progeny cases. RJR Tobacco had been served as of December 31, 2012 in 5,756 of these cases on behalf of approximately 6,937 plaintiffs. The Engle Progeny cases have resulted and will continue to result in increased litigation and trial activity and increased product liability defense costs. As of December 31, 2012, outstanding jury verdicts in favor of the Engle Progeny plaintiffs had been entered against RJR Tobacco in the amount of $59,784,000 in compensatory damages (as adjusted) and in the amount of $125,820,000 in punitive damages, for a total of $185,604,000. All of these verdicts are in various stages in the appellate process. No liability for pending smoking and health litigation related to Engle Progeny cases was recorded in RAI’s consolidated balance sheet as of December 31, 2012. For a more complete description of the Engle Progeny cases, see “— Litigation Affecting the Cigarette Industry — Overview” and “— Engle and Engle Progeny Cases” in Item 8, note 13 to consolidated financial statements.

Also, the consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases, is pending in West Virginia, against both RJR Tobacco and B&W. This case consists of 564 plaintiffs and will be tried in a single proceeding. The court declared a mistrial in November 2011 and has scheduled a new trial for April 15, 2013. For a more complete description of this case, see “— Litigation Affecting the Cigarette Industry — West Virginia IPIC” in Item 8, note 13 to consolidated financial statements.

RAI’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, or the loss of any particular claim concerning the use of smokeless tobacco against American Snuff Co., when viewed on an individual basis, is not probable or estimable, as described in “— Litigation Affecting the Cigarette Industry — Overview” in Item 8, note 13 to consolidated financial statements. RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts against them and have valid defenses to all actions and intend to defend all actions vigorously. Nonetheless, the possibility of material losses related to tobacco litigation is more than remote. Litigation is subject to many uncertainties, and generally it is not possible to predict the outcome of the litigation pending against RJR Tobacco, American Snuff Co. or their affiliates or indemnitees, or to reasonably estimate the amount or range of any possible loss. Moreover, notwithstanding the quality of defenses available to it and its affiliates in tobacco-related litigation matters, it is possible that RAI’s consolidated results of operations, cash flows or financial position could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters or difficulties in obtaining the bonds required to stay execution of judgments on appeal. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 13 to consolidated financial statements.

In 1998, RJR Tobacco, B&W and the other major U.S. cigarette manufacturers entered into the MSA with attorneys general representing most U.S. states, territories and possessions. The State Settlement Agreements

 

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impose a perpetual stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers, and place significant restrictions on their ability to market and sell tobacco products in the future. For more information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 to consolidated financial statements. The State Settlement Agreements have materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial position of RAI and RJR Tobacco in future periods.

RJR Tobacco and certain of the other PMs under the MSA are currently involved in litigation with the settling states with respect to the availability for certain market years of a downward adjustment to the annual MSA settlement payment obligation, known as the NPM Adjustment. RJR Tobacco has disputed a total of $4.3 billion for the years 2003 through 2011.

On November 14, 2012, RJR Tobacco, certain other PMs and certain settling states entered into a Term Sheet that set forth terms on which accrued and potential NPM Adjustment claims for 2003 through 2014 could be resolved. The Term Sheet also set forth a restructured NPM Adjustment process to be applied on a going-forward basis, starting with the 2013 volume year. The Term Sheet was provided to all of the settling states for their review and consideration. For more information related to this litigation and its potential resolution, see “—Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements — Enforcement and Validity” in Item 8, note 13 to consolidated financial statements.

Employees

At December 31, 2012, RAI and its subsidiaries had approximately 5,000 full-time employees and approximately 50 part-time employees. The 5,000 full-time employees include approximately 3,600 RJR Tobacco employees, 500 American Snuff employees and 400 Santa Fe employees. No employees of RAI or its subsidiaries are unionized.

Executive Officers and Certain Significant Employees of the Registrant

The executive officers of RAI are set forth below:

Daniel (Daan) M. Delen. Mr. Delen, 47, has been President and Chief Executive Officer of RAI since March 1, 2011. He served as the President and Chief Executive Officer-Elect of RAI from January 1, 2011 to February 28, 2011. Mr. Delen also has served as the President of RAI Services Company, a wholly owned subsidiary of RAI and referred to as RAISC, since January 2011. Mr. Delen served as Chairman of the Board of RJR Tobacco, from May 2008 to December 2010. From January 2007 to December 2010, he also served as the President and Chief Executive Officer of RJR Tobacco. Prior to joining RJR Tobacco, Mr. Delen was President of BAT Ltd. — Japan from August 2004 to December 2006, and prior to that time, held various other positions with BAT after joining BAT in 1989. Mr. Delen commenced serving on the Board of RAI as of January 1, 2011. He also is a member of the board of trustees of Wake Forest University.

Thomas R. Adams. Mr. Adams, 62, has been Executive Vice President and Chief Financial Officer of RAI since January 2008 and Executive Vice President, Chief Financial Officer and Chief Information Officer of RAISC since January 2011. He served as Executive Vice President and Chief Financial Officer of RAISC from January 2010 to December 2010. In addition, he has served on the board of directors for RAISC since January 2010. Mr. Adams previously served as Senior Vice President and Chief Accounting Officer of RAI from March 2007 to December 2007. He served as Senior Vice President-Business Processes of RAI from September 2006 to March 2007 and of RJR Tobacco from May 2005 to November 2006. Mr. Adams also served as Senior Vice President and Chief Accounting Officer of both RAI and RJR Tobacco from July 2004 to April 2005. From

 

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June 1999 to July 2004, he served as Senior Vice President and Controller of both RJR Tobacco and RJR. Mr. Adams is a member of the boards of directors of Allegacy Federal Credit Union, the Old Hickory Council of the Boy Scouts of America and ABC of NC Child Development Center and the board of commissioners of the Housing Authority of Winston-Salem.

Lisa J. Caldwell. Ms. Caldwell, 52, has been Executive Vice President and Chief Human Resources Officer of RAI since May 2009 and RAISC since January 2010. Ms. Caldwell has served on the board of directors of RAISC since January 2010. She was previously Executive Vice President and Chief Human Resources Officer for RJR Tobacco from May 2009 to January 2010. Ms. Caldwell served as Executive Vice President — Human Resources of RAI and RJR Tobacco from June 2008 to May 2009. She served as Senior Vice President — Human Resources of RAI from November 2006 to June 2008, after having served as Vice President — Human Resources of RAI from September 2004 to November 2006. She also served as Senior Vice President — Human Resources of RJR Tobacco from July 2007 to June 2008, after having served as Vice President — Human Resources of RJR Tobacco from January 2002 to November 2006. Prior to 2002, Ms. Caldwell held numerous human resources positions with RJR Tobacco since joining RJR Tobacco in 1991. Ms. Caldwell serves on the Wake Forest University School of Business board of visitors and the board of directors for the Winston-Salem Industries for the Blind.

Walton T. Carpenter. Mr. Carpenter, 60, has been Senior Vice President — Strategy and Planning of RJR Tobacco since November 2006. Mr. Carpenter has served on the board of directors for RJR Tobacco since January 2011. Mr. Carpenter previously served as Senior Vice President — Strategy and Planning for RAI from January 2006 to November 2006, after having served as Vice President — Strategy and Planning for RAI from July 2004 to January 2006. Prior to joining RAI in 2004, Mr. Carpenter held various positions with B&W and its parent company, BAT. Mr. Carpenter serves on the board of directors of the Arts Council of Winston-Salem and Forsyth County and also serves on the Forsyth Technical Community College Foundation Board.

Robert H. Dunham. Mr. Dunham, 46, has been Executive Vice President — Public Affairs for RAI, RJR Tobacco and RAISC since August 2011. Mr. Dunham served as Senior Vice President — Public Affairs for RAI, RAISC and RJR Tobacco from January 2010 to July 2011, after having served as Senior Vice President of Marketing of RJR Tobacco from October 2008 to December 2009. Mr. Dunham served as Vice President of Marketing of RJR Tobacco from July 2004 to October 2008. Prior to joining RJR Tobacco in 2004, Mr. Dunham held various positions with B&W and its parent company, BAT. Mr. Dunham is a member of the boards of directors of the Reynolds American Foundation and the Forsyth Medical Center Foundation.

Daniel A. Fawley. Mr. Fawley, 55, has served as Senior Vice President and Treasurer of RAI, RJR Tobacco and RJR since September 2004 and Senior Vice President and Treasurer of RAISC since January 2010. Since joining RJR in 1999, he was Vice President and Assistant Treasurer of RJR until July 2004. Mr. Fawley is a member of the boards of directors of the Reynolds American Foundation and Santa Fe Natural Tobacco Company Foundation, the board of trustees of the Arts Council Endowment Fund, Inc. and the Finance Advisory Board for the Finance Academy.

McDara P. Folan, III. Mr. Folan, 54, has been Senior Vice President, Deputy General Counsel and Secretary of RAI since July 2004 and Senior Vice President, Deputy General Counsel and Secretary of RAISC since January 2010. He also serves as Assistant Secretary of RJR Tobacco. Prior to 2004, Mr. Folan served in various positions with RJR and RJR Tobacco since joining RJR in 1999. Mr. Folan serves on the boards of trustees for Salem College and Academy and Reynolda House Museum of American Art and the board of directors of Downtown Winston-Salem Partnership Inc. He also is chairman of the board of trustees of the Arts Council Endowment Fund, Inc.

Jeffery S. Gentry, PhD. Dr. Gentry, 55, became Executive Vice President of RAISC on January 1, 2013, and has been Executive Vice President — Operations and Chief Scientific Officer of RJR Tobacco since January 2010, after having served as RAI Group Executive Vice President since April 1, 2008. Dr. Gentry has served on the board of directors of RJR Tobacco since January 2010. He was previously Executive

 

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Vice President — Research and Development of RJR Tobacco from December 2004. Dr. Gentry has served in various other positions with RJR Tobacco since joining RJR Tobacco in 1986 as a research and development chemist. He is the co-founder of No Limits II, a non-profit organization providing social opportunities for disabled adults in the Winston-Salem area.

Andrew D. Gilchrist. Mr. Gilchrist, 40, has served as President and Chief Commercial Officer of RJR Tobacco since January 1, 2011, after having served as Executive Vice President and Chief Financial Officer of RJR Tobacco and Executive Vice President and Chief Information Officer of RAISC from January 2010 to December 2010. He previously served as Executive Vice President, Chief Financial Officer and Chief Information Officer of RJR Tobacco from July 2008 until January 2010. Mr. Gilchrist has served on the board of directors of RJR Tobacco since May 2008. He also served as Senior Vice President and Chief Financial Officer of RJR Tobacco from November 2006 to July 2008, after having served as Vice President — Integrated Business Management of RJR Tobacco from January 2006 to November 2006. Prior to 2006, Mr. Gilchrist served as Senior Director — Business Development since joining RAI in 2004. Prior to July 2004, Mr. Gilchrist held various positions with B&W and its parent company, BAT. Mr. Gilchrist is a member of the board of trustees of the Arts Council of Winston-Salem and Forsyth County and a member of the board for the Piedmont Triad Partnership.

Martin L. Holton III. Mr. Holton, 55, has been Executive Vice President, General Counsel and Assistant Secretary of RAI and RAISC and Executive Vice President and General Counsel of RJR Tobacco since January 2011. Mr. Holton previously served as Senior Vice President and Deputy General Counsel of RAISC since January 2010 and Senior Vice President, General Counsel and Secretary of RJR Tobacco from November 2006 through December 2010. In addition, Mr. Holton has served on the board of directors of RAISC since January 2011. Previously, Mr. Holton served as Senior Vice President, Deputy General Counsel and Secretary of RJR Tobacco from February 2005 to November 2006 and Vice President and Assistant General Counsel — Litigation from July 2004 to February 2005. Mr. Holton serves on the board of managers for YMCA Camp Hanes and the boards of directors for the Winston-Salem Symphony and the Carolina Business Coalition.

J. Brice O’Brien. Mr. O’Brien, 44, has served as Executive Vice President — Consumer Marketing of RJR Tobacco since January 2010, after having served as President of Reynolds Innovations Inc. since January 2009. He served as Senior Vice President — Consumer Marketing of RJR Tobacco from January 2006 until January 2009, after serving as Vice President — Marketing since October 2004. Prior to 2004, he held various positions with RJR Tobacco after joining RJR Tobacco in 1995. Mr. O’Brien serves on the board of directors for the Juvenile Diabetes Research Foundation.

Frederick W. Smothers. Mr. Smothers, 49, has served as Senior Vice President and Chief Accounting Officer of RAI since January 2008 and RAISC since January 2010. Mr. Smothers served as Vice President and Corporate Controller of RAI from October 2007 to December 2007. Prior to joining RAI, Mr. Smothers was an independent management consultant from 2002 until 2007, serving as Chief Executive Officer of ATRS Consulting from 2005 until October 2007, providing general management consulting to consumer products and manufacturing clients, including RAI. Prior to 2002, Mr. Smothers was employed by the accounting firm of Deloitte & Touche LLP, including four years as partner.

Robert D. Stowe. Mr. Stowe, 55, has been Executive Vice President — Trade Marketing of RJR Tobacco since January 2010, after having served as Senior Vice President — Trade Marketing of RJR Tobacco from January 2006 to January 2010. He also served as an Area Vice President of RJR Tobacco from July 2004 to January 2006. Prior to July 2004, Mr. Stowe held various positions with B&W. Mr. Stowe serves as the Vice Chairman of the board of directors of the Second Harvest Food Bank of Northwest North Carolina.

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

Mike Little. Mr. Little, 53, has served as President of SFNTC since December 2011. Previously he served as Senior Vice President, Manufacturing from January 2002 until November 2011. Prior to 2002, Mr. Little held various positions with SFNTC after joining SFNTC in 1995.

 

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Tommy J. Payne. Mr. Payne, 55, has served as President of Niconovum USA, Inc. since January 2010, after having served as Executive Vice President — Public Affairs of RAI from November 2006 to January 2010 and RJR Tobacco from May 2008 to January 2010. Mr. Payne previously served as Executive Vice President — External Relations of RAI from July 2004 to November 2006, and RJR Tobacco from September 1999 to November 2006. Prior to that time, he held various positions after joining RJR Nabisco in 1988. Mr. Payne serves on the boards of directors of the North Carolina Community Colleges Foundation, Inc. and Senior Services, Inc. of Winston-Salem.

Randall M. (Mick) Spach. Mr. Spach, 54, has been President of American Snuff Co. since January 2011. Previously he served as Vice President — Operations of American Snuff Co. from February 2009 until December 2010. Mr. Spach served as Vice President — Manufacturing/R&D of American Snuff Co. from August 2007 to February 2009. He served as Assistant Vice President — Manufacturing at American Snuff Co. from 2001 to August 2007. Between 1977 and 2001, Mr. Spach held various positions with American Snuff Co.

Item 1A. Risk Factors

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

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

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

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

In Engle v. R. J. Reynolds Tobacco Co., the Florida Supreme Court issued a ruling that, while determining that the case could not proceed further as a class action, permitted members of the Engle class to file individual claims, including claims for punitive damages, through January 11, 2008. RJR Tobacco had been served, as of December 31, 2012, in 5,756 Engle Progeny cases on behalf of approximately 6,937 plaintiffs. The Engle Progeny cases have resulted in increased litigation and trial activity, including an increased number of adverse verdicts, and increased expenses. As of December 31, 2012, RJR Tobacco has paid $18,453,000 in compensatory damages and $60,680,000 in punitive damages, for a total of $79,133,000, in these cases. In addition, as of

 

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December 31, 2012, outstanding jury verdicts in favor of the Engle Progeny plaintiffs had been entered against RJR Tobacco in the amount of $59,784,000 in compensatory damages (as adjusted) and in the amount of $125,820,000 in punitive damages, for a total of $185,604,000. All of these verdicts are in various stages in the appellate process. RJR Tobacco may be required to pay additional judgments as the litigation proceeds. For a more complete description of this litigation, see “— Litigation Affecting the Cigarette Industry — Engle and Engle Progeny Cases” in Item 8, note 13 to consolidated financial statements.

Also, the consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases, is pending in West Virginia, against both RJR Tobacco and B&W. The case consists of 564 plaintiffs and will be tried in a single proceeding. The court declared a mistrial on November 8, 2011, and scheduled a new trial for April 15, 2013.

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

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

For a more complete description of the above cases and other significant litigation involving RAI and its operating subsidiaries, including RJR Tobacco and American Snuff Co., see “— Litigation Affecting the Cigarette Industry” and “— Smokeless Tobacco Litigation” in Item 8, note 13 to consolidated financial statements.

The verdict and order in the case brought by the U.S. Department of Justice, while not final, could subject RJR Tobacco to significant compliance costs, which could negatively impact the results of operations, cash flows and the financial position of RJR Tobacco and, consequently, of RAI.

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

Both sides appealed. In 2009, the Court of Appeals affirmed in part the trial court’s order and remanded for further proceedings. Both sides’ petitions for writ of certiorari from the U.S. Supreme Court were denied in June 2010, including the DOJ’s request for review of the district court’s denial of the government’s request for disgorgement of profits and certain other remedies. In November 2012, the trial court specified the text of the “corrective statements” that it has ordered the defendants to disseminate. The court ordered the parties to enter mediation on a number of issues related to the implementation of the “corrective-statements” remedy. That mediation is scheduled to conclude by March 1, 2013. Further proceedings are pending before the trial court to determine whether those “corrective statements” will have to be displayed at retail points-of-sale. If the “corrective-statements” remedy is implemented, RJR Tobacco would incur significant compliance costs and

 

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there could be an adverse effect on the sales of operating company products. Additionally, in connection with the document-disclosure remedy ordered by the trial court, RJR Tobacco has agreed to deposit $3.125 million in the district court’s account across three years.

For a more complete description of this case, see “— Health-Care Cost Recovery Cases — Department of Justice Case” in Item 8, note 13 to consolidated financial statements.

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

RJR Tobacco’s U.S. retail market share of cigarettes has been declining for a number of years, and is expected to continue to decline. According to data from IRI/Capstone, RJR Tobacco’s share of the U.S. cigarette retail market declined to 26.5% in 2012 from 27.6% in 2011, continuing a trend in effect for several years. If RJR Tobacco’s growth brands do not continue to grow combined market share, results of operations, cash flows and financial position could be adversely affected. In addition, consumer health concerns, changes in adult consumer preferences and changes in regulations have prompted RJR Tobacco and other RAI operating companies to introduce new alternative tobacco products. Consumer acceptance of these new products, such as CAMEL Snus and electronic cigarettes, may fall below expectations. Furthermore, RAI’s operating companies may not find vendors willing to produce alternative tobacco products, or components or raw materials used in such products, resulting in additional capital expenditures for RAI’s operating companies.

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

The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to JTI, and no international rights were acquired in connection with the B&W business combination. Therefore, RJR Tobacco is dependent on the U.S. cigarette market. Price increases, restrictions on advertising and promotions, funding of smoking prevention campaigns, increases in regulation and excise taxes, health concerns, a decline in the social acceptability of smoking, increased pressure from anti-tobacco groups and other factors have reduced U.S. cigarette consumption. U.S. cigarette consumption is expected to continue to decline. MSAi reported that U.S. cigarette shipments declined 2.3% in 2012, to 286.5 billion cigarettes, 3.5% in 2011 and 3.8% in 2010. In addition, RJR Tobacco believes its consumers are more price-sensitive than consumers of competing brands, which may result in some consumers switching to a lower priced brand.

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

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

Tobacco products are subject to substantial federal and state excise taxes in the United States. Certain city and county governments also impose substantial excise taxes on tobacco products sold. Increased excise taxes are likely to result in declines in overall sales volume and shifts by consumers to less expensive brands.

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

 

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

In the United States, television and radio advertisements of cigarettes have been prohibited since 1971, and television and radio advertisements of smokeless tobacco products have been prohibited since 1986. Under the MSA, RAI’s operating subsidiaries, RJR Tobacco and SFNTC, cannot use billboard advertising, cartoon characters, sponsorship of certain events, non-tobacco merchandise bearing their brand names and various other advertising and marketing techniques. The MSA also prohibits targeting of youth in advertising, promotion or marketing of tobacco products, including the smokeless tobacco products of RJR Tobacco. American Snuff Co. is not a participant in the MSA. Although these restrictions were intended to ensure that tobacco advertising was not aimed at young people, some of the restrictions also may limit the ability of RAI’s operating subsidiaries to communicate with adult tobacco users. In addition, pursuant to the FDA Tobacco Act, the FDA has reissued regulations addressing advertising and marketing restrictions that were originally promulgated in 1996. Additional restrictions under the FDA regulations, or otherwise, may be imposed or agreed to in the future.

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

The FDA Tobacco Act grants the FDA broad authority over the manufacture, sale, marketing and packaging of tobacco products. It is likely that the FDA Tobacco Act could result in a decrease in cigarette and smokeless tobacco sales in the United States, including sales of RJR Tobacco’s, American Snuff’s and Santa Fe’s brands, and an increase in costs to RJR Tobacco, American Snuff and Santa Fe, resulting in a material adverse effect on RAI’s financial condition, results of operations and cash flows. RAI believes that such regulation may adversely affect the ability of its operating subsidiaries to compete against their larger competitor, Altria Group Inc., which may be able to more quickly and cost-effectively comply with these new rules and regulations. The FDA has yet to issue guidance with respect to many provisions of the FDA Tobacco Act, which may result in less efficient compliance efforts. Finally, the ability of RAI’s operating companies to gain efficient market clearance for new tobacco products could be affected by FDA rules and regulations.

For a detailed description of the FDA Tobacco Act, see “— Governmental Activity” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

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

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

In addition, substantial payment obligations under the State Settlement Agreements adversely affect RJR Tobacco’s ability to compete with manufacturers of deep-discount cigarettes that are not subject to such substantial obligations. For a more complete description of the State Settlement Agreements, see “— Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 to consolidated financial statements.

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

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

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

 

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Intangible assets include goodwill, trademarks and other intangibles. The determination of fair value involves considerable estimates and judgment. For goodwill, the determination of fair value of a reporting unit involves, among other things, RAI’s market capitalization, and application of the income approach, which includes developing forecasts of future cash flows and determining an appropriate discount rate. If goodwill impairment is implied, the fair values of individual assets and liabilities, including unrecorded intangibles, must be determined. RAI believes it has based its goodwill impairment testing on reasonable estimates and assumptions, and during the annual testing in the fourth quarter of 2012, the estimated fair value of each of RAI’s reporting units was substantially in excess of its respective carrying value.

Trademarks and other intangible assets with indefinite lives also are tested for impairment annually, in the fourth quarter. At December 31, 2012, the aggregate fair value of RAI’s operating units’ trademarks and other intangible assets was substantially in excess of their aggregate carrying value. However, at December 31, 2012, the individual fair values of seven trademarks were less than 15% in excess of their respective carrying values. The aggregate carrying value of these seven trademarks was $430 million at December 31, 2012. See Item 8, note 3 to consolidated financial statements for a discussion of the intangible asset impairment charges.

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

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

Goodwill, all trademarks and other intangible assets are tested more frequently if events and circumstances indicate that the asset might be impaired. The carrying value of these intangible assets could be impaired if a significant adverse change in the use, life, or brand strategy of the asset is determined, or if a significant adverse change in the legal and regulatory environment, business or competitive climate occurs that would adversely impact the asset. See Item 8, note 3 to consolidated financial statements for a discussion of the impairment charges, including a goodwill impairment charge in connection with the classification of the Lane operations as held for sale in the fourth quarter of 2010.

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

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

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

Adverse changes in the liquidity in the financial markets could result in additional realized or unrealized losses associated with the value of RAI’s investments, which would negatively impact RAI’s consolidated results of operations, cash flows and financial position. As of December 31, 2012, $36 million of unrealized losses remain in other comprehensive loss. For more information on investment losses, see Item 8, note 2 to consolidated financial statements.

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

RAI’s profitability is affected by the costs of pension benefits available to employees generally hired prior to 2004. Adverse changes in investment returns earned on pension assets and discount rates used to calculate pension and related liabilities or changes in required pension funding levels may have an unfavorable impact on

 

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pension expense and cash flows. During 2012, RAI contributed $110 million to its pension plans and expects to contribute $110 million to its pension plans in 2013. RAI actively seeks to control increases in pension expense, but there can be no assurance that profitability will not be adversely affected. In addition, changes to pension legislation or changes in pension accounting may adversely affect profitability and cash flow.

RAI and its operating subsidiaries rely on outside suppliers to manage certain non-core business processes. Any interruption in these services could negatively affect the operations of RJR Tobacco, American Snuff and Santa Fe and harm their reputation and consequently the operations and reputation of RAI.

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

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

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

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

Revenues from two distributors, McLane Company, Inc. and Core-Mark International, Inc., comprised approximately 31% and 10%, respectively, of RAI’s consolidated revenues in 2012. The loss of these customers, or a significant decline in their purchases, could have a material adverse effect on revenue of RAI.

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

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

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

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

 

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

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

Because RAI and RJR have, in the aggregate, principal outstanding notes of $5.0 billion:

 

   

RAI’s ability to obtain additional financing for working capital, capital expenditures, acquisitions, debt service requirements or general corporate purposes, and its ability to satisfy its obligations with respect to its indebtedness, may be impaired in the future;

 

   

a substantial portion of RAI’s cash flow from operations must be dedicated to the payment of principal and interest on its indebtedness, thereby reducing the funds available to it for other purposes;

 

   

RAI may be at a disadvantage compared to its competitors with less debt or comparable debt at more favorable interest rates; and

 

   

RAI’s flexibility to adjust to changing market conditions and ability to withstand competitive pressures could be limited, and it may be more vulnerable to a downturn in general economic conditions or its business, or be unable to carry out capital spending that is necessary or important to its growth strategy and its efforts to improve operating margins.

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

The outstanding notes issued by RAI and RJR are rated investment grade. If RAI’s credit rating falls below investment grade, RAI may not be able to sell additional debt securities or borrow money in such amounts, at the times, at the lower interest rates or upon the more favorable terms and conditions that might be available if its debt was rated investment grade. In addition, future debt security issuances or other borrowings may be subject to further negative terms, including provisions for collateral or limitations on indebtedness or more restrictive covenants.

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

For more complete information on RAI’s borrowing arrangements, see Item 8, notes 11 and 12 to consolidated financial statements.

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

 

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

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

 

   

the sale or transfer of certain RAI intellectual property associated with B&W brands having an international presence, other than in connection with a sale of RAI; and

 

   

RAI’s adoption of any takeover defense measures that would apply to the acquisition of equity securities of RAI by B&W or its affiliates, other than the re-adoption of the RAI rights plan in its present form.

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

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

Under the governance agreement, B&W, based upon its current equity stake in RAI, is entitled to nominate five directors to RAI’s Board, at least three of whom are required to be independent directors and two of whom may be executive officers of BAT or any of its subsidiaries. RAI’s Board currently is composed of 13 persons, including five designees of B&W. Matters requiring the approval of RAI’s Board generally require the affirmative vote of a majority of the directors present at a meeting. Under the governance agreement, however, the approval of a majority of B&W’s designees on RAI’s Board is required in connection with the following matters:

 

   

any issuance of RAI securities in excess of 5% of its outstanding voting stock, unless at such time B&W’s ownership interest in RAI is less than 32%; and

 

   

any repurchase of RAI common stock, subject to a number of exceptions, unless at such time B&W’s ownership interest in RAI is less than 25%.

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

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

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

As RAI’s largest shareholder, B&W could vote its shares of RAI common stock against any takeover proposal submitted for shareholder approval or refuse to accept any tender offer for shares of RAI common

 

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

RAI shareholders may be adversely affected by the July 30, 2014 expiration, or earlier termination, of the “standstill” provisions in the governance agreement. These events would enable B&W to, among other things, acquire some or all of the shares of RAI common stock not held by B&W or otherwise seek to influence or gain control of RAI, subject to governance agreement limitations on changes in the composition of RAI’s Board.

The standstill provisions contained in the governance agreement generally restrict B&W from acquiring additional shares of RAI common stock, seeking to remove RAI directors not designated by B&W, or taking other specified actions to influence or gain control of RAI. These restrictions will expire upon the earlier of July 30, 2014, or the date on which a significant transaction (as defined in the governance agreement) is consummated. A significant transaction is generally defined as the acquisition by a third party or group of 30% or more of the share voting power or consolidated total assets of RAI.

After the expiration (or earlier termination) of the standstill period, B&W will be permitted to increase its ownership interest in RAI without limitation, subject to the RAI shareholder rights plan described below. The RAI shareholder rights plan also expires on July 30, 2014, but the RAI Board is permitted under the governance agreement to readopt the existing RAI shareholder rights plan in its present form. However, the existing RAI shareholder rights plan generally exempts B&W from its application. B&W’s ownership will only be restricted by the RAI shareholder rights plan if all or part of the governance agreement is terminated as described in the following risk factor. See the following risk factors for a summary description of the rights plan.

The governance agreement limits B&W representation on the RAI Board to five directors (out of an entire Board of 13 directors), of whom three must be independent of both RAI and BAT. If B&W’s voting percentage of RAI drops below 32%, B&W’s board representation will be reduced to a level approximately proportionate to its level of all RAI equity ownership. The governance agreement also requires B&W to vote for the RAI board-proposed slate of director nominees (unless an unaffiliated third party makes a material effort to solicit proxies voting against that slate). These provisions will remain in effect indefinitely after July 30, 2014, unless all or part of the governance agreement is terminated as described below.

The governance agreement, as amended, and RAI shareholder rights plan are Exhibits 10.8 through 10.11 and 4.1, respectively, to this Annual Report on Form 10-K.

RAI shareholders may be adversely affected if all or part of the governance agreement were to be terminated because in some circumstances the standstill, board composition and share transfer restrictions on B&W would no longer apply. These developments could enable B&W to, among other things, acquire some or all of the shares of RAI common stock not held by B&W, seek additional representation on the RAI Board, replace existing RAI directors, solicit proxies, otherwise influence or gain control of RAI or transfer all or a significant percentage of its shares of RAI common stock to a third party.

The governance agreement provides that it will terminate automatically in its entirety if B&W owns less than 15%, referred to as a 15% termination, or if any third party or group controls more than 50%, referred to as a third party termination, of the voting power of all RAI shares. In addition, B&W may terminate the governance agreement in its entirety if B&W nominees proposed in accordance with the governance agreement are not elected to serve on the RAI Board or its committees, referred to as an election termination, or if RAI has deprived B&W nominees of such representation for “fiduciary” reasons, referred to as a fiduciary termination, or has willfully deprived B&W or its board nominees of any veto rights, referred to as a veto termination.

 

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B&W also may terminate the standstill, the obligation to vote its shares of RAI common stock for Board-proposed director nominees, the restriction on Board representation in excess of proportionate representation and the RAI share transfer restrictions of the governance agreement if RAI willfully and deliberately breaches the provisions regarding B&W’s Board and Board committee representation, referred to as a willful termination.

See the preceding and following risk factors regarding the possible consequences of the termination of the standstill provision as it limits B&W’s ability to acquire additional shares of RAI common stock, to seek to remove RAI directors, or to otherwise increase its influence over RAI.

If the share transfer restrictions in the governance agreement are terminated, there will be no contractual restrictions on B&W’s ability to sell or transfer its shares of RAI common stock on the open market, in privately negotiated transactions or otherwise. These sales or transfers could create a substantial decline in the price of shares of RAI common stock or, if these sales or transfers were made to a single buyer or group of buyers that own shares of RAI common stock, could result in a third party acquiring control of or influence over RAI. However, any existing RAI shareholder rights plan could effectively restrict such third party’s acquisition of shares of RAI common stock as described in the following risk factor.

The RAI shareholder rights plan may effectively restrict the acquisition of beneficial ownership of 15% or more of the shares of RAI common stock. However, absent a termination of all or certain provisions of the governance agreement, B&W is generally exempt from the application of the rights plan.

In general terms, the RAI rights plan imposes a substantial penalty upon any person or group that acquires beneficial ownership of 15% or more of the outstanding shares of RAI common stock without the approval of the RAI Board.

Termination of some or all of the provisions of the governance agreement would have differing effects on the applicability of the rights plan to B&W. If a 15% termination occurred, the rights plan would fully apply to B&W. If a third party termination occurred, the rights plan would not apply to B&W. If an election termination, a fiduciary termination, or a veto termination occurred, the rights plan would apply if B&W sought to increase its RAI share ownership above approximately 43% (or higher if the termination occurred after the July 30, 2014 expiration of the standstill provisions and B&W had acquired ownership of RAI above 43%). If a willful termination occurred, the rights plan would not apply to B&W.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The executive offices of RAI and its material subsidiaries are located in Winston-Salem, North Carolina. RJR Tobacco’s manufacturing facilities are located in the Winston-Salem, North Carolina area, and American Snuff’s manufacturing facilities are located in Memphis, Tennessee; Clarksville, Tennessee; Winston-Salem, North Carolina; and Bowling Green, Kentucky. During 2009, American Snuff began capacity upgrade and expansion projects at newly acquired sites in Memphis, Tennessee and Clarksville, Tennessee. Production began at the new Memphis facility, which replaced the former Memphis facility, in early 2012. Processing began at the new, expanded Clarksville facility in 2011. Santa Fe’s manufacturing facility is located in Oxford, North Carolina, and its executive offices are located in Santa Fe, New Mexico. All of RAI’s material operating subsidiaries’ executive offices and manufacturing facilities are owned.

 

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Item 3. Legal Proceedings

See Item 8, note 13 to consolidated financial statements for disclosure of legal proceedings involving RAI and its operating subsidiaries.

Item 4. Mine Safety Disclosures

Not applicable.

 

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PART II

 

Item 5.   Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

RAI common stock, par value $.0001 per share, is listed on the NYSE under the trading symbol “RAI.” On January 28, 2013, there were approximately 14,300 holders of record of RAI common stock. Shareholders whose shares are held of record by a broker or clearing agency are not included in this amount; however, each of those brokers or clearing agencies is included as one holder of record. The closing price of RAI common stock on January 28, 2013, was $43.95 per share.

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

 

                  

Cash

Dividends

Declared per

 
                  
     Price Per Share     
     High      Low      Share  

2012:

        

First Quarter

   $ 42.81       $ 38.95       $ 0.56   

Second Quarter

     44.90         39.45         0.59   

Third Quarter

     46.93         43.11         0.59   

Fourth Quarter

     44.51         39.70         0.59   

2011:

        

First Quarter

   $ 36.11       $ 31.54       $ 0.53   

Second Quarter

     39.87         35.58         0.53   

Third Quarter

     38.64         31.82         0.53   

Fourth Quarter

     42.18         36.69         0.56   

On February 7, 2013, the board of directors of RAI declared a quarterly cash dividend of $0.59, or $2.36 on an annualized basis, per common share. The dividends will be paid on April 1, 2013, to shareholders of record as of March 8, 2013. The current dividend reflects RAI’s policy of paying dividends to the holders of RAI common stock in an aggregate amount that is approximately 80% of RAI’s annual consolidated net income.

On November 14, 2011, the board of directors of RAI authorized the repurchase, from time to time on or before mid-2014, of up to $2.5 billion of outstanding shares of RAI common stock in open-market or privately negotiated transactions. The repurchases are subject to prevailing market and business conditions, and the program may be terminated or suspended at any time. In connection with the share repurchase program, RAI and B&W entered into an agreement, pursuant to which B&W has agreed to participate in the repurchase program on a basis approximately proportionate with B&W’s 42% ownership of RAI’s common stock. RAI, B&W and BAT also entered into Amendment No. 3 to the governance agreement, pursuant to which RAI has agreed that, so long as B&W’s ownership interest has not dropped below 25%, if RAI issues shares of its common stock or any other RAI equity security to certain designated persons, including its directors, officers or employees, then RAI will repurchase a number of shares of outstanding RAI common stock so that the number of outstanding shares of RAI common stock are not increased, and B&W’s ownership interest is not decreased, by such issuance after taking into account such repurchase. In addition, RAI repurchased shares of its common stock forfeited with respect to the tax liability associated with certain stock option exercises and vesting of restricted stock units granted under the RAI Long-Term Incentive Plan, referred to as the LTIP.

Due to RAI’s incorporation in North Carolina, which does not recognize treasury shares, the shares repurchased are cancelled at the time of repurchase. During the year ended December 31, 2012, RAI repurchased and cancelled 24,944,233 shares of RAI common stock for $1.1 billion under the above-described share repurchase program. As of December 31, 2012, RAI had repurchased and cancelled 31,720,870 shares of RAI common stock for $1.3 billion under the above-described share repurchase program.

 

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Additionally, during 2012, at a cost of $39 million, RAI purchased 921,646 shares that were cancelled with respect to tax liabilities associated with restricted stock units vesting under its LTIP.

The following table summarizes RAI’s purchases of its common stock during the fourth quarter of 2012:

 

    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 that May
Yet Be Purchased
Under the Plans
or Programs
 

November 1, 2012 to November 30, 2012

    5,044,194      $ 41.28        5,044,194      $ 1,204   

December 1, 2012 to December 31, 2012

    963,510        43.37        963,510        1,162   
 

 

 

     

 

 

   

Fourth Quarter Total

    6,007,704        41.61        6,007,704        1,162   
 

 

 

     

 

 

   

For equity-based benefit plan information, see Item 8, note 15 to consolidated financial statements.

Performance Graph

Set forth below is a line graph comparing, for the period which commenced on December 31, 2007, and ended on December 31, 2012, the cumulative shareholder return of $100 invested in RAI common stock with the cumulative return of $100 invested in the Standard & Poor’s 500 Index and the Standard & Poor’s Tobacco Index.

COMPARISON OF 5-YEAR CUMULATIVE TOTAL RETURN(1)

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

and The S&P Tobacco Index

 

LOGO

 

     12/31/07      12/31/08      12/31/09      12/31/10      12/31/11      12/31/12  

Reynolds American Inc.

   $ 100.00       $ 65.30       $ 93.28       $ 122.60       $ 164.79       $ 174.00   

S&P 500

     100.00         63.00         79.67         91.67         93.61         108.59   

S&P Tobacco(2)

     100.00         81.75         102.69         131.13         178.88         197.52   

 

(1)

Assumes that $100 was invested in RAI common stock and indexes on December 31, 2007, and that in each case all dividends were reinvested.

 

(2)

The S&P Tobacco Index includes as of December 31, 2012, the following companies: Altria Group, Inc.; Lorillard, Inc.; Philip Morris International Inc.; and Reynolds American Inc.

 

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Item 6. Selected Financial Data

The selected historical consolidated financial data as of December 31, 2012 and 2011, and for each of the years in the three-year period ended December 31, 2012, are derived from the consolidated financial statements and accompanying notes, which have been audited by RAI’s independent registered public accounting firm. The selected historical consolidated financial data as of December 31, 2010, 2009 and 2008, and for the years ended December 31, 2009 and 2008, are derived from audited consolidated financial statements not presented or incorporated by reference. For further information, including the impact of new accounting developments, restructuring and impairment charges, you should read this table in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and the consolidated financial statements.

 

     For the Years Ended December 31,  
     2012     2011     2010     2009     2008  
     (Dollars in Millions, Except Per Share Amounts)  

Results of Operations:

          

Net sales(1)

   $ 8,304      $ 8,541      $ 8,551      $ 8,419      $ 8,845   

Income from continuing operations before extraordinary item(1)(2)(3)(4)

     1,272        1,406        1,337        955        444   

Losses from discontinued operations

                   (216              

Net income

     1,272        1,406        1,121        955        444   

Per Share Data:

          

Basic income from continuing operations

     2.25        2.41        2.29        1.64        0.76   

Diluted income from continuing operations

     2.24        2.40        2.29        1.64        0.76   

Basic losses from discontinued operations

                   (0.37              

Diluted losses from discontinued operations

                   (0.37              

Basic net income

     2.25        2.41        1.92        1.64        0.76   

Diluted net income

     2.24        2.40        1.92        1.64        0.76   

Basic weighted average shares, in thousands

     565,570        582,320        582,996        582,761        586,802   

Diluted weighted average shares, in thousands

     567,873        585,383        584,854        583,652        587,201   

Cash dividends declared per share of common stock

   $ 2.33      $ 2.15      $ 1.84      $ 1.73      $ 1.70   

Balance Sheet Data (at end of periods):

          

Total assets

     16,557        16,254        17,078        18,009        18,154   

Long-term debt (less current maturities)

     5,035        3,206        3,701        4,136        4,486   

Shareholders’ equity

     5,257        6,251        6,510        6,498        6,237   

Cash Flow Data:

          

Net cash from operating activities

     1,568        1,420        1,265        1,454        1,315   

Net cash from (used in) investing activities

     (54     60        (126     (123     278   

Net cash used in financing activities

     (971     (1,714     (1,349     (1,192     (1,206

Net cash related to discontinued operations, net of tax benefit

                   (307              

Other Data:

          

Ratio of earnings to fixed charges(5)

     9.1        10.6        10.2        6.9        3.3   

 

(1)

Net sales and cost of products sold exclude excise taxes of $3,923 million, $4,107 million, $4,340 million, $3,927 million and $1,890 million for the years ended December 31, 2012, 2011, 2010, 2009 and 2008, respectively.

 

(2)

Includes gain on termination of joint venture of $328 million in 2008.

 

(3)

Includes restructuring and/or asset impairment charges of $149 million, $38 million, $56 million and $90 million for the years ended December 31, 2012, 2010, 2009 and 2008, respectively.

 

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(4)

Includes trademark, goodwill and/or other intangible asset impairment charges of $129 million, $48 million, $32 million, $567 million and $318 million for the years ended December 31, 2012, 2011, 2010, 2009 and 2008, respectively.

 

(5)

Earnings consist of income from continuing operations before equity earnings, income taxes and fixed charges. Fixed charges consist of interest on indebtedness, amortization of debt issuance costs and the interest portion of rental expense.

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following is a discussion and analysis of RAI’s business, initiatives, critical accounting estimates and its consolidated results of operations and financial position. Following the overview and discussion of business initiatives, the critical accounting estimates disclose certain accounting estimates that are material to RAI’s results of operations and financial position for the periods presented in this report. The discussion and analysis of RAI’s results of operations is presented in two comparative sections, 2012 compared with 2011, and 2011 compared with 2010. Disclosures related to liquidity and financial position complete management’s discussion and analysis. You should read this discussion and analysis of RAI’s consolidated financial position and results of operations in conjunction with the consolidated financial statements and the related notes as of December 31, 2012 and 2011, and for each of the years in the three-year period ended December 31, 2012.

Overview and Business Initiatives

RAI’s reportable operating segments are RJR Tobacco, American Snuff and Santa Fe. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The American Snuff segment consists of the primary operations of American Snuff Co. and, prior to its sale, Lane. The Santa Fe segment consists of the primary operations of SFNTC. Niconovum AB, a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name, among other RAI subsidiaries, is included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance. Certain of RAI’s operating subsidiaries have entered into intercompany agreements for products or services with other subsidiaries. As a result, certain activities of an operating subsidiary may be included in a different segment of RAI. For net sales and operating income attributable to each segment, see Item 8, note 17 to consolidated financial statements.

RAI’s largest reportable operating segment, RJR Tobacco, is the second largest tobacco company in the United States. RJR Tobacco’s brands include many of the best-selling cigarettes in the United States: CAMEL, PALL MALL, WINSTON, KOOL, DORAL and SALEM. Those brands, and its other brands, including MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. As part of its total tobacco strategy, RJR Tobacco also offers a modern smoke-free tobacco product, CAMEL Snus. RJR Tobacco also manages contract manufacturing of cigarette and tobacco products through arrangements with BAT affiliates, and manages the export of tobacco products to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases. Effective January 1, 2012, the management of super premium cigarette brands, DUNHILL and STATE EXPRESS 555, which are licensed from BAT, transferred to RJR Tobacco from Santa Fe.

American Snuff is the second largest smokeless tobacco products manufacturer in the United States. American Snuff’s primary brands include its largest selling moist snuff brands, GRIZZLY and KODIAK.

Santa Fe manufactures and markets super-premium cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand.

RJR Tobacco

RJR Tobacco primarily conducts business in the highly competitive U.S. cigarette market, which has a few large manufacturers and many smaller participants. The U.S. cigarette market is a mature market in which overall

 

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consumer demand has declined since 1981 and is expected to continue to decline. Profitability of the U.S. cigarette industry and RJR Tobacco continues to be adversely impacted by decreases in consumption, increases in state excise taxes and governmental regulations and restrictions, such as marketing limitations, product standards and ingredients legislation.

The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to JTI, and no international rights were acquired in connection with the B&W business combination.

RJR Tobacco’s cigarette brand portfolio strategy is based upon three brand categories: growth, support and non-support. The growth brands consist of a premium brand, CAMEL, and a value brand, PALL MALL. Although both of these brands are managed for long-term market share and profit growth, CAMEL will continue to receive the most significant equity support. The support brands include four premium brands, WINSTON, KOOL, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The non-support brands, consisting of all other brands, are managed to maximize near-term profitability. The key objectives of the portfolio strategy are designed to focus on the long-term market share growth of the growth brands while managing the support brands for long-term sustainability and profitability.

RJR Tobacco’s portfolio includes CAMEL Snus, a modern smoke-free tobacco that focuses on long-term growth. CAMEL Snus is heat-treated tobacco in individual pouches that provides convenient tobacco consumption.

Competition is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other incentives to maintain or improve market position or to introduce a new brand or brand style.

RJR Tobacco is committed to building and maintaining a portfolio of profitable brands. RJR Tobacco’s marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokers of competing brands to RJR Tobacco brands. In addition to building strong brand equity, RJR Tobacco’s marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend certain brands’ shares of market against competitive pricing pressure. RJR Tobacco’s competitive pricing methods may include list price changes, discounting programs, such as retail and wholesale buydowns, periodic price reductions, off-invoice price reductions, dollar-off promotions and consumer coupons. Retail buydowns refer to payments made to the retailer to reduce the price that consumers pay at retail. Consumer coupons generally are distributed by a variety of methods, including in, or on, the pack and by direct mail.

American Snuff

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

In contrast to the declining U.S. cigarette market, U.S. moist snuff volumes grew approximately 5% in 2012. Profit margins on moist snuff products are generally higher than on cigarette products. Moist snuff’s growth is partially attributable to cigarette smokers switching from cigarettes to smokeless tobacco products or using both.

American Snuff faces significant competition in the smokeless tobacco categories. Similar to the cigarette market, competition is based primarily on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence.

 

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Santa Fe

Santa Fe competes in the U.S. cigarette market. Santa Fe’s cigarette brand, NATURAL AMERICAN SPIRIT, is priced at a premium compared with most other competitive brands, and is differentiated from key competitors through its use of all natural, additive-free tobacco. Competition in the cigarette category is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence.

Other

RAI’s subsidiary, Niconovum USA, Inc. has entered its first lead market in the United States with ZONNIC, a nicotine replacement therapy gum, while another subsidiary, R.J. Reynolds Vapor Company, has introduced an electronic cigarette, VUSE, in limited distribution. RAI’s subsdiairy, Niconovum AB, is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name.

Critical Accounting Estimates

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

Litigation

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

As discussed in Item 8, note 13 to consolidated financial statements, RJR Tobacco, American Snuff Co. and their affiliates, including RAI, and indemnitees, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of December 31, 2012, RJR Tobacco had paid approximately $118 million since January 1, 2010, related to unfavorable smoking and health litigation judgments. During 2011, RJR Tobacco paid $139 million related to an unfavorable medical monitoring and smoking cessation case.

RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts against them and believe they have valid defenses to all actions, and they intend to defend all actions vigorously. RAI’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, including B&W, or the loss of any particular claim concerning the use of smokeless tobacco against American Snuff Co., when viewed on an individual basis, is not probable or estimable, as described in “— Litigation Affecting the Cigarette Industry — Overview” in Item 8, note 13 to consolidated financial statements.

 

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Litigation is subject to many uncertainties, and it is possible that some of the tobacco-related legal actions, proceedings or claims could ultimately be decided against RJR Tobacco, American Snuff Co. or their affiliates, including RAI, and indemnitees. Any unfavorable outcome of such actions could have a material adverse effect on the consolidated results of operations, cash flows or financial position of RAI or its subsidiaries. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 13 to consolidated financial statements.

State Settlement Agreements

RJR Tobacco and Santa Fe are participants in the MSA, and RJR Tobacco is a participant in the other State Settlement Agreements. Their obligations and the related expense charges under the State Settlement Agreements are subject to adjustments based upon, among other things, the volume of cigarettes sold by the operating subsidiaries, their relative market share and inflation. Since relative market share is based on cigarette shipments, the best estimate of the allocation of charges to RJR Tobacco and Santa Fe under these agreements is recorded in cost of products sold as the products are shipped. Adjustments to these estimates are recorded in the period that the change becomes probable and the amount can be reasonably estimated. American Snuff Co. is not a participant in the State Settlement Agreements. For more information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” and “— State Settlement Agreements — Enforcement and Validity; Adjustments” in Item 8, note 13 to consolidated financial statements.

Pension and Postretirement Benefits

RAI sponsors a number of non-contributory defined benefit pension plans covering most of the employees of RAI and certain of its subsidiaries, and also provides certain health and life insurance benefits for most of the retired employees of RAI and certain of its subsidiaries and their dependents. These benefits are generally no longer provided to employees hired on or after January 1, 2004. For additional information relating to pension and postretirement benefits, see Item 8, note 16 to consolidated financial statements.

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

Actuarial gains or losses are annual changes in the amount of either the benefit obligation or the fair value of plan assets resulting from experience different from that assumed or from changes in assumptions. RAI immediately recognizes actuarial gains and losses in its operating results in the year in which they occur, to the extent such gains and losses were in excess of 10% of the greater of the market-related value of plan assets or the plan’s projected benefit obligation, referred to as the corridor. Actuarial gains and losses outside the corridor are generally recognized annually as of December 31, or when the plans are remeasured during an interim period, and are recorded as a mark-to-market, referred to as an MTM adjustment. Additionally, for purposes of calculating the expected return on plan assets, RAI uses the actual fair value of plan assets.

Prior service costs of pension expense, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees. Prior service costs of postretirement benefits, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the service period to expected full eligibility age for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

 

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In recent years, actual results have varied significantly from actuarial assumptions. In particular, pension and postretirement obligations have increased due to significant decreases in discount rates. These changes have resulted in an increase in charges to other comprehensive loss and increased pension and postretirement expense. The Pension Protection Act of 2006 may require additional cash funding of the increased pension obligations in the future.

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

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

 

     1-Percentage Point
Increase
    1-Percentage Point
Decrease
 
     Pension
Plans
    Postretirement
Plans
    Pension
Plans
    Postretirement
Plans
 

Effect on 2012 net periodic benefit cost

   $ 19      $ 7      $ (25   $ (8

Effect on December 31, 2012, projected benefit obligation and accumulated postretirement benefit obligation

     (639     (119     778        143   

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

 

     1-Percentage Point
Increase
    1-Percentage Point
Decrease
 
     Pension
Plans
    Postretirement
Plans
    Pension
Plans
     Postretirement
Plans
 

Effect on 2012 net periodic benefit cost

   $ (51   $ (2   $ 51       $ 2   

Intangible Assets

Intangible assets include goodwill, trademarks and other intangibles. The determination of fair value involves considerable estimates and judgment. For goodwill, the determination of fair value of a reporting unit involves, among other things, RAI’s market capitalization, and application of the income approach, which includes developing forecasts of future cash flows and determining an appropriate discount rate. If goodwill impairment is implied, the fair values of individual assets and liabilities, including unrecorded intangibles, must be determined. RAI believes it has based its goodwill impairment testing on reasonable estimates and assumptions, and during the annual testing in the fourth quarter of 2012, the estimated fair value of each of RAI’s reporting units was substantially in excess of its respective carrying value.

Trademarks and other intangible assets with indefinite lives also are tested for impairment annually, in the fourth quarter. The aggregate fair value of RAI’s operating units’ trademarks and other intangible assets was substantially in excess of their aggregate carrying value. However, the individual fair values of seven trademarks were less than 15% in excess of their respective carrying values. The aggregate carrying value of these seven trademarks was $430 million at December 31, 2012.

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

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

 

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

Fair Value Measurement

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

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

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

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

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

See Item 8, note 2 to consolidated financial statements for information on assets and liabilities recorded at fair value.

Income Taxes

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

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

To the extent that any book and tax differences are temporary in nature, that is, the book realization will occur in a different period than the tax realization, a deferred tax asset or liability is established. To the extent that a deferred tax asset is created, management evaluates RAI’s ability to realize this asset. RAI maintains a valuation allowance to reduce certain deferred tax assets to amounts that are more likely than not to be realized. This allowance is attributable to deferred tax assets established for capital loss carryforwards.

The financial statements reflect management’s best estimate of RAI’s current and deferred tax liabilities and assets. Future events, including, but not limited to, additional resolutions with taxing authorities, could have an impact on RAI’s current estimate of tax liabilities, realization of tax assets and effective income tax rate. See Item 8, note 10 to consolidated financial statements for additional information on income taxes.

 

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Recently Adopted and Issued Accounting Pronouncements

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

Results of Operations

 

     For the Twelve Months Ended December 31,  
     2012     2011     % Change     2010     % Change  

Net sales:(1)

          

RJR Tobacco

   $ 6,960      $ 7,317        (4.9 )%    $ 7,368        (0.7 )% 

American Snuff

     681        648        5.1     719        (9.9 )% 

Santa Fe

     486        416        16.8     338        23.1

All other

     177        160        10.6     126        27.0
  

 

 

   

 

 

     

 

 

   

Net sales

     8,304        8,541        (2.8 )%      8,551        (0.1 )% 

Cost of products sold(1)(2)

     4,321        4,464        (3.2 )%      4,544        (1.8 )% 

Selling, general and administrative expenses

     1,470        1,606        (8.5 )%      1,480        8.5

Amortization expense

     21        24        (12.5 )%      25        (4.0 )% 

Asset impairment and exit charges

                   NM (3)      38        NM (3) 

Restructuring charge

     149               NM (3)             NM (3) 

Trademark and other intangible asset impairment charges

     129        48        NM (3)      6        NM (3) 

Goodwill impairment charge

                   NM (3)      26        NM (3) 

Operating income:

          

RJR Tobacco

     1,735        1,958        (11.4 )%      2,096        (6.6 )% 

American Snuff

     374        331        13.0     320        3.4

Santa Fe

     237        186        27.4     123        51.2

All other

     (36     18        NM (3)      (14     NM (3) 

Corporate expense

     (96     (94     2.1     (93     1.1
  

 

 

   

 

 

     

 

 

   
   $ 2,214      $ 2,399        (7.7 )%    $ 2,432        (1.4 )% 
  

 

 

   

 

 

     

 

 

   

 

(1)

Excludes excise taxes of:

 

     2012      2011      2010  

RJR Tobacco

   $ 3,467       $ 3,672       $ 3,904   

American Snuff

     50         57         106   

Santa Fe

     169         154         138   

All other

     237         224         192   
  

 

 

    

 

 

    

 

 

 
   $ 3,923       $ 4,107       $ 4,340   
  

 

 

    

 

 

    

 

 

 

 

(2)

See below for further information related to State Settlement Agreements, federal tobacco buyout and FDA expense included in cost of products sold.

 

(3)

Percentage change not meaningful.

In the following discussion, the amounts presented in the operating companies’ shipment volume and share tables are rounded on an individual basis and, accordingly, may not sum in the aggregate. Percentages are calculated on unrounded numbers.

 

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2012 Compared with 2011

RJR Tobacco

Net Sales

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

 

     For the Twelve Months Ended
December 31,
 
     2012     2011     % Change  

RJR Tobacco(1):

      

Growth brands:

      

CAMEL

     21.2        21.7        (2.3 )% 

PALL MALL

     21.9        22.0        (0.6 )% 
  

 

 

   

 

 

   
     43.1        43.7        (1.4 )% 

Other

     25.8        29.3        (11.8 )% 
  

 

 

   

 

 

   

Total RJR Tobacco domestic cigarette shipment volume

     68.9        73.0        (5.6 )% 
  

 

 

   

 

 

   

Total premium

     39.8        41.6        (4.2 )% 

Total value

     29.1        31.4        (7.4 )% 

Premium/Total mix

     57.8     57.0  

Industry(1):

      

Premium

     202.6        206.6        (2.0 )% 

Value

     83.9        86.5        (2.9 )% 
  

 

 

   

 

 

   

Total industry domestic cigarette shipment volume

     286.5        293.1        (2.3 )% 
  

 

 

   

 

 

   

Premium/Total mix

     70.7     70.5  

 

(1)

Based on information from MSAi.

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

RJR Tobacco’s net sales for the year ended December 31, 2012, decreased from the year ended December 31, 2011, due to $446 million attributable to lower cigarette volume and lower related party sales of $136 million, partially offset by higher pricing of $246 million and a favorable premium-to-value brand mix.

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

 

     For the Twelve Months Ended
December 31,
 
     2012     2011     Share Point
Change
 

Growth brands:

      

CAMEL

     8.5     8.5     0.0   

PALL MALL

     8.6     8.5     0.1   
  

 

 

   

 

 

   

 

 

 

Total growth brands

     17.1     17.0     0.1   

Other

     9.4     10.6     (1.2
  

 

 

   

 

 

   

 

 

 

Total RJR Tobacco domestic cigarette retail share of market

     26.5     27.6     (1.1

 

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(1)

Retail share of U.S. cigarette sales data is included in this document because it is used by RJR Tobacco primarily as an indicator of the relative performance of industry participants, and brands and market trends. You should not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone is not able to effectively track all volume. Moreover, you should be aware that in a product market experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes.

 

(2)

In 2012, at the request of RJR Tobacco, the IRI/Capstone model was revised to better reflect actual retail sales. All data reflects the new methodology.

The retail share of market of CAMEL, at 8.5 share points, remained stable in 2012 compared with 2011. In addition to a significant level of competitive line extensions and promotional support, the market continues to be challenging for premium-priced products.

CAMEL’s cigarette market share continued to be favorably impacted by its menthol styles, which feature the same innovative capsule technology used in CAMEL Crush, allowing adult smokers to choose the level of menthol flavor on demand. CAMEL Crush, featuring the menthol capsule, allows adult smokers the choice between regular or menthol. CAMEL’s menthol market share at December 31, 2012, including CAMEL Crush, increased 0.5 percentage points to 3.0 percent.

CAMEL Snus, a smoke-free tobacco product, continues to bring awareness to the marketplace in this growing smoke-free category. CAMEL Snus mint was expanded nationwide in the third quarter of 2012. CAMEL Snus continued to show steady growth in 2012 as interest builds in this convenient option for adult tobacco consumers. CAMEL Snus will introduce new Fresh Seal packaging in February 2013, which will eliminate the need for refrigeration, while continuing to ensure that adult tobacco consumers benefit from the freshness and flavor of this product.

PALL MALL, a product that offers a high quality, longer-lasting cigarette at a value price, continues to attract interest from adult tobacco consumers. PALL MALL’s 2012 market share of 8.6% was up slightly compared with the prior-year period. PALL MALL continued to be negatively impacted by significant competition from other value brands, as well as value-priced line extensions of competitive premium brands that sell at or below PALL MALL’s price point. In the third quarter of 2012, PALL MALL expanded its portfolio with additional menthol styles, PALL MALL Black, which offers a full-flavor tobacco blend, and PALL MALL White, which has a smoother tobacco blend.

The combined share of market of RJR Tobacco’s growth brands during 2012 showed improvement over 2011. RJR Tobacco’s total cigarette market share declined slightly from the prior year, mainly driven by losses on the company’s non-focus value brands, consistent with its strategy of focusing on growth brands.

Operating Income

RJR Tobacco’s operating income for the year ended December 31, 2012, decreased from the year ended December 31, 2011, due to lower cigarette volume, increased promotional spending, a trademark impairment charge of $82 million on four cigarette brands and a restructuring charge in 2012 of $149 million, partially offset by lower litigation charges, higher cigarette pricing and productivity improvements. During 2012, RJR Tobacco recorded charges of $37 million related to Engle Progeny cases in Florida. Additionally, lower cigarette volume and a trademark impairment charge of $43 million, partially offset by growth brand volume gains, higher pricing and productivity improvements impacted operating income in 2011. Also, during 2011, RJR Tobacco recorded charges of $64 million related to four Engle Progeny cases in Florida and $139 million related to the Scott lawsuit in Louisiana. For additional information, see “— Litigation Affecting the Cigarette Industry — Overview,” “— Engle and Engle Progeny Cases” and “— Class-Action Suits — Medical Monitoring and Smoking Cessation Case” in Item 8, note 13 to consolidated financial statements.

 

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RJR Tobacco’s expense under the State Settlement Agreements, federal tobacco quota buyout and FDA user fees, included in cost of products sold, are detailed in the schedule below:

 

     For the Twelve
Months Ended
December 31,
 
     2012      2011  

State Settlement Agreements

   $ 2,286       $ 2,359   

Federal tobacco quota buyout

     206         218   

FDA user fees

     115         114   

Expenses under the State Settlement Agreements are expected to be approximately $2.3 billion in 2013, subject to adjustment for changes in volume and other factors, and expense for the federal tobacco quota buyout is expected to be approximately $200 million to $210 million in 2013. For additional information, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” and “— Tobacco Buyout Legislation and Related Litigation” in Item 8, note 13 to consolidated financial statements. Expenses for FDA user fees are expected to be approximately $120 million to $130 million in 2013. For additional information, see “— Governmental Activity” below.

Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. For the years ended December 31, 2012 and 2011, RJR Tobacco’s product liability defense costs were $155 million and $160 million, respectively.

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

 

   

Individual Smoking and Health;

 

   

West Virginia IPIC;

 

   

Engle Progeny;

 

   

Broin II;

 

   

Class Actions; and

 

   

Health-Care Cost Recovery Claims.

“Product liability defense costs” include the following items:

 

   

direct and indirect compensation, fees and related costs and expenses for internal legal and related administrative staff administering product liability claims;

 

   

fees and cost reimbursements paid to outside attorneys;

 

   

direct and indirect payments to third party vendors for litigation support activities;

 

   

expert witness costs and fees; and

 

   

payments to fund legal defense costs for the now dissolved Council for Tobacco Research — U.S.A.

 

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Numerous factors affect product liability defense costs. The most important factors are the number of cases pending and the number of cases in trial or in preparation for trial, that is, with active discovery and motions practice. See “— Litigation Affecting the Cigarette Industry — Overview — Introduction” in Item 8, note 13 to consolidated financial statements for detailed information regarding the number and type of cases pending, and “— Litigation Affecting the Cigarette Industry — Overview — Scheduled Trials” in Item 8, note 13 to consolidated financial statements for detailed information regarding the number and nature of cases in trial and scheduled for trial through December 31, 2013.

RJR Tobacco expects that the factors described above will continue to have the primary impact on its product liability defense costs in the future. Given the level of activity in RJR Tobacco’s pending cases, including the number of cases in trial and scheduled for trial, particularly with respect to the Engle Progeny cases, RJR Tobacco’s product liability defense costs continue to remain at a high level. See “— Litigation Affecting the Cigarette Industry — Engle and Engle Progeny Cases” in Item 8, note 13 to consolidated financial statements for additional information. In addition, it is possible that other adverse developments in the factors discussed above, as well as other circumstances beyond the control of RJR Tobacco, could have a material adverse effect on the consolidated results of operations, cash flows or financial position of RAI or its subsidiaries. Those other circumstances beyond the control of RJR Tobacco include the results of present and future trials and appeals, and the development of possible new theories of liability by plaintiffs and their counsel.

American Snuff

Net Sales

The moist snuff shipment volume, in millions of cans, for American Snuff was as follows:

 

     For the Twelve Months Ended
December 31,
 
     2012      2011      % Change  

GRIZZLY

     389.2         355.8         9.4

Other

     48.0         48.9         (1.9 )% 
  

 

 

    

 

 

    

Total American Snuff moist snuff shipment volume

     437.1         404.7         8.0

American Snuff’s net sales for the year ended December 31, 2012, were favorably impacted by higher moist snuff volume of $31 million and higher pricing of $4 million.

Moist snuff has been the key driver to American Snuff’s overall growth and profitability within the U.S. smokeless tobacco market. Moist snuff accounted for approximately 86% of American Snuff’s revenue in 2012 and approximately 83% in 2011, reflecting the impact from the sale of Lane in 2011. U.S. moist snuff industry shipment volume grew by approximately 5% in 2012 compared with 2011.

The shares of American Snuff’s moist snuff brands as a percentage of total share of U.S. retail moist snuff sales according to IRI/Capstone(1)(2) were as follows:

 

     For the Twelve Months Ended
December 31,
 
     2012     2011     Share Point
Change
 

GRIZZLY

     29.0     27.3     1.6   

Other

     3.4     3.7     (0.3
  

 

 

   

 

 

   

 

 

 

Total American Snuff moist snuff retail share of market

     32.4     31.0     1.4   

 

(1)

Retail share of U.S. moist snuff sales data is included in this document because it is used by American Snuff primarily as an indicator of the relative performance of industry participants, and brands and market trends.

 

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  You should not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone is not able to effectively track all volume.

 

(2)

In 2012, at the request of American Snuff, the IRI/Capstone model was revised to better reflect actual retail sales. All data reflects the new methodology.

GRIZZLY’s market share of moist snuff shipments in 2012 increased compared with 2011. Retail contracts introduced in the first quarter of 2011, and support from RJR Tobacco’s larger field trade marketing organization, through a services agreement, continue to benefit GRIZZLY’s market performance, strengthening product distribution and retail presence. Additionally, GRIZZLY is benefiting from activities to build the brand’s equity.

Operating Income

American Snuff’s operating income for the year ended December 31, 2012, increased due to higher moist snuff pricing and sales volumes, partially offset by high levels of promotional activity. Operating income in 2011 was impacted by trademark impairment charges of $5 million on several loose leaf brands.

Santa Fe

Net Sales

Domestic cigarette shipment volume, in billions of units for Santa Fe, was as follows:

 

     For the Twelve Months Ended
December 31,
 
     2012      2011      % Change  

NATURAL AMERICAN SPIRIT

     3.1         2.8         11.3

Santa Fe’s net sales for the year ended December 31, 2012, increased over 2011 and were favorably impacted by higher volume and pricing. The cigarette shipment volume growth was negatively impacted by Santa Fe’s shift to a more efficient integrated supply chain in the first quarter of 2012. The shift resulted in a one-time reduction of wholesale inventory levels.

The cigarette shipment volume growth reflects strong consumer demand, supported by expanded domestic distribution and style presence at retail.

The shares of Santa Fe’s NATURAL AMERICAN SPIRIT as a percentage of total share of U.S. retail cigarette sales according to data from IRI/Capstone(1) were as follows:

 

     For the Twelve Months Ended
December 31,
 
     2012     2011     Share Point
Change
 

NATURAL AMERICAN SPIRIT

     1.2     1.0     0.2   

 

(1)

Retail share of U.S. cigarette sales data is included in this document because it is used by Santa Fe primarily as an indicator of the relative performance of industry participants, and brands and market trends. You should not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone is not able to effectively track all volume. Moreover, you should be aware that in a product market experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes.

 

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Operating Income

Santa Fe’s operating income for the year ended December 31, 2012, increased as compared with the year ended December 31, 2011, as a result of higher cigarette volumes and pricing, partially offset by higher MSA costs.

Santa Fe’s expense under the MSA, federal tobacco quota buyout and FDA user fees, included in cost of products sold, are detailed in the schedule below:

 

     For the Twelve
Months Ended
December 31,
 
     2012      2011  

MSA

   $ 80       $ 72   

Federal tobacco quota buyout

     9         9   

FDA user fees

     5         4   

Expenses under the MSA are expected to be approximately $90 million to $100 million in 2013, subject to adjustment for changes in volume and other factors. For additional information, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 to consolidated financial statements.

Other

During the fourth quarter of 2012, Niconovum AB recorded an impairment charge of $47 million, reflecting a change in the use of other intangible assets.

RAI Consolidated

Interest and debt expense for the year ended December 31, 2012, increased $13 million from the comparable prior year, primarily due to higher debt balances during 2012.

Restructuring costs of $149 million were recorded during the first quarter of 2012. RAI and its subsidiaries, RJR Tobacco and RAISC, completed a business analysis designed to identify resources to reinvest in their businesses. As a result of this initiative, the total U.S. workforce of RAI and its subsidiaries will decline by a net of approximately 10% upon the completion of the restructuring by the end of 2014. Job eliminations, a majority of which were voluntary, during that period will be partially offset by the hiring of new employees as and where needed.

Under existing severance plans, $111 million of cash severance, benefits and related costs and $38 million of non-cash pension-related benefits comprised this restructuring charge. Of the cash portion, $40 million had been paid as of December 31, 2012. Accordingly, in the consolidated balance sheet as of December 31, 2012, $15 million was included in other current liabilities and $56 million was included in other noncurrent liabilities. Cost savings related to the restructuring were approximately $25 million during 2012 and are expected to increase to approximately $70 million in 2015.

Provision for income taxes reflected an effective rate of 34.9%, for the year ended December 31, 2012, compared with an effective rate of 35.7%, for the year ended December 31, 2011. The effective tax rate for 2012 was favorably impacted by a $39 million decrease in tax attributable to the reversal of tax reserves and interest related to various state statute expirations and audit settlements. The effective tax rate for 2011 was favorably impacted by a $22 million decrease in tax attributable to the reversal of tax reserves and interest on a state statute expiration. The effective tax rate for 2011 exceeded the federal statutory rate of 35% primarily due to the impact of state taxes and certain non-deductible items, offset by the domestic production activities deduction of the American Jobs Creation Act of 2004.

RAI expects its effective tax rate to be between 37% and 38% in 2013.

 

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2011 Compared with 2010

RJR Tobacco

Net Sales

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

 

     For the Twelve Months Ended
December 31,
 
     2011     2010     % Change  

RJR Tobacco(1):

      

Growth brands:

      

CAMEL

     21.7        22.1        (2.2 )% 

PALL MALL

     22.0        20.5        7.6
  

 

 

   

 

 

   
     43.7        42.6        2.5

Other

     29.3        35.0        (16.2 )% 

Total RJR Tobacco domestic cigarette shipment volume

     73.0        77.6        (6.0 )% 
  

 

 

   

 

 

   

Total premium

     41.6        44.6        (6.7 )% 

Total value

     31.4        33.0        (4.7 )% 

Premium/Total mix

     57.0     57.5  

Industry(1):

      

Premium

     206.6        213.3        (3.1 )% 

Value

     86.5        90.4        (4.4 )% 
  

 

 

   

 

 

   

Total industry domestic cigarette shipment volume

     293.1        303.7        (3.5 )% 
  

 

 

   

 

 

   

Premium/Total mix

     70.5     70.2  

 

(1)

Based on information from MSAi.

RJR Tobacco’s net sales for the year ended December 31, 2011, decreased from the year ended December 31, 2010, due to $529 million attributable to lower cigarette volume and an unfavorable premium-to-value brand mix, partially offset by higher pricing of $398 million and higher related party sales of $107 million.

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

 

     For the Twelve Months Ended
December 31,
 
     2011     2010     Share Point
Change
 

Growth brands:

      

CAMEL excluding non-filter

     7.8     7.7     0.1   

PALL MALL

     8.5     7.4     1.1   
  

 

 

   

 

 

   

 

 

 

Total growth brands

     16.4     15.1     1.3   

Other

     11.0     12.9     (1.9
  

 

 

   

 

 

   

 

 

 

Total RJR Tobacco domestic cigarette retail share of market

     27.4     28.1     (0.7

 

(1)

Retail share of U.S. cigarette sales data is included in this document because it is used by RJR Tobacco primarily as an indicator of the relative performance of industry participants, and brands and market trends. You should not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone is not able to effectively track all volume. Moreover, you should be

 

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  aware that in a product market experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes.

 

(2)

In 2012, at the request of RJR Tobacco, IRI/Capstone revised its sampling model to better reflect the current retail environment. Data provided herein reflects previously published data using IRI/Capstone’s historical methodology.

The retail share of market of CAMEL’s filtered styles increased slightly in 2011 compared with 2010. In addition to a significant level of competitive line extensions and promotional support, the market continued to be challenging for premium-priced products.

CAMEL’s cigarette market share was favorably impacted by its menthol styles. CAMEL’s menthol market share at December 31, 2011, including CAMEL Crush, increased 0.4 percentage points to 2.3 percent.

CAMEL Snus continued to show steady growth in 2011 as interest built in this convenient option for adult tobacco consumers.

CAMEL’s refined and improved line of dissolvable tobacco products continued to generate new consumer insights after being introduced in two new lead markets in the first quarter of 2011.

PALL MALL continued to perform well in 2011 with both volume and share gains. PALL MALL’s growth is believed to be the result of the brand’s position as a product that offers a high quality, longer-lasting cigarette at a value price. Despite significant competitive activity and many offerings below PALL MALL’s price point, the brand’s 2011 market share rose 1.1 percentage points from the prior-year, to 8.5%.

The combined share of market of RJR Tobacco’s growth brands during 2011 showed improvement over 2010. RJR Tobacco’s total cigarette market share declined slightly from the prior year as RJR Tobacco has discontinued many of its non-core cigarette styles and de-emphasized private-label cigarette brands.

Operating Income

RJR Tobacco’s operating income for the year ended December 31, 2011, decreased from the year ended December 31, 2010, due to lower cigarette volume on support and non-support brands and trademark impairment for 2011, partially offset by growth brand volume gains, higher cigarette pricing and productivity improvements. Also, during 2011, RJR Tobacco recorded charges of $64 million related to four Engle Progeny cases in Florida and $139 million related to the Scott lawsuit in Louisiana. Additionally, unfavorable premium-to-value mix and asset impairment charges of $24 million related to a plant closing impacted the operating income in 2010.

RJR Tobacco’s expense under the State Settlement Agreements, federal tobacco quota buyout and FDA user fees, included in cost of products sold, are detailed in the schedule below:

 

     For the Twelve
Months Ended
December 31,
 
     2011      2010  

State Settlement Agreements

   $ 2,359       $ 2,436   

Federal tobacco quota buyout

     218         232   

FDA user fees

     114         71   

Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. For the years ended December 31, 2011 and 2010, RJR

 

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Tobacco’s product liability defense costs were $160 million and $153 million, respectively. The increase in product liability defense costs in 2011 compared with 2010 is due primarily to the increase in the number of Engle Progeny cases in or scheduled for trial.

American Snuff

Net Sales

The moist snuff shipment volume, in millions of cans, for American Snuff was as follows:

 

     For the Twelve Months Ended
December 31,
 
     2011      2010      % Change  

GRIZZLY

     355.8         325.3         9.4

Other

     48.9         52.0         (6.0 )% 
  

 

 

    

 

 

    

Total American Snuff moist snuff shipment volume

     404.7         377.3         7.3
  

 

 

    

 

 

    

American Snuff’s net sales for the year ended December 31, 2011, were unfavorably impacted by higher levels of competitive promotional activity and by the lack of sales from Lane subsequent to its sale on February 28, 2011, partially offset by higher volumes. Shipments of GRIZZLY increased in 2011 with gains on core styles. Shipments of KODIAK declined slightly in 2011 due to high levels of competitive promotional activity.

Moist snuff accounted for approximately 83% of American Snuff’s revenue in 2011 and approximately 74% in 2010 reflecting the impact from the sale of Lane in 2011. Moist snuff industry volume grew nearly 5% in 2011 compared with 2010. In 2011, moist snuff industry volume growth returned to historic levels after a higher-than-expected level in 2010, as the growth in 2010 was positively impacted by competitive promotional strategies.

The shares of American Snuff’s moist snuff brands as a percentage of total share of U.S. retail moist snuff sales according to IRI/Capstone(1)(2), were as follows:

 

     For the Twelve Months Ended
December 31,
 
     2011     2010     Share Point
Change
 

GRIZZLY

     27.7     26.1     1.6   

Other

     3.8     4.2     (0.1
  

 

 

   

 

 

   

 

 

 

Total American Snuff moist snuff retail share of market

     31.5     30.3     1.2   

 

(1)

Retail share of U.S. moist snuff sales data is included in this document because it is used by American Snuff primarily as an indicator of the relative performance of industry participants, and brands and market trends. You should not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone is not able to effectively track all volume.

 

(2)

In 2012, at the request of American Snuff, IRI/Capstone revised its sampling model to better reflect the current retail environment. Data provided herein reflects previously published data using IRI/Capstone’s historical methodology.

GRIZZLY’s market share of moist snuff shipments in 2011 increased compared with 2010 despite competitive promotional activity. In the industry, the moist pouch segment grew approximately 11.4% in 2011, and at December 31, 2011, accounted for over 9% of all moist snuff volume. GRIZZLY’s pouch styles accounted for over 27% of moist pouch industry volume at December 31, 2011.

 

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Operating Income

American Snuff’s operating income for the year ended December 31, 2011, increased due to higher moist snuff pricing and sales volumes, partially offset by high levels of promotional activity and by the lack of earnings from Lane subsequent to its sale on February 28, 2011. In addition, as a result of fourth quarter impairment testing, trademark impairment charges of $5 million and $6 million were recorded in 2011 and 2010, respectively, on several loose leaf brands.

During 2010, in order to facilitate its strategic focus on key brands in the cigarette, moist-snuff and modern smoke-free categories of the tobacco business, RAI determined that it was probable that it would dispose of the operations of Lane. In connection with this determination, the goodwill of American Snuff was allocated between the disposal group and the retained operations based on relative fair values. The resulting goodwill was tested for impairment comparing its fair value with its carrying value. Because the fair value, less estimated cost of disposal, of the disposal group was less than its carrying value, a goodwill impairment loss of $26 million was recorded in 2010.

Santa Fe

Net Sales

Domestic cigarette shipment volume, in billions of units for Santa Fe, was as follows:

 

     For the Twelve Months Ended
December 31,
 
     2011      2010      % Change  

NATURAL AMERICAN SPIRIT

     2.8         2.5         13.5

Santa Fe’s net sales for the year ended December 31, 2011, increased over 2010 and were favorably impacted by higher volume and pricing.

The cigarette shipment volume growth of 13.5% reflects strong consumer demand, supported by expanded domestic distribution and style presence at retail.

The share of Santa Fe’s NATURAL AMERICAN SPIRIT as a percentage of total share of U.S. retail cigarette sales according to data from IRI/Capstone(1), were as follows:

 

     For the Twelve Months Ended
December 31,
 
     2011     2010     Share Point
Change
 

NATURAL AMERICAN SPIRIT

     1.0     0.8     0.2   

 

(1)

Retail share of U.S. cigarette sales data is included in this document because it is used by Santa Fe primarily as an indicator of the relative performance of industry participants, and brands and market trends. You should not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone is not able to effectively track all volume. Moreover, you should be aware that in a product market experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes.

Operating Income

Santa Fe’s operating income for the year ended December 31, 2011, increased as compared with the year ended December 31, 2010, as a result of higher cigarette volumes and pricing, partially offset by higher MSA costs.

 

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Santa Fe’s expense under the MSA, federal tobacco quota buyout and FDA user fees, included in cost of products sold, are detailed in the schedule below:

 

     For the Twelve
Months Ended
December 31,
 
     2011      2010  

MSA

   $ 72       $ 57   

Federal tobacco quota buyout

     9         8   

FDA user fees

     4         2   

RAI Consolidated

Interest and debt expense for the year ended December 31, 2011, decreased $11 million from the comparable prior year, primarily due to lower debt balances during 2011.

Provision for income taxes reflected an effective rate of 35.7%, for the year ended December 31, 2011, compared with an effective rate of 39.4%, for the year ended December 31, 2010. The effective tax rate for 2011 was favorably impacted by a $22 million decrease in tax attributable to the reversal of tax reserves and interest on a state statute expiration. The effective tax rate for 2010 was unfavorably impacted by a $27 million increase in tax attributable to the Patient Protection and Affordable Care Act of 2010 and the Health Care and Education Reconciliation Act of 2010. The effective tax rates exceeded the federal statutory rate of 35% primarily due to the impact of state taxes and certain non-deductible items, offset by the domestic production activities deduction of the American Jobs Creation Act of 2004.

Liquidity and Financial Condition

Liquidity

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

The negative impact, if any, on the sources of liquidity that could result from a decrease in demand for products due to short-term inventory adjustments by wholesale and retail distributors, changes in competitive pricing, accelerated declines in consumption, particularly from increases in regulation or excise taxes, or adverse impacts from financial markets, cannot be predicted. RAI cannot predict its cash requirements or those of its subsidiaries related to any future settlements or judgments, including cash required to be held in escrow or to bond any appeals, if necessary, and RAI makes no assurance that it or its subsidiaries will be able to meet all of those requirements.

RAI’s operating companies monitored the liquidity of key suppliers and customers throughout 2012, and where liquidity concerns were identified, appropriate contingency plans were developed. To date, no business interruptions have occurred caused by key supplier liquidity, and no liquidity issues were identified involving significant customers.

RAI’s excess cash may be invested in money market funds, commercial paper, U.S. treasuries, U.S. government agencies and time deposits in major institutions to minimize risk. At present, RAI primarily invests cash in U.S. treasuries.

 

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As of December 31, 2012, R.J. Reynolds Tobacco C.V., referred to as RJRTCV, an indirect wholly owned subsidiary of RAI, held approximately 72 million euros in a euro government liquidity fund, included in cash and cash equivalents in RAI’s consolidated balance sheet. Nearly one-third of the fund is comprised of repurchase agreements with financial institutions that are collateralized by sovereign debt of approved countries. The fund has investments in sovereign debt of France, Belgium and Germany. The average maturity of the fund was 41 days as of December 31, 2012. RAI’s management believes that this cash equivalent is not reasonably likely to have a material impact on RAI’s liquidity or results of operations. RAI has no hedge in place with respect to this exposure.

As of December 31, 2012, RAI held investments in auction rate securities, a mortgage-backed security and a marketable equity security. Adverse changes in financial markets caused the auction rate securities and the mortgage-backed security to revalue lower than carrying value and become less liquid. The auction rate securities and mortgage-backed security will not become liquid until a successful auction occurs or a buyer is found. RAI intends, and has the ability, to hold these auction rate securities and the mortgage-backed security for a period of time sufficient to allow for sale, redemption or anticipated recovery in fair value.

On February 28, 2011, RAI completed the sale of all of the capital stock of Lane and certain other assets related to the Lane operations to STG for net proceeds of $202 million in cash. Its results of operations were included through February 28, 2011, in income from continuing operations in the American Snuff segment.

Contractual obligations as of December 31, 2012, were as follows:

 

     Payments Due by Period  
     Total      Less than  1
Year-2013
     1-3  Years
2014-2015
     4-5  Years
2016-2017
     Thereafter  

Long-term notes, exclusive of interest(1)

   $ 4,985       $ 60       $ 650       $ 1,475       $ 2,800   

Interest payments related to long-term notes(1)

     3,171         266         522         371         2,012   

Operating leases(2)

     65         20         32         13           

Non-qualified pension obligations(3)

     94         10         18         18         48   

Postretirement benefit obligations(3)

     550         60         117         118         255   

Qualified pension funding(3)

     100         100            

Purchase obligations(4)

     391         216         175                   

Other noncurrent liabilities(5)

     101         N/A         66         12         23   

State Settlement Agreements’ obligations(6)

     11,500         2,300         4,600         4,600      

Gross unrecognized tax benefit(7)

     68               

Federal tobacco buyout obligations(8)

     390         220         170                   

FDA user fee(9)

     732         130         282         320      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total cash obligations

   $ 22,147       $ 3,382       $ 6,632       $ 6,927       $ 5,138   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

For more information about RAI’s and RJR’s long-term notes, see Item 8, note 12 to consolidated financial statements.

 

(2)

Operating lease obligations represent estimated lease payments primarily related to office space, automobiles, warehouse space and computer equipment. See Item 8, note 13 to consolidated financial statements for additional information.

 

(3)

For more information about RAI’s pension plans and postretirement benefits, see Item 8, note 16 to consolidated financial statements. Non-qualified pension and postretirement benefit obligations captioned under “Thereafter” include obligations during the next five years only. These obligations are not reasonably estimable beyond ten years. Qualified pension plan funding is based on the Pension Protection Act of 2006 and tax deductibility and is not reasonably estimable beyond one year.

 

(4)

Purchase obligations primarily include commitments to acquire tobacco leaf. Purchase orders for the purchase of other raw materials and other goods and services are not included in the table. RAI’s operating subsidiaries are not able to determine the aggregate amount of such purchase orders that represent contractual obligations, as purchase orders typically represent authorizations to purchase rather than binding agreements.

 

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  For purposes of this table, contractual obligations for the purchase of goods or services are defined by RAI’s operating subsidiaries as agreements that are enforceable and legally binding that specify all significant terms, including fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Purchase orders of RAI’s operating subsidiaries are based on current demand expectations and are fulfilled by vendors within short time horizons. RAI’s operating subsidiaries do not have significant non-cancelable agreements for the purchase of raw materials or other goods or services specifying minimum quantities or set prices that exceed their expected requirements. RAI’s operating subsidiaries also enter into contracts for outsourced services; however, the obligations under these contracts were generally not significant and the contracts generally contain clauses allowing for the cancellation without significant penalty.

 

(5)

Other noncurrent liabilities include primarily restructuring and bonus compensation. Certain other noncurrent liabilities are excluded from the table above, for which timing of payments are not estimable.

 

(6)

State Settlement Agreements’ obligation amounts in the aggregate beyond five years are not presented as these are obligations into perpetuity. For more information about the State Settlement Agreements, see Item 8, note 13 to consolidated financial statements.

 

(7)

For more information on gross unrecognized tax benefits, see Item 8, note 10 to consolidated financial statements. Due to inherent uncertainties regarding the timing of payment of these amounts, RAI cannot reasonably estimate the payment period.

 

(8)

For more information about the tobacco buyout legislation, see “— Governmental Activity” below and Item 8, note 13 to consolidated financial statements.

 

(9)

FDA user fee obligation amounts in the aggregate beyond five years are not presented as these are obligations that extend beyond ten years. For more information about FDA user fees, see Item 8, note 13 to consolidated financial statements.

Commitments as of December 31, 2012, were as follows:

 

     Commitment
Expiration  Period
 
     Total      Less than
1  Year
 

Standby letters of credit backed by revolving credit facility

   $ 6       $ 6   
  

 

 

    

 

 

 

Cash Flows

2012 Compared with 2011

Net cash flows from operating activities increased $148 million in 2012, compared with 2011. This change was driven primarily by favorable accounts payable changes and lower pension contributions in 2012, partially offset by unfavorable changes in inventory and higher income tax payments and interest paid in 2012.

Net cash flows from investing activities decreased $114 million in 2012, compared with 2011 primarily due to proceeds from the sale of the Lane business during 2011, partially offset by higher capital expenditures for American Snuff’s facility expansion projects in 2011.

Net cash flows used in financing activities decreased $743 million in 2012, compared with the prior-year period. This decrease in usage was the result of the receipt of cash from the issuance of debt, partially offset by an increase in the comparable quarterly common stock dividend, higher debt repayments in 2012 and higher stock repurchases in 2012. Additionally, the 2011 period benefitted from the receipt of cash from the termination of interest rate swaps.

 

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2011 Compared with 2010

Net cash flows from operating activities increased $155 million in 2011, compared with 2010. This change was driven by lower pension contributions in 2011, partially offset by higher income tax payments and litigation bonds in 2011.

Net cash flows from investing activities increased $186 million in 2011, compared with 2010 primarily due to proceeds from the sale of the Lane business during 2011, partially offset by higher capital expenditures for American Snuff’s facility expansion projects.

Net cash flows used in financing activities increased $365 million in 2011, compared with the prior-year period. This increase was the result of an increase in the comparable quarterly common stock dividend, a higher debt payment in 2011, and stock repurchases, partially offset by the receipt of cash from the termination of interest rate swaps.

Borrowing Arrangements

RAI and RJR Notes

As of December 31, 2012, the principal amount of RAI’s and RJR’s outstanding notes was $5.0 billion, with maturity dates ranging from 2013 to 2042. RAI, at its option, may redeem any or all of its outstanding notes, in whole or in part at any time, subject to the payment of a make-whole premium. RJR’s 9.25% notes due in 2013, $60 million in principal amount of which was outstanding as of December 31, 2012, are not redeemable.

On June 1, 2012, RAI repaid $450 million in principal of debt due in 2012 from the proceeds of the Term Loan described below. In addition, in June 2012, RJR prepaid the remaining insignificant amount of RJR’s guaranteed, unsecured long-term debt due in 2015. See Item 8, note 12 to consolidated financial statements for more information on these notes.

In October 2012, RAI completed the sale of $2.55 billion in aggregate principal amount of senior notes, consisting of $450 million of 1.05% senior notes due October 30, 2015, $1.1 billion of 3.25% senior notes due November 1, 2022 and $1 billion of 4.75% senior notes due November 1, 2042. The net proceeds from the offering were used to prepay in full the principal balance of the Term Loan, together with accrued interest. A portion of the proceeds also was used in December 2012 to pay the redemption price of $625 million aggregate principal amount of RAI’s outstanding 7.25% notes due in 2013.

See Item 8, note 12 to consolidated financial statements for additional information on Long-Term Debt.

Credit Agreement

On July 29, 2011, RAI entered into a Credit Agreement with a syndicate of lenders, providing for a four-year $750 million senior unsecured revolving credit facility, which may be increased to $1 billion at the discretion of the lenders upon the request of RAI. This agreement replaced RAI’s Fifth Amended and Restated Credit Agreement, dated as of June 28, 2007, as amended. The obligations of RAI under the Credit Agreement are unsecured. Certain of RAI’s subsidiaries, including its Material Subsidiaries, as defined in the Credit Agreement, have guaranteed, on an unsecured basis, RAI’s obligations under the Credit Agreement.

On March 27, 2012, RAI and the subsidiary guarantors entered into a First Amendment to the Credit Agreement and First Amendment to the Subsidiary Guarantee Agreement to provide for the further guarantee by the subsidiary guarantors of RAI’s obligations to the lenders and affiliates thereof under certain designated swap, forward, future or derivative transactions or options or similar agreements from time to time entered into between RAI and such lenders or affiliates.

 

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

 

Lender

   Commitment  

JP Morgan Chase Bank, N.A.

   $ 67.00   

Citibank N.A.

     67.00   

Goldman Sachs Bank USA

     67.00   

Mizuho Corporate Bank, Ltd.

     67.00   

Morgan Stanley Bank

     67.00   

The Bank of Nova Scotia

     67.00   

AG First Farm Credit Bank

     47.00   

Royal Bank of Canada

     47.00   

The Bank of New York Mellon

     47.00   

Wells Fargo Bank, National Association

     47.00   

Farm Credit Bank of Texas

     40.00   

Credit Suisse AG Cayman Islands Branch

     35.00   

Fifth Third Bank

     35.00   

Northern Trust Company

     25.00   

United FCS, PCA dba FCS Commercial Finance Group

     25.00   
  

 

 

 
   $ 750.00   
  

 

 

 

See Item 8, note 11 to consolidated financial statements for additional information on the Credit Agreement.

Term Loans

On February 24, 2012, RAI entered into a term loan, referred to as the Term Loan, with a syndicate of lenders, providing for an unsecured, delayed draw term loan facility, with a maximum borrowing capacity of up to $750 million. On April 11, 2012, RAI borrowed the entire $750 million under the Term Loan. RAI repaid the balance of the Term Loan in 2012. See Item 8, note 11 to consolidated financial statements for additional information on the Term Loan.

In February 2013, RAI executed a commitment letter with certain lenders, pursuant to which RAI expects to enter into, in the first half of 2013, a new unsecured delayed draw term loan facility with an anticipated maximum aggregate borrowing amount of up to $500 million. It is expected that this new term loan will mature in December 2013, and will have covenants substantially similar to those in the Term Loan and the Credit Agreement. The completion of the new term loan is subject to, among other customary conditions, securing sufficient loan commitments from lenders, and the negotiation and execution of final credit documentation. There is no assurance that the conditions to completing the new term loan will be satisfied. RAI anticipates using the proceeds of the new term loan for general corporate purposes.

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

RAI, RJR and their affiliates were in compliance with all covenants and restrictions imposed by their indebtedness for the year ended December 31, 2012.

 

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Dividends

On February 7, 2013, RAI’s board of directors declared a quarterly cash dividend of $0.59 per common share. The dividend will be paid on April 1, 2013, to shareholders of record as of March 8, 2013. On an annualized basis, the dividend rate is $2.36 per common share. The current dividend reflects RAI’s policy of paying dividends to the holders of RAI common stock in an aggregate amount that is approximately 80% of RAI’s annual consolidated net income.

Stock Repurchases

On November 14, 2011, the board of directors of RAI authorized the repurchase, from time to time on or before mid-2014, of up to $2.5 billion of outstanding shares of RAI common stock in open-market or privately negotiated transactions.

During the year ended December 31, 2012, RAI repurchased and cancelled 24,944,233 shares of RAI common stock for $1.1 billion under the above share repurchase program. As of December 31, 2012, RAI had repurchased and cancelled 31,720,870 shares of RAI common stock for $1.3 billion under the above share repurchase program.

Additionally, during 2012, at a cost of $39 million, RAI purchased 921,646 shares that were cancelled with respect to tax liabilities associated with restricted stock units vesting under its LTIP. See Item 8, note 14 to consolidated financial statements for additional information on stock repurchases.

Capital Expenditures

RAI’s operating subsidiaries’ recorded cash capital expenditures of $88 million, $190 million and $174 million in 2012, 2011 and 2010, respectively. Of the 2012 amount, $36 million related to RJR Tobacco, $24 million related to American Snuff and $4 million related to Santa Fe. During 2013, capital expenditures, primarily on non-discretionary business requirements, are planned to be $60 million to $70 million for RJR Tobacco, $15 million to $25 million for American Snuff and $4 million to $9 million for Santa Fe. In 2013, RAI’s other operating subsidiaries also plan to make additional investments to support expansion of the VUSE e-cigarette. Capital expenditures are funded primarily by cash flows from operations. RAI’s operating subsidiaries’ capital expenditure programs are expected to continue at a level sufficient to support their strategic and operating needs. There were no material long-term commitments for capital expenditures as of December 31, 2012.

Retirement Benefits

RAI assessed the asset allocation and investment strategy of its pension plans and is phasing in appropriate changes to balance funded status, interest rate risk and asset returns. These changes will reduce the pension fund’s exposure to equities and increase exposure to fixed income. As a result of changes to the asset allocation and investment strategy, RAI lowered the expected long-term return on pension assets, referred to as the ELTRA, to 7.00% in 2012, from 7.75% in 2011 and will further lower it to 6.70% in 2013. The ELTRA, asset allocation, current asset performance and the discount rate may impact the funded status of RAI’s pension plans. As a result, to improve the funded status, RAI contributed $110 million to the pension assets in 2012.

In 2013, RAI plans to contribute $110 million to its pension plans and $65 million to its postretirement plans.

RAI’s fixed income exposure includes debt securities issued by European countries whose S&P credit rating is AA+ or below and also debt securities issued by other entities domiciled in those same countries. The countries include France, Belgium, Spain, Ireland, Italy, Russia, Poland and Austria. RAI’s net exposure to this group of countries is 4.2%, which is comprised of 1.4% in sovereign bonds and 2.8% in corporate bonds. Italy is RAI’s single largest net exposure at 1.6%.

 

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Income Taxes

At December 31, 2012, RAI had a net deferred tax asset of $447 million. RAI has determined that a valuation allowance of $33 million is required to fully offset a deferred tax asset related to the federal capital loss carryforward resulting from the sale of Lane. RAI believes it is unlikely that this deferred tax asset will be realized through the expected generation of future net capital gains. No valuation allowance has been provided on other deferred tax assets as RAI believes it is more likely than not that all of such deferred tax assets will be realized through the expected generation of future taxable income.

Litigation and Settlements

As discussed in Item 8, note 13 to consolidated financial statements, various legal proceedings or claims, including litigation claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RAI’s operating subsidiaries’ products, and seeking damages in amounts ranging into the hundreds of millions or even billions of dollars, are pending or may be instituted against RJR Tobacco, American Snuff Co. or their affiliates, including RAI or RJR, or indemnitees, including B&W. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of December 31, 2012, RJR Tobacco had paid approximately $118 million since January 1, 2010, related to unfavorable smoking and health litigation judgments and $139 million related to an unfavorable medical monitoring and smoking cessation case.

In particular, in Engle v. R. J. Reynolds Tobacco Co., the Florida Supreme Court issued a ruling in 2006 that, while determining that the case could not proceed further as a class action, permitted members of the Engle class to file individual claims, including claims for punitive damages, through January 11, 2008. RJR Tobacco refers to these cases as the Engle Progeny cases. RJR Tobacco had been served, as of December 31, 2012, in 5,756 of these cases on behalf of approximately 6,937 plaintiffs. The Engle Progeny cases have resulted and will continue to result in increased litigation and trial activity and increased expenses. For a more complete description of the Engle Progeny cases, see “— Litigation Affecting the Cigarette Industry — Overview” and “— Engle and Engle Progeny Cases” in Item 8, note 13 to consolidated financial statements.

Also, the consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases, is pending in West Virginia, against both RJR Tobacco and B&W. This case consists of 564 plaintiffs and will be tried in a single proceeding. After mistrials in 2010 and 2011, the court scheduled a new trial for April 15, 2013. For a more complete description of this case, see “— Litigation Affecting the Cigarette Industry — West Virginia IPIC” in Item 8, note 13 to consolidated financial statements.

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

In 1998, RJR Tobacco, B&W and the other major U.S. cigarette manufacturers entered into the MSA with attorneys general representing most U.S. states, territories and possessions. As described in Item 8, note 13 to consolidated financial statements, the State Settlement Agreements impose a perpetual stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers and place significant restrictions

 

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on their ability to market and sell cigarettes in the future. For more information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 to consolidated financial statements. The State Settlement Agreements have materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial position of RAI and RJR Tobacco in future periods. The degree of the adverse impact will depend, among other things, on the rate of decline in U.S. cigarette sales in the premium and value categories, RJR Tobacco’s share of the domestic premium and value cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the State Settlement Agreements.

RJR Tobacco and certain of the other PMs under the MSA are currently involved in litigation with the settling states with respect to the availability for certain market years of a downward adjustment to the annual MSA settlement payment obligation, known as the NPM Adjustment. RJR Tobacco has disputed a total of $4.3 billion for the years 2003 through 2011.

On November 14, 2012, RJR Tobacco, certain other PMs and certain settling states entered into a Term Sheet that set forth terms on which accrued and potential NPM Adjustment claims for 2003 through 2014 could be resolved. The Term Sheet also set forth a restructured NPM Adjustment process to be applied on a going-forward basis, starting with the 2013 volume year. The Term Sheet was provided to all of the settling states for their review and consideration. For more information related to this litigation and its potential resolution, see “—Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements — Enforcement and Validity” in Item 8, note 13 to consolidated financial statements.

Governmental Activity

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

 

   

significantly increase their taxes on tobacco products;

 

   

restrict displays, advertising and sampling of tobacco products;

 

   

raise the minimum age to possess or purchase tobacco products;

 

   

restrict or ban the use of menthol in cigarettes or prohibit mint or wintergreen as a flavor in smokeless tobacco products;

 

   

require the disclosure of ingredients used in the manufacture of tobacco products;

 

   

require the disclosure of nicotine yield information for cigarettes;

 

   

impose restrictions on smoking in public and private areas; and

 

   

restrict the sale of tobacco products directly to consumers or other unlicensed recipients, including over the Internet.

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

 

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Cigarettes and other tobacco products are subject to substantial taxes in the United States. On February 4, 2009, President Obama signed into law, effective April 1, 2009, an increase of $0.62 in the excise tax per pack of cigarettes, and significant tax increases on other tobacco products, to fund expansion of the State Children’s Health Insurance Program. Under these federal tax increases:

 

   

the federal excise tax per pack of 20 cigarettes increased to $1.01; and

 

   

the federal excise tax rate for chewing tobacco increased $0.3083 per pound to $0.5033 per pound, and for snuff increased $0.925 per pound to $1.51 per pound.

The 2009 federal excise tax increase on tobacco products increased taxes on ready-made cigarettes, such as those made by RJR Tobacco, at a much higher rate than taxes on loose tobacco. As a result of that tax disparity, the number of retailers selling loose tobacco and operating RYO machines, allowing consumers to convert the loose tobacco into finished cigarettes, greatly increased following the 2009 federal tax hike on tobacco products. On July 6, 2012, President Obama signed into law a provision classifying retailers which operate RYO machines as cigarette manufacturers, and thus requiring those retailers to pay the same tax rate as other cigarette manufacturers.

All states and the District of Columbia currently impose cigarette excise taxes at levels ranging from $0.17 per pack in Missouri to $4.35 per pack in New York. As of December 31, 2012, the weighted average state cigarette excise tax per pack, calculated on a 12-month rolling average basis, was approximately $1.28, compared with the 12-month rolling average of $1.22 as of December 31, 2011. During 2012, two states, Illinois and Rhode Island, passed cigarette excise tax increases, and a number of other states are considering an increase in their cigarette excise taxes for 2013. Certain city and county governments, such as New York and Chicago, also impose substantial excise taxes on cigarettes sold in those jurisdictions.

Forty-nine states and the District of Columbia also subject smokeless tobacco to excise taxes, and the Commonwealth of Pennsylvania, the singular exception, may consider such a tax during its 2013 legislative session. As of December 31, 2012,

 

   

28 states taxed moist snuff on an ad valorem basis, at rates ranging from 5% in South Carolina to 100% in Wisconsin;

 

   

19 states and the District of Columbia had weight-based taxes on moist snuff, ranging from $0.02 for cans weighing between 5/8 of an ounce and 15/8 ounces in Alabama to $2.02 per ounce in Maine; and

 

   

two states imposed a unit tax on moist snuff: Kentucky with a tax of $0.19 per unit, and Washington, with a tax of $2.526 per unit for units weighing 1.2 ounces or less and a proportionate amount above that weight.

Legislation to convert from an ad valorem to a weight-based tax on moist snuff was introduced in several states in 2012 and one state, Illinois, adopted such a change effective January 1, 2013. During 2012, two states, Maryland and Illinois, adopted legislation increasing their respective taxes on smokeless tobacco products, and other states may adopt such increases during their 2013 legislative sessions.

On March 31, 2010, President Obama signed into law the Prevent All Cigarette Trafficking Act. This legislation, among other things, restricts the sale of tobacco products directly to consumers or unlicensed recipients, including over the Internet, through expanded reporting requirements, requirements for delivery, sales and penalties. It is not anticipated that this legislation will have a material adverse effect on the sale of tobacco products by RAI’s operating companies.

In 1964, the Report of the Advisory Committee to the Surgeon General of the U.S. Public Health Service concluded that cigarette smoking was a health hazard of sufficient importance to warrant appropriate remedial

 

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action. Since 1966, federal law has required a warning statement on cigarette packaging, and cigarette advertising in other media also is required to contain a warning statement. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States.

The warnings currently required on cigarette packages and advertisements are:

 

   

“SURGEON GENERAL’S WARNING: Smoking Causes Lung Cancer, Heart Disease, Emphysema, And May Complicate Pregnancy;”

 

   

“SURGEON GENERAL’S WARNING: Quitting Smoking Now Greatly Reduces Serious Risks to Your Health;”

 

   

“SURGEON GENERAL’S WARNING: Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, And Low Birth Weight;” and

 

   

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

As noted below, the FDA has proposed regulations that would revise the foregoing warnings.

Since the initial report in 1964, the Secretary of Health, Education and Welfare, now the Secretary of Health and Human Services, and the Surgeon General have issued a number of other reports which purport to find the nicotine in cigarettes addictive and to link cigarette smoking and exposure to cigarette smoke with certain health hazards, including various types of cancer, coronary heart disease and chronic obstructive lung disease. These reports have recommended various governmental measures to reduce the incidence of smoking. In 1992, the federal Alcohol, Drug Abuse and Mental Health Act was signed into law. This act required states to adopt a minimum age of 18 for purchase of tobacco products and to establish a system to monitor, report and reduce the illegal sale of tobacco products to minors in order to continue receiving federal funding for mental health and drug abuse programs. In 1996, the U.S. Department of Health and Human Services announced regulations implementing this legislation. And in 2006, the Surgeon General released a report entitled “The Health Consequences of Involuntary Exposure to Tobacco Smoke.” Among its conclusions, the report found the following: exposure of adults to secondhand smoke causes coronary heart disease and lung cancer, exposure of children to secondhand smoke results in an increased risk of sudden infant death syndrome, acute respiratory infections, ear problems and more severe asthma; and that there is no risk-free level of exposure to secondhand smoke.

In 1986, Congress enacted the Comprehensive Smokeless Tobacco Health Education Act of 1986, which, among other things, required health warning notices on smokeless tobacco packages and advertising and prohibited the advertising of smokeless tobacco products on any medium of electronic communications subject to the jurisdiction of the Federal Communications Commission. In 2009, the FDA Tobacco Act (discussed below) amended the Comprehensive Smokeless Tobacco Health Education Act to require the following warnings on smokeless tobacco packaging and advertising, displayed randomly and as equally as possible in each 12-month period:

 

   

“WARNING: THIS PRODUCT CAN CAUSE MOUTH CANCER;”

 

   

“WARNING: THIS PRODUCT CAN CAUSE GUM DISEASE AND TOOTH LOSS;”

 

   

“WARNING: THIS PRODUCT IS NOT A SAFE ALTERNATIVE TO CIGARETTES;” and

 

   

“WARNING: SMOKELESS TOBACCO IS ADDICTIVE.”

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

 

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

 

   

no charitable distribution of tobacco products;

 

   

prohibitions on statements that would lead consumers to believe that a tobacco product is approved, endorsed, or deemed safe by the FDA;

 

   

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

 

   

prohibition on the marketing of tobacco products in conjunction with any other class of product regulated by the FDA.

In addition, pursuant to the FDA Tobacco Act:

 

   

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

 

   

on February 28, 2010, all manufacturers registered with the FDA their domestic manufacturing facilities as well as all cigarette and smokeless tobacco products sold in the United States;

 

   

on March 18, 2010, the FDA reissued regulations addressing advertising and marketing restrictions that were originally promulgated in 1996;

 

   

as of April 30, 2010, manufacturers were required to produce health-related documents generated from and after June 22, 2009 through December 31, 2009 (the FDA has interpreted the FDA Tobacco Act as establishing an ongoing requirement to submit health-related documents; however, the FDA has not yet established a timetable for further production);

 

   

as of June 22, 2010, manufacturers were required to make by-brand ingredient submissions, place different and larger warnings on packaging and advertising for smokeless tobacco products and eliminate the use of descriptors on tobacco products, such as “low-tar” and “lights”;

 

   

as of March 22, 2011, manufacturers were required to submit documentation to obtain FDA clearance for cigarettes and smokeless tobacco products commercially launched after February 15, 2007;

 

   

on June 22, 2011, the FDA issued a final regulation for the imposition of larger, graphic health warnings on cigarette packaging and advertising, which was scheduled to take effect September 22, 2012, but the FDA is currently enjoined from enforcing such regulation. For more information concerning this matter, see “— Litigation Affecting the Cigarette Industry — Other Litigation and Developments — FDA Litigation” in Item 8, note 13 to consolidated financial statements;

 

   

on July 5, 2011, the FDA issued a final regulation setting forth a process by which manufacturers may seek an exemption to the substantial equivalence review process for tobacco additive changes;

 

   

on August 16, 2011, the FDA announced that it would inspect every domestic establishment that manufactured cigarettes, cigarette tobacco, roll-your-own tobacco or smokeless tobacco products once in a two-year cycle beginning on October 1, 2011; and

 

   

on March 30, 2012, the FDA issued draft guidance on: (1) the reporting of harmful and potentially harmful constituents in tobacco products and tobacco smoke pursuant to Section 904(a)(3) of the FDA Tobacco Act, and (2) preparing and submitting applications for modified risk tobacco products pursuant to Section 911 of the FDA Tobacco Act.

 

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On a going forward basis, various provisions under the FDA Tobacco Act and regulations to be issued under the FDA Tobacco Act will become effective and will:

 

   

require manufacturers to test ingredients and constituents identified by the FDA and disclose this information to the public;

 

   

prohibit use of tobacco containing a pesticide chemical residue at a level greater than allowed under Federal law;

 

   

establish “good manufacturing practices” to be followed at tobacco manufacturing facilities;

 

   

authorize the FDA to place more severe restrictions on the advertising, marketing and sale of tobacco products;

 

   

permit inconsistent state regulation of labeling and advertising and eliminate the existing federal preemption of such regulation;

 

   

authorize the FDA to require the reduction of nicotine and the reduction or elimination of other constituents; and

 

   

grant the FDA the regulatory authority to impose broad additional restrictions.

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

 

   

banning all tobacco products; and

 

   

requiring the reduction of nicotine yields of a tobacco product to zero.

A “Center for Tobacco Products” has been established within the FDA, funded through quarterly user fees that will be assessed against tobacco product manufacturers and importers based on market share. The total amount of user fees to be collected over the first ten years will be approximately $5.4 billion. The expense related to the FDA user fees of RAI’s operating companies for 2012 was $122 million.

Within the Center, a Tobacco Products Scientific Advisory Committee, referred to as the TPSAC, was established on March 22, 2010, to provide advice, information and recommendations with respect to the safety, dependence or health issues related to tobacco products. The TPSAC is scheduled to meet quarterly to address matters brought to it by the Center as well as those required of it by the Act, including:

 

   

a recommendation on modified risk applications;

 

   

a recommendation as to whether there is a threshold level below which nicotine yields do not produce dependence;

 

   

a report on the impact of the use of menthol in cigarettes on the public health; and

 

   

a report on the impact of dissolvable tobacco products on the public health.

At a meeting held on March 18, 2011, the TPSAC presented its final report on the use of menthol, which concluded that removal of menthol cigarettes from the marketplace would benefit public health in the United States. At a meeting on July 21, 2011, the TPSAC met to discuss and formally adopt editorial changes to the menthol report proposed by the committee members. The FDA is not required to follow the TPSAC’s recommendations, and the agency has not yet taken any action with respect to menthol use. The FDA issued a

 

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status report on the issue on June 27, 2011, indicating that the agency will prepare an independent, peer-reviewed analysis of the available science on menthol and make a report available for public comment in the Federal Register.

At a meeting on March 1, 2012, the TPSAC presented to the FDA its final report and recommendations with respect to dissolvable tobacco products. The FDA will consider the report and recommendations and determine what future action, if any, is warranted with respect to dissolvable tobacco products. There is no timeline or statutory requirement for the FDA to act on the TPSAC’s recommendations.

On February 25, 2011, RJR Tobacco, Lorillard, Inc. and Lorillard Tobacco Company jointly filed in the U.S. District Court for the District of Columbia a lawsuit, Lorillard, Inc. v. U.S. Food and Drug Administration, challenging the composition of the TPSAC. For additional information concerning this case, see “— Litigation Affecting the Cigarette Industry — Other Cases” in Item 8, note 13 to consolidated financial statements.

On August 31, 2009, RJR Tobacco and American Snuff Co. joined other tobacco manufacturers and a tobacco retailer in filing a lawsuit, Commonwealth Brands, Inc. v. United States of America, in the U.S. District Court for the Western District of Kentucky, challenging certain provisions of the FDA Tobacco Act that severely restrict the few remaining channels available to communicate with adult tobacco consumers. RAI believes these provisions cannot be justified on any basis consistent with the demands of the First Amendment. The suit does not challenge the U.S. Congress’s decision to give the FDA regulatory authority over tobacco products, nor does it challenge the vast majority of the provisions of the new law. For further information regarding this case, see “— Litigation Affecting the Cigarette Industry — Other Cases” in Item 8, note 13 to consolidated financial statements.

On August 16, 2011, RJR Tobacco and SFNTC joined other tobacco manufacturers in filing a lawsuit, R.J. Reynolds Tobacco Company v. U.S. Food and Drug Administration, in the U.S. District Court for the District of Columbia, challenging the final regulation specifying nine new graphic “warnings” pursuant to the FDA Tobacco Act that violates the plaintiffs’ rights under the First Amendment to the U.S. Constitution and the Administrative Procedure Act, referred to as the APA. For additional information concerning this case, see “— Litigation Affecting the Cigarette Industry — Other Cases” in Item 8, note 13 to consolidated financial statements.

It is likely that the FDA Tobacco Act could result in a decrease in cigarette and smokeless tobacco sales in the United States, including sales of RJR Tobacco’s, American Snuff Co.’s and SFNTC’s brands, and an increase in costs to RJR Tobacco, American Snuff Co. and SFNTC that could have a material adverse effect on RAI’s financial condition, results of operations and cash flows. RAI believes that such regulation may adversely affect the ability of its operating subsidiaries to compete against their larger competitor, which may be able to more quickly and cost-effectively comply with these new rules and regulations. The FDA has yet to issue guidance with respect to many provisions of the FDA Tobacco Act, which may result in less efficient compliance efforts. Finally, the ability of RAI’s operating companies to gain efficient market clearance for new tobacco products could be affected by FDA rules and regulations.

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

All states and Washington, D.C. have enacted fire standards compliance legislation, adopting the same testing standard first adopted by New York in 2003, a standard requiring cigarettes to achieve specified test results when placed on ten layers of filter paper in controlled laboratory conditions. The cigarettes that RAI’s

 

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operating companies sell in these jurisdictions comply with this standard, with RJR Tobacco, in recognition of legislative trends and in an effort to increase productivity and reduce complexity, having voluntarily converted all of its brands to fire standard compliant paper by the end of 2009.

In July 2007, the State of Maine became the first state to enact a statute that prohibits the sale of cigarettes and cigars that have a characterizing flavor. The legislation defines characterizing flavor as “a distinguishable taste or aroma that is imparted to tobacco or tobacco smoke either prior to or during consumption, other than a taste or aroma from tobacco, menthol, clove, coffee, nuts or peppers.” In October 2008, the State of New Jersey passed a similar ban on flavored cigarettes with a similar definition of characterizing flavor but excluding only tobacco, menthol or clove. Additionally, New Jersey extended the ban not only to whether the product itself has a characterizing flavor as part of the aroma of the product or smoke, but also if the product was marketed or advertised as producing such a flavor, taste or aroma. During 2009, New York City passed legislation that bans characterizing flavors in tobacco products other than cigarettes beginning on February 25, 2010. An exemption applies if the characterizing flavor is tobacco, menthol, mint or wintergreen. The New York City rule is the subject of a pending federal court challenge by certain industry participants, on the basis that the local law is preempted by the FDA Tobacco Act and violates the Commerce Clause of the U.S. Constitution. A federal court upheld the ban in November 2011; the case is currently on appeal. In January 2012, the City of Providence, Rhode Island enacted a similar ban on characterizing flavors in tobacco products other than cigarettes, with an exemption for tobacco, menthol, mint or wintergreen. Unlike previous bans, Providence included in its definition of characterizing flavors “concepts such as spicy, arctic, ice, cool, warm, hot, mellow, fresh, and breeze.” In December 2012, a federal court upheld most of the ban, but struck down the “concepts” portion of the ban. The plaintiffs, RJR Tobacco and other industry participants, have appealed. In December 2012, Florida’s Wakulla County enacted an ordinance banning characterizing flavors in all tobacco products with an exemption only for tobacco or menthol. Similar bills banning characterizing flavors in tobacco products are pending in other states.

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

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

Additionally, 45 states have enacted legislation that closes a loophole in the MSA. The loophole allows NPMs that concentrate their sales in a single state, or a limited number of states, to recover most of the funds from their escrow accounts. To obtain the refunds, the manufacturers must establish that their escrow deposit was greater than the amount the state would have received had the manufacturer been a “subsequent participating manufacturer” under the MSA, that is, the state’s “allocable share.” The National Association of Attorneys General, referred to as NAAG, has endorsed adoption of the allocable share legislation needed to eliminate this loophole.

Finally, five states, Alaska, Michigan, Minnesota, Mississippi and Utah, have enacted “equity assessments” on NPMs’ products. This legislative initiative has not been endorsed by NAAG.

Thirty-nine states by statute or court rule have limited, in at least some circumstances, the amount of the bond required to stay execution of an adverse judgment pending an appeal in state court. The limitation on the amount of such bonds ranges generally from $1 million to $150 million. In five other states and Puerto Rico, the filing of a notice of appeal automatically stays the judgment of the trial court.

 

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In 2003, the World Health Organization adopted a broad tobacco-control treaty. The treaty recommends and requires enactment of legislation establishing specific actions to prevent youth smoking, restrict and gradually eliminate tobacco products marketing, provide greater regulation and disclosure of ingredients, increase the size and scope of package warning labels to cover at least 30% of each package and include graphic pictures on packages. The treaty entered into force on February 27, 2005 — 90 days after ratification by the 40th country. In February 2006, the first session of the Conference of the Parties, referred to as the COP, occurred. Since then, the COP has met several times and adopted guidelines with respect to various provisions of the tobacco control treaty. Although the U.S. delegate to the World Health Organization voted for the treaty in May 2003, and the Secretary for Health and Human Services signed the document in May 2004, the Bush Administration did not send the treaty to the U.S. Senate for ratification. Ratification by the United States could lead to broader regulation of the industry.

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

Tobacco Buyout Legislation

For information relating to tobacco buyout legislation, see “—Tobacco Buyout Legislation and Related Litigation” in Item 8, note 13 to consolidated financial statements.

Other Contingencies

For information relating to other contingencies of RAI, RJR, RJR Tobacco, American Snuff Co. and SFNTC, see “—Other Contingencies” in Item 8, note 13 to consolidated financial statements.

Off-Balance Sheet Arrangements

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

Cautionary Information Regarding Forward-Looking Statements

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

 

   

the substantial and increasing taxation and regulation of tobacco products, including the regulation of tobacco products by the FDA;

 

   

the possibility that the FDA will issue a regulation prohibiting menthol as a flavor in cigarettes or prohibit mint or wintergreen as a flavor in smokeless tobacco products;

 

   

decreased sales resulting from the future issuance of “corrective communications,” required by the order in the United States v. Phillip Morris USA, Inc., on five subjects, including smoking and health, and addiction;

 

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various legal actions, proceedings and claims relating to the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of tobacco products that are pending or may be instituted against RAI or its subsidiaries;

 

   

the possibility of being required to pay various adverse judgments in the Engle Progeny and/or other litigation;

 

   

the substantial payment obligations with respect to cigarette sales, and the substantial limitations on the advertising and marketing of cigarettes (and of RJR Tobacco’s smoke-free tobacco products) under the State Settlement Agreements;

 

   

the continuing decline in volume in the U.S. cigarette industry and RAI’s dependence on the U.S. cigarette industry;

 

   

concentration of a material amount of sales with a single customer or distributor;

 

   

competition from other manufacturers, including industry consolidations or any new entrants in the marketplace;

 

   

increased promotional activities by competitors, including manufacturers of deep-discount cigarette brands;

 

   

the success or failure of new product innovations and acquisitions;

 

   

the responsiveness of both the trade and consumers to new products, marketing strategies and promotional programs;

 

   

the ability to achieve efficiencies in the businesses of RAI’s operating companies without negatively affecting financial or operating results;

 

   

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

 

   

the cost of tobacco leaf, and other raw materials and other commodities used in products;

 

   

the effect of market conditions on interest rate risk, foreign currency exchange rate risk and the return on corporate cash;

 

   

changes in the financial position or strength of lenders participating in RAI’s credit facility;

 

   

the impairment of goodwill and other intangible assets, including trademarks;

 

   

the effect of market conditions on the performance of pension assets or any adverse effects of any new legislation or regulations changing pension expense accounting or required pension funding levels;

 

   

the substantial amount of RAI debt;

 

   

the credit ratings of RAI;

 

   

any restrictive covenants imposed under RAI’s debt agreements;

 

   

the possibility of natural or man-made disasters or other disruptions that may adversely affect manufacturing or other operations and other facilities;

 

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the significant ownership interest of B&W, RAI’s largest shareholder, in RAI and the rights of B&W under the governance agreement between the companies;

 

   

the expiration of the standstill provisions of the governance agreement on July 30, 2014;

 

   

a termination of the governance agreement or certain provisions of it in accordance with its terms, including the limitations on B&W’s representation on RAI’s Board and its board committees;

 

   

RAI’s shareholder rights plan (which, generally, will expire on July 30, 2014) not applying to BAT except in limited circumstances; and,

 

   

the expiration of the non-competition agreement between RAI and BAT in 2014.

For a further discussion of these and other risks and uncertainties, see Part I, Item 1A. Risk Factors.

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

 

Item 7A.   Quantitative and Qualitative Disclosures about Market Risk

Market risk represents the risk of loss that may impact the consolidated results of operations, cash flows and financial position due to adverse changes in financial market prices and rates. RAI and its subsidiaries are exposed to interest rate risk directly related to their normal investing and funding activities. In addition, RAI and its subsidiaries have immaterial exposure to foreign currency exchange rate risk related primarily to purchases and foreign operations denominated in euros, British pounds, Swiss francs, Swedish krona, Chinese renminbi and Japanese yen. RAI and its subsidiaries have established policies and procedures to manage their exposure to market risks.

The table below provides information, as of December 31, 2012, about RAI’s financial instruments that are sensitive to changes in interest rates. The table presents notional amounts and weighted average interest rates by contractual maturity dates for the years ending December 31:

 

     2013     2014      2015     2016     2017     Thereafter     Total     Fair
Value(1)
 

Investments:

                 

Variable Rate

   $ 2,113      $  —       $      $      $ 63      $      $ 2,176      $ 2,176   

Average Interest Rate

     0.1                           2.4            0.1       

Fixed-Rate

                                       $ 7      $ 7      $ 7   

Average interest rate(2)

                                         4.7     4.7       

Debt:

                 

Fixed-Rate

   $ 60      $       $ 650      $ 775      $ 700      $ 2,800      $ 4,985      $ 5,536   

Average Interest Rate(2)

     9.3             3.0     7.6     6.8     4.8     5.3       

 

(1) 

Fair values are based on current market rates available or on rates available for instruments with similar terms and maturities and quoted fair values.

 

(2)

Based upon coupon interest rates for fixed-rate indebtedness.

RAI’s exposure to foreign currency transactions was not material to results of operations for the year ended December 31, 2012, but may become material in future periods in relation to activity associated with RAI’s international operations. RAI currently has no hedges for its exposure to foreign currency.

 

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Item 8. Financial Statements and Supplementary Data

Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Reynolds American Inc.:

We have audited the accompanying consolidated balance sheets of Reynolds American Inc. and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Reynolds American Inc. and subsidiaries as of December 31, 2012 and 2011, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2012, in conformity with U.S. generally accepted accounting principles.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Reynolds American Inc.’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 12, 2013 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/    KPMG LLP

Greensboro, North Carolina

February 12, 2013

 

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Management’s Report on Internal Control over Financial Reporting

Management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Rule 13a-15(f) of the Securities Exchange Act of 1934. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements in accordance with generally accepted accounting principles and includes those policies and procedures that:

(i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of RAI,

(ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of RAI are being made only in accordance with authorizations of management and directors of RAI, and

(iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of RAI’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements and even when determined to be effective, can only provide reasonable assurance with respect to financial statement preparation and presentation. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies and procedures may deteriorate.

Management conducted an evaluation of the effectiveness of RAI’s internal control over financial reporting based on the framework in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on this evaluation, management concluded that RAI’s system of internal control over financial reporting was effective as of December 31, 2012.

KPMG LLP, independent registered public accounting firm, has audited RAI’s consolidated financial statements and issued an attestation report on RAI’s internal control over financial reporting as of December 31, 2012.

Dated: February 12, 2013

 

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Report of Independent Registered Public Accounting Firm

The Board of Directors and Shareholders

Reynolds American Inc.:

We have audited Reynolds American Inc.’s internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Reynolds American Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.

We conducted our audit 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 effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, Reynolds American Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2012, based on criteria established in Internal Control — Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.

We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Reynolds American Inc. and subsidiaries as of December 31, 2012 and 2011, and the related consolidated statements of income, comprehensive income, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2012, and our report dated February 12, 2013 expressed an unqualified opinion on those consolidated financial statements.

/s/    KPMG LLP

Greensboro, North Carolina

February 12, 2013

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Millions, Except Per Share Amounts)

 

     For the Years Ended
December 31,
 
     2012     2011     2010  

Net sales(1)

   $ 7,962      $ 8,062      $ 8,170   

Net sales, related party

     342        479        381   
  

 

 

   

 

 

   

 

 

 

Net sales

     8,304        8,541        8,551   

Costs and expenses:

      

Cost of products sold(1)

     4,321        4,464        4,544   

Selling, general and administrative expenses

     1,470        1,606        1,480   

Amortization expense

     21        24        25   

Trademark and other intangible asset impairment charges

     129        48        6   

Restructuring charge

     149                 

Asset impairment and exit charges

                   38   

Goodwill impairment charge

                   26   
  

 

 

   

 

 

   

 

 

 

Operating income

     2,214        2,399        2,432   

Interest and debt expense

     234        221        232   

Interest income

     (7     (11     (12

Other expense, net

     34        3        7   
  

 

 

   

 

 

   

 

 

 

Income from continuing operations before income taxes

     1,953        2,186        2,205   

Provision for income taxes

     681        780        868   
  

 

 

   

 

 

   

 

 

 

Income from continuing operations

     1,272        1,406        1,337   

Losses from discontinued operations, net of tax

                   (216
  

 

 

   

 

 

   

 

 

 

Net income

   $ 1,272      $ 1,406      $ 1,121   
  

 

 

   

 

 

   

 

 

 

Basic income per share:

      

Income from continuing operations

   $ 2.25      $ 2.41      $ 2.29   

Losses from discontinued operations

                   (0.37
  

 

 

   

 

 

   

 

 

 

Net income

   $ 2.25      $ 2.41      $ 1.92   
  

 

 

   

 

 

   

 

 

 

Diluted income per share:

      

Income from continuing operations

   $ 2.24      $ 2.40      $ 2.29   

Losses from discontinued operations

                   (0.37
  

 

 

   

 

 

   

 

 

 

Net income

   $ 2.24      $ 2.40      $ 1.92   
  

 

 

   

 

 

   

 

 

 

Dividends declared per share

   $ 2.33      $ 2.15      $ 1.84   
  

 

 

   

 

 

   

 

 

 

 

(1)

Excludes excise taxes of $3,923 million, $4,107 million and $4,340 million for the years ended December 31, 2012, 2011 and 2010, respectively.

See Notes to Consolidated Financial Statements

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Dollars in Millions)

 

     For the Years Ended
December 31,
 
     2012     2011     2010  

Net income

   $ 1,272      $ 1,406      $ 1,121   

Other comprehensive income (loss), net of tax:

      

Retirement benefits, net of tax expense (benefit) (2012 — $45; 2011 — $(95); 2010 — $(102))

     65        (144     (78

Unrealized gain (loss) on long-term investments, net of tax expense (benefit) (2012 — $5; 2011 — $(6); 2010 — $13)

     7        (12     21   

Realized loss on hedging instruments, net of tax benefit (2012 — $9)

     (14              

Cumulative translation adjustment and other, net of tax benefit (2012 — $3;
2011 — $4; 2010 — $10)

     13        (8     (8
  

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 1,343      $ 1,242      $ 1,056   
  

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Millions)

 

    For the Years Ended
December 31,
 
    2012     2011     2010  

Cash flows from (used in) operating activities:

     

Net income

  $ 1,272      $ 1,406      $ 1,121   

Losses from discontinued operations, net of tax

                  216   

Adjustments to reconcile to net cash flows from (used in) continuing operating activities:

     

Depreciation and amortization

    131        138        151   

Asset impairment and exit charges, net of cash payments

                  37   

Restructuring charge, net of cash payments

    109        (35     (51

Trademark and other intangible asset impairment charges

    129        48        6   

Goodwill impairment charge

                  26   

Loss on early extinguishment of debt

    21                 

Deferred income tax expense (benefit)

    (44     100        187   

Other changes that provided (used) cash:

     

Accounts and other receivables

    11        12        (3

Inventories

    (17     88        164   

Related party, net

    5        (32     45   

Accounts payable

    74        (66     (17

Accrued liabilities, including income taxes and other working capital

    (174     10        (64

Litigation bonds

    31        (35     (21

Tobacco settlement

    (40     (58     (22

Pension and postretirement

    129        (165     (715

Other, net

    (69     9        205   
 

 

 

   

 

 

   

 

 

 

Net cash flows from operating activities

    1,568        1,420        1,265   
 

 

 

   

 

 

   

 

 

 

Cash flows from (used in) investing activities:

     

Capital expenditures

    (88     (190     (174

Proceeds from termination of joint venture

    30        32        28   

Net proceeds from sale of business

           202          

Other, net

    4        16        20   
 

 

 

   

 

 

   

 

 

 

Net cash flows from (used in) investing activities

    (54     60        (126
 

 

 

   

 

 

   

 

 

 

Cash flows from (used in) financing activities:

     

Dividends paid on common stock

    (1,307     (1,212     (1,049

Repurchase of common stock

    (1,101     (282     (5

Excess tax benefit on stock-based compensation plans

    39        1        2   

Principal borrowings under term loan credit facility

    750                 

Repayments of term loan credit facility

    (750              

Proceeds from issuance of long-term debt, net of issuance costs

    2,539                 

Repayments of long-term debt

    (1,076     (400     (300

Debt issuance costs

    (22     (7       

Payment to settle forward starting interest rate contracts

    (23              

Proceeds from termination of interest rate swaps

           186          

Other, net

    (20            3   
 

 

 

   

 

 

   

 

 

 

Net cash flows used in financing activities

    (971     (1,714     (1,349
 

 

 

   

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

    3        (5     (11
 

 

 

   

 

 

   

 

 

 

Net cash flow related to discontinued operations, net of tax benefit

                  (307
 

 

 

   

 

 

   

 

 

 

Net change in cash and cash equivalents

    546        (239     (528

Cash and cash equivalents at beginning of year

    1,956        2,195        2,723   
 

 

 

   

 

 

   

 

 

 

Cash and cash equivalents at end of year

  $ 2,502      $ 1,956      $ 2,195   
 

 

 

   

 

 

   

 

 

 

Income taxes paid, net of refunds

  $ 785      $ 694      $ 573   

Interest paid, net of capitalized interest (2011 — $3; 2010 — $3)

  $ 249      $ 232      $ 231   

See Notes to Consolidated Financial Statements

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in Millions)

 

     December 31,  
     2012     2011  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 2,502      $ 1,956   

Accounts receivable

     87        101   

Accounts receivable, related party

     61        67   

Notes receivable

     35        33   

Other receivables

     16        13   

Inventories

     984        967   

Deferred income taxes, net

     908        945   

Prepaid expenses and other

     219        225   
  

 

 

   

 

 

 

Total current assets

     4,812        4,307   

Property, plant and equipment, at cost:

    

Land and land improvements

     93        91   

Buildings and leasehold improvements

     758        748   

Machinery and equipment

     1,758        1,756   

Construction-in-process

     46        90   
  

 

 

   

 

 

 

Total property, plant and equipment

     2,655        2,685   

Less accumulated depreciation

     1,618        1,615   
  

 

 

   

 

 

 

Property, plant and equipment, net

     1,037        1,070   

Trademarks and other intangible assets, net of accumulated amortization (2012 — $717; 2011 — $696)

     2,455        2,602   

Goodwill

     8,011        8,010   

Other assets and deferred charges

     242        265   
  

 

 

   

 

 

 
   $ 16,557      $ 16,254   
  

 

 

   

 

 

 

Liabilities and shareholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 187      $ 113   

Tobacco settlement accruals

     2,489        2,530   

Due to related party

     1        2   

Deferred revenue, related party

     42        42   

Current maturities of long-term debt

     60        457   

Other current liabilities

     990        1,132   
  

 

 

   

 

 

 

Total current liabilities

     3,769        4,276   

Long-term debt (less current maturities)

     5,035        3,206   

Deferred income taxes, net

     461        511   

Long-term retirement benefits (less current portion)

     1,821        1,759   

Other noncurrent liabilities

     214        251   

Commitments and contingencies:

    

Shareholders’ equity:

    

Common stock (shares issued: 2012 — 552,940,767; 2011 — 576,135,199)

              

Paid-in capital

     7,275        8,293   

Accumulated deficit

     (1,707     (1,660

Accumulated other comprehensive loss — (Defined benefit pension and postretirement plans: 2012 — $(265) and 2011 — $(330), net of tax)

     (311     (382
  

 

 

   

 

 

 

Total shareholders’ equity

     5,257        6,251   
  

 

 

   

 

 

 
   $ 16,557      $ 16,254   
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY

(Dollars in Millions, Except Per Share Amounts)

 

     Common
Stock
     Paid-In
Capital
    Accumulated
Deficit
    Accumulated
Other
Comprehensive
Loss
    Total
Shareholders’
Equity
 

Balance at December 31, 2009

   $       $ 8,498      $ (1,847   $ (153   $ 6,498   

Net income

                    1,121               1,121   

Retirement benefits, net of $102 tax benefit

                           (78     (78

Unrealized gain on investments, net of $13 tax expense

                           21        21   

Cumulative translation adjustment and other, net of $10 tax benefit

                           (8     (8

Dividends — $1.84 per share

                    (1,081            (1,081

Equity incentive award plan and stock-based compensation

             40                      40   

Common stock repurchased

             (5                   (5

Excess tax benefit on stock-based compensation plans

             2                      2   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2010

             8,535        (1,807     (218     6,510   

Net income

                    1,406               1,406   

Retirement benefits, net of $95 tax benefit

                           (144     (144

Unrealized loss on investments, net of $6 tax benefit

                           (12     (12

Cumulative translation adjustment and other, net of $4 tax benefit

                           (8     (8

Dividends — $2.15 per share

                    (1,259            (1,259

Equity incentive award plan and stock-based compensation

             39                      39   

Common stock repurchased

             (282                   (282

Excess tax benefit on stock-based compensation plans

             1                      1   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2011

             8,293        (1,660     (382     6,251   

Net income

                    1,272               1,272   

Retirement benefits, net of $45 tax expense

                           65        65   

Unrealized gain on investments, net of $5 tax expense

                           7        7   

Realized loss on hedging instruments, net of $9 tax benefit

                           (14     (14

Cumulative translation adjustment and other, net of $3 tax benefit

                           13        13   

Dividends — $2.33 per share

                    (1,319            (1,319

Equity incentive award plan and stock-based compensation

             44                      44   

Common stock repurchased

             (1,101                   (1,101

Excess tax benefit on stock-based compensation plans

             39                      39   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2012

   $       $ 7,275      $ (1,707   $ (311   $ 5,257   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Business and Summary of Significant Accounting Policies

Overview

The consolidated financial statements include the accounts of Reynolds American Inc., referred to as RAI, and its wholly owned subsidiaries. RAI’s wholly owned operating subsidiaries include R. J. Reynolds Tobacco Company; American Snuff Company, LLC, referred to as American Snuff Co.; Santa Fe Natural Tobacco Company, Inc., referred to as SFNTC; and Niconovum AB.

RAI was incorporated as a holding company in the state of North Carolina on January 5, 2004, and its common stock is listed on the NYSE under the symbol “RAI.” On July 30, 2004, the U.S. assets, liabilities and operations of Brown & Williamson Tobacco Corporation, now known as Brown & Williamson Holdings, Inc., referred to as B&W, an indirect, wholly owned subsidiary of British American Tobacco p.l.c., referred to as BAT, were combined with R. J. Reynolds Tobacco Company, a wholly owned operating subsidiary of R.J. Reynolds Tobacco Holdings, Inc., referred to as RJR. These July 30, 2004, transactions generally are referred to as the B&W business combination.

References to RJR Tobacco prior to July 30, 2004, relate to R. J. Reynolds Tobacco Company, a New Jersey corporation and a wholly owned subsidiary of RJR. References to RJR Tobacco on and subsequent to July 30, 2004, relate to the combined U.S. assets, liabilities and operations of B&W and R. J. Reynolds Tobacco Company, a North Carolina corporation.

RAI’s reportable operating segments are RJR Tobacco, American Snuff and Santa Fe. The RJR Tobacco segment consists of the primary operations of R. J. Reynolds Tobacco Company. The American Snuff segment consists of the primary operations of American Snuff Co. and, prior to its sale, Lane, Limited, referred to as Lane. The Santa Fe segment consists of the primary operations of SFNTC. Niconovum AB, a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name, among other RAI subsidiaries, is included in All Other. The segments were identified based on how RAI’s chief operating decision maker allocates resources and assesses performance. Certain of RAI’s operating subsidiaries have entered into intercompany agreements for products or services with other subsidiaries. As a result, certain activities of an operating subsidiary may be included in a different segment of RAI.

As a result of the B&W business combination, Lane became a wholly owned subsidiary of RAI. On February 28, 2011, RAI completed the sale of all of the capital stock of Lane and certain other assets related to the Lane operations, to an affiliate of Scandinavian Tobacco Group A/S, referred to as STG, for net proceeds of $202 million in cash. The results of operations of the disposal group were included through February 28, 2011, in income from continuing operations in the American Snuff segment.

RAI’s operating subsidiaries primarily conduct their business in the United States.

Basis of Presentation

The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, referred to as GAAP, requires estimates and assumptions to be made that affect the reported amounts in the consolidated financial statements and accompanying notes. Volatile credit and equity markets, changes to regulatory and legal environments, and consumer spending may affect the uncertainty inherent in such estimates and assumptions. Actual results could differ from those estimates. Certain reclassifications were made to conform prior years’ financial statements to the current presentation.

All dollar amounts, other than per share amounts, are presented in millions, except for amounts set forth in note 13 and as otherwise noted.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Cash and Cash Equivalents

Cash balances are recorded net of book overdrafts when a bank right-of-offset exists. All other book overdrafts are recorded in accounts payable. Cash equivalents may include money market funds, commercial paper and time deposits in major institutions to minimize investment risk. As short-term, highly liquid investments readily convertible to known amounts of cash, with remaining maturities of three months or less at the time of purchase, cash equivalents have carrying values that approximate fair values.

Fair Value Measurement

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

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

The levels of the fair value hierarchy are:

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

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

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

Investments

Marketable securities are classified as available-for-sale and are carried at fair value. RAI reviews these investments on a quarterly basis to determine if it is probable that RAI will realize some portion of the unrealized loss and to determine the classification of the impairment as temporary or other-than-temporary. For those securities that RAI does not intend to sell and it is more likely than not that RAI will not be required to sell the securities prior to recovery, RAI recognizes the credit loss component of an other-than-temporary impairment in earnings, and recognizes the noncredit component in accumulated other comprehensive loss. All losses deemed to be other than temporarily impaired are recorded in earnings.

Inventories

Inventories are stated at the lower of cost or market. The cost of tobacco inventories is determined principally under the last-in, first-out, or LIFO, method and is calculated at the end of each year. The cost of work in process and finished goods includes materials, direct labor, variable costs and overhead and full absorption of fixed manufacturing overhead. Stocks of tobacco, which have an operating cycle that exceeds 12 months due to aging requirements, are classified as current assets, consistent with recognized industry practice.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Long-lived Assets

Long-lived assets, such as property, plant and equipment, trademarks and other intangible assets with finite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the book value of the asset may not be recoverable. Impairment of the carrying value of long-lived assets would be indicated if the best estimate of future undiscounted cash flows expected to be generated by the asset grouping is less than its carrying value. If an impairment is indicated, any loss is measured as the difference between estimated fair value and carrying value and is recognized in operating income.

Property, Plant and Equipment

Property, plant and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Useful lives range from 20 to 50 years for buildings and improvements, and from 3 to 30 years for machinery and equipment. The cost and related accumulated depreciation of assets sold or retired are removed from the accounts and the gain or loss on disposition is recognized in operating income.

Intangible Assets

Intangible assets include goodwill, trademarks and other intangible assets and are capitalized when acquired. The determination of fair value involves considerable estimates and judgment. In particular, the fair value of a reporting unit involves, among other things, developing forecasts of future cash flows, determining an appropriate discount rate, and when goodwill impairment is implied, determining the fair value of individual assets and liabilities, including unrecorded intangibles. Although RAI believes it has based its impairment testing and impairment charges on reasonable estimates and assumptions, the use of different estimates and assumptions could result in materially different results. Generally, if the current competitive or regulatory environment worsens or RAI’s operating companies’ strategic initiatives adversely affect their financial performance, the fair value of goodwill, trademarks and other intangible assets could be impaired in future periods. Trademarks and other intangible assets with indefinite lives are not amortized, but are tested for impairment annually, in the fourth quarter, and more frequently if events and circumstances indicate that the asset might be impaired.

Accounting for Derivative Instruments and Hedging Activities

RAI measures any derivative instruments, including certain derivative instruments embedded in other contracts, at fair value and records them in the balance sheet as either an asset or liability. Changes in fair value of derivatives are recorded in earnings unless hedge accounting criteria are met. For derivatives designated as fair value hedges, the changes in fair value of both the derivative instrument and the hedged item are recorded in earnings. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in accumulated other comprehensive loss. The ineffective portions of hedges are recognized in earnings in the current period.

RAI formally assesses at inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item, and formally designates as a hedge those derivatives that qualify for hedge accounting. If it is determined that a derivative is not highly effective as a hedge or if a derivative ceases to be a highly effective hedge, RAI will discontinue hedge accounting prospectively. Any unrecognized gain or loss will be deferred and recognized into income as the formerly hedged item is recognized in earnings. At December 31, 2012 and 2011, RAI had no derivative instruments.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Software Costs

Computer software and software development costs incurred in connection with developing or obtaining computer software for internal use that has an extended useful life are capitalized. These costs are amortized over their estimated useful life, which is typically five years or less. During 2012 and 2011, software costs of $12 million and $24 million, respectively, were capitalized or included in construction-in-process. At each of December 31, 2012 and 2011, the unamortized balance was $55 million and $64 million, respectively. Software amortization expense was $21 million, $24 million and $30 million for the years ended December 31, 2012, 2011 and 2010, respectively.

Revenue Recognition

Revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. These criteria are generally met when title and risk of loss pass to the customer. Payments received in advance of shipments are deferred and recorded in other accrued liabilities until shipment occurs. Certain sales of leaf to a related party, considered as bill-and-hold for accounting purposes, are recorded as deferred revenue when all of the above revenue recognition criteria are met except delivery, postponed at the customer’s request. Revenue is subsequently recognized upon delivery. The revenues recorded are presented net of excise tax collected on behalf of government authorities.

Shipping and handling costs are classified as cost of products sold. Net sales include certain sales incentives, including retail discounting, promotional allowances and coupons.

Cost of Products Sold

Cost of products sold includes the expenses for the Master Settlement Agreement, referred to as the MSA, and other settlement agreements with the states of Mississippi, Florida, Texas and Minnesota, which together with the MSA are collectively referred to as the State Settlement Agreements; the federal tobacco quota buyout; and the user fees charged by the U.S. Food and Drug Administration, referred to as the FDA; which were as follows for the years ended December 31:

 

     2012      2011      2010  

State Settlement Agreements

   $ 2,370       $ 2,435       $ 2,496   

Federal tobacco quota buyout

     218         229         243   

FDA user fees

     122         120         75   

Advertising

Advertising costs, which are expensed as incurred, were $72 million, $65 million and $72 million for the years ended December 31, 2012, 2011 and 2010, respectively.

Research and Development

Research and development costs, which are expensed as incurred, were $62 million, $69 million and $71 million for the years ended December 31, 2012, 2011 and 2010, respectively.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Income Taxes

Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Interest and penalties related to uncertain tax positions are accounted for as tax expense. Federal income taxes for RAI and its subsidiaries are calculated on a consolidated basis. State income taxes for RAI and its subsidiaries are primarily calculated on a separate return basis.

RAI accounts for uncertain tax positions which require that a position taken or expected to be taken in a tax return be recognized in the financial statements when it is more likely than not (a likelihood of more than 50%) that the position would be sustained upon examination by tax authorities. A recognized tax position is then measured at the largest amount of benefit that is greater than 50% likely of being realized upon ultimate settlement.

Stock-Based Compensation

Stock-based compensation expense is recognized for all forms of share-based payment awards, including shares issued to employees under restricted stock units.

Litigation Contingencies

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

Pension and Postretirement

Pension and postretirement benefits require balance sheet recognition of the net asset or liability for the overfunded or underfunded status of defined benefit pension and other postretirement benefit plans, on a plan-by-plan basis, and recognition of changes in the funded status in the year in which the changes occur.

Actuarial gains or losses are annual changes in the amount of either the benefit obligation or the fair value of plan assets resulting from experience different from that assumed or from changes in assumptions. Differences between actual results and actuarial assumptions are accumulated and recognized in the year in which they occur as a mark-to-market adjustment, referred to as an MTM adjustment, to the extent such net gains and losses are in excess of 10% of the greater of the fair value of plan assets or the plan’s projected benefit obligation, referred to as the corridor. Actuarial gains and losses outside the corridor are recognized annually as of December 31 or when the plans are remeasured during an interim period.

Prior service costs of pension expense, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Prior service costs of postretirement benefits, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the expected service period to full eligibility age for active employees, or average remaining life expectancies for inactive employees if most of the plan obligations are due to inactive employees.

Recently Adopted Accounting Pronouncements

In May 2011, the Financial Accounting Standards Board, referred to as FASB, amended certain accounting and disclosure requirements related to fair value measurements. For fair value measurements categorized as Level 1 and Level 2, requirements have been expanded to include disclosures of transfers between these levels. For fair value measurements categorized as Level 3, a reporting entity should disclose quantitative information of the unobservable inputs and assumptions, a description of the valuation processes and a qualitative discussion about the sensitivity of the fair value measurement to changes in unobservable inputs. The guidance was effective for RAI for interim and annual reporting periods beginning January 1, 2012, and its adoption did not have a material impact on RAI’s results of operations, cash flows or financial position.

In June 2011, the FASB issued amended guidance which requires comprehensive income to be reported in either a single statement or in two consecutive statements reporting net income and other comprehensive income. The amendment eliminates the option to report other comprehensive income and its components in the statement of changes in shareholders’ equity. The guidance was effective for fiscal years, and interim periods within those years, beginning January 1, 2012. In December 2011, the FASB deferred the changes related to the presentation of reclassification adjustments. The adoption of the amendment had no impact on RAI’s results of operations, cash flows or financial position.

In September 2011, the FASB issued amended guidance that permits an entity to make a qualitative assessment of whether it is more likely than not that a reporting unit’s fair value is less than its carrying amount before applying the current two-step goodwill impairment test. If an entity concludes that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, it would not be required to perform the two-step impairment test for that reporting unit. The guidance was effective for RAI for interim and annual reporting periods beginning January 1, 2012, and its adoption had no impact on RAI’s results of operations, cash flows or financial position.

Recently Issued Accounting Pronouncements

In July 2012, the FASB issued amended guidance that permits an entity to make a qualitative assessment to determine whether it is more likely than not that an indefinite-lived intangible asset, other than goodwill, is impaired. If an entity concludes that it is not more likely than not that the fair value of an indefinite-lived intangible asset is less than its carrying amount, it is not required to perform the quantitative impairment test for that asset. The FASB issued similar guidance for testing goodwill for impairment in September 2011. The guidance is effective for RAI for annual and interim periods beginning after January 1, 2013, and will have no impact on RAI’s results of operations, cash flows or financial position.

 

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

 

Note 2 — Fair Value Measurement

Fair Value of Financial Assets

Financial assets carried at fair value as of December 31, 2012, were as follows:

 

     Level 1      Level 2      Level 3      Total  

Cash and cash equivalents:

           

Cash equivalents

   $ 2,100       $       $       $ 2,100   

Other assets and deferred charges:

           

Auction rate securities

                     70         70   

Mortgage-backed security

                     13         13   

Marketable equity security

     4                         4