10-K 1 d627677d10k.htm 10-K 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, 2013

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 28, 2013, was approximately $15 billion, based on the closing price of $48.37. Directors, executive officers and a significant shareholder of Reynolds American Inc. are considered affiliates for purposes of this calculation, but should not necessarily be deemed affiliates for any other purpose.

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: January 29, 2014: 536,947,152 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 21, 2014, are incorporated by reference into Part III of this report.

 

 

 


Table of Contents

INDEX

 

PART I

    

Item 1.

  Business      2   

Item 1A.

  Risk Factors      15   

Item 1B.

  Unresolved Staff Comments      28   

Item 2.

  Properties      28   

Item 3.

  Legal Proceedings      29   

Item 4.

  Mine Safety Disclosures      29   

PART II

    

Item 5.

  Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities      30   

Item 6.

  Selected Financial Data      32   

Item 7.

  Management’s Discussion and Analysis of Financial Condition and Results of Operations      33   

Item 7A.

  Quantitative and Qualitative Disclosures about Market Risk      69   

Item 8.

  Financial Statements and Supplementary Data      71   

Item 9.

  Changes in and Disagreements With Accountants on Accounting and Financial Disclosure      174   

Item 9A.

  Controls and Procedures      174   

Item 9B.

  Other Information      174   

PART III

    

Item 10.

  Directors, Executive Officers and Corporate Governance      175   

Item 11.

  Executive Compensation      175   

Item 12.

  Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters      175   

Item 13.

  Certain Relationships and Related Transactions, and Director Independence      175   

Item 14.

  Principal Accountant Fees and Services      175   

PART IV

    

Item 15.

  Exhibits, Financial Statement Schedules      176   
Signatures      183   

 

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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 leading super-premium cigarette brand, Santa Fe Natural Tobacco Company, Inc., referred to as SFNTC; Niconovum AB and Niconovum USA, Inc., marketers of nicotine replacement therapy products in Sweden and the United States, respectively; and R. J. Reynolds Vapor Company, referred to as RJR Vapor, a manufacturer and distributor of digital vapor cigarettes in the United States. 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, Niconovum USA, Inc. and RJR Vapor, among other RAI subsidiaries, are 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 15 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.

 

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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 transformation strategy includes growing the core cigarette business, moist-snuff business and focusing on innovation, while maintaining efficient and effective operations.

To achieve its strategy, RAI encourages the migration of adult smokers to smoke-free tobacco products and other products, which it believes 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, heat-not-burn cigarettes, digital vapor cigarettes 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 two of the best-selling cigarettes in the United States: CAMEL and PALL MALL. These brands, and its other brands, including WINSTON, KOOL, DORAL, SALEM, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. RJR Tobacco also manages contract manufacturing of cigarettes and tobacco products through arrangements with BAT affiliates, and manages the export of tobacco products to certain U.S. territories, U.S. duty-free shops and U.S. overseas military bases. RJR Tobacco manages the super-premium cigarette brands, DUNHILL and STATE EXPRESS 555, which are licensed from BAT.

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 4.6% in 2013, to 273.3 billion cigarettes, 2.3% in 2012 and 3.5% in 2011. 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 provide 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. Accordingly, these manufacturers do not have cost structures burdened with payments related to State Settlement Agreements to the same extent as the original participating manufacturers. For further discussion of the State Settlement

 

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Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 11 to consolidated financial statements.

Based on data collected by SymphonyIRI Group, Inc. and Capstone Research Inc., collectively referred to as IRI/Capstone, and processed and managed by MSAi, during 2013 and 2012, RJR Tobacco had an overall retail share of the U.S. cigarette market of 26.0% and 26.5%, respectively. During these same years, Philip Morris USA Inc. had an overall retail share of the U.S. cigarette market of 49.7% and 49.3%, respectively.

Domestic industry shipment volume, and retail share of market data that appear in this document have been obtained from MSAi and IRI/Capstone, respectively. These 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 methodology that does not track all volume and trade channels. Accordingly, the retail share of the U.S. cigarette market of RJR Tobacco and its brands as reported by IRI/Capstone may overstate or understate their actual market share. Moreover, you should be aware that in a product market experiencing overall declining consumption, like the U.S. cigarette market, 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.

Competition is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence, as well as finding efficient and effective means of balancing market share and profit growth. 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 continues to be intense and includes product innovation and expansion into smoke-free tobacco categories.

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 the largest traditional 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

 

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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. Consistent with that strategy, RJR Tobacco continues to evaluate for potential elimination some of its non-core cigarette styles as well as private-label cigarette brands. CAMEL Snus is also focused on long-term growth.

Anti-tobacco groups continue to attempt 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. 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%, 4% and 6% of RAI’s total net sales in 2013, 2012 and 2011, 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.

 

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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 Lane and certain other assets related to the Lane operations to STG.

American Snuff offers a range of differentiated smokeless tobacco products to adult tobacco consumers, primarily moist snuff. 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 retail volumes grew approximately 5% in each of 2013, 2012 and 2011. 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 88%, 86% and 83% of American Snuff’s revenue in 2013, 2012 and 2011, respectively.

Competition

American Snuff is dependent on the U.S. smokeless tobacco products market and competes in the U.S. smokeless tobacco products market with other domestic and international companies. 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. 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.

American Snuff’s retail share of the U.S. moist snuff market, according to data processed by IRI/Capstone, was 33.2% and 32.4% in 2013 and 2012, respectively. GRIZZLY moist snuff had a market share of 30.1% and 29.0% in 2013 and 2012, respectively. American Snuff’s largest competitor is U.S. Smokeless Tobacco Company LLC, referred to as USSTC, which had approximately 55.6% and 55.8% of the U.S. moist snuff market share in 2013 and 2012, respectively.

Marketing

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

American Snuff’s brand portfolio strategy consists of the investment brand, GRIZZLY, the leading moist snuff brand in the United States, and non-support brands that consist of 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 are the fastest growing segment in the moist

 

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snuff category and represented approximately 16% of the total U.S. moist snuff market as of December 31, 2013. During 2013, demand for pouches continued to grow at more than double the overall category rate.

Manufacturing and Distribution

American Snuff owns its manufacturing facilities located in Memphis, Tennessee; Clarksville, Tennessee; and Winston-Salem, North Carolina. In 2012 and 2011, American Snuff completed capacity upgrade and expansion projects at newly acquired sites in Memphis, Tennessee and Clarksville, Tennessee. 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.

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.

Competition

Santa Fe competes in the U.S. cigarette market with its NATURAL AMERICAN SPIRIT brand, which is the leading super-premium cigarette brand. It is priced higher than most other competitive brands, and is differentiated from key competitors through its use of all natural, additive-free tobacco, including styles made with organic 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.

Santa Fe is the leader in the super-premium cigarette category. Based upon data collected by IRI/Capstone, during 2013 and 2012, Santa Fe had an overall retail share of the U.S. cigarette market of 1.4% and 1.2%, 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 in 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 other tobacco products. Santa Fe uses direct mailings and other means to market its brand and enhance its appeal among age-verified adults who use tobacco products. Santa Fe advertises and promotes at retail locations and in adult venues and also uses print advertising in consumer magazines and other publications in the United States, where permitted.

 

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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.

In its production of tobacco products, Santa Fe relies on sustainable resources, such as purchasing electricity generated from renewable sources, including wind power, and operates a zero waste-to-landfill manufacturing facility.

All Other

RAI’s subsidiary, Niconovum AB, is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name. RAI’s subsidiary, Niconovum USA, Inc. has entered into its first lead market in Iowa with ZONNIC, a nicotine replacement therapy gum, and recently introduced two new styles of ZONNIC into the lead market. Another RAI subsidiary, RJR Vapor, expanded the distribution of VUSE digital vapor cigarettes to retail outlets throughout Colorado in the third quarter of 2013. RJR Vapor is expanding VUSE into Utah in the first quarter of 2014, and a national expansion is planned for VUSE during 2014. VUSE’s innovative digital technology is designed to deliver a consistent flavor and vapor experience.

Consolidated RAI

Customers

The largest customer of RJR Tobacco, American Snuff and Santa Fe is McLane Company, Inc. referred to as McLane. Sales to McLane, a distributor, constituted approximately 31% of RAI’s consolidated revenue in each of 2013 and 2012, and 27% in 2011. RJR Tobacco, American Snuff and Santa Fe sales to Core-Mark International, Inc., referred to as Core-Mark, a distributor, represented approximately 11% of RAI’s consolidated revenue in 2013 and 10% of RAI’s consolidated revenue in 2012. 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 and Core-Mark are not governed by any written supply contract. RJR Tobacco, American Snuff and Santa Fe believe that their relationships with McLane and Core-Mark are good. No significant backlog of orders existed at RJR Tobacco, American Snuff or Santa Fe as of December 31, 2013 or 2012.

Sales to Foreign Countries

RAI’s operating subsidiaries’ sales to foreign countries, primarily to BAT affiliates, for the years ended December 31, 2013, 2012 and 2011 were $497 million, $494 million and $613 million, respectively.

Raw Materials

In 2004, legislation was passed eliminating the U.S. government’s tobacco production controls and price support program. The buyout is funded by a direct quarterly assessment on every tobacco product manufacturer and importer, on a market-share basis measured on volume to which federal excise tax is applied. The aggregate

 

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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. For additional information see “— Tobacco Buyout Legislation” in Item 8, note 11 to consolidated financial statements.

Research and Development

The research and development activities of RAI’s operating subsidiaries are primarily conducted at RJR Tobacco’s facility in Winston-Salem through various service agreements. 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 regulations and approval processes.

RAI’s operating subsidiaries’ research and development expense for the years ended December 31, 2013, 2012 and 2011, was $72 million, $62 million and $69 million, respectively.

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. 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;

 

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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 by mail or 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 effect on the sale of tobacco products. 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 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, 2013, RJR Tobacco had paid approximately $114 million since January 1, 2011, related to unfavorable smoking and health litigation judgments and $139 million related to an unfavorable 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. As of December 31, 2013 RJR Tobacco has been served in 5,131 of these cases on behalf of approximately 6,323 plaintiffs. The Engle Progeny cases have resulted and will continue to result in increased litigation and trial activity and increased product liability defense costs. Outstanding jury verdicts in favor of the Engle Progeny plaintiffs have been entered against RJR Tobacco in the amount of $111,459,200 in compensatory damages (as adjusted) and in the amount of $120,965,000 in punitive damages, for a total of $232,424,200. All of these verdicts are in various stages in the appellate process. An accrual of $11 million has been recorded in RAI’s consolidated balance sheet as of December 31, 2013 for nine Engle Progeny cases — Jimmie Lee Brown, Sherman, Koballa, Ward, Duke, Walker, Hiott, Kirkland and Sury. This amount includes $5.4 million for compensatory and punitive damages and $5.6 million for attorneys’ fees and statutory interest through December 31, 2013. During the fourth quarter of 2013, a payment of $305,000 was made in satisfaction of the adverse judgment in the Douglas case. Finally, payment in Ward, of $2.4 million was made on January 31, 2014. 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 11 to consolidated financial statements.

Also, during the fourth quarter of 2013, $10 million was accrued for estimated costs of the corrective communications in connection with the U.S. Department of Justice case. For additional information, see “— Health-Care Cost Recovery Cases — U.S. Department of Justice Case” in Item 8, note 11 to consolidated financial statements.

 

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In addition, the consolidated action, In re: Tobacco Litigation Individual Personal Injury Cases, is pending in West Virginia, against both RJR Tobacco and B&W. On April 15, 2013, the Phase I jury trial began and ended with a virtually complete defense verdict on May 15, 2013. The only claim remaining after the verdict was the jury’s finding that all ventilated filter cigarettes manufactured and sold between 1964 and July 1, 1969, were defective for a failure to instruct. The court entered judgment in October 2013, dismissing all claims lost by the plaintiffs and purporting to make those claims and all of the jury rulings immediately subject to appeal. The plaintiffs filed a notice of appeal to the West Virginia Supreme Court of Appeals in November 2013, with briefing expected to occur during the first quarter of 2014. The defendants did not file a notice of appeal on the ventilated filter finding, but retained the right to file a cross appeal on that issue in response to the plaintiff’s initial brief. For additional information, see “— Litigation Affecting the Cigarette Industry — West Virginia IPIC” in Item 8, note 11 to consolidated financial statements.

RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claims against RJR Tobacco or its affiliates or indemnitees, or the loss of any particular case concerning the use of smokeless tobacco products against American Snuff Co., when viewed on an individual case-by-case basis, is not probable or estimable, except for the nine Engle Progeny cases noted above, as described in “— Litigation Affecting the Cigarette Industry – Overview” in Item 8, note 11 to consolidated financial statements. 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 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 11 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 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 11 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 other participating manufacturers, referred to as the PMs, under the MSA are involved in an arbitration with certain of the settling states with respect to the availability of a downward adjustment to the annual MSA settlement payment obligation, referred to as the NPM Adjustment, for market year 2003. RJR Tobacco disputed a total of $4.7 billion for the years 2003 through 2012.

In November 2012, RJR Tobacco, certain other PMs and certain settling states entered into a term sheet, referred to as the Term Sheet, that sets forth the terms on which accrued and potential NPM Adjustment claims for 2003 through 2014 could be resolved. The Term Sheet also sets forth a restructured NPM Adjustment process to be applied on a going-forward basis, starting with the 2013 volume year. Based on the jurisdictions that signed the Term Sheet and are bound by its terms, RJR Tobacco and SFNTC will receive credits, collectively, currently estimated to total approximately $1.1 billion, with respect to their NPM Adjustment claims for the period from 2003 to 2012. The expenses for the MSA were reduced by $483 million for the year ended December 31, 2013.

 

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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; Adjustments” in Item 8, note 11 to consolidated financial statements.

Employees

At December 31, 2013, RAI and its subsidiaries had approximately 5,200 full-time employees and approximately 90 part-time employees. The 5,200 full-time employees include approximately 3,700 RJR Tobacco employees, 550 American Snuff employees and 350 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, 48, 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, 63, 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 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, 53, 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.

 

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Robert H. Dunham. Mr. Dunham, 47, has been Executive Vice President — Public Affairs and Chief Communication Officer for RAI, RJR Tobacco, RAISC and RJR Vapor since February 2014. Previously, Mr. Dunham served as Executive Vice President – Public Affairs for RAI, RJR Tobacco and RAISC from August 2011 to February 2014. 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 Novant Health Foundation — Forsyth Medical Center.

Daniel A. Fawley. Mr. Fawley, 56, 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, 55, 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, Reynolda House Museum of American Art and the Arts Council Endowment Fund, Inc. and the board of directors of Downtown Winston-Salem Partnership Inc.

Jeffery S. Gentry, PhD. Dr. Gentry, 56, 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 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, 41, 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. He also serves on the boards of directors for the Piedmont Triad Partnership and the Winston-Salem Alliance.

Martin L. Holton III. Mr. Holton, 56, 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

 

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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, 45, 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, 50, 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, 56, 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 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:

Stephanie Cordisco. Ms. Cordisco, 36, has served as President of RJR Vapor since September 2012. Previously she served as Senior Director Consumer Marketing for RJR Tobacco from April 2012 to September 2012. Prior to that time, she held various marketing positions since joining RJR Tobacco in August 2005. She currently serves on the board of trustees for the Greensboro Montessori School.

Mike Little. Mr. Little, 54, 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.

Tommy J. Payne. Mr. Payne, 56, 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, 55, 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.

 

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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 and in other documents filed with the SEC.

Adverse litigation outcomes could have an adverse effect on the results of operations, cash flows and financial position of RAI. Additionally, RAI’s operating subsidiaries could be subject to substantial liabilities and bonding difficulties from litigation related to cigarette products or smokeless tobacco products, which could also have an adverse effect on their results of operations, cash flows and financial position.

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, failure to warn, fraud, misrepresentation, unfair trade practices, conspiracy, medical monitoring 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 its ability to pay the judgment or obtain any 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. The decision preserved several of the Engle jury findings for use in adjudicating these subsequent individual actions, which are now known as Engle Progeny cases. As of December 31, 2013, RJR Tobacco had been served in 5,131 Engle Progeny cases filed on behalf of approximately 6,323 plaintiffs. Many of these cases are in active discovery or nearing trial. In all Engle Progeny cases tried to date, a central issue has been the proper use of the preserved Engle findings. RJR Tobacco has argued that use of the Engle findings to establish individual elements of claims (such as defect, negligence and concealment) is a violation of federal due process. In 2013, both the Florida Supreme Court and the U.S. Court of Appeals for the Eleventh Circuit rejected that argument.

The Engle Progeny cases have resulted in increased litigation and trial activity, including an increased number of adverse verdicts, and increased expenses. To date, RJR Tobacco had paid $20,708,000 in compensatory damages and $62,380,000 in punitive damages, for a total of $83,088,000 in these cases. In addition, outstanding jury verdicts in favor of the Engle Progeny plaintiffs had been entered against RJR Tobacco in the amount of $111,459,200 in compensatory damages (as adjusted) and in the amount of $120,965,000 in punitive damages, for a total of $232,424,200. All of these verdicts are in various stages in the appellate process. Although RJR Tobacco cannot currently predict when or how much it may be required to pay, RJR Tobacco will likely be required to pay additional judgments as the litigation proceeds. For a more complete

 

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description of this litigation, see “— Litigation Affecting the Cigarette Industry — Engle and Engle Progeny Cases” in Item 8, note 11 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. On April 15, 2013, the Phase I jury trial began and ended with a virtually complete defense verdict on May 15, 2013. The only claim remaining after the verdict was the jury’s finding that all ventilated filter cigarettes manufactured and sold between 1964 and July 1, 1969 were defective for a failure to instruct. The court entered judgment in October 2013, dismissing all claims lost by the plaintiffs and purporting to make those claims and all of the jury rulings immediately subject to appeal. The plaintiffs filed a notice of appeal to the West Virginia Supreme Court of Appeals in November 2013, with briefing expected to occur during the first quarter of 2014. The defendants did not file a notice of appeal on the ventilated filter finding, but retained the right to file a cross appeal on that issue in response to the plaintiff’s initial brief. For additional information, see “— Litigation Affecting the Cigarette Industry — West Virginia IPIC” in Item 8, note 11 to consolidated financial statements.

It is likely that 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.

Any or all of the events described above could impose substantial monetary obligations on RAI and its operating subsidiaries and could have an adverse effect on the results of operations, cash flows and financial position of these companies and RAI. 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 11 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 and adversely affect the sales of RJR Tobacco’s products, which could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and 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, which 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 the case 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

 

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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, which order is subject to a pending notice of appeal. The court also ordered the parties to enter mediation on a number of issues related to the implementation of the “corrective-statements” remedy. The mediation process has largely concluded, and the parties have jointly filed a motion seeking entry of a consent order to govern implementation issues. Further proceedings are pending before the trial court to determine whether those “corrective statements” will have to be displayed at retail points-of-sale. Implementation of the “corrective-statements” remedy could cause RJR Tobacco to incur significant compliance costs and there could be an adverse effect on the sales of its products which could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI.

For a more complete description of this case, including the $10 million accrued for the estimated costs of corrective communications, see “— Health-Care Cost Recovery Cases — U.S. Department of Justice Case” in Item 8, note 11 to consolidated financial statements.

Significant monetary obligations imposed under the State Settlement Agreements, the size of which are subject to suits challenging several arbitration awards favorable to RJR Tobacco, could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI.

In 1998, RJR Tobacco, B&W and the other major U.S. cigarette manufacturers entered into a Master Settlement Agreement, referred to as the MSA, with attorneys general representing most U.S. states, territories and possessions. The State Settlement Agreements, of which the MSA is the most wide-reaching, 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. They have materially adversely affected RJR Tobacco’s shipment volumes, and they are expected to have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI in future periods.

RJR Tobacco and certain other PMs are involved in an arbitration with certain of the settling states with respect to the availability of the NPM Adjustment for market year 2003. RJR Tobacco disputed a total of $4.7 billion in potential NPM Adjustment claims for the years 2003 through 2012.

RJR Tobacco, certain other PMs and certain “signatory” states are parties to a binding Term Sheet that sets forth terms resolving accrued and potential NPM Adjustment claims for 2003 through 2012. The Term Sheet also sets forth a restructured NPM Adjustment process to be applied on a going-forward basis, starting with the 2013 volume year. The Arbitration Panel for the 2003 NPM Adjustment dispute entered a Stipulated Partial Settlement and Award, reflecting the financial terms of the Term Sheet. As of December 31, 2013, a total of 20 states, the District of Columbia and Puerto Rico, have joined the settlement. Under the settlement, RJR Tobacco is to receive more than $1 billion worth of credits, a portion of which have been applied to its MSA payments in 2013, and the remainder is to be applied over the following four years. Motions have been filed by 14 non-signatory states, in their respective MSA courts, as of December 31, 2013, to vacate or modify this settlement. If one or more courts grant such a motion, that could, depending on the basis and extent of the order, have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI.

In September 2013, the same Arbitration Panel issued Final Awards on the 2003 NPM Adjustment claims with respect to the 15 states whom the PMs continued to contest. The Arbitration Panel ruled that six states (representing approximately 14.68% of the allocable share) — Indiana, Kentucky, Maryland, Missouri, New Mexico and Pennsylvania — were subject to the 2003 NPM Adjustment. RJR Tobacco estimates the remaining amount due it as a result of these rulings to be approximately $266 million plus interest. Each of these six states, however, has moved to vacate the Final Award with respect to that state. Due to the resulting uncertainty over the final resolution of the 2003 NPM Adjustment, no amounts resulting from the ruling of the Arbitration Panel have been recognized for 2013 and any adverse decision could impact RJR Tobacco’s receipt, or timing of receipt, of some or all of this remaining amount.

 

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For a more complete description of the State Settlement Agreements and the Arbitration Panel’s awards, see “— Health-Care Cost Recovery Cases — State Settlement Agreements” and “— Health-Care Cost Recovery Cases — State Settlement Agreements-Enforcement and Validity; Adjustments” in Item 8, note 11 to consolidated financial statements.

Reports from the U.S. Surgeon General regarding the risks of cigarette smoking and second-hand smoke may result in additional litigation and regulation that could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI.

The U.S. Surgeon General has issued reports that attribute negative health consequences to cigarette smoking, including involuntary exposure to tobacco smoke, referred to as second-hand smoke or ETS. On January 17, 2014, the Surgeon General issued an additional report that contends that smoking is linked to a higher number of deaths to Americans than previous estimates, that filtered cigarettes may increase the risk of certain diseases, and that cigarettes are a causal factor in certain conditions and diseases that had not previously been linked to cigarette smoking. Litigation could be stimulated due to these reports, and the Surgeon General’s findings could cause additional regulations or restrictions to be imposed on the use, manufacture or sale of cigarettes. These factors could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI.

RJR Tobacco’s overall retail market share of cigarettes has been declining and is expected to continue to decline. If RJR Tobacco is not able to increase sales and market share of its growth brands, and if RJR Tobacco and RAI’s other operating companies are not able to develop, produce or market new alternative products profitably, the results of operations, cash flows and financial position of RAI and its operating subsidiaries could be adversely affected.

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 was 26.0% in 2013, compared to 26.5% in 2012. In addition, consumer health concerns, changes in adult tobacco consumer preferences and changes in regulations have prompted RJR Tobacco and other RAI operating companies to introduce new alternative products. Consumer acceptance of these new products, such as CAMEL Snus and electronic cigarettes, referred to as e-cigarettes, may fall below expectations, in which event RAI’s operating subsidiaries may be unable to replace all or any significant portion of lost revenues resulting from the continuing decline in market share and cigarette consumption generally.

Furthermore, an RAI subsidiary, RJR Vapor, expects to launch its digital vapor cigarette, VUSE, on a national basis in 2014. If the national launch of VUSE (which has been in limited distribution to date) is not successful, or is significantly delayed, RJR Vapor’s e-cigarette business could be at a significant disadvantage to other e-cigarette manufacturers, making it difficult for RAI to capitalize upon this potentially expanding category of alternative products, which could have an adverse effect on the results of operations, cash flows and financial position of RJR Vapor and RAI.

In addition, RAI’s operating companies may not find vendors willing to produce alternative products, or components or raw materials used in such products, resulting in additional capital expenditures for RAI’s operating companies. The ability of RAI’s operating companies to gain efficient market clearance for new products could also be adversely affected by FDA rules and regulations.

If RJR Tobacco’s cigarette market share continues to decline, and if RJR Tobacco and RAI’s other operating companies are not able to develop, produce or market new alternative products to replace past and any future loss of the cigarette market share and declining cigarette sales, then there could be an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

 

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RJR Tobacco is dependent on the U.S. cigarette market, which it expects to continue to decline, and this decline could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco and RAI.

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. U.S. cigarette consumption has declined since 1981, for a variety of factors, including, for example, price increases, restrictions on advertising and promotions, 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 migration to smoke-free products. U.S. cigarette consumption is expected to continue to decline. MSAi reported that U.S. cigarette shipments declined 4.6% in 2013, 2.3% in 2012 and 3.5% in 2011. In addition, RJR Tobacco believes its consumers are more price-sensitive than consumers of some competing brands, which may result in some consumers switching to a lower priced brand than any of those offered by RJR Tobacco.

RAI is a holding company and is entirely dependent on the results of its operating subsidiaries. RJR Tobacco is RAI’s largest operating segment. As such, it is the primary source of RAI’s revenue, and a decline in U.S. cigarette consumption could have an adverse effect on the results of operations, cash flows and financial position of RAI.

Competitive actions and pricing pressures in the marketplace could have an adverse effect on the results of operations, cash flows and financial position of RJR Tobacco, American Snuff and Santa Fe.

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. Competitors may also have certain advantages, including stronger financial position and liquidity, enabling them to better withstand the effects of competition and declines in price.

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 11 to consolidated financial statements.

Inability to compete effectively may result in loss of market share, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

In the United States, tobacco products are subject to substantial and increasing regulation and taxation, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

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. Over the last several years, these taxing authorities have significantly increased the magnitude of excise taxes on tobacco products. Increased excise taxes have resulted in declines in overall sales volume and shifts by consumers to less expensive brands, and additional increases could result in future sales declines.

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 policies that prohibit or restrict, or are intended to discourage, smoking. These laws and regulations also are likely to result in a decline in the overall sales volume of cigarettes, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its

 

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operating subsidiaries. For additional information on the issues described above, see “— Governmental Activity” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

RAI’s operating subsidiaries are subject to significant limitations on advertising and marketing of tobacco products, which could harm the value of their existing brands and their ability to launch new brands, and could have an adverse effect on the results of operations, cash flows and financial position of these companies and RAI.

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 consumers. 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. These limitations on the advertising and marketing of tobacco products inhibit RAI’s operating subsidiaries from promoting and maintaining the value of their existing brands and limit their ability to launch new brands, which could have an adverse effect on the results of operations, cash flows and financial position of these companies and RAI.

The regulation of tobacco products by the FDA could have an adverse effect on the results of operations, cash flows and financial position of RAI.

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 product sales in the United States, including sales of RJR Tobacco’s, American Snuff’s and Santa Fe’s brands, and has resulted in an increase in costs to RJR Tobacco, American Snuff and Santa Fe, which could have an adverse effect on the results of operations, cash flows and financial position of RAI. RAI believes that these rules and regulations 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 ability of RAI’s operating companies to gain efficient market clearance for new products could be adversely affected by FDA rules and regulations. In addition, the FDA has announced its intention to issue regulations that would bring e-cigarettes within that agency’s jurisdiction, subjecting these products to many of the requirements already in place for cigarettes and smokeless tobacco products. The adoption of new rules and regulations could make it more difficult for RAI’s operating companies to grow their e-cigarette business, which could have an adverse effect on the results of operations, cash flows and financial position of RAI.

In 2013, the FDA issued its preliminary scientific evaluation regarding menthol cigarettes, concluding that menthol cigarettes adversely affect initiation, addiction and cessation compared to non-menthol cigarettes. Also in 2013, the FDA issued an Advance Notice of Proposed Rulemaking, seeking comments on various issues relating to the potential regulation of menthol cigarettes. In addition, the FDA has the authority to require the reduction of nicotine levels and may also require reduction or elimination of other constituents. Although it is not possible to predict whether or when the FDA will take actions, if the FDA were to adopt regulations banning or severely restricting the sale of menthol cigarettes, or were to require the reduction of nicotine levels or the reduction or elimination of other constituents, those regulations could have a material adverse effect on the cigarette sales of RAI’s operating companies, which could have an adverse effect on the results of operations, cash flows and financial position of those companies and RAI.

 

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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.

Changes in and compliance with state or federal legislation or regulations could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

In addition to FDA regulation, the passage of new legislative or regulatory initiatives including those relating to U.S. health-care reform, climate change and other environmental legislation and changes in federal or state wage requirements, could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries. RAI and its operating subsidiaries regularly assess the impact that health-care reform could have on its employer-sponsored medical plans. Due to the breadth and complexity of the health-care reform legislation, the current lack of implementation regulations and interpretive guidance and the phased-in nature of the implementation, it is difficult to predict the overall impact. The passage of new legislative or regulatory initiatives may increase compliance costs, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

Increases in commodity prices will increase costs and may reduce profitability, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

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 which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

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

Intangible assets include goodwill, trademarks and other intangibles. The determination of fair value involves considerable estimates and judgment. For goodwill, the determination of fair value of a reporting unit involves, among other things, RAI’s market capitalization, and application of the income approach, which includes developing forecasts of future cash flows and determining an appropriate discount rate. If goodwill impairment is implied, the fair values of individual assets and liabilities, including unrecorded intangibles, must be determined. During the annual testing in the fourth quarter of 2013, 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, 2013, 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, 2013, 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 $460 million at December 31, 2013. 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 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.

Goodwill, 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

 

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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.

Changes in financial market conditions could result in higher costs and decreased profitability, which could have an adverse effect on the results of operations, cash flows and financial position of RAI.

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, which could have an adverse effect on the results of operations, cash flows and financial position of RAI. Due to recent market conditions, RAI has invested any excess cash in either low interest or near zero interest investments, thereby lowering interest income.

Adverse changes in liquidity in the financial markets could result in additional realized or unrealized losses on investments, which could have an adverse effect on the results of operations, cash flows and financial position of RAI.

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 could have an adverse effect on the results of operations, cash flows and financial position of RAI. As of December 31, 2013, $28 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, which could have an adverse effect on the results of operations, cash flows and financial position of RAI.

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 pension expense, which could have an adverse effect on the results of operations, cash flows and financial position of RAI. During 2013, RAI contributed $60 million to its pension plans and expects to contribute $109 million to its pension plans in 2014. 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, which could also have an adverse effect on the results of operations, cash flows and financial position of RAI.

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, which could have an adverse effect on the results of operations, cash flows and financial position of these companies and 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, which could have an adverse effect on the results of operations, cash flows and financial position of these companies and RAI.

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 have an adverse effect on the results of operations, cash flows and financial position of RAI.

 

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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, which could have an adverse effect on the results of operations, cash flows and financial position of RAI.

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 could have an adverse effect on the results of operations, cash flows and financial position of RAI.

Revenues from two distributors, McLane and Core-Mark, constituted approximately 31% and 11%, respectively, of RAI’s consolidated revenue in 2013. The loss of these customers, or a significant decline in their purchases, could have an adverse effect on the results of operations, cash flows and financial position of RAI.

Fire, violent weather conditions and other disasters could have an adverse effect on the results of operations, cash flows and financial position 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. In particular, RJR Tobacco’s cigarette manufacturing is conducted primarily at a single facility. Additionally, Santa Fe’s cigarette manufacturing is conducted at a single facility. 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, which could have an adverse effect on the results of operations, cash flows and financial position of these companies.

The loss of key personnel or difficulties recruiting and retaining qualified personnel could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

The future success of RAI and its operating subsidiaries is dependent on the continued availability and service of senior management personnel. The loss of any executive officers or other key senior management personnel could inhibit the ability of RAI and its operating subsidiaries to manage effectively their businesses. In addition, recruiting and retaining qualified personnel may be difficult given the health and social issues associated with the tobacco industry. If RAI and its operating subsidiaries are unable to recruit, retain and motivate key personnel to maintain the current businesses of these companies and support development of new products, it could have an adverse effect on the results of operations, cash flows and financial position of these companies.

Disruptions in information technology systems or a security breach could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

RAI and its operating subsidiaries are dependent on complex information technology systems to operate their businesses, enhance customer service, improve the efficiency of production and increase employee efficiency. These information technology systems are subject to damage or interruption from power outages, computer and telecommunications failures, computer viruses, catastrophic events and user errors. In addition, these information technology systems are also subject to security breaches, including cyber security breaches and breaches of transaction processing that could result in the compromise of confidential customer or consumer data. Any disruptions in information technology systems or a security breach could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

Inability to protect the intellectual property rights of RAI and its operating subsidiaries could have an adverse effect on the results of operations, cash flows and financial position of these companies.

 

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RAI and its operating subsidiaries rely on a combination of trademark laws, trade secret protection, confidentiality agreements and other contractual arrangements to protect their intellectual property rights. Although a substantial amount of resources have been devoted to the establishment and protection of intellectual property, these steps may be inadequate to deter misappropriation. Failure to protect sufficiently intellectual property could affect the ability of RAI and its operating subsidiaries to compete effectively and could harm the value of these subsidiaries’ brands. In addition, defending intellectual property rights could result in the expenditure of significant financial and managerial resources. These events could have an adverse effect on the results of operations, cash flows and financial position of RAI and its operating subsidiaries.

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.

For more information on the restrictive covenants in RAI’s credit facility, see Item 8, note 9 to consolidated financial statements.

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

Because RAI has, in the aggregate, principal outstanding notes of $5.1 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. Borrowing costs under RAI’s revolving credit facility could increase as the credit ratings of RAI’s long-term debt falls.

The outstanding notes issued by RAI are rated investment grade. If RAI’s credit rating falls, particularly 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 maintained its current or higher ratings. 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, if RAI’s ratings decline.

 

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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.

In addition, the interest rate RAI pays on borrowings (and for commitments) under its revolving credit facility is equal to an underlying interest rate plus an applicable margin, which margin is based on the ratings of RAI’s senior, unsecured, long-term indebtedness. If these ratings decline, the applicable margin RAI is required to pay would increase. As a result, although the revolving credit facility provides RAI with a source of liquidity, the cost of borrowing under, and of maintaining, that facility could be at a higher rate at a time when RAI most needs to utilize that facility.

For more complete information on RAI’s borrowing arrangements, see Item 8, notes 9 and 10 to consolidated financial statements.

An adverse effect on the results of operations, cash flows and financial position of RAI or its operating subsidiaries could cause RAI’s Board to depart from or change its historical dividend policy.

RAI’s Board could, in its discretion, depart from or change its dividend policy at any time. 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. RAI is not required to pay dividends and its shareholders do not have contractual or other legal rights to receive them. RAI’s ability to pay dividends is dependent on its earnings, capital requirements, financial condition, expected cash needs, debt covenant compliance and other factors considered relevant by RAI’s Board. To the extent that RAI or its operating subsidiaries experience an adverse effect on their results of operations, cash flows or financial position, RAI’s Board may decide, in its discretion, to decrease the amount of dividends, change or revoke the dividend policy or discontinue paying dividends entirely. In addition, if RAI does not pay or reduces its historical dividend rate, the market price of its common stock could decline.

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

B&W owns approximately 42% of the outstanding shares of RAI common stock. No other 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.

 

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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 four 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 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

 

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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.

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

 

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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.

The amended and restated bylaws of RAI designate the state courts of North Carolina or the U.S. District Court for the Middle District of North Carolina as the sole and exclusive forum for certain legal actions, which could limit the ability of RAI shareholders to obtain a favorable judicial forum for disputes with RAI.

In December 2013, RAI’s Board approved an amendment to RAI’s amended and restated bylaws, which provides that, unless RAI consents in writing to the selection of an alternative forum, the state courts of North Carolina or the U.S. District Court for the Middle District of North Carolina will be the sole and exclusive forum for:

 

   

any derivative action or proceeding brought on behalf of RAI;

 

   

any action asserting a claim of breach of a fiduciary duty owed by any director, officer or other employee of RAI to RAI or its shareholders;

 

   

any action asserting a claim arising pursuant to any provision of the North Carolina Business Corporation Act, the bylaws or the articles of incorporation of RAI (as each may be amended from time to time); or

 

   

any action asserting a claim governed by the internal affairs doctrine.

Any person or entity purchasing or otherwise acquiring any interest in shares of RAI’s capital stock may be deemed to have notice of and to have consented to the provisions described above. This forum selection provision may limit RAI shareholders’ ability to obtain a judicial forum that they find favorable for certain disputes with RAI or its directors, officers or other employees or shareholders.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

The executive offices of RAI and its material subsidiaries, other than SFNTC, are located in Winston-Salem, North Carolina. RJR Tobacco’s manufacturing facilities are located in the Winston-Salem, North

 

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Carolina area, and American Snuff’s manufacturing facilities are located in Memphis, Tennessee; Clarksville, Tennessee; and Winston-Salem, North Carolina. 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.

Item 3. Legal Proceedings

See Item 8, note 11 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 29, 2014, there were approximately 13,700 holders of record of RAI common stock. Shareholders whose shares are held of record by a broker or clearing agency are not included in this amount; however, each of those brokers or clearing agencies is included as one holder of record. The closing price of RAI common stock on January 29, 2014, was $48.61 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
Share
 
           
     Price Per Share     
     High      Low     

2013:

        

First Quarter

   $ 45.17       $ 41.50       $ 0.59   

Second Quarter

     50.15         44.01         0.63   

Third Quarter

     52.93         46.82         0.63   

Fourth Quarter

     52.57         48.01         0.63   

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   

In addition, the board of directors of RAI declared a quarterly cash dividend of $0.67, or $2.68 on an annualized basis, per common share, effective February 10, 2014. The dividends will be paid on April 1, 2014, to shareholders of record as of March 10, 2014. 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.

During 2013, under the above-described share repurchase program, RAI repurchased and cancelled 15,917,174 shares for $750 million, resulting in total repurchases of 47,638,044 shares for $2.1 billion as of December 31, 2013. Due to RAI’s incorporation in North Carolina, which does not recognize treasury shares, the shares are cancelled at the time of repurchase.

In addition, during 2013, RAI repurchased 574,383 shares at a cost of $25 million that were forfeited and cancelled with respect to tax liabilities associated with vesting of restricted stock units granted under the Reynolds American Inc. 2009 Omnibus Incentive Plan, referred to as the Omnibus Plan.

 

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The following table summarizes RAI’s purchases of its common stock during the fourth quarter of 2013:

 

     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
 

October 1, 2013 to October 31, 2013

     1,235,105       $ 49.99         1,235,105       $ 500   

November 1, 2013 to November 30, 2013

     1,131,737         51.48         1,131,737         442   

December 1, 2013 to December 31, 2013

     607,712         49.47         607,712         412   
  

 

 

       

 

 

    

Fourth Quarter Total

     2,974,554         50.45         2,974,554         412   
  

 

 

       

 

 

    

For equity-based benefit plan information, see Item 8, note 13 to consolidated financial statements.

Performance Graph

Set forth below is a line graph comparing, for the period which commenced on December 31, 2008, and ended on December 31, 2013, 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(2)

 

LOGO

 

     12/31/08      12/31/09      12/31/10      12/31/11      12/31/12      12/31/13  

Reynolds American Inc.

   $ 100.00       $ 142.85       $ 187.74       $ 252.34       $ 266.46       $ 338.86   

S&P 500

     100.00         126.46         145.51         148.59         172.37         228.19   

S&P Tobacco(2)

     100.00         125.61         160.40         218.81         241.61         282.59   

 

(1)

Assumes that $100 was invested in RAI common stock and indexes on December 31, 2008, and that in each case all dividends were reinvested.

 

(2) 

The S&P Tobacco Index includes as of December 31, 2013, 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, 2013 and 2012, and for each of the years in the three-year period ended December 31, 2013, 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, 2011 and 2010 and 2009, and for the years ended December 31, 2010 and 2009, 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 in Item 8.

 

     For the Years Ended December 31,  
     2013     2012     2011     2010     2009  
     (Dollars in Millions, Except Per Share Amounts)  

Results of Operations:

          

Net sales(1)

   $ 8,236      $ 8,304      $ 8,541      $ 8,551      $ 8,419   

Income from continuing operations(1)(2)(3)(4)

     1,718        1,272        1,406        1,337        955   

Losses from discontinued operations

                          (216       

Net income

     1,718        1,272        1,406        1,121        955   

Per Share Data:

          

Basic income from continuing operations

     3.15        2.25        2.41        2.29        1.64   

Diluted income from continuing operations

     3.14        2.24        2.40        2.29        1.64   

Basic losses from discontinued operations

                          (0.37       

Diluted losses from discontinued operations

                          (0.37       

Basic net income

     3.15        2.25        2.41        1.92        1.64   

Diluted net income

     3.14        2.24        2.40        1.92        1.64   

Basic weighted average shares, in thousands

     544,925        565,570        582,320        582,996        582,761   

Diluted weighted average shares, in thousands

     546,949        567,873        585,383        584,854        583,652   

Cash dividends declared per share of common stock

   $ 2.48      $ 2.33      $ 2.15      $ 1.84      $ 1.73   

Balance Sheet Data (at end of periods):

          

Total assets

     15,402        16,557        16,254        17,078        18,009   

Long-term debt (less current maturities)

     5,099        5,035        3,206        3,701        4,136   

Shareholders’ equity

     5,167        5,257        6,251        6,510        6,498   

Cash Flow Data:

          

Net cash from operating activities

     1,308        1,568        1,420        1,265        1,454   

Net cash from (used in) investing activities

     (113     (54     60        (126     (123

Net cash used in financing activities

     (2,207     (971     (1,714     (1,349     (1,192

Net cash related to discontinued operations, net of tax benefit

                          (307       

Other Data:

          

Ratio of earnings to fixed charges(5)

     11.3        9.1        10.6        10.2        6.9   

 

(1) 

Net sales and cost of products sold exclude excise taxes of $3,730 million, $3,923 million, $4,107 million, $4,340 million and $3,927 million for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively.

 

(2) 

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

 

(3) 

Includes trademark, goodwill and/or other intangible asset impairment charges of $32 million, $129 million, $48 million, $32 million and $567 million for the years ended December 31, 2013, 2012, 2011, 2010 and 2009, respectively.

 

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(4) 

Includes NPM Adjustment credits of $483 million for the year ended December 31, 2013.

 

(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, 2013 compared with 2012, and 2012 compared with 2011. 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 in Item 8, as of December 31, 2013 and 2012, and for each of the years in the three-year period ended December 31, 2013.

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, Niconovum USA, Inc. and RJR Vapor, among other RAI subsidiaries, are 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 15 to consolidated financial statements.

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 transformation strategy includes growing the core cigarette business, moist-snuff business and focusing on innovation, while maintaining efficient and effective operations.

To achieve its strategy, RAI encourages the migration of adult smokers to smoke-free tobacco products and other products, which it believes 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, heat-not-burn cigarettes, digital vapor cigarettes and nicotine replacement therapy technologies. RAI remains committed to maintaining high standards of corporate governance and business conduct in a high performing culture.

RAI’s largest reportable operating segment, RJR Tobacco, is the second largest tobacco company in the United States. RJR Tobacco’s brands include two of the best-selling cigarettes in the United States: CAMEL and PALL MALL. These brands, and its other brands, including WINSTON, KOOL, DORAL, SALEM, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. 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. RJR Tobacco manages the super-premium cigarette brands, DUNHILL and STATE EXPRESS 555, which are licensed from BAT.

 

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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 adult tobacco 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 the largest traditional 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. Consistent with that strategy, RJR Tobacco continues to evaluate for potential elimination some of its non-core cigarette styles as well as private-label cigarette brands.

RJR Tobacco’s portfolio includes CAMEL Snus, a modern smoke-free tobacco product 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 as well as finding efficient and effective means of balancing market share and profit growth. 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 tobacco products to adult tobacco consumers, primarily moist snuff. The moist snuff category is divided into premium and price-value brands. The moist snuff

 

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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 retail volumes grew approximately 5% in 2013. 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 category. 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.

Santa Fe

Santa Fe competes in the U.S. cigarette market with its NATURAL AMERICAN SPIRIT brand, which is the leading super-premium cigarette brand. It is priced higher than most other competitive brands, and is differentiated from key competitors through its use of all natural, additive-free tobacco, including styles made with organic 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.

All Other

RAI’s subsidiary, Niconovum AB, is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name. RAI’s subsidiary, Niconovum USA, Inc., has entered into its first lead market in Iowa with ZONNIC, a nicotine replacement therapy gum, and recently introduced two new styles of ZONNIC into the lead market. Another RAI subsidiary, RJR Vapor, expanded the distribution of VUSE digital vapor cigarettes to retail outlets throughout Colorado in the third quarter of 2013. RJR Vapor is expanding VUSE into Utah in the first quarter of 2014, and a national expansion is planned for VUSE during 2014. VUSE’s innovative digital technology is designed to deliver a consistent flavor and vapor experience.

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.

 

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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.

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 products against American Snuff Co., when viewed on an individual basis, is not probable or estimable, except for nine Engle Progeny cases described in “— Litigation Affecting the Cigarette Industry — Overview” in Item 8, note 11 to consolidated financial statements.

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 11 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 these 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. Included in these adjustments is an NPM Adjustment that potentially reduces the annual payment obligation of RJR Tobacco, SFNTC and other PMs. 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 11 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 their retired employees and their dependents. These benefits are generally no longer provided to employees hired on or after January 1, 2004. For additional information relating to pension and postretirement benefits, see Item 8, note 14 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 historical 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.

 

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Actuarial gains or losses are 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 are in excess of 10% of the greater of the fair value of the plan assets or the plan’s 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, and are recorded as a mark-to-market adjustment, referred to as an MTM adjustment. Additionally, for the purpose of calculating the expected return on plan assets, RAI uses the actual fair value of plan assets.

Prior service costs of pension benefits, 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 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.

Actual results have varied from actuarial assumptions. In particular, pension and postretirement obligations are impacted by changes in the discount rates. These changes can result in gains or losses to other comprehensive loss. The Pension Protection Act of 2006 may require additional cash funding of the pension obligations in the future.

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

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

 

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

Effect on 2013 net periodic benefit cost

   $ 25      $ 6      $ (33   $ (8

Effect on December 31, 2013, projected benefit obligation and accumulated postretirement benefit obligation

     (527     (101     633        120   

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 2013 net periodic benefit cost

   $ (53   $ (2   $ 53       $ 2   

Intangible Assets

Intangible assets include goodwill, trademarks and other intangible assets. 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

 

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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 2013, 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 $460 million at December 31, 2013.

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.

Goodwill, 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.

 

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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 8 to consolidated financial statements for additional information on income taxes.

Recently Issued and Adopted Accounting Pronouncements

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

Results of Operations

 

     For the Twelve Months Ended December 31,  
     2013     2012     % Change     2011     % Change  

Net sales:(1)

          

RJR Tobacco

   $ 6,728      $ 6,960        (3.3 )%    $ 7,317        (4.9 )% 

American Snuff

     745        681        9.4     648        5.1

Santa Fe

     572        486        17.7     416        16.8

All other

     191        177        7.9     160        10.6
  

 

 

   

 

 

     

 

 

   

Net sales

     8,236        8,304        (0.8 )%      8,541        (2.8 )% 

Cost of products sold(1)(2)

     3,678        4,321        (14.9 )%      4,464        (3.2 )% 

Selling, general and administrative expenses

     1,389        1,470        (5.5 )%      1,606        (8.5 )% 

Amortization expense

     5        21        (76.2 )%      24        (12.5 )% 

Restructuring charge

            149        NM (3)             NM (3) 

Trademark and other intangible asset impairment charges

     32        129        (75.2 )%      48        NM (3) 

Operating income (loss):

          

RJR Tobacco

     2,587        1,735        49.1     1,958        (11.4 )% 

American Snuff

     420        374        12.3     331        13.0

Santa Fe

     280        237        18.1     186        27.4

All other

     (70     (36     (94.4 )%      18        NM (3) 

Corporate expense

     (85     (96     11.5     (94     (2.1 )% 
  

 

 

   

 

 

     

 

 

   
   $ 3,132      $ 2,214        41.5   $ 2,399        (7.7 )% 
  

 

 

   

 

 

     

 

 

   

 

(1) 

Excludes excise taxes of:

 

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     2013      2012      2011  

RJR Tobacco

   $ 3,231       $ 3,467       $ 3,672   

American Snuff

     52         50         57   

Santa Fe

     193         169         154   

All other

     254         237         224   
  

 

 

    

 

 

    

 

 

 
   $ 3,730       $ 3,923       $ 4,107   
  

 

 

    

 

 

    

 

 

 

 

(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.

2013 Compared with 2012

RJR Tobacco

Net Sales

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

 

     For the Twelve Months Ended
December 31,
 
     2013     2012     % Change  

RJR Tobacco:

      

Growth brands:

      

CAMEL

     20.9        21.2        (1.4 )% 

PALL MALL

     21.3        21.9        (2.7 )% 
  

 

 

   

 

 

   
     42.2        43.1        (2.0 )% 

Other

     22.0        25.8        (14.8 )% 
  

 

 

   

 

 

   

Total RJR Tobacco domestic cigarette shipment volume

     64.2        68.9        (6.8 )% 
  

 

 

   

 

 

   

Total premium

     37.2        39.8        (6.6 )% 

Total value

     27.0        29.1        (7.1 )% 

Premium/Total mix

     58.0     57.8  

Industry(1):

      

Premium

     194.7        202.6        (3.9 )% 

Value

     78.6        83.9        (6.3 )% 
  

 

 

   

 

 

   

Total industry domestic cigarette shipment volume

     273.3        286.5        (4.6 )% 
  

 

 

   

 

 

   

Premium/Total mix

     71.2     70.7  

 

(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’s net sales for the year ended December 31, 2013, decreased from the year ended December 31, 2012, primarily due to $457 million attributable to lower domestic cigarette volume and $57 million attributable to unfavorable premium-to-value mix, partially offset by higher net pricing of $291 million.

 

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The shares of RJR Tobacco’s cigarette brands as a percentage of total share of U.S. retail cigarette sales, based on data collected by IRI/Capstone, and processed and managed by MSAi(1), were as follows:

 

     For the Twelve Months Ended
December 31,
 
     2013     2012     Share Point
Change
 

Growth brands:

      

CAMEL

     8.8     8.5     0.3   

PALL MALL

     9.0     8.6     0.4   
  

 

 

   

 

 

   

 

 

 

Total growth brands

     17.8     17.1     0.7   

Other

     8.3     9.4     (1.1
  

 

 

   

 

 

   

 

 

 

Total RJR Tobacco domestic cigarette retail share of market

     26.0     26.5     (0.4

 

(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 uses a sample methodology that does not track all volume and trade channels. Accordingly, the retail share of the U.S. cigarette market of RJR Tobacco and its brands as reported by IRI/Capstone may overstate or understate their actual market share. 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.

The retail share of market of CAMEL, at 8.8 share points, increased in 2013 compared with 2012, in spite of significant competitive activity.

CAMEL’s cigarette market share continued to be favorably impacted by its innovative capsule technology offered in CAMEL Crush and CAMEL menthol styles. CAMEL Crush styles provide adult smokers the choice of switching from non-menthol to menthol; CAMEL menthol styles allow adult smokers to choose the level of menthol flavor on demand. CAMEL’s menthol market share at December 31, 2013, including CAMEL Crush, increased 0.4 percentage points to 3.4 percent.

CAMEL Snus, a smoke-free tobacco product, continues to lead the growing U.S. snus category with market share of nearly 80%. CAMEL Snus continued to maintain steady growth in 2013. CAMEL Snus broadened its portfolio in the third quarter of 2013 with the national expansion of Frost Large.

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 2013 market share of 9.0% was up compared with the prior-year period despite continued competitive pressure. The expansion of PALL MALL’s menthol portfolio is providing the brand incremental growth.

The combined share of market of RJR Tobacco’s growth brands during 2013 showed improvement over 2012. RJR Tobacco’s total cigarette market share declined from the prior year, mainly driven by losses on the company’s support and non-support brands, consistent with its strategy of focusing on growth brands.

Operating Income

RJR Tobacco’s operating income for the year ended December 31, 2013, increased from the year ended December 31, 2012, due to the favorable impact of certain partial NPM Adjustments of $478 million and higher net cigarette pricing, offset by lower cigarette volume. In addition, RJR Tobacco incurred a restructuring charge of $138 million and a MTM adjustment of $300 million in 2012.

 

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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,
 
     2013      2012  

State Settlement Agreements

   $ 1,724       $ 2,286   

Federal tobacco quota buyout

     196         206   

FDA user fees

     119         115   

Expenses under the State Settlement Agreements are expected to be approximately $1.9 billion in 2014, subject to adjustment for changes in volume and other factors. Pursuant to the Term Sheet, RJR Tobacco will receive credits with respect to its NPM Adjustment claims for the period from 2003 through 2012. These credits will be applied against annual payments under the MSA over a five-year period, which commenced with the April 2013 MSA payment. RJR Tobacco’s MSA expenses were reduced by $217 million for the year ended December 31, 2013. This includes the credit that reduced the April 2013 MSA payment by $202 million and future MSA payments by $15 million for the two additional states that signed the Term Sheet during May 2013.

In addition, for the year ended December 31, 2013, RJR Tobacco recognized additional credits of $261 million. RJR Tobacco will recognize additional credits in 2014 through 2016, subject to meeting the various performance obligations associated with the Term Sheet.

For additional information, see “— Cost of Products Sold” in Item 8, note 1 and “— 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 11 to consolidated financial statements.

Expense for the federal tobacco quota buyout is expected to be approximately $145 million to $155 million in 2014. Expenses for FDA user fees are expected to be approximately $120 million to $130 million in 2014. For additional information, see “— Tobacco Buyout Legislation” in Item 8, note 11 to consolidated financial statements and “— Governmental Activity” below.

Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. For the years ended December 31, 2013 and 2012, RJR Tobacco’s product liability defense costs were $160 million and $155 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.

 

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“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.

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 11 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 11 to consolidated financial statements for detailed information regarding the number and nature of cases in trial and scheduled for trial through December 31, 2014.

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 11 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,
 
     2013      2012      % Change  

GRIZZLY

     419.3         389.2         7.7

Other

     46.5         48.0         (3.0 )% 
  

 

 

    

 

 

    

Total American Snuff moist snuff shipment volume

     465.8         437.1         6.5

American Snuff’s net sales for the year ended December 31, 2013, increased compared with the prior-year period primarily due to higher net pricing and higher moist snuff volume.

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 88% of American Snuff’s revenue in 2013 and approximately 86% in 2012. U.S. moist snuff industry retail shipment volume grew by approximately 5% in 2013 compared with 2012.

 

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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) were as follows:

 

     For the Twelve Months Ended
December 31,
 
     2013     2012     Share Point
Change
 

GRIZZLY

     30.1     29.0     1.2   

Other

     3.1     3.4     (0.3
  

 

 

   

 

 

   

 

 

 

Total American Snuff moist snuff retail share of market

     33.2     32.4     0.8   

 

(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 uses a sample methodology that does not track all volume and trade channels.

GRIZZLY, the leading U.S. moist snuff brand, grew 1.2 share points in 2013. GRIZZLY’s increase in full-year shipment volume was driven by growth in the wintergreen and pouch offerings. In January 2014, American Snuff expanded the distribution of GRIZZLY Wide Cut Wintergreen nationwide. The wider cut offers adult smokeless tobacco consumers a bold long-lasting wintergreen flavor and easy packing.

Operating Income

American Snuff’s operating income for the year ended December 31, 2013, increased compared to the prior-year period primarily due to higher net pricing and higher moist snuff volume.

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,
 
     2013      2012      % Change  

NATURAL AMERICAN SPIRIT

     3.6         3.1         15.1

Santa Fe’s net sales for the year ended December 31, 2013, increased over 2012 primarily due to higher volume. Additionally, the cigarette shipment volume in 2012 was negatively impacted by Santa Fe’s shift to a more efficient integrated supply chain. This shift resulted in a one-time reduction of wholesale inventory levels.

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,
 
     2013     2012     Share Point
Change
 

NATURAL AMERICAN SPIRIT

     1.4     1.2     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

 

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  not rely on the market share data reported by IRI/Capstone as being a precise measurement of actual market share because IRI/Capstone uses a sample methodology that does not track all volume and trade channels. Accordingly, the retail share of the U.S. cigarette market of Santa Fe’s NATURAL AMERICAN SPIRIT as reported by IRI/Capstone may overstate or understate its actual market share. 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, 2013, increased as compared with the prior-year period primarily due to higher volume.

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,
 
     2013      2012  

MSA

   $ 92       $ 80   

Federal tobacco quota buyout

     11         9   

FDA user fees

     7         5   

Expenses under the MSA are expected to be approximately $110 million to $120 million in 2014, subject to adjustment for changes in volume and other factors. Pursuant to the Term Sheet, SFNTC will receive credits with respect to its NPM Adjustment claims for the period from 2003 to 2012. Santa Fe’s expenses for the MSA were reduced by $2 million for the year ended December 31, 2013, including the credit that reduced the April 2013 MSA payment by $2 million and future MSA payments by an insignificant amount for the two additional states that signed the Term Sheet during May 2013.

In addition, for the year ended December 31, 2013, Santa Fe recognized additional credits of $3 million. Santa Fe will recognize additional credits in 2014 through 2016, subject to meeting the various performance obligations associated with the Term Sheet.

For additional information, see “— Cost of Products Sold” in Item 8, note 1 and “— 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 11 to consolidated financial statements.

All Other

RAI’s subsidiary, Niconovum AB, is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name. RAI’s subsidiary, Niconovum USA, Inc., has entered into its first lead market in Iowa with ZONNIC, a nicotine replacement therapy gum, and recently introduced two new styles of ZONNIC into the lead market. Another RAI subsidiary, RJR Vapor, expanded the distribution of VUSE digital vapor cigarettes to retail outlets throughout Colorado in the third quarter of 2013. RJR Vapor is expanding VUSE into Utah in the first quarter of 2014, and a national expansion is planned for VUSE during 2014. VUSE is a highly differentiated product with innovative digital technology designed to deliver a consistent flavor and vapor experience.

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.

 

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RAI Consolidated

Interest and debt expense for the year ended December 31, 2013, increased $25 million from the comparable prior year, primarily due to higher average debt balances during 2013, partially offset by lower interest rates.

Other expense, net for the year ended December 31, 2013, increased $103 million from the comparable prior year, primarily due to a loss on the early extinguishment of debt in the fourth quarter of 2013.

Restructuring costs of $149 million were recorded in 2012, and $92 million had been utilized as of December 31, 2013. Accordingly, in the consolidated balance sheet as of December 31, 2013, $19 million was included in other current liabilities and $38 million was included in other noncurrent liabilities.

Provision for income taxes reflected an effective rate of 37.3%, for the year ended December 31, 2013, compared with an effective rate of 34.9%, for the year ended December 31, 2012. The effective tax rate for the year ended December 31, 2013, was unfavorably impacted by an increase in tax attributable to a decrease in the domestic production activities deduction of the American Jobs Creation Act of 2004. The effective tax rate for the year ended December 31, 2012, was favorably impacted by a decrease in tax attributable to the reversal of tax reserves and interest related to various state statute expirations. The effective tax rate for each period differed from the federal statutory rate of 35% due to the impact of state taxes and certain nondeductible items, offset by the favorable impact of the domestic production activities deduction.

RAI expects its effective tax rate to be between 37% and 38% in 2014.

2012 Compared with 2011

RJR Tobacco

Net Sales

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

 

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

RJR Tobacco:

      

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.

 

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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), 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

 

(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 uses a sample methodology that does not track all volume and trade channels. Accordingly, the retail share of the U.S. cigarette market of RJR Tobacco and its brands as reported by IRI/Capstone may overstate or understate their actual market share. 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.

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 continued to be challenging for premium-priced products.

CAMEL’s cigarette market share continued to be favorably impacted by its menthol styles. CAMEL’s menthol market share at December 31, 2012, including CAMEL Crush, increased 0.5 percentage points to 3.0 percent.

CAMEL Snus mint was expanded nationwide in the third quarter of 2012.

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.

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

 

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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.

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   

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.

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 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) 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 uses a sample methodology that does not track all volume and trade channels.

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 benefited 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 uses a sample methodology that does not track all volume and trade channels. Accordingly, the retail share of the U.S. cigarette market of Santa Fe’s NATURAL AMERICAN SPIRIT as reported by IRI/Capstone may overstate or understate its actual market share. 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   

All 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 2015. 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 severance, benefits and related costs and $38 million of pension-related benefits comprised this restructuring charge. As of December 31, 2012, $78 million had been utilized. 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.

 

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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 New 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 2013, 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.

As of December 31, 2013, R.J. Reynolds Tobacco C.V., 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. Approximately 55% 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 Austria, Belgium, Finland, France, Germany and the Netherlands. The average maturity of the fund was 11 days as of December 31, 2013. 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, 2013, RAI held investments primarily in auction rate securities and a mortgage-backed security totaling $89 million. 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. Lane’s results of operations were included through February 28, 2011, in income from operations in the American Snuff segment.

 

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Contractual obligations as of December 31, 2013, were as follows:

 

     Payments Due by Period  
     Total      Less than  1
Year-2014
     1-3 Years
2015-2016
     4-5 Years
2017-2018
     Thereafter  

Long-term notes, exclusive of interest(1)

   $ 5,050       $       $ 450       $ 950       $ 3,650   

Interest payments related to long-term notes(1)

     4,009         248         491         405         2,865   

Operating leases(2)

     68         22         31         14         1   

Non-qualified pension obligations(3)

     95         9         18         19         49   

Postretirement benefit obligations(3)

     543         65         118         113         247   

Qualified pension funding(3)

     100         100            

Purchase obligations(4)

     244         167         76         1           

Other noncurrent liabilities(5)

     84         N/A         60         6         18   

State Settlement Agreements’ obligations(6)

     10,100         2,100         4,000         4,000      

Gross unrecognized income tax benefit(7)

     62               

Federal tobacco buyout obligations(8)

     220         220                           

FDA user fee(9)

     750         140         290         320      
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total cash obligations

   $ 21,325       $ 3,071       $ 5,534       $ 5,828       $ 6,830   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1)

For more information about RAI’s long-term notes, see Item 8, note 10 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 11 to consolidated financial statements for additional information.

 

(3)

For more information about RAI’s pension plans and postretirement benefits, see Item 8, note 14 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. 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 primarily include long-term disability insurance 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 11 to consolidated financial statements.

 

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(7)

For more information on gross unrecognized income tax benefits, see Item 8, note 8 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 federal tobacco buyout legislation, see “— Governmental Activity” below and Item 8, note 11 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 11 to consolidated financial statements.

Commitments as of December 31, 2013, were as follows:

 

     Commitment
Expiration  Period
 
     Total      Less than
1  Year
 

Standby letters of credit backed by revolving credit facility

   $ 6       $ 6   
  

 

 

    

 

 

 

Cash Flows

2013 Compared with 2012

Net cash flows from operating activities decreased $260 million in 2013, compared with 2012. This change was driven primarily by the impact associated with tobacco settlements, which includes the partial settlement of certain NPM Adjustment claims, offset by higher net income in 2013.

Net cash flows used in investing activities increased $59 million in 2013, compared with 2012, driven primarily by higher capital expenditures in 2013.

Net cash flows used in financing activities increased $1,236 million in 2013, compared with 2012. This change was primarily the result of lower proceeds from the issuance of long-term debt and payments related to the early extinguishment of debt in 2013, partially offset by lower share repurchases in 2013.

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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Borrowing Arrangements

RAI and RJR Notes

On August 15, 2013, RJR repaid at maturity $60 million in principal amount of notes with cash from operating activities. RJR has no remaining outstanding debt.

As of December 31, 2013, the principal amount of RAI’s outstanding notes was $5.1 billion, with maturity dates ranging from 2015 to 2043. 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.

In September 2013, RAI completed the sale of $1.1 billion in aggregate principal amount of senior notes, consisting of $550 million 4.85% notes due September 15, 2023, and $550 million 6.15% notes due September 15, 2043. The proceeds were used in October 2013 to redeem the $200 million outstanding principal amount of its 7.30% notes due in 2015, and the $775 million outstanding principal amount of its 7.625% notes due in 2016. A loss of $124 million on the early extinguishment was recorded in the fourth quarter of 2013 and included in other expense, net in the consolidated statements of income.

See Item 8, note 10 to consolidated financial statements for additional information on long-term debt.

Credit Agreement

On October 8, 2013, RAI entered into a credit agreement, referred to as the New Credit Agreement, with a syndicate of lenders, providing for a four-year $1.35 billion senior unsecured revolving credit facility, which may be increased to $1.6 billion at the discretion of the lenders upon the request of RAI. The New Credit Agreement replaced RAI’s previous $750 million revolving credit facility, which would have matured on July 29, 2015. Certain of RAI’s subsidiaries, including its Material Subsidiaries, as such term is defined in the New Credit Agreement, have guaranteed, on an unsecured basis, RAI’s obligations under the New Credit Agreement. At December 31, 2013, RAI had no borrowings outstanding under the New Credit Agreement.

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

 

Lender

   Commitment  

Citibank, N.A.

   $ 112.00   

Credit Suisse AG, Cayman Islands Branch

     112.00   

Fifth Third Bank

     112.00   

Goldman Sachs Bank USA

     112.00   

JP Morgan Chase Bank, N.A.

     112.00   

Mizuho Bank, Ltd.

     112.00   

Royal Bank of Canada

     112.00   

Scotiabanc Inc.

     56.00   

The Bank of Nova Scotia

     56.00   

Wells Fargo Bank, National Association

     89.00   

AgFirst Farm Credit Bank

     75.00   

Farm Credit Bank of Texas

     75.00   

The Bank of New York Mellon

     65.00   

Northern Trust Company

     50.00   

PNC Bank, National Association

     50.00   

United FCS, PCA

     50.00   
  

 

 

 
   $ 1,350.00   
  

 

 

 

 

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See Item 8, note 9 to consolidated financial statements for additional information on the New Credit Agreement.

Term Loan

On March 15, 2013, 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 $500 million and a maturity date of December 27, 2013. In the second quarter of 2013, RAI borrowed the entire $500 million under the Term Loan. RAI repaid the Term Loan in 2013.

Other

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 and its affiliates were in compliance with all covenants and restrictions imposed by RAI’s indebtedness for the year ended December 31, 2013.

Dividends

RAI’s board of directors declared a quarterly cash dividend of $0.67 per common share, effective February 10, 2014. The dividend will be paid on April 1, 2014, to shareholders of record as of March 10, 2014. On an annualized basis, the dividend rate is $2.68 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 2013, under the above-described share repurchase program, RAI repurchased and cancelled 15,917,174 shares for $750 million, resulting in total repurchases of 47,638,044 shares for $2.1 billion as of December 31, 2013. RAI repurchased and cancelled an additional 1,105,872 shares of RAI common stock for $54 million through January 29, 2014, under the above share repurchase program. Due to RAI’s incorporation in North Carolina, which does not recognize treasury shares, the shares are cancelled at the time of repurchase.

Additionally, during 2013, at a cost of $25 million, RAI purchased 574,383 shares that were forfeited and cancelled with respect to tax liabilities associated with restricted stock units vesting under the Omnibus Plan.

See Item 8, note 12 to consolidated financial statements for additional information on stock repurchases.

Capital Expenditures

RAI’s operating subsidiaries recorded cash capital expenditures of $153 million, $88 million and $190 million in 2013, 2012 and 2011, respectively. Of the 2013 amount, $55 million related to RJR Tobacco,

 

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$15 million related to American Snuff and $2 million related to Santa Fe. During 2014, 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 $5 million to $10 million for Santa Fe. In 2014, RAI’s other operating subsidiaries plan to make additional investments to support expansion of the VUSE digital vapor 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, 2013.

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’s expected long-term return on pension assets, referred to as the ELTRA, was 6.70% in 2013, 7.00% in 2012 and will be 7.15% in 2014. 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 $60 million to the pension assets in 2013.

In 2014, RAI plans to contribute $109 million to its pension plans and $70 million to its postretirement plans.

Income Taxes

At December 31, 2013, RAI had a net deferred tax liability of $40 million.

RAI has determined that a valuation allowance of $36 million is required to fully offset a deferred tax asset related to the federal capital loss carryforward resulting from the sale of Lane and other investments. 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 of the years ended December 31, 2013, 2012 and 2011, 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.

On December 31, 2013, the Federal Research and Development Tax Credit expired. It is unclear if and when Congress will reinstate and extend the credit in 2014. RAI’s management does not believe this will have a material impact on RAI’s results of operations, cash flows or financial position, in either case.

Litigation and Settlements

As discussed in Item 8, note 11 to consolidated financial statements, various legal proceedings or claims, including litigation claiming 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, 2013, RJR Tobacco had paid approximately $114 million since January 1, 2011, related to unfavorable smoking and health litigation judgments and $139 million related to an unfavorable 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

 

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class to file individual claims, including claims for punitive damages, through January 11, 2008. RJR Tobacco had been served, as of December 31, 2013, in 5,131 of these cases on behalf of approximately 6,323 plaintiffs. The Engle Progeny cases have resulted and will continue to result in increased litigation and trial activity and increased expenses. Outstanding jury verdicts in favor of the Engle Progeny plaintiffs have been entered against RJR Tobacco in the amount of $111,459,200 in compensatory damages (as adjusted) and in the amount of $120,965,000 in punitive damages, for a total of $232,424,200. All of these verdicts are in various stages in the appellate process. An accrual of $11 million has been recorded in RAI’s consolidated balance sheet as of December 31, 2013 for nine Engle Progeny cases — Jimmie Lee Brown, Sherman, Koballa, Ward, Duke, Walker, Hiott, Kirkland and Sury. This amount includes $5.4 million for compensatory and punitive damages and $5.6 million for attorneys’ fees and statutory interest through December 31, 2013. During the fourth quarter of 2013, a payment of $305,000 was made in satisfaction of the adverse judgment in the Douglas case. Finally, payment in Ward, of $2.4 million was made on January 31, 2014. 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 11 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. On April 15, 2013, the Phase I jury trial began and ended with a virtually complete defense verdict on May 15, 2013. The only claim remaining after the verdict was the jury’s finding that all ventilated filter cigarettes manufactured and sold between 1964 and July 1, 1969, were defective for a failure to instruct. The court entered judgment in October 2013, dismissing all claims lost by the plaintiffs and purporting to make those claims and all of the jury rulings immediately subject to appeal. The plaintiffs filed a notice of appeal to the West Virginia Supreme Court of Appeals in November 2013, with briefing expected to occur during the first quarter of 2014. The defendants did not file a notice of appeal on the ventilated filter finding, but retained the right to file a cross appeal on that issue in response to the plaintiff’s initial brief. For additional information, see “— Litigation Affecting the Cigarette Industry — West Virginia IPIC” in Item 8, note 11 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 products against American Snuff Co., when viewed on an individual case-by-case basis, is not probable or estimable except for the nine Engle Progeny cases noted above, as described in “— Litigation Affecting the Cigarette Industry – Overview” in Item 8, note 11 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.

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 11 to consolidated financial statements, the State Settlement Agreements impose a perpetual stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers and place significant restrictions on their ability to market and sell cigarettes in the future. For more information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 11 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

 

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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 an arbitration with certain of 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 disputed a total of $4.7 billion for the years 2003 through 2012.

In November 2012, RJR Tobacco, certain other PMs and certain settling states entered into a Term Sheet that sets forth the terms on which accrued and potential NPM Adjustment claims for 2003 through 2014 could be resolved. The Term Sheet also sets forth a restructured NPM Adjustment process to be applied on a going-forward basis, starting with the 2013 volume year. Based on the jurisdictions that signed the Term Sheet and are bound by its terms, RJR Tobacco and SFNTC will receive credits, collectively, currently estimated to total approximately $1.1 billion, with respect to their NPM Adjustment claims for the period from 2003 to 2012. The expenses for the MSA were reduced by $483 million for the year ended December 31, 2013. 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; Adjustments” in Item 8, note 11 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 by mail or 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 effect on the sale of tobacco products.

Cigarettes and other tobacco products are subject to substantial taxes in the United States. On February 4, 2009, President Obama signed into law, effective April 1, 2009, an increase of $0.62 in the excise tax per pack of

 

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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.

Currently, there is no federal tax on e-cigarettes.

On April 10, 2013, President Obama released a proposed budget which, if approved by the U.S. Congress, would increase the federal excise tax: on a pack of cigarettes from $1.01 to $1.95; for snuff from $1.51 per pound to $2.93 per pound; and for chewing tobacco from $0.5033 per pound to $0.98 per pound. These proposed tax increases would fund a new initiative for pre-kindergarten education for lower-income children. Although the likelihood of the foregoing federal tax increases becoming law is uncertain, RAI’s management believes that such tax increases, if approved by the U.S. Congress, would have an adverse impact on the sale of tobacco products by RAI’s operating companies and could have a material adverse effect on the results of operations, cash flows or financial position of RAI, including impairment of the value of its operating subsidiaries’ trademarks.

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 roll-your-own 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 roll-your-own 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. In 2013, the cigarette excise tax increased in three states. As of December 31, 2013, the weighted average state cigarette excise tax per pack, calculated on a 12-month rolling average basis, was approximately $1.30, compared with the 12-month rolling average of $1.28 as of December 31, 2012. Certain city and county governments, such as New York and Chicago, also impose substantial excise taxes on cigarettes sold in those jurisdictions.

Effective in the third quarter of 2013, Minnesota increased its NPM fee (from $0.35 to $0.50 per pack) and Texas established an NPM fee of $0.55 per pack. Six states now require NPMs to pay a fee on each pack of cigarettes sold in their respective states, ranging from $0.25 per pack in Alaska to $0.55 per pack in Texas.

The Texas NPM fee has been challenged by a coalition of small tobacco manufacturers. This group asserts that the Texas fee violates the Texas Constitution’s “Equal and Uniform” Clause, as well as the Equal Protection and Due Process Clauses of the U.S. Constitution. On November 15, 2013, a state trial court in Texas declared the NPM fee unconstitutional and enjoined the state from “assessing, collecting, and enforcing” the fee. The State of Texas has appealed the court’s order. In doing so, enforcement of the trial court’s order, including the injunction, is suspended. The coalition has filed a motion for a “hardship exemption” from payment of the fee during the pendency of the state’s appeal. That motion is pending.

Forty-nine states and the District of Columbia also subject smokeless tobacco products to excise taxes. The Commonwealth of Pennsylvania, considered such a tax during its 2013 legislative session, but no decision was reached. As of December 31, 2013:

 

   

26 states taxed moist snuff on an ad valorem basis, at rates ranging from 5% in South Carolina to 210% in Wisconsin;

 

   

21 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

 

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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. In addition, as of January 1, 2014, Minnesota imposed a tax on moist snuff at a rate equal to the greater of (1) 95% of the wholesale price and (2) generally, the tax equal to the rate imposed on a pack of 20 cigarettes.

In 2013, legislation to convert from an ad valorem to a weight-based tax on moist snuff failed in Hawaii and Mississippi.

One state (Minnesota) taxes e-cigarettes, with that state taxing e-cigarettes at the same rate as it taxes smokeless tobacco products (with such rate having increased from 70% to 95% at the beginning of the third quarter of 2013).

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

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. A follow-up report issued by the U.S. Surgeon General in 2010, “How Tobacco Smoke Causes Disease: The Biology and Behavioral Basis for Smoking-Attributable Disease,” determined that tobacco smoke causes immediate cellular damage and tissue inflammation and that repeated exposure impedes the healing of such damage and inflammation. On January 17, 2014, the Surgeon General issued an additional report that contends that smoking is linked to a higher number of deaths to Americans than previous estimates, and that cigarettes are a causal factor in ten conditions and diseases that had not previously been directly linked to cigarette smoking.

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

 

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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 of 1986 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, which grants the FDA broad authority over the manufacture, sale, marketing and packaging of tobacco products.

Pursuant to the FDA Tobacco Act:

 

   

charitable distributions of tobacco products are prohibited;

 

   

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

 

   

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

 

   

the marketing of tobacco products in conjunction with any other class of product regulated by the FDA is prohibited;

 

   

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

 

   

all manufacturers are required to register with the FDA their domestic manufacturing facilities as well as all cigarette and smokeless tobacco products sold in the United States;

 

   

the FDA reissued regulations addressing advertising and marketing restrictions that were originally promulgated in 1996 (including, among other restrictions, prohibitions on: the sale of cigarettes and smokeless tobacco products to persons under the age of 18; the sale of packages of cigarettes with less than 20 cigarettes; the distribution of free samples of cigarettes; and brand name sponsorship of any athletic, musical or other social/cultural events);

 

   

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);

 

   

manufacturers are 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”;

 

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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 additional information concerning this matter, see “— Litigation Affecting the Cigarette Industry — Other Litigation and Developments — FDA Litigation” in Item 8, note 11 to consolidated financial statements;

 

   

for certain tobacco products introduced after February 15, 2007 and before March 22, 2011, manufacturers were required to submit to the FDA documentation demonstrating (1) that such products are “substantially equivalent” to products commercially available as of February 15, 2007, or (2) that such products are exempt from the substantial equivalence provision of the FDA Tobacco Act. Products introduced after March 22, 2011 must be determined by the FDA to be exempt from the substantial equivalence provisions, or receive pre-market approval through the new product application process;

 

   

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;

 

   

in April 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; and

 

   

in 2013, the FDA issued its first decisions with regard to industry substantial equivalence submissions, authorizing the marketing of 17 tobacco products and denying the marketing of 13 others, none of which were RJR Tobacco products.

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.

 

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In September 2009, a “Center for Tobacco Products” was 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 2013 was $127 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 periodically 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. On July 24, 2013, the FDA issued a report detailing its own preliminary scientific evaluation of public health issues related to the use of menthol in cigarettes, including a determination that there is likely a public health impact of menthol in cigarettes. The FDA’s report found that the weight of the evidence supports the conclusion that menthol in cigarettes is associated with:

 

   

increased initiation among youth and young adults;

 

   

reduced success in smoking cessation; and

 

   

increased dependence.

The report found that menthol in cigarettes is not associated with:

 

   

increased smoke toxicity;

 

   

increased levels of biomarkers of exposure; or

 

   

increased disease risk.

The FDA concurrently published in the Federal Register an Advance Notice of Proposed Rulemaking, referred to as the ANPRM, to obtain information related to the potential regulation of menthol in cigarettes. The ANPRM sought comments from interested stakeholders on the FDA’s preliminary evaluation, as well as any data, research, or other information on various topics, including, but not limited to:

 

   

potential product standards for menthol and the potential period for compliance with such standards;

 

   

potential restrictions on the sale and/or distribution of menthol products; and

 

   

evidence regarding illicit trade in menthol cigarettes (including the public health impact thereof) should the use of menthol in cigarettes be restricted or banned.

 

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In November 2013, RAI’s operating companies submitted comments on the ANPRM. The FDA will evaluate all comments it has received from interested stakeholders in response to the ANPRM, as the agency considers whether to require additional standards or restrictions with respect to menthol cigarettes. The FDA Tobacco Act does not require the FDA to adopt any such standards or restrictions. Any rule that the FDA may propose will be subject to a 60-day comment period, and may only become effective at least one year after the rule’s adoption.

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.

As described below, litigation is pending concerning the TPSAC and other aspects of the FDA Tobacco Act.

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.

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.

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 the above FDA-related cases, see “— Litigation Affecting the Cigarette Industry — Other Cases” in Item 8, note 11 to consolidated financial statements.

The FDA has recently indicated that it intends to propose a regulation that would extend the agency’s authority under the FDA Tobacco Act, which currently only applies to certain specifically enumerated “tobacco products,” to other categories of tobacco products, such as e-cigarettes. Such a regulation could subject other tobacco product categories to the current requirements of the FDA Tobacco Act, including that act’s restrictions on product advertising, marketing and sales; good manufacturing practice requirements; and pre-market review requirements for “new tobacco products” and “modified risk tobacco products.”

It is likely that the FDA Tobacco Act could result in a decrease in cigarette and smokeless tobacco product sales in the United States, including sales of RJR Tobacco’s, American Snuff Co.’s and SFNTC’s brands, that, together with increased costs incurred by RAI’s operating companies arising from the FDA Tobacco Act, 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 comply more quickly and cost-effectively with these new rules and regulations. Finally, the ability of RAI’s operating companies to gain efficient market clearance for new tobacco products could be adversely affected by FDA rules and regulations.

All 50 states and a large number of local jurisdictions have introduced or enacted legislation imposing various restrictions on public smoking. Additionally, many employers have initiated programs restricting or

 

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eliminating smoking in the workplace. A number of states have enacted legislation designating a portion of increased cigarette excise taxes to fund 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 interstate passenger buses. Certain common carriers have imposed additional restrictions on passenger smoking.

All states and Washington, D.C. have enacted legislation setting reduced ignition propensity standards. Each such jurisdiction has adopted the same testing standard first adopted by New York in 2003, which requires cigarettes to achieve specified test results when placed on ten layers of filter paper in controlled laboratory conditions. All cigarettes sold by RAI’s operating companies are tested annually to demonstrate compliance with this standard.

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 (principally resulting from different tax rates) exists between tobacco products manufactured for sale abroad and tobacco products manufactured for sale in the United States. Consequently, a market has developed for tobacco products manufactured for sale abroad, but instead diverted for sale in the United States at prices substantially lower than tobacco products produced for sale in the United States. Furthermore, within the United States, tobacco products are often purchased in states having low excise taxes and then resold illegally in states having higher excise taxes. These smuggling activities are often conducted by criminal organizations on a large scale. The sale of diverted or smuggled tobacco products is unlawful, and facilitates the sale of tobacco products to underage persons — undermining a key objective of RAI and its operating companies to prevent youth access to tobacco products. In addition, smuggling activities adversely impact the sale of tobacco products by RAI’s operating companies by: disrupting the contractual relationships between RAI’s operating companies and their wholesalers and retailers; damaging the equity of the brands sold by RAI’s operating companies in terms of the pricing and positioning of those brands; injuring the reputation of RAI’s operating companies by wrongly associating their brands with illegal smuggling activity; and making it difficult for retailers located in high tax jurisdictions to sell the products of RAI’s operating companies, given the competitive price advantage that smuggled products have in such jurisdictions. RAI undertakes a variety of actions to help combat illicit trade in tobacco products, including promoting greater awareness among government officials, law enforcement and the public of the problem, supporting law enforcement investigations of illicit trade in tobacco products, and supporting legislative efforts to increase both the enforcement of anti-illicit trade laws and the penalties for the violations of such laws.

 

 

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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.

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.

In 2003, the World Health Organization adopted a broad tobacco-control treaty, the Framework Convention on Tobacco Control, which entered into force in February 2005. 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. As of November 2013, there were 177 parties to the treaty. The United States was an original signatory to the treaty. The treaty, however, has not been referred to, or ratified by, the U.S. Senate and, as a result, the United States is not a party to the treaty. Ratification of the treaty 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, SFNTC or the cigarette industry in general, but any new legislation or regulations could have an adverse effect on RJR Tobacco, SFNTC 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 regulations 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 11 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 11 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.

 

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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. When used in this document and in documents incorporated by reference, forward-looking statements include, without limitation, statements regarding financial forecasts or projections, and RAI and its subsidiaries’ expectations, beliefs, intentions or future strategies that are signified by the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “may,” “objective,” “outlook,” “plan,” “project,” “possible,” “potential,” “should” and similar expressions. These statements regarding future events or the future performance or results of RAI and its subsidiaries inherently are subject to a variety of risks, contingencies and other uncertainties that could cause actual results, performance or achievements to differ materially from those described in or implied by the forward-looking statements. These risks, contingencies and other 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 regulations prohibiting menthol as a flavor in cigarettes, or the possibility that the FDA will require the reduction of nicotine levels or the reduction or elimination of other constituents;

 

   

the possibility that the FDA will issue regulations extending the FDA’s authority over tobacco products to e-cigarettes, subjecting e-cigarettes to restrictions on, among other things, the manufacturing, marketing and sale of such products;

 

   

decreased sales resulting from the future issuance of “corrective communications,” required by the order in the U.S. Department of Justice case on five subjects, including smoking and health, and addiction;

 

   

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 that reports from the U.S. Surgeon General regarding the negative health consequences associated with cigarette smoking and second-hand smoke may result in additional litigation and/or regulation;

 

   

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 possibility that the Arbitration Panel’s Award reflecting the partial resolution of the NPM Adjustment disputes will be vacated or otherwise modified;

 

   

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 limited number of customers and potential loss of these customers;

 

   

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

 

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

 

   

the success or failure of new product innovations, including the digital vapor cigarette, VUSE, which is manufactured and distributed by an RAI subsidiary, RJR Vapor;

 

   

the success or failure of acquisitions or dispositions, which RAI or its subsidiaries may engage in from time to time;

 

   

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

 

   

the reliance on outside suppliers to manage certain non-core business processes;

 

   

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 passage of new federal or state legislation or regulation;

 

   

the effect of market conditions on interest rate risk, foreign currency exchange rate risk and the return on corporate cash, or adverse changes in liquidity in the financial markets;

 

   

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 assigned to RAI, and to the senior unsecured long-term debt of RAI;

 

   

changes in RAI’s historical dividend policy;

 

   

the restrictive covenants imposed under RAI’s debt agreements;

 

   

the possibility of natural or man-made disasters or other disruptions, including disruptions in information technology systems or security breaches, that may adversely affect manufacturing or other operations and other facilities or data;

 

   

the loss of key personnel or difficulties recruiting and retaining qualified personnel;

 

   

the inability to protect adequately intellectual property rights;

 

   

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 and its subsidiaries, except in limited circumstances; and,

 

   

the expiration of the non-competition agreement between RAI and BAT on July 30, 2014.

 

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

Due to these risks, contingencies and other uncertainties, 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, 2013, 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:

 

     2014     2015     2016      2017     2018     Thereafter     Total     Fair
Value(1)
 

Investments:

                 

Variable Rate

   $ 1,456      $      $       $ 69      $      $      $ 1,525      $ 1,525   

Average Interest Rate

     0.1                    2.4                   0.2       

Fixed-Rate

                                       $ 7      $ 7      $ 7   

Average interest rate(2)

                                         4.7     4.7       

Debt:

                 

Fixed-Rate

   $      $ 450      $       $ 700      $ 250      $ 3,650      $ 5,050      $ 5,175   

Average Interest Rate(2)

            1.1             6.8     7.8     4.8     4.9       

 

(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 instruments.

RAI’s exposure to foreign currency transactions was not material to results of operations for the year ended December 31, 2013, 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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Index to Consolidated Financial Statements

 

Report of Independent Registered Public Accounting Firm

     71   

Management’s Report on Internal Control over Financial Reporting

     72   

Report of Independent Registered Public Accounting Firm

     73   

Consolidated Statements of Income

     74   

Consolidated Statements of Comprehensive Income

     75   

Consolidated Statements of Cash Flows

     76   

Consolidated Balance Sheets

     77   

Consolidated Statements of Shareholders’ Equity

     78   

Notes to Consolidated Financial Statements

     79   

  1     Business and Summary of Significant Accounting Policies

     79   

  2     Fair Value Measurement

     85   

  3     Intangible Assets

     88   

  4     Restructuring Charges

     90   

  5     Income Per Share

     91   

  6     Inventories

     91   

  7     Other Current Liabilities

     91   

  8     Income Taxes

     92   

  9     Borrowing Arrangements

     94   

10     Long-Term Debt

     96   

11     Commitments and Contingencies

     97   

12     Shareholders’ Equity

     148   

13     Stock Plans

     150   

14     Retirement Benefits

     153   

15     Segment Information

     162   

16     Related Party Transactions

     164   

17      RAI Guaranteed, Unsecured Notes — Condensed Consolidating Financial Statements

     165   

18     Quarterly Results of Operations (Unaudited)

     173   

 

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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, 2013 and 2012, 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, 2013. 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, 2013 and 2012, and the results of their operations and their cash flows for each of the years in the three year period ended December 31, 2013, 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, 2013, based on criteria established in Internal Control — Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 11, 2014 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

/s/    KPMG LLP

Greensboro, North Carolina

February 11, 2014

 

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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 (1992) 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, 2013.

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, 2013.

Dated: February 11, 2014

 

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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, 2013, based on criteria established in Internal Control – Integrated Framework (1992) 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, 2013, based on criteria established in Internal Control — Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

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, 2013 and 2012, 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, 2013, and our report dated February 11, 2014 expressed an unqualified opinion on those consolidated financial statements.

/s/    KPMG LLP

Greensboro, North Carolina

February 11, 2014

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Millions, Except Per Share Amounts)

 

     For the Years Ended
December 31,
 
     2013     2012     2011  

Net sales(1)

   $ 7,899      $ 7,962      $ 8,062   

Net sales, related party

     337        342        479   
  

 

 

   

 

 

   

 

 

 

Net sales

     8,236        8,304        8,541   

Costs and expenses:

      

Cost of products sold(1)

     3,678        4,321        4,464   

Selling, general and administrative expenses

     1,389        1,470        1,606   

Amortization expense

     5        21        24   

Trademark and other intangible asset impairment charges

     32        129        48   

Restructuring charge

            149          
  

 

 

   

 

 

   

 

 

 

Operating income

     3,132        2,214        2,399   

Interest and debt expense

     259        234        221   

Interest income

     (5     (7     (11

Other expense, net

     137        34        3   
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     2,741        1,953        2,186   

Provision for income taxes

     1,023        681        780   
  

 

 

   

 

 

   

 

 

 

Net income

   $ 1,718      $ 1,272      $ 1,406   
  

 

 

   

 

 

   

 

 

 

Basic income per share:

      

Net income

   $ 3.15      $ 2.25      $ 2.41   
  

 

 

   

 

 

   

 

 

 

Diluted income per share:

      

Net income

   $ 3.14      $ 2.24      $ 2.40   
  

 

 

   

 

 

   

 

 

 

Dividends declared per share

   $ 2.48      $ 2.33      $ 2.15   
  

 

 

   

 

 

   

 

 

 

  

 

(1)

Excludes excise taxes of $3,730 million, $3,923 million and $4,107 million for the years ended December 31, 2013, 2012 and 2011, 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,
 
     2013      2012     2011  

Net income

   $ 1,718       $ 1,272      $ 1,406   

Other comprehensive income (loss), net of tax:

       

Retirement benefits, net of tax expense (benefit) (2013 — $160; 2012 — $45; 2011 — $(95))

     248         65        (144

Unrealized gain (loss) on long-term investments, net of tax expense (benefit) (2013 — $3; 2012 — $5; 2011 — $(6))

     5         7        (12

Realized loss on hedging instruments, net of tax expense (benefit) (2013 — $1; 2012 — $(9))

     1         (14       

Cumulative translation adjustment and other, net of tax benefit (expense) (2013 — $(12); 2012 — $3; 2011 — $4)

     1         13        (8
  

 

 

    

 

 

   

 

 

 

Comprehensive income

   $ 1,973       $ 1,343      $ 1,242   
  

 

 

    

 

 

   

 

 

 

 

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,
 
     2013     2012     2011  

Cash flows from (used in) operating activities:

      

Net income

   $ 1,718      $ 1,272      $ 1,406   

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

      

Depreciation and amortization

     103        131        138   

Restructuring charge, net of cash payments

     (14     109        (35

Trademark and other intangible asset impairment charges

     32        129        48   

Loss on early extinguishment of debt

     124        21          

Deferred income tax expense (benefit)

     312        (44     100   

Other changes that provided (used) cash:

      

Accounts and other receivables

     (18     11        12   

Inventories

     (143     (17     88   

Related party, net

     10        5        (32

Accounts payable

     (2     74        (66

Accrued liabilities, including income taxes and other working capital

     92        (174     10   

Litigation bonds

     (6     31        (35

Tobacco settlement

     (763     (40     (58

Pension and postretirement

     (185     129        (165

Other, net

     48        (69     9   
  

 

 

   

 

 

   

 

 

 

Net cash flows from operating activities

     1,308        1,568        1,420   
  

 

 

   

 

 

   

 

 

 

Cash flows from (used in) investing activities:

      

Capital expenditures

     (153     (88     (190

Proceeds from termination of joint venture

     31        30        32   

Net proceeds from sale of business

                   202   

Other, net

     9        4        16   
  

 

 

   

 

 

   

 

 

 

Net cash flows from (used in) investing activities

     (113     (54     60   
  

 

 

   

 

 

   

 

 

 

Cash flows from (used in) financing activities:

      

Dividends paid on common stock

     (1,335     (1,307     (1,212

Repurchase of common stock

     (775     (1,101     (282

Excess tax benefit on stock-based compensation plans

     14        39        1   

Principal borrowings under term loan credit facility

     500        750          

Repayments of term loan credit facility

     (500     (750       

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

     1,097        2,539          

Repayments of long-term debt

     (1,035     (1,076     (400

Debt issuance costs and financing fees

     (18     (22     (7

Payment to settle forward starting interest rate contracts

            (23       

Proceeds from termination of interest rate swaps

                   186   

Make-whole premium for early extinguishment of debt

     (155     (20       
  

 

 

   

 

 

   

 

 

 

Net cash flows used in financing activities

     (2,207     (971     (1,714
  

 

 

   

 

 

   

 

 

 

Effect of exchange rate changes on cash and cash equivalents

     10        3        (5
  

 

 

   

 

 

   

 

 

 

Net change in cash and cash equivalents

     (1,002     546        (239

Cash and cash equivalents at beginning of year

     2,502        1,956        2,195   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents at end of year

   $ 1,500      $ 2,502      $ 1,956   
  

 

 

   

 

 

   

 

 

 

Income taxes paid, net of refunds

   $ 713      $ 785      $ 694   

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

   $ 267      $ 249      $ 232   

See Notes to Consolidated Financial Statements

 

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REYNOLDS AMERICAN INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in Millions)

 

     December 31,  
     2013     2012  

Assets

    

Current assets:

    

Cash and cash equivalents

   $ 1,500      $ 2,502   

Accounts receivable

     106        87   

Accounts receivable, related party

     56        61   

Notes receivable

     37        35   

Other receivables

     16        16   

Inventories

     1,127        984   

Deferred income taxes, net

     606        908   

Prepaid expenses and other

     207        219   
  

 

 

   

 

 

 

Total current assets

     3,655        4,812   

Property, plant and equipment, at cost:

    

Land and land improvements

     92        93   

Buildings and leasehold improvements

     717        758   

Machinery and equipment

     1,739        1,758   

Construction-in-process

     105        46   
  

 

 

   

 

 

 

Total property, plant and equipment

     2,653        2,655   

Less accumulated depreciation

     1,579        1,618   
  

 

 

   

 

 

 

Property, plant and equipment, net

     1,074        1,037   

Trademarks and other intangible assets, net of accumulated amortization

     2,417        2,455   

Goodwill

     8,011        8,011   

Other assets and deferred charges

     245        242   
  

 

 

   

 

 

 
   $ 15,402      $ 16,557   
  

 

 

   

 

 

 

Liabilities and shareholders’ equity

    

Current liabilities:

    

Accounts payable

   $ 185      $ 187   

Tobacco settlement accruals

     1,727        2,489   

Due to related party

            1   

Deferred revenue, related party

     48        42   

Current maturities of long-term debt

            60   

Other current liabilities

     1,116        990   
  

 

 

   

 

 

 

Total current liabilities

     3,076        3,769   

Long-term debt (less current maturities)

     5,099        5,035   

Deferred income taxes, net

     658        461   

Long-term retirement benefits (less current portion)

     1,221        1,821   

Other noncurrent liabilities

     181        214   

Commitments and contingencies:

    

Shareholders’ equity:

    

Common stock (shares issued: 2013 — 538,053,024; 2012 — 552,940,767)

              

Paid-in capital

     6,571        7,275   

Accumulated deficit

     (1,348     (1,707

Accumulated other comprehensive loss

     (56     (311
  

 

 

   

 

 

 

Total shareholders’ equity

     5,167        5,257   
  

 

 

   

 

 

 
   $ 15,402      $ 16,557   
  

 

 

   

 

 

 

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, 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 long-term 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

Common stock repurchased

           (282                   (282

Equity incentive award plan and stock-based compensation

           39                      39   

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 long-term 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

Common stock repurchased

           (1,101                   (1,101

Equity incentive award plan and stock-based compensation

           44                      44   

Excess tax benefit on stock-based compensation plans

           39                      39   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2012

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

Net income

                  1,718               1,718   

Retirement benefits, net of $160 tax expense

                         248        248   

Unrealized gain on long-term investments, net of $3 tax expense

                         5        5   

Realized loss on hedging instruments, net of $1 tax expense

                         1        1   

Cumulative translation adjustment and other, net of $12 tax expense

                         1        1   

Dividends — $2.48 per share

                  (1,359            (1,359

Common stock repurchased

           (775                   (775

Equity incentive award plan and stock-based compensation

           57                      57   

Excess tax benefit on stock-based compensation plans

           14                      14   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at December 31, 2013

  $      $ 6,571      $ (1,348   $ (56   $ 5,167   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

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; Niconovum AB; Niconovum USA, Inc.; and R. J. Reynolds Vapor Company, referred to as RJR Vapor.

RAI was incorporated as a holding company in the state of North Carolina on January 2, 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, Niconovum USA, Inc. and RJR Vapor, among other RAI subsidiaries, are 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 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. Certain amounts presented in note 11 are rounded in the aggregate and may not sum from the individually presented components.

 

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All dollar amounts, other than per share amounts, are presented in millions, except for amounts set forth in note 11 and as otherwise noted.

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 the fair value of assets and liabilities, if any, 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 its 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 which RAI does not intend to sell and for which 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 of its debt securities in earnings and 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

 

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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.

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 of its intangibles on reasonable estimates and assumptions, the use of different estimates and assumptions could result in materially different results. 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

 

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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, 2013 and 2012, RAI had no derivative instruments.

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 2013 and 2012, software costs of $13 million and $12 million, respectively, were capitalized or included in construction-in-process. At December 31, 2013 and 2012, the unamortized balance was $51 million and $55 million, respectively. Software amortization expense was $17 million, $21 million and $24 million for the years ended December 31, 2013, 2012 and 2011, 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: