10-K 1 rai-10k_20151231.htm 10-K rai-10k_20151231.htm

 

 

 

 

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, 2015

OR

o

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

Common stock, par value $.0001 per share

 

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  o

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

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

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.  ¨

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  

¨

(Do not check if a smaller reporting company)

 

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 30, 2015, was approximately $31 billion, based on the closing price of $37.33. 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 25, 2016: 1,427,341,341 shares of common stock, par value $.0001 per share.

Documents Incorporated by Reference:

Portions of the Definitive Proxy Statement of Reynolds American Inc. to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Securities Exchange Act of 1934 on or about March 23, 2016, are incorporated by reference into Part III of this report.

 

 

 

 

 

 


 

INDEX

 

PART I

 

 

 

 

 

 

Item 1.

 

Business

2

 

 

 

Item 1A.

 

Risk Factors

13

 

 

 

Item 1B.

 

Unresolved Staff Comments

27

 

 

 

Item 2.

 

Properties

27

 

 

 

Item 3.

 

Legal Proceedings

27

 

 

 

Item 4.

 

Mine Safety Disclosures

27

 

 

 

PART II

 

 

 

 

 

 

Item 5.

 

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

28

 

 

 

Item 6.

 

Selected Financial Data

30

 

 

 

Item 7.

 

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

31

 

 

 

Item 7A.

 

Quantitative and Qualitative Disclosures about Market Risk

65

 

 

 

Item 8.

 

Financial Statements and Supplementary Data

67

 

 

 

Item 9.

 

Changes in and Disagreements With Accountants on Accounting and Financial Disclosure

188

 

 

 

Item 9A.

 

Controls and Procedures

188

 

 

 

Item 9B.

 

Other Information

188

 

 

 

PART III

 

 

 

 

 

 

Item 10.

 

Directors, Executive Officers and Corporate Governance

189

 

 

 

Item 11.

 

Executive Compensation

189

 

 

 

Item 12.

 

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

189

 

 

 

Item 13.

 

Certain Relationships and Related Transactions, and Director Independence

189

 

 

 

Item 14.

 

Principal Accountant Fees and Services

189

 

 

 

PART IV

 

 

 

 

 

 

Item 15.

 

Exhibits, Financial Statement Schedules

190

 

 

Signatures

197

 

 

 

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PART I

Item 1. Business

Reynolds American Inc., referred to as RAI, is a holding company whose wholly owned operating subsidiaries include the second largest tobacco company in the United States, R. J. Reynolds Tobacco Company; the manufacturer of the leading super-premium cigarette brand, Santa Fe Natural Tobacco Company, Inc., referred to as SFNTC; the second largest smokeless tobacco products manufacturer in the United States, American Snuff Company, LLC, referred to as American Snuff Co.; R. J. Reynolds Vapor Company, referred to as RJR Vapor, a manufacturer and marketer of digital vapor cigarettes in the United States; Niconovum USA, Inc. and Niconovum AB, marketers of nicotine replacement therapy products in the United States and Sweden, respectively; and until their sale on January 13, 2016, as described below, SFR Tobacco International GmbH, referred to as SFRTI, and various foreign subsidiaries affiliated with SFRTI. RAI was incorporated in the State of North Carolina on January 2, 2004, and its common stock is listed on the New York Stock Exchange, referred to as 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 transactions on July 30, 2004, generally are referred to as the B&W business combination. As a result of the B&W business combination and BAT Share Purchase, as defined below, BAT, through wholly owned subsidiaries, beneficially 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.

Lorillard Transactions

On June 12, 2015, RAI acquired Lorillard, Inc., n/k/a Lorillard, LLC, referred to as Lorillard, in a cash and stock transaction, valued at $25.8 billion, referred to as the Merger, pursuant to which a wholly owned subsidiary of RAI, referred to as Merger Sub, merged with and into Lorillard, with Lorillard surviving as a wholly owned subsidiary of RAI, all in accordance with an agreement and plan of merger, dated July 15, 2014, among RAI, Merger Sub and Lorillard, referred to as the Merger Agreement.

Also on June 12, 2015, a wholly owned subsidiary, referred to as Imperial Sub, of Imperial Tobacco Group, PLC, referred to as Imperial, acquired for approximately $7.1 billion certain assets (1) owned by RAI subsidiaries or affiliates relating to the cigarette brands WINSTON, KOOL and SALEM, and (2) owned by Lorillard subsidiaries or affiliates related to the cigarette brand MAVERICK and the “e-vapor” brand blu (including SKYCIG), as well as Lorillard’s owned and leased real property, and certain transferred employees, together with associated liabilities, all in accordance with (a) an asset purchase agreement, dated July 15, 2014, as amended, referred to as the Asset Purchase Agreement, among RAI and Imperial Sub, and for certain provisions of the Asset Purchase Agreement and as guarantor of certain obligations of Imperial Sub, Imperial, and (b) a transfer agreement, dated July 15, 2014, referred to as the Transfer Agreement, between Lorillard and Imperial Sub. The transactions pursuant to the Asset Purchase Agreement and Transfer Agreement are collectively referred to as the Divestiture.

In addition, on June 12, 2015, shortly after the completion of the Merger, Lorillard Tobacco Company, LLC, a wholly owned subsidiary of Lorillard, referred to as Lorillard Tobacco, merged with and into RJR Tobacco, with RJR Tobacco continuing as the surviving entity, referred to as the Lorillard Tobacco Merger. The statements of financial position and results of operations contained in the consolidated financial statements reflect the results of the Merger and Divestiture and related transactions.

In connection with the Merger and Divestiture, on July 15, 2014, RAI, BAT, and for limited purposes only, B&W, entered into a subscription and support agreement, referred to as the Subscription Agreement, pursuant to which BAT agreed to subscribe for and purchase, directly or indirectly through one or more of its wholly owned subsidiaries, simultaneously with the completion of the Merger and at a price of approximately $4.7 billion in the aggregate, shares of RAI common stock such that BAT, directly or indirectly through its affiliates, would maintain its approximately 42% beneficial ownership in RAI (the foregoing purchase is referred to as the BAT Share Purchase).

On June 12, 2015, concurrently with the completion of the Merger and Divestiture and pursuant to the Subscription Agreement, BAT indirectly (through a wholly owned subsidiary) purchased 77,680,259 shares of RAI common stock, prior to giving effect to the stock split, described below, for approximately $4.7 billion, which was sufficient for BAT and its subsidiaries collectively to maintain their approximately 42% beneficial ownership in RAI. Upon completion of the transactions on June 12, 2015, BAT and its

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subsidiaries collectively owned 301,014,278 shares, prior to giving effect to the stock split, or approximately 42%, of RAI’s outstanding common stock. After giving effect to the stock split, BAT indirectly purchased 155,360,518 shares of RAI common stock, and BAT and its subsidiaries collectively own 602,028,556 shares of RAI common stock. For additional information on the Merger and Divestiture, and related transactions, see Item 8, note 2 to consolidated financial statements.

Sale of International Rights of NATURAL AMERICAN SPIRIT Brand

On January 13, 2016, RAI, through various subsidiaries, referred to as the Sellers, completed the sale of the international rights to the NATURAL AMERICAN SPIRIT brand name and associated trademarks, along with the international companies that distribute and market the brand outside the United States, to JT International Holding BV, referred to as JTI Holding, a subsidiary of Japan Tobacco Inc., referred to as JTI, in an all-cash transaction with a value of approximately $5 billion.

The purchase agreement, dated as of September 28, 2015, between the Sellers and JTI Holding, referred to as the 2015 Purchase Agreement, contains customary representations, warranties and covenants made by the Sellers and JTI Holding, and, for certain provisions, RAI and JTI, and contains indemnification provisions, subject to customary limitations, with respect to these and other matters, including potential litigation related to specified claims. The 2015 Purchase Agreement also contains a guarantee of Sellers’ obligations by RAI, and a guarantee of JTI Holding’s obligations by JTI. Further, in the 2015 Purchase Agreement, RAI has agreed not to, and agreed to cause its controlled affiliates not to, engage in the business of producing, selling, distributing and developing natural, organic and additive-free combustible tobacco cigarettes and roll-your-own or make-your-own tobacco products outside of the United States, and JTI has agreed not to, and agreed to cause its controlled affiliates not to, engage in the conduct of such business in the United States, in each case, for five years following the closing of the transaction.

The transaction does not include the rights to the NATURAL AMERICAN SPIRIT brand name and associated trademarks in the U.S. market, U.S. duty-free locations, and U.S. territories or in U.S. military outlets, all of which have been retained by SFNTC. With this transaction completed, the international rights to nearly all of RAI’s operating companies’ cigarette trademarks are now owned by international tobacco companies. For additional information on the transaction, see Item 8, note 4 and note 22 to consolidated financial statements.

RAI’s reportable operating segments are RJR Tobacco, Santa Fe and American Snuff. The RJR Tobacco segment consists principally of the primary operations of R. J. Reynolds Tobacco Company. The Santa Fe segment consists of the domestic operations of SFNTC. The American Snuff segment consists of the primary operations of American Snuff Co. Included in All Other, among other RAI subsidiaries, are RJR Vapor, Niconovum USA, Inc., Niconovum AB, and until their sale on January 13, 2016, as described below, SFRTI and various foreign subsidiaries affiliated with SFRTI. 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 7 and Item 8, note 17 to consolidated financial statements.

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 through RAI’s Web site, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the U.S. Securities and Exchange Commission, referred to as 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.

All dollar amounts, other than per share amounts, are presented in millions, except as otherwise noted.

Stock Split

On July 27, 2015, RAI’s board of directors approved a two-for-one stock split of RAI’s common stock, in the form of a 100 percent stock dividend, which was issued on August 31, 2015, to shareholders of record on August 17, 2015. Shareholders of record received one additional share of RAI common stock for each share owned. All current and prior period share and per share amounts have been adjusted to reflect this stock split, unless otherwise noted.

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RAI Strategy

As a result of shifts in consumer preferences, RAI’s strategy continues to focus on transforming tobacco to deliver sustainable earnings growth, strong cash flow and enhanced long-term shareholder value. This transformation strategy includes growing the core cigarette and moist-snuff businesses, focusing on innovation and engaging with adult tobacco consumers, 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 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 three of the top four best-selling cigarettes in the United States: NEWPORT, CAMEL and PALL MALL. These brands, and its other brands, including DORAL, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. RJR Tobacco 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 also 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 JTI, and no international rights were acquired in connection with the B&W business combination or the Merger. The U.S. cigarette market, which has a few large manufacturers and many smaller participants, is a mature market in which overall adult 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 0.1% in 2015, to 264.3 billion cigarettes, 3.2% in 2014 and 4.6% in 2013. 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 and ingredients legislation.

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

Competition

RJR Tobacco’s primary competitors include Philip Morris USA Inc., Imperial and Liggett Group, 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, which together with the MSA are 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 Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 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 2015 and 2014, RJR Tobacco had an overall retail share of the U.S. cigarette market of 32.0% and 32.1%, respectively, and reflecting the impact of the Merger and Divestiture. During these same years, Philip Morris USA Inc. had an overall retail share of the U.S. cigarette market of 49.6% and 49.3%, respectively. RJR Tobacco believes that deep-discount brands made by small manufacturers had combined shipments of approximately 13% of total U.S. industry shipments.

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 tobacco industry. This information is included in this document because it is used primarily as an indicator of the relative performance of

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industry participants, brands and market trends. Effective in 2015, all share results that appear, except as noted otherwise, in this document are based on U.S. cigarette (or smokeless tobacco products, as applicable) shipments to retail outlets, referred to as STR data, based on information submitted by wholesale locations and processed and managed by MSAi, instead of information based on a sampling of retail cigarette (or smokeless tobacco products, as applicable) sales, referred to as retail scan data. Management believes that STR data more accurately reflects marketplace performance across all channels of trade. All retail share results for 2014 when compared with 2015 have been restated to reflect this change. However, you should not rely on the STR data reported by MSAi as being a precise measurement of actual market share as the shipments to retail outlets do not reflect actual consumer sales and do not track all volume and trade channels. Accordingly, the STR data of the U.S. tobacco industry as reported by MSAi may overstate or understate 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.

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 highly competitive 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.

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 two brand categories: drive and other. The drive brands now consist of two premium brands, NEWPORT and CAMEL, and the largest traditional-value brand, PALL MALL. Although these three brands are managed for long-term market share and profit growth, NEWPORT and CAMEL will continue to receive the most significant equity support. The other brand category includes the premium brand, CAPRI, and the value brands, DORAL and MISTY, along with other smaller brands, all of which receive limited marketing support and 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 drive brands while managing the other brands for long-term sustainability and profitability. Consistent with that strategy, RJR Tobacco continues to evaluate some of its brands’ non-core cigarette styles for potential elimination.

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, websites 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 and also uses print advertising in newspapers and consumer magazines in the United States, where permitted.

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.

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RJR Tobacco has entered into various transactions with affiliates of BAT. RJR Tobacco sells contract-manufactured cigarettes, which will be in effect through 2018, tobacco leaf and processed tobacco to BAT affiliates. Net sales, primarily of cigarettes, to BAT affiliates represented approximately 2% of RAI’s total net sales in 2015, and 4% in each of 2014 and 2013.

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 was 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.

Santa Fe

Overview

RAI’s reportable operating segment, Santa Fe, manufactures and markets super-premium 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 fastest growing super-premium cigarette brand and is a top 10 best-selling 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. Based upon data collected by IRI/Capstone and processed and managed by MSAi, during 2015 and 2014, Santa Fe had an overall retail share of the U.S. cigarette market of 1.9% and 1.5%, 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. SFNTC 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 continues to use direct mailings, websites and other means to market its brand and enhance its appeal among age-verified adults who use tobacco products. Santa Fe continues to advertise and promote at retail locations and in adult venues, and uses print advertising in consumer magazines and other publications in the United States, where permitted.

Manufacturing and Distribution

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

Santa Fe’s support for sustainable agriculture and natural resources is part of its commitment to the environment. Santa Fe contracts directly with independent farmers and advocates earth-friendly practices through its two growing programs, Purity Residue Clean, which utilizes environmentally friendly cultivation practices, and Certified Organic, which follows the guidelines of the United

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States Department of Agriculture’s National Organic Program. In the production of its tobacco products, Santa Fe purchases electricity generated from renewable sources, including wind power, and operates a zero waste-to-landfill manufacturing facility.

American Snuff

Overview

RAI’s reportable operating segment, American Snuff, is the second largest smokeless tobacco products manufacturer in the United States, and offers adult tobacco consumers a range of differentiated smokeless tobacco products, primarily moist snuff. The moist snuff category is divided into premium, price-value and popular-price brands. American Snuff’s primary brands 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 2.5%, 2% and 5% in 2015, 2014 and 2013, respectively. 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 and accounted for approximately 90%, 89% and 88% of its revenue in 2015, 2014 and 2013, respectively. Profit margins on moist snuff products are generally higher than on cigarette products.

Competition

American Snuff is dependent on the U.S. smokeless tobacco products market and competes in that market with other domestic and international companies. The highly competitive moist snuff category has developed many of the characteristics of the larger cigarette market, including multiple pricing tiers, 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 collected by IRI/Capstone and processed and managed by MSAi, was 33.5% and 32.9% in 2015 and 2014, respectively. GRIZZLY moist snuff had a market share of 30.7% and 30.0% in 2015 and 2014, respectively. American Snuff’s largest competitor is U.S. Smokeless Tobacco Company LLC, referred to as USSTC, which had approximately 54.0% and 54.4% of the U.S. moist snuff market share in 2015 and 2014, 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 snuff category and represented approximately 18% of the total U.S. moist snuff market as of December 31, 2015. During 2015, demand for pouches continued to grow at more than double the overall category rate.

Manufacturing and Distribution

American Snuff Co. owns its manufacturing facilities located in Memphis, Tennessee; Clarksville, Tennessee; and Winston-Salem, North Carolina. American Snuff distributes its products primarily through a combination of direct wholesale deliveries from a distribution center in North Carolina and public warehouses located throughout the United States.

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Raw Materials

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

All Other

RJR Vapor is the manufacturer and marketer of VUSE Digital Vapor Cigarette. The national expansion of VUSE began in 2014, and was completed in early 2015. VUSE is now the top-selling vapor product in convenience/gas stores, and its innovative digital technology is designed to deliver a consistent flavor and vapor experience.

During 2015, RAI announced that certain of its operating companies consolidated manufacturing operations for the VUSE Digital Vapor Cigarette, which should generate manufacturing and cost efficiencies. In addition to in-house production at RJR Tobacco’s manufacturing facility in Tobaccoville, North Carolina, certain production of VUSE cartridges was previously performed for RJR Vapor at a contractor’s facility in Kansas. Effective September 30, 2015, all production of VUSE cartridges occurs at the Tobaccoville facility, pursuant to a services agreement between RJR Tobacco and RJR Vapor.

Niconovum USA, Inc. was in lead markets in Iowa and Nebraska with ZONNIC, a nicotine replacement therapy gum, until September 2014, when it began its national expansion. ZONNIC is now available in many retail outlets across the United States. Niconovum AB is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name.

SFRTI and various foreign subsidiaries affiliated with SFRTI distribute the NATURAL AMERICAN SPIRIT brand outside the United States. On January 13, 2016, RAI, through the Sellers, completed the sale of the international rights to the NATURAL AMERICAN SPIRIT brand name and associated trademarks, along with the international companies that distribute and market the brand outside the United States to JTI Holding, a subsidiary of JTI, in an all-cash transaction with a value of approximately $5 billion.

Consolidated RAI

Customers

The largest customer of RJR Tobacco, Santa Fe and American Snuff is McLane Company, Inc. referred to as McLane. Sales to McLane, a distributor, constituted approximately 28% of RAI’s consolidated revenue in 2015 and 31% in each of 2014 and 2013. RJR Tobacco, Santa Fe and American Snuff sales to Core-Mark International, Inc., referred to as Core-Mark, a distributor, represented approximately 10% of RAI’s consolidated revenue in 2015 and 11% in each of 2014 and 2013. No other customer accounted for 10% or more of RAI’s consolidated revenue during those periods. Sales of RJR Tobacco, Santa Fe and American Snuff to McLane and Core-Mark are not governed by any written supply contract. RJR Tobacco, Santa Fe and American Snuff believe that their relationships with McLane and Core-Mark are good. No significant backlog of orders existed at RJR Tobacco, Santa Fe or American Snuff as of December 31, 2015 or 2014.

Sales to Foreign Countries

RAI’s operating subsidiaries’ sales to foreign countries, including sales to BAT affiliates, for the years ended December 31, 2015, 2014 and 2013 were $482 million, $497 million and $496 million, respectively.

Raw Materials

In 2004, legislation was passed eliminating the U.S. government’s tobacco production controls and price support program. The buyout of tobacco quota holders provided for in the Fair and Equitable Tobacco Reform Act, referred to as FETRA, was 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 was applied. The aggregate cost of the buyout to the tobacco industry was approximately $9.9 billion, including approximately $9.6 billion payable to quota tobacco holders and growers through industry assessments over ten years, to 2014, and approximately $290 million for the liquidation of quota tobacco stock. The FETRA assessment expired in September 2014. RAI’s operating subsidiaries’ overall share of the buyout approximated $2.5 billion prior to the deduction of permitted offsets under the MSA. For additional information see “— Tobacco Buyout Legislation” in Item 8, note 13 to consolidated financial statements.

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Research and Development

The research and development activities of RAI’s operating subsidiaries are primarily conducted at RJR Tobacco’s facility in Winston-Salem, North Carolina through various intercompany service agreements. Scientists and engineers continue to explore the development of 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, 2015, 2014 and 2013, was $107 million, $88 million and $72 million, respectively.

Intellectual Property

RAI’s operating subsidiaries own or have the right to use numerous trademarks, including the brand names of their products and the distinctive elements of their packaging and displays, and numerous patents. RAI’s operating subsidiaries’ material patents and trademarks are registered with the U.S. Patent and Trademark Office, and certain corresponding patents and trademarks are registered in other countries throughout the world. Rights in the U.S. patents will expire in accordance with their individual statutory terms, and rights in the 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.

On June 12, 2015, Imperial Sub acquired certain assets (1) owned by RAI subsidiaries or affiliates relating to the cigarette brands WINSTON, KOOL and SALEM, and (2) owned by Lorillard subsidiaries or affiliates related to the cigarette brand MAVERICK and the “e-vapor” brand blu (including SKYCIG), all in accordance with the Asset Purchase Agreement.

On January 13, 2016, RAI, through the Sellers, completed the sale of the international rights to the NATURAL AMERICAN SPIRIT brand name and associated trademarks, along with the international companies that distribute and market the brand outside the United States to JTI Holding, a subsidiary of JTI.

For additional information see Item 8, note 2, note 4 and note 22 to consolidated financial statements.

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;

 

·

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

 

·

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

 

·

require the disclosure of nicotine yield information for cigarettes;

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·

impose restrictions on smoking and vaping 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 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. Products that are alternatives to traditional tobacco products also have become subject to increasing regulation. For example, in addition to the anticipated regulation by the FDA of electronic cigarettes, referred to as e-cigarettes, various states have adopted, or are considering adoption of, taxes on e-cigarettes, restrictions on the promotion and distribution of e-cigarettes and tamper resistant and child resistant packaging requirements for e-cigarettes. For further discussion of the regulatory and legislative environment applicable to the tobacco industry and FDA-related matters, see Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Governmental Activity.”

Litigation and Settlements

Various legal proceedings or claims, including litigation claiming 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 (including as successor by merger of Lorillard Tobacco), American Snuff Co., SFNTC or RJR Vapor or their affiliates, including RAI, RJR, Lorillard or indemnitees, including B&W, sometimes collectively referred to as Reynolds Defendants. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of December 31, 2015, RJR Tobacco had paid approximately $130 million since January 1, 2013, related to unfavorable smoking and health litigation judgments.

RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claims against Reynolds Defendants, 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 certain Engle Progeny cases, as described in “— Litigation Affecting the Cigarette Industry — Overview” in Item 8, note 13 to consolidated financial statements. RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts in their pending cases and 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 Reynolds Defendants, 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, Lorillard Tobacco, B&W, SFNTC 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, 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 cigarettes in the future. The State Settlement Agreements have materially adversely affected RJR Tobacco’s shipment volumes. RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows or financial position of RAI and RJR Tobacco in future periods. The degree of the adverse impact will depend, among other things, on the rate of decline in U.S. cigarette sales in the premium and value categories, RJR Tobacco’s share of the domestic premium and value cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the State Settlement Agreements.

Payments under the State Settlement Agreements are subject to various adjustments for, among other things, the volume of cigarettes sold, relative market share, operating profit and inflation. See “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” in Item 8, note 13 to consolidated financial statements for a detailed discussion of the State Settlement Agreements, including RAI’s operating subsidiaries’ monetary obligations under these agreements. RJR Tobacco records the allocation of settlement charges as products are shipped.

For disclosure of legal proceedings involving RAI and its operating subsidiaries, see Item 8, note 13 to consolidated financial statements. For additional information related to settlements, see Item 8, note 1 “— Cost of Products Sold” and note 13 “— Litigation Affecting the Cigarette Industry — State Settlement Agreements — Enforcement and Validity; Adjustments”, to consolidated financial statements.

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Employees

At December 31, 2015, RAI and its subsidiaries had approximately 5,600 full-time employees and approximately 100 part-time employees. The 5,600 full-time employees include approximately 3,800 RJR Tobacco employees, 500 Santa Fe employees and 600 American Snuff 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:

Susan M. Cameron. Ms. Cameron, 57, has served as the President and Chief Executive Officer of RAI and President of RAI Services Company, a wholly owned subsidiary of RAI and referred to as RAISC, since May 1, 2014, after previously serving as the President and Chief Executive Officer of RAI from 2004 through her retirement in February 2011. She also served as the Chairman of the Board of RAI from 2006 to October 2010. In addition, Ms. Cameron served as Chairman of the Board of RJR Tobacco from July 2004 to May 2008. From July 2004 to December 2006, she also served as Chief Executive Officer of RJR Tobacco. She served as President and Chief Executive Officer of B&W from 2001 to 2004, and also served as a director of B&W from 2000 to 2004, and Chairman of the Board from January 2003 to 2004. Prior to 2001, Ms. Cameron held various marketing positions with B&W and BAT after joining B&W in 1981. Ms. Cameron served on the Board of RAI from January 2004 through her retirement in February 2011 and then recommenced serving on the Board in December 2013. She also is a member of the boards of directors of R. R. Donnelley & Sons Company and Tupperware Brands Corporation. In addition, Ms. Cameron is a member of the board of trustees of the University of Florida.

Michael P. Auger. Mr. Auger, 48, became Executive Vice President — Trade Marketing of RJR Tobacco on January 1, 2015. Mr. Auger served as Vice President — Trade Marketing Development of RJR Tobacco from May 2011 to December 2014. Prior to 2011, Mr. Auger held numerous managerial positions with RJR Tobacco, including Area Vice President from May 2006 to April 2011. Prior to this, Mr. Auger held various additional positions with both RJR Tobacco and B&W. Mr. Auger currently serves on the Eckerd College Alumni Leadership Council.

Lisa J. Caldwell. Ms. Caldwell, 55, has been Executive Vice President and Chief Human Resources Officer of RAI since May 2009, RAISC since January 2010 and RJR Tobacco since October 2014. 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.

Debra A. Crew. Ms. Crew, 45, became President and Chief Operating Officer of RJR Tobacco on October 1, 2015. She was previously the President and Chief Commercial Officer of RJR Tobacco from October 1, 2014 to September 30, 2015. Prior to joining RJR Tobacco, Ms. Crew was the President and General Manager of PepsiCo North America Nutrition from August 2014 to September 2014. She served as President of PepsiCo Americas Beverage from September 2012 until August 2014. Ms. Crew was also President of the Western Europe Region of PepsiCo Europe from April 2010 to August 2012. Prior to joining PepsiCo, Inc. in 2010, Ms. Crew held various positions with Mars, Incorporated, Nestle S.A. and Kraft Foods, Inc. Ms. Crew served in the U.S. Army from 1993 to 1997, rising to the rank of captain and military intelligence officer. She serves on the board of directors of Stanley Black & Decker, Inc.

Robert H. Dunham. Mr. Dunham, 49, 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, 58, 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 August 2004. Mr. Fawley is a member of the boards of directors of the Reynolds

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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. Mr. Fawley also serves on the Abbott Capital Private Equity Advisory Board.

McDara P. Folan, III. Mr. Folan, 57, 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 the Downtown Winston-Salem Foundation.

Jeffery S. Gentry, PhD. Dr. Gentry, 58, has been Executive Vice President of RJR Tobacco since January 2010, and Executive Vice President of RAISC since January 1, 2013. Dr. Gentry was previously the Executive Vice President — Operations and Chief Scientific Officer of RJR Tobacco from January 2010 to October 2015. He also served as RAI Group Executive Vice President from April 1, 2008 to January 2010. Dr. Gentry served on the board of directors of RJR Tobacco from January 2010 to October 2015. He was previously Executive Vice President — Research and Development of RJR Tobacco from December 2004 to April 2008. 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, 43, has been Executive Vice President and Chief Financial Officer of RAI, and Executive Vice President, Chief Financial Officer and Chief Information Officer of RAISC since March 1, 2015. Mr. Gilchrist was the Executive Vice President of RAI from October 2014 to March 2015. He previously served as President and Chief Commercial Officer of RJR Tobacco from January 1, 2011 to September 30, 2014. He previously 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 RAISC since March 2015 and served on the board of directors of RJR Tobacco from May 2008 to March 2015. 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 serves on the board of directors for the Winston-Salem Alliance.

Nancy H. Hawley. Ms. Hawley, 53, has been Executive Vice President of Operations at RJR Tobacco since October 2015. Ms. Hawley previously served as Senior Vice President of Operations for RJR Tobacco from July 2014 to October 2015. Prior to that, Ms. Hawley was Vice President of Manufacturing for RJR Tobacco from October 2008 through June 2014. Ms. Hawley joined RJR Tobacco in 1984 as a staff engineer and held a number of operations positions. Ms. Hawley currently serves on the boards of directors for the Foundation of Forsyth Technical College and the Reynolds American Foundation. In addition, Ms. Hawley currently serves as a member of the United Way Basic Needs Impact Committee and serves on the Personnel Committee for First Baptist Church on Fifth.

Daniel J. Herko. Mr. Herko, 55, has been Executive Vice President – Scientific and Regulatory Affairs of RAISC since January 1, 2016 and Executive Vice President – Research and Development of RJR Tobacco since October 2015. Mr. Herko served as Executive Vice President of RAISC from October 2015 until December 2015. Mr. Herko previously served as Senior Vice President – Research and Development of RJR Tobacco from March 2008 to September 2015, after serving as Vice President – Product Development from November 2007 to March 2008. Mr. Herko joined RJR Tobacco in 1980 in the manufacturing division and held a variety of production positions in manufacturing before joining JTI, following the sale of the international tobacco business to JTI in 1999. In 2002, Mr. Herko returned to RJR Tobacco as Director of Product Development until becoming Senior Director of Product Development in 2005. He serves on the board of Big Brothers Big Sisters Inc. in Winston-Salem.

Martin L. Holton III. Mr. Holton, 58, has been Executive Vice President, General Counsel and Assistant Secretary of RAI and RAISC and Executive Vice President and General Counsel of RJR Tobacco since January 2011. Mr. Holton previously served as Senior Vice President and Deputy General Counsel of RAISC since January 2010 and Senior Vice President, General Counsel and Secretary of RJR Tobacco from November 2006 through December 2010. In addition, Mr. Holton has served on the board of directors of RAISC since January 2011. Previously, Mr. Holton served as Senior Vice President, Deputy General Counsel and Secretary of RJR Tobacco from February 2005 to November 2006 and Vice President and Assistant General Counsel — Litigation from July 2004 to February 2005. Mr. Holton serves on the board of managers for YMCA Camp Hanes and the board of directors for the Winston-Salem Symphony. Mr. Holton also serves on the board of trustees for Eaglebrook School.

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J. Brice O’Brien. Mr. O’Brien, 47, 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. Mr. O’Brien 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, Mr. O’Brien held various positions with RJR Tobacco after joining RJR Tobacco in 1995.

Frederick W. Smothers. Mr. Smothers, 52, 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.

Other significant employees of the Registrant include the chief executive officers of SFNTC and American Snuff Co., as listed below:

Mike Little. Mr. Little, 56, has served as President of SFNTC since December 2011. Previously, he served as Senior Vice President — Manufacturing of SFNTC from January 2002 until November 2011. Prior to 2002, Mr. Little held various positions with SFNTC after joining SFNTC in 1995.

Randall M. (Mick) Spach. Mr. Spach, 57, has been President of American Snuff Co. since January 2011. Previously he served as Vice President — Operations of American Snuff Co. from February 2009 until December 2010. Mr. Spach served as Vice President — Manufacturing/R&D of American Snuff Co. from August 2007 to February 2009. He served as Assistant Vice President — Manufacturing at American Snuff Co. from 2001 to August 2007. Between 1977 and 2001, Mr. Spach held various positions with American Snuff Co.

 

 

Item 1A. Risk Factors

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

Reynolds Defendants have been named in a 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, deceptive and unfair trade practices, conspiracy, medical monitoring, and violations of state and federal antitrust and racketeering laws. Various forms of relief are sought, including compensatory damages, attorneys’ fees, 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 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, 2015, RJR Tobacco had been served in 3,111 Engle Progeny cases filed on behalf of approximately 4,046 individual 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. Through December 31, 2015, RJR Tobacco or Lorillard Tobacco cumulatively paid $214.9 million in compensatory and punitive damages and $66.8 million for attorneys’ and statutory interest, for a total of $281.7 million, in these

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cases. In addition, outstanding jury verdicts in favor of the Engle Progeny plaintiffs had been entered against RJR Tobacco or Lorillard Tobacco in the amount of $184.2 million in compensatory damages (as adjusted) and in the amount of $191.1 million in punitive damages, for a total of $375.3 million. 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 description of this litigation, see “— Litigation Affecting the Cigarette Industry — Engle and Engle Progeny Cases” in Item 8, note 13 to consolidated financial statements.

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 addition, several class actions have been filed against SFNTC and RAI asserting that use of the terms “natural”, “additive-free” and “organic” in the product labeling and advertising for SFNTC’s NATURAL AMERICAN SPIRIT cigarette brand violates state disclosure, and deceptive and unfair trade practice, statutes. In the event RJR Tobacco, SFNTC or their affiliates and indemnitees lose one or more of the pending class-action suits, they could face, depending upon the amount of any damages ordered, difficulties in their ability to pay the judgment or obtain any bond required to stay execution of the judgment. For a more complete description of class-action litigation, see “— Class-Action Suits” in Item 8, note 13 to consolidated financial statements.

In 1999, the U.S. Department of Justice bought an action against RJR Tobacco, Lorillard Tobacco, B&W, and other tobacco companies pursuant to the civil provisions of the federal Racketeer Influenced and Corrupt Organizations Act, referred to as RICO. The government sought, among other remedies, disgorgement of profits in an amount of approximately $280 billion allegedly earned as a consequence of a RICO racketeering “enterprise” and injunctive relief. In February 2005, an appellate court ruled that disgorgement was not an available remedy. In 2006, the trial court found certain defendants, including RJR Tobacco, liable for the RICO claims (but did not impose any direct financial penalties), enjoined the defendants from committing future racketeering acts, and ordered the defendants to issue “corrective communications” on five subjects, including smoking and health and addiction. The trial court’s “corrective-statements” remedy is subject to continuing proceedings to determine, among other things, whether the “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 have an adverse effect on the sales of RJR Tobacco’s products. For a more complete description of this litigation, see “— Health-Care Cost Recovery Cases — U.S. Department of Justice Case” in Item 8, note 13 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 other tobacco products will continue to be filed against Reynolds Defendants 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, Lorillard Tobacco and American Snuff Co., see “— Litigation Affecting the Cigarette Industry” and “— Smokeless Tobacco Litigation” in Item 8, note 13 to consolidated financial statements.

On June 12, 2015, RAI, through its subsidiaries, acquired Lorillard’s NEWPORT brand, the leading U.S. menthol cigarette brand, resulting in a substantial portion of RAI’s consolidated net sales being attributable to products that contain menthol. Any action by the FDA or any other governmental authority that could have the effect of banning or materially restricting the use of menthol in tobacco products could have an adverse effect on the results of operations, cash flows and financial position of RAI and its subsidiaries.

As a result of the Merger, RAI, through its subsidiaries, acquired Lorillard’s NEWPORT brand, the leading U.S. menthol cigarette brand. NEWPORT menthol cigarette styles were added to the brand portfolio of RAI’s operating companies, a portfolio which includes other brands with menthol styles. On a pro forma basis, assuming the Lorillard transactions had occurred on January 1, 2015, RAI estimates that approximately 50% of the combined company’s total net sales through December 31, 2015, would have been attributable to menthol cigarettes, see Item 8, note 2 to consolidated financial statements.

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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. In 2013, the FDA also issued an Advance Notice of Proposed Rulemaking, seeking comments on various issues relating to the potential regulation of menthol cigarettes. Although it is not possible to predict whether or when the FDA will take actions, if the FDA or any other governmental authority were to adopt regulations banning or severely restricting the use of menthol in tobacco products or the sale of menthol cigarettes, those regulations could have a material adverse effect on sales of the NEWPORT brand, and the menthol styles of other brands in the portfolio of RAI’s operating companies, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its subsidiaries.

In addition to regulatory action affecting the use of menthol in cigarettes, the FDA could regulate tobacco products in other aspects that could have an adverse effect on the results of operations, cash flows and financial position of RAI and its subsidiaries.

The FDA Tobacco Act grants the FDA broad authority over the manufacture, sale, marketing and packaging of tobacco products. 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, and has resulted in an increase in costs to RJR Tobacco, American Snuff Co. and SFNTC, which could have an adverse effect on the results of operations, cash flows and financial position of RAI.

The ability of RAI’s operating companies to introduce new tobacco products, a critical component of RAI’s strategy of focusing on innovation to transform the tobacco industry, could be adversely affected by FDA rules and regulations. Under the FDA Tobacco Act, for a manufacturer to launch a new tobacco product or modify an existing tobacco product after March 22, 2011, the manufacturer must obtain an order from the FDA’s “Center for Tobacco Products,” referred to as the CTP, allowing the new or modified product to be marketed. Similarly, a manufacturer that introduced a product between February 15, 2007, and March 22, 2011, was required to file a substantial equivalence report with the CTP demonstrating either (1) that the new or modified product had the same characteristics as a product commercially available as of February 15, 2007, referred to as a predicate product, or (2) if the new or modified product had different characteristics than the predicate product, that it did not raise different questions of public health. A product subject to such report is referred to as a provisional product. A manufacturer may continue to market a provisional product unless and until the CTP issues an order that the provisional product is not substantially equivalent, in which case the FDA could then require the manufacturer to remove the provisional product from the market. On September 15, 2015, the CTP issued four Not Substantially Equivalent orders, referred to as NSE orders, to RJR Tobacco, determining that four cigarette styles are not substantially equivalent to their respective predicate products, and ordering that RJR Tobacco immediately stop all distribution, importation, sale, marketing and promotion of these provisional products. RJR Tobacco has taken action to comply with these NSE orders, and continues to evaluate its options in connection with this matter. Although the sales of the provisional products subject to the foregoing NSE orders are not material to RJR Tobacco, substantially all of RAI’s operating companies’ products currently on the market are provisional products. If the CTP were to issue NSE orders with respect to other provisional products of RAI’s operating companies, such orders, if not withdrawn or invalidated, would have an adverse impact on the sales of the products subject to the orders, and could have an adverse impact on the results of operations, cash flows and financial position of RAI and its subsidiaries.

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. Chief among these requirements would be a decision by the agency to leave the grandfather date of February 15, 2007 in place for e-cigarettes. Given that few, if any, e-cigarettes were on the market as of that date, manufacturers would not be able to rely on filing substantial equivalence applications to keep existing products on the market, but instead would have to file new tobacco product applications with the agency. 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 and its subsidiaries.

On August 27, 2015, the FDA sent a warning letter to SFNTC, claiming that SFNTC’s use of the terms “Natural” and “Additive Free” in the product labeling and advertising for NATURAL AMERICAN SPIRIT cigarettes violates the Modified Risk Tobacco Products provision of the FDA Tobacco Act. On September 18, 2015, SFNTC provided a written response to the FDA, explaining why it believes its use of these terms does not violate the FDA Tobacco Act. SFNTC has not modified the product labeling or advertising for its NATURAL AMERICAN SPIRIT cigarettes since the receipt of the FDA’s warning letter. If SFNTC ultimately is required by the FDA to delete, or substantially modify, the terms “Natural” and/or “Additive Free” appearing on the labeling and/or advertising of its NATURAL AMERICAN SPIRIT cigarettes, that requirement could have an adverse effect on the sale of such cigarettes, and on the results of operations, cash flows and financial position of SFNTC and RAI. Further, if the FDA determines that the use of those terms violates the FDA Tobacco Act, the FDA could take a variety of enforcement actions against SFNTC, including, without limitation, forcing SFNTC to recall from the market NATURAL AMERICAN SPIRIT cigarettes bearing such terms, and imposing penalties on SFNTC. The costs that SFNTC would incur in connection with any such enforcement actions could be material.

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Further, the FDA has the authority to require the reduction of nicotine levels and may also require reduction or elimination of other constituents.

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.

Significant monetary obligations imposed under the State Settlement Agreements, the size of which may be impacted by 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, Lorillard Tobacco 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, 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 Lorillard Tobacco disputed a total of $5.6 billion and $1.2 billion, respectively, in potential MSA non-participating manufacturer adjustment, referred to as the NPM Adjustment, claims for the years 2003 through 2014. A nationwide arbitration, referred to as the Arbitration Panel, was initiated with respect to the 2003 NPM Adjustment claim. Preliminary proceedings before the Arbitration Panel began in July 2010. Merits hearings began in April 2012.

In December 2012, RJR Tobacco, Lorillard Tobacco, SFNTC and certain other participating manufacturers, referred to as the PMs, and certain “signatory” states entered into a binding Term Sheet that set forth terms for resolving accrued and potential NPM Adjustment claims for 2003 through 2012. The Term Sheet also set forth a restructured NPM Adjustment process to be applied on a going-forward basis, starting with the 2013 volume year. The Arbitration Panel for the 2003 NPM Adjustment dispute entered a Stipulated Partial Settlement and Award, reflecting the financial terms of the Term Sheet. Under the settlement, RJR Tobacco is to receive more than $1.1 billion worth of credits, a portion of which have been applied to its MSA payments in 2013, 2014 and 2015, and the remainder is to be applied over the following two years.

In September 2013, the Arbitration Panel issued Final Awards on the 2003 NPM Adjustment claim with respect to the 15 states who at that point in the proceedings 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. Of these six states, two (Kentucky and Indiana) decided to join the settlement, three (Maryland, Missouri and Pennsylvania) unsuccessfully challenged in their respective state courts the finding of their responsibility for the 2003 NPM Adjustment; and one state court challenge (New Mexico) has yet to be decided. Additionally, these four states challenged the amount of the judgment reduction accorded to them by the Arbitration Panel by virtue of the settlement. Two of these challenges (Maryland and Pennsylvania) were successful; and one was not (Missouri). The challenge filed in New Mexico has not yet been decided at the trial court level.

If the amount of the judgment reduction is ultimately modified in the manner urged by Missouri and New Mexico, RJR Tobacco’s and Lorillard Tobacco’s recovery of the 2003 NPM Adjustment would be reduced by $27 million and $5 million, respectively, in the April following the conclusion of the appeal. In contrast, if RJR Tobacco and Lorillard Tobacco prevail on appeal in Maryland and Pennsylvania, RJR Tobacco and Lorillard Tobacco would receive an additional $75 million and $13 million, respectively, for the 2003 NPM Adjustment in the April following the conclusion of the appeal.

In light of the fact that three of the non-diligent states (Maryland, Missouri and Pennsylvania) are no longer challenging the findings on non-diligence entered against them, RJR Tobacco has recognized the minimum amount that it has recovered from these three states, a total of approximately $93 million. Remaining amounts that will potentially be recovered from these non-diligent states, depending on the outcome of their challenges to the judgment reduction method adopted by the Arbitration Panel, have not been recognized in RAI’s consolidated financial statements as of December 31, 2015, due to the uncertainty over the final resolution of the pending motions and appeals with respect to the judgment reduction issue. No amounts have been recognized with respect to New Mexico given the uncertainty with the pending trial court motions on both the finding of non-diligence and the judgment reduction issue.

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 13 to consolidated financial statements.

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RAI, through its subsidiaries, is dependent on the U.S. cigarette market, which is expected to continue to decline. In addition, RAI is dependent on premium and super-premium cigarette brands. The continued decline in U.S. cigarette consumption, or the transition of consumers away from premium cigarette brands, could have an adverse effect on the consolidated results of operations, cash flows and financial position of RAI.

RAI’s subsidiaries are dependent on the U.S. cigarette market. In connection with the Merger, RAI did not acquire any brands outside of the United States and the assets of Lorillard’s subsidiaries related to the “e-vapor” brand blu (including SKYCIG) were included in the Divestiture. Lorillard, like RAI, previously divested its international cigarette business.

Furthermore, the sale of the international NATURAL AMERICAN SPIRIT brand to JTI Holding increases the reliance of RAI’s operating subsidiaries on the U.S. cigarette market. In addition, pursuant to the 2015 Purchase Agreement, RAI has agreed not to, and agreed to cause its controlled affiliates not to, engage in the business of producing, selling, distributing and developing natural, organic and additive-free combustible tobacco cigarettes and roll-your-own or make-your-own tobacco products outside of the United States for a period of five years after the closing.

RAI’s subsidiaries’ U.S. combustible cigarette brands include, among others, NEWPORT, CAMEL, PALL MALL and NATURAL AMERICAN SPIRIT. RAI estimates that its sales in the United States attributable to combustible cigarettes would have represented approximately 90% of RAI’s pro forma 2015 net sales, assuming the Merger and Divestiture had occurred on January 1, 2015. 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. consumption is expected to continue to decline. MSAi reported that, on a year-over-year basis, U.S. cigarette shipments declined 0.1% in 2015, 3.2% in 2014 and 4.6% in 2013.

In addition, RAI’s subsidiaries’ brands are subject to consumer price sensitivities, with certain brands subject to greater price sensitivities than others or competitors’ brands. Some consumers may switch to a lower priced brand than the brands offered by RAI’s subsidiaries. As a result of the acquisition of Lorillard’s subsidiaries’ brands, which principally consist of NEWPORT, RAI’s subsidiaries’ concentration of premium brands increased significantly. As a result, RAI’s subsidiaries are more susceptible to consumer price sensitivities following the Merger. A downturn in the economy or other adverse financial or economic conditions could increase the number of consumers switching to a lower priced brand than any of those offered by RAI’s subsidiaries.

The continued decline in U.S. cigarette consumption, or the transition of consumers away from premium cigarette brands, could have an adverse effect on the consolidated results of operations, cash flows and financial position of RAI.

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.

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 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 cigarette consumption generally.

Furthermore, while VUSE, RJR Vapor’s e-cigarette product, is currently the number one e-cigarette product sold in convenience/gas stores, sales of closed system products like VUSE continue to decline in comparison to the sale of tanks and liquid nicotine containers typically sold in vapor shops and on-line. The future success of VUSE and other RJR Vapor e-cigarette offerings will depend on the ability to innovate in an evolving category of alternative tobacco products.

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.

If RJR Tobacco and RAI’s other operating companies are not able to develop, produce or market new alternative products to replace 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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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, Santa Fe and American Snuff.

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 13 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/or use of tobacco products. These laws have proliferated in recent years. For example, some local laws prohibit the sale of certain tobacco products. Another example is that some local laws prohibit certain types of marketing practices, such as consumer coupons. In addition, there are many local laws that prohibit the consumption of cigarettes and other tobacco products in restaurants and other public places. Private businesses also have adopted policies that prohibit or restrict, or are intended to discourage, smoking and tobacco use. These laws and regulations could result in a decline in the overall sales volume of tobacco products, which could have an adverse effect on the results of operations, cash flows and financial position of RAI and its 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.

Many of 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.

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 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 subsidiaries. RAI and its 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

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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 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 2015, 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, 2015, 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, 2015, as a result of the Merger, the individual fair values of four trademarks were less than 15% in excess of their respective carrying values. The aggregate carrying value of these four trademarks was $27.2 billion at December 31, 2015.

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.

For additional information, see Item 8, note 4 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 obligations or changes in required pension funding levels may have an unfavorable impact on pension cost, which could have an adverse effect on the results of operations, cash flows and financial position of RAI. RAI contributed $18 million to its pension plans in 2015. During 2016, RAI expects to contribute $335 million to its pension plans, of which $325 million was contributed in January 2016. RAI actively seeks to control increases in pension cost, 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 may have to make additional contributions beyond what is currently contemplated to fund its pension and other postretirement benefit plans.

For additional information, see Item 8, note 16 to consolidated financial statements.

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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, SFNTC and American Snuff Co. 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 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, SFNTC and American Snuff Co. 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 raw 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.

RAI’s operating subsidiaries rely on a limited number of suppliers for raw materials. If a supplier fails to meet any of RAI’s operating subsidiaries’ demands for raw materials, any such 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 28% and 10%, respectively, of RAI’s consolidated revenue in 2015. 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 (except for the manufacturing of cigarettes by Imperial Sub pursuant to the reciprocal manufacturing agreement described below), RJR Tobacco’s cigarette manufacturing is conducted primarily at a single facility. Additionally, SFNTC’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 subsidiaries.

The future success of RAI and its 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 subsidiaries to effectively manage 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 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 subsidiaries.

RAI and its subsidiaries are dependent on information technology systems to operate and manage all aspects of their businesses, including, without limitation, to comply with regulatory, legal, financial reporting and tax requirements, and to collect and store confidential information.   Such confidential information may include proprietary business information, and what is often referred to as “personally identifiable information,” or certain information about individuals (such as employees and, in the case of RAI’s subsidiaries, consumers).  The use and handling of personally identifiable information is subject to developing regulations, which vary from jurisdiction to jurisdiction, and the cost of regulatory compliance may be significant.

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RAI and its subsidiaries also rely on third party vendors to operate their information technology and to perform certain services for the companies. Certain of these vendors store, process or otherwise handle confidential information, including personally identifiable information.  

RAI’s and its subsidiaries’ information technology systems, and the systems of their vendors, may not function as intended, and may be vulnerable to damage, interruption, or shutdown from a variety of events, such as computer system and telecommunications failures, computer viruses, user errors and catastrophic events. Cybersecurity threats, which are constantly evolving, also pose a risk to the security and viability of RAI’s and its subsidiaries’ information technology systems, and the systems of their vendors.  Security breaches could be committed by third parties intending to access, misappropriate or corrupt confidential information and personally identifiable information, or otherwise to disrupt the business of RAI and its subsidiaries.  Any interruptions, failures or breaches of RAI’s and its subsidiaries’ information technology systems, or the systems of their vendors, could result in: the loss of revenue and customers; transaction errors and processing inefficiencies; the loss or unauthorized disclosure of, or damage to, confidential and personally identifiable information and/or other assets; damage to the reputation of RAI and its subsidiaries and to the brands of those subsidiaries; litigation and regulatory enforcement actions; and increased costs.  Any of these events could have an adverse effect on the results of operations, cash flows and financial position of RAI and its 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.

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.

RJR Tobacco will be reliant on Imperial Sub to manufacture NEWPORT on RJR Tobacco’s behalf for a period of time, and RJR Tobacco will manufacture WINSTON, KOOL and SALEM on Imperial Sub’s behalf. RJR Tobacco’s reliance on Imperial Sub for the manufacture of NEWPORT will subject RAI and RJR Tobacco to risks and uncertainties to which it would not otherwise be subject, and Imperial Sub’s inability to manufacture NEWPORT as required could adversely affect RAI and RJR Tobacco’s results of operations, cash flows, financial position and ability to realize any or all of the synergies expected as a result of the Merger and Divestiture.

RJR Tobacco and Imperial Sub entered into a reciprocal manufacturing agreement at the closing of the Merger and the Divestiture, pursuant to which for a period of up to two years, subject to extension as provided therein, Imperial Sub will manufacture NEWPORT, KENT, OLD GOLD and TRUE on RJR Tobacco’s behalf and RJR Tobacco will manufacture WINSTON, KOOL and SALEM on Imperial Sub’s behalf. Reliance on Imperial Sub for the manufacture of NEWPORT will subject RAI and RJR Tobacco to risks and uncertainties to which it would not be subject if RJR Tobacco manufactured NEWPORT itself, including, among others:

 

·

reduced control over the manufacturing process and quality control;

 

·

disruptions to Imperial Sub’s operations and the production of NEWPORT caused by conditions unrelated to RAI’s and its subsidiaries’ businesses or operations, including disputes under collective bargaining agreements with labor unions or in connection with negotiation of new collective bargaining agreements, strikes or other work stoppages at the Imperial Sub plant that manufactures NEWPORT or the occurrence of a catastrophic event affecting Imperial Sub; and

 

·

loss of market share and reputational harm to RAI and RJR Tobacco in the event a disruption of the production of NEWPORT by Imperial Sub results in insufficient supply.

In addition, Imperial Sub may not transition the manufacturing of WINSTON, KOOL and SALEM to the Greensboro plant acquired by Imperial Sub in the Divestiture as quickly as currently contemplated.

If Imperial Sub fails to or is unable to perform under the reciprocal manufacturing agreement, RAI’s and RJR Tobacco’s results of operations, cash flows and financial position could be adversely affected, and there could be a delay to RAI and RJR Tobacco’s ability to realize any or all of the synergies expected as a result of the Merger and Divestiture.

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RAI is obligated to indemnify Imperial Sub for specified matters and to retain certain liabilities related to the divested brands and other assets.

Under the Asset Purchase Agreement, RAI will indemnify Imperial Sub against losses arising from, among other things, breaches of representations and warranties, breaches of covenants, assets excluded from the transaction, excluded liabilities, certain specific tobacco liabilities, certain assumed plaintiff fees, certain employment related obligations, and liabilities in connection with certain tobacco litigation, settlement and regulatory matters. The Asset Purchase Agreement does not cap RAI’s indemnification obligations, except with respect to any indemnification arising from breaches of certain representations and warranties or pre-closing covenants. Accordingly, these indemnification obligations could be substantial and could have an adverse effect on RAI’s results of operations, cash flows and financial position.

RAI may fail to realize the expected synergies and other benefits of the Merger, which could adversely affect the value of RAI common stock.

The success of the Merger will depend, in part, on RAI’s ability to realize the expected synergies and other benefits from combining the businesses of RAI and Lorillard and their respective subsidiaries and affiliates. RAI’s ability to realize these anticipated benefits and cost savings is subject to certain risks, including the following:

 

·

the ability to successfully combine and integrate the businesses of RAI, Lorillard and their respective subsidiaries;

 

·

RAI’s ability to reduce its level of indebtedness in a timely manner following the Merger; and

 

·

the ability to successfully transition manufacturing of NEWPORT from Lorillard’s manufacturing facility to RJR Tobacco’s manufacturing facility when and as expected.

If RAI is not able to successfully combine the businesses of RAI, Lorillard and their respective subsidiaries within the anticipated time frame, or at all, the expected synergies and other benefits of the Merger may not be realized fully or at all or may take longer to realize than expected, the combined businesses may not perform as expected and the value of RAI common stock may be adversely affected. In addition, if RAI is unable to timely reduce its level of indebtedness following the Merger, RAI will be subject to increased demands on its cash resources and tightening financial covenants under its revolving credit agreement, which could result in a breach of the covenants or otherwise adversely affect the business and financial results of the combined company.

SFNTC is obligated to indemnify JTI Holding for certain liabilities relating to specified pre-sale statements made by the disposed-of entities relating to NATURAL AMERICAN SPIRIT brand cigarettes consumed outside the United States.

Under the 2015 Purchase Agreement, SFNTC and two other RAI subsidiaries will indemnify JTI Holding against liabilities resulting from breaches of representations, warranties, or covenants; certain pre-sale debts of the disposed-of entities; the operation of the NATURAL AMERICAN SPIRIT brand business in the United States; and liabilities arising from either personal injury actions commenced on or before January 13, 2019, or other actions commenced on or before January 13, 2021, where such actions are based on pre-sale statements by the disposed-of entities that NATURAL AMERICAN SPIRIT brand cigarettes intended to be consumed outside the United States were natural, organic, or additive free.  The 2015 Purchase Agreement does not cap these indemnification obligations, except with respect to breaches of representations or warranties.  Accordingly, these indemnification obligations could be substantial and could have an adverse effect on RAI’s results of operations, cash flows and financial position.

Changes in financial market conditions, including adverse changes in the liquidity of financial markets, 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, including adverse changes in the liquidity of financial markets, could result in additional realized or unrealized losses associated with the value of RAI’s investments. Additionally, these changes could negatively impact RAI’s interest rate risk, foreign currency exchange rate risk and the return on corporate cash, resulting in increased costs and reduced profitability. Accordingly, the results of operations, cash flows and financial position of RAI could be adversely affected. Due to recent market conditions, RAI has invested any excess cash in either low interest or near zero interest investments, thereby lowering interest income. As of December 31, 2015, $24 million of unrealized losses remain in other comprehensive loss. For more information on investment losses, see Item 8, note 3 to consolidated financial statements.

22


 

RAI and RJR Tobacco have substantial long-term debt, including the debt assumed and incurred in connection with the Merger, which could adversely affect its financial position and its ability to obtain financing in the future and react to changes in its business.

Following completion of the Merger, RAI substantially increased its consolidated indebtedness compared to its recent historical indebtedness. As of December 31, 2015, RAI and RJR Tobacco had, in the aggregate, principal outstanding notes of $16.7 billion and $377 million, respectively.

Because of this increased level of debt as a result of the Merger:

 

·

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.

For more information on RAI’s long-term debt, see Item 8, note 12 to consolidated financial statements.

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 11 to consolidated financial statements.

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.

RAI’s credit ratings impact the cost and availability of future borrowings and, accordingly, RAI’s cost of capital. As of December 31, 2015, the outstanding notes issued by RAI were rated investment grade. Following the close of the Merger, Standard & Poor’s Ratings Services reaffirmed all of its ratings on RAI, including its BBB- corporate credit ratings, and Moody’s Investor Service downgraded RAI’s Baa2 senior unsecured debt rating one notch, to Baa3. If RAI’s credit rating falls further, 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 credit ratings decline.

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.

23


 

In addition, the interest rate RAI pays on borrowings 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. RAI pays a fee on commitments under its revolving credit facility based on the ratings of RAI’s senior, unsecured, long-term indebtedness. 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 and long-term debt, see Item 8, notes 11 and 12 to consolidated financial statements.

RAI may have to reduce its indebtedness in order to remain in compliance with a covenant under its revolving credit facility. There is no guarantee RAI will be able to reduce its indebtedness in the amount or at the times needed to maintain compliance, which could result in a default under the revolving credit facility.

Under the revolving credit facility, RAI’s consolidated leverage ratio (as defined therein) may not exceed:

 

·

3.00 to 1.00 as of the last day of any period of four consecutive fiscal quarters, referred to as a Reference Period, ending prior to the closing of the Merger;

 

·

4.50 to 1.00 for the Reference Periods ending on the last day of each of RAI’s fiscal quarters ending on June 30, September 30, and December 31, 2015;

 

·

4.25 to 1.00 for the Reference Periods ending on the last day of each of RAI’s fiscal quarters ending on March 31, June 30, and September 30, 2016;

 

·

3.75 to 1.00 for the Reference Periods ending on the last day of each of RAI’s fiscal quarters ending on December 31, 2016, and March 31, and June 30, 2017; and

 

·

3.50 to 1.00 thereafter.

Since the leverage ratio becomes more restrictive as time passes after the completion of the Merger, RAI may need to reduce its indebtedness in order to remain in compliance with the covenant. There is no guarantee that RAI will be able to reduce its indebtedness in the amount or at the times needed, which could result in RAI defaulting under the revolving credit facility. In such event, the agents or lenders under the revolving credit facility could exercise remedies, including acceleration of any amounts outstanding under the revolving credit facility or termination of the facility, which could have a material negative effect on RAI’s financial position.

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, at its discretion, depart from or change its dividend policy at any time. 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, at 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.

BAT’s significant beneficial 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. BAT and B&W also have influence over RAI by virtue of the governance agreement, which requires B&W’s approval before RAI takes certain actions.

BAT, through its subsidiaries, beneficially 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, BAT, through its subsidiaries, would have the power to determine the outcome of matters submitted to a shareholder vote, subject to the governance agreement described below.

24


 

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 BAT or its affiliates, other than a re-adoption of the RAI rights plan in the form permitted by the governance agreement.

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 individuals to RAI’s Board, and the approvals of the majority of those individuals is required before certain actions may be taken, even though those individuals represent less than a majority of the entire Board.

Under the governance agreement, B&W, based upon the current beneficial ownership of BAT through its subsidiaries, is entitled to nominate five directors to RAI’s Board, at least three of whom are required to be independent directors and two of whom may be executive officers of BAT or any of its subsidiaries. RAI’s Board currently is composed of 13 persons, including five designees of B&W, the maximum number of designees that B&W is entitled to nominate under the governance agreement. 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 equity securities in excess of 5% of its outstanding voting stock, unless at such time BAT and its subsidiaries’ 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 BAT and its subsidiaries’ 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 the RAI articles of incorporation, neither BAT nor any director of RAI who is affiliated with, or employed by, BAT is required to present a business opportunity to RAI if the business opportunity does not primarily relate to the United States. The loss of favorable business opportunities could have an adverse effect on the results of operations, cash flows and financial position of RAI.

Unless otherwise agreed by the parties, under the RAI articles of incorporation, neither BAT or any of its subsidiaries or affiliates nor any director of RAI who is affiliated with, or employed by, BAT or its subsidiaries and affiliates, including any B&W designated director, is required to present a transaction, relationship, arrangement or other opportunity, all of which are collectively referred to as a business opportunity to RAI, RAI’s Board or any RAI officer or employee if the business opportunity does not relate primarily to the United States. RAI has renounced any expectancy or interest in, or in being offered an opportunity to participate in, any such business opportunity, and BAT and its subsidiaries and affiliates are entitled to act upon any such business opportunity and will not be liable to RAI or any RAI shareholders for taking any such action or not presenting such business opportunity to RAI. As a result, RAI may not be presented with certain favorable business opportunities that are known to BAT or a BAT affiliated director of RAI, and BAT may take advantage and receive the benefits of those business opportunities. The loss of favorable business opportunities could have an adverse effect on the results of operations, cash flows and financial position of RAI.

BAT’s significant beneficial ownership interest in RAI, and RAI’s 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 BAT. This could have a negative effect on the price of RAI common stock.

BAT, through its subsidiaries, 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. As a result, it would make it very difficult for a third party to acquire RAI without BAT consent. In addition, RAI has a classified board of directors and other takeover defenses in its articles of incorporation and bylaws. BAT’s beneficial 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 BAT.

25


 

RAI shareholders may be adversely affected by the July 30, 2014 expiration of the “standstill” provisions in the governance agreement. This event enables BAT and its subsidiaries to, among other things, acquire some or all of the shares of RAI common stock not held by BAT and its subsidiaries 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 restricted BAT and its subsidiaries from acquiring additional shares of RAI common stock, seeking to remove RAI directors not designated by B&W, or taking other specified actions to influence or gain control of RAI. These restrictions expired on July 30, 2014.

As a consequence of the expiration of the “standstill” period, BAT and its subsidiaries are permitted to increase their ownership interest in RAI without limitation. The RAI shareholder rights plan also expired on July 30, 2014, but RAI’s Board is permitted under the governance agreement to readopt a shareholder rights plan in the form permitted by the governance agreement.

The governance agreement limits B&W representation on RAI’s Board to five directors (out of an entire Board of 13 directors), of whom at least three must be independent of both RAI and BAT. If the voting percentage of BAT and its subsidiaries in 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 BAT and its subsidiaries 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 and amendments thereto are filed as Exhibits 10.13 to 10.16 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 board composition and share transfer restrictions on BAT and its subsidiaries would no longer apply. These developments could enable BAT and its subsidiaries to, among other things, acquire some or all of the shares of RAI common stock not held by BAT and its subsidiaries, seek additional representation on RAI’s Board, replace existing RAI directors, solicit proxies, otherwise influence or gain control of RAI or transfer all or a significant percentage of their shares of RAI common stock to a third party.

The governance agreement provides that it will terminate automatically in its entirety if BAT and its subsidiaries own less than 15% or if any third party or group controls more than 50% of the voting power of all RAI shares. In addition, BAT and 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 RAI’s Board or its committees or if RAI has deprived B&W nominees of such representation for “fiduciary” reasons or has willfully deprived B&W or its board nominees of any veto rights.

BAT and B&W also may terminate the obligation to vote their 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.

If the share transfer restrictions in the governance agreement are terminated, there will be no contractual restrictions on the ability of BAT and its subsidiaries to sell or transfer their shares of RAI common stock on the open market, in privately negotiated transactions or otherwise. These sales or transfers could create a substantial decline in the price of shares of RAI common stock or, if these sales or transfers were made to a single buyer or group of buyers that own shares of RAI common stock, could result in a third party acquiring control of or influence over RAI.

The 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.

RAI’s bylaws provide 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;

26


 

 

·

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 Carolina area, and American Snuff Co.’s manufacturing facilities are located in Memphis, Tennessee; Clarksville, Tennessee; and Winston-Salem, North Carolina. SFNTC’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 13 to consolidated financial statements for disclosure of legal proceedings involving RAI and its operating subsidiaries.

Item 4. Mine Safety Disclosures

Not applicable.

 

 

27


 

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 25, 2016, there were approximately 12,412 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 25, 2016, was $46.89 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 (1):

 

 

 

Price Per Share

 

 

Cash

Dividends

Declared Per

 

 

 

High

 

 

Low

 

 

Share

 

2015:

 

 

 

 

 

 

 

 

 

 

 

 

First Quarter

 

$

38.12

 

 

$

31.35

 

 

$

0.335

 

Second Quarter

 

 

38.98

 

 

 

34.33

 

 

 

0.335

 

Third Quarter

 

 

44.44

 

 

 

35.70

 

 

 

0.360

 

Fourth Quarter

 

 

49.56

 

 

 

43.02

 

 

 

0.360

 

2014:

 

 

 

 

 

 

 

 

 

 

 

 

First Quarter

 

$

28.39

 

 

$

23.28

 

 

$

0.335

 

Second Quarter

 

 

31.32

 

 

 

26.53

 

 

 

0.335

 

Third Quarter

 

 

31.70

 

 

 

27.61

 

 

 

0.335

 

Fourth Quarter

 

 

33.80

 

 

 

28.14

 

 

 

0.335

 

 

(1)

All per share amounts have been retroactively adjusted to reflect the August 31, 2015, two-for-one stock split. See “—Business” in Item 1 for additional information.

In addition, the board of directors of RAI declared a quarterly cash dividend of $0.42, or $1.68 on an annualized basis, per common share, on February 10, 2016. The dividends will be paid on April 1, 2016, to shareholders of record as of March 10, 2016. The dividend reflects RAI’s current policy of paying dividends to the holders of RAI common stock in an aggregate amount that is approximately 75% of RAI’s annual consolidated net income.

RAI, B&W and BAT entered into Amendment No. 3, dated November 11, 2011, to the governance agreement, pursuant to which RAI has agreed that, so long as the ownership interest of BAT and its subsidiaries in RAI 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 the ownership interest of BAT and its subsidiaries in RAI is not decreased, by such issuance after taking into account such repurchase. During 2015, in accordance with the governance agreement, at a cost of $82 million, RAI repurchased 1,820,453 shares of RAI common stock in open-market transactions.

During 2015, RAI repurchased 1,111,835 shares of RAI common stock at a cost of $42 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 Compensation Plan, referred to as the Omnibus Plan. The Amended and Restated Omnibus Plan was approved by shareholders in 2014.

Due to RAI’s incorporation in North Carolina, which does not recognize treasury shares, the shares repurchased were cancelled at the time of repurchase.

28


 

The following table summarizes RAI’s purchases of its common stock during the fourth quarter of 2015:

 

 

 

Total

Number of

Shares

Purchased

 

 

Average

Price Paid

per Share

 

 

Total Number of

Shares Purchased

as Part of Publicly

Announced Plans

or Programs

 

 

Approximate

Dollar Value of Shares that May

Yet be Purchased Under the Plans

or Programs

 

October 1, 2015 to October 31, 2015 (1)

 

 

53,685

 

 

$

44.27

 

 

 

53,685

 

 

$

 

November 1, 2015 to November 30, 2015

 

 

1,820,453

 

 

 

45.05

 

 

 

1,820,453

 

 

 

 

December 1, 2015 to December 31, 2015 (1)

 

 

2

 

 

 

27.87

 

 

 

2

 

 

 

 

Total

 

 

1,874,140

 

 

 

 

 

 

 

1,874,140

 

 

 

 

 

 

(1)

During 2015, RAI repurchased and cancelled shares of its common stock with respect to the tax liability associated with the vesting of restricted stock grants under the Omnibus Plan. For equity-based benefit plan information, see Item 8, note 15 to consolidated financial statements.

Performance Graph

Set forth below is a line graph comparing, for the period which commenced on December 31, 2010, and ended on December 31, 2015, 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.

 

 

 

 

12/31/10

 

 

12/31/11

 

 

12/31/12

 

 

12/31/13

 

 

12/31/14

 

 

12/31/15

 

Reynolds American Inc.(1)

 

$

100.00

 

 

$

134.41

 

 

$

141.93

 

 

$

180.50

 

 

$

242.85

 

 

$

361.29

 

S&P 500

 

 

100.00

 

 

 

102.11

 

 

 

118.45

 

 

 

156.82

 

 

 

178.29

 

 

 

180.75

 

S&P Tobacco (2)

 

 

100.00

 

 

 

136.42

 

 

 

150.64

 

 

 

176.18

 

 

 

200.51

 

 

 

244.35

 

 

(1)

Assumes that $100 was invested in RAI common stock and indexes on December 31, 2010, and that in each case all dividends were reinvested.

(2)

The S&P Tobacco Index includes as of December 31, 2015, the following companies: Altria Group, Inc., Philip Morris International Inc. and Reynolds American Inc.

 

 

29


 

Item 6. Selected Financial Data

The selected historical consolidated financial data as of December 31, 2015 and 2014, and for each of the years in the three-year period ended December 31, 2015, 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, 2013, 2012 and 2011, and for the years ended December 31, 2012 and 2011, 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,

 

 

 

2015 (7)

 

 

2014

 

 

2013

 

 

2012

 

 

2011

 

 

 

(Dollars in Millions, Except Per Share Amounts)

 

Results of Operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net sales (1)

 

$

10,675

 

 

$

8,471

 

 

$

8,236

 

 

$

8,304

 

 

$

8,541

 

Income from continuing operations (1)(2)(3)(4)(5)(6)

 

 

3,253

 

 

 

1,445

 

 

 

1,718

 

 

 

1,272

 

 

 

1,406

 

Income from discontinued operations

 

 

 

 

 

25

 

 

 

 

 

 

 

 

 

 

Net income

 

 

3,253

 

 

 

1,470

 

 

 

1,718

 

 

 

1,272

 

 

 

1,406

 

Per Share Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic income from continuing operations

 

 

2.57

 

 

 

1.36

 

 

 

1.58

 

 

 

1.12

 

 

 

1.21

 

Diluted income from continuing operations

 

 

2.57

 

 

 

1.35

 

 

 

1.57

 

 

 

1.12

 

 

 

1.20

 

Basic income from discontinued operations

 

 

 

 

 

0.02

 

 

 

 

 

 

 

 

 

 

Diluted income from discontinued operations

 

 

 

 

 

0.02

 

 

 

 

 

 

 

 

 

 

Basic net income

 

 

2.57

 

 

 

1.38

 

 

 

1.58

 

 

 

1.12

 

 

 

1.21

 

Diluted net income

 

 

2.57

 

 

 

1.37

 

 

 

1.57

 

 

 

1.12

 

 

 

1.20

 

Basic weighted average shares, in thousands

 

 

1,264,182

 

 

 

1,066,320

 

 

 

1,089,849

 

 

 

1,131,139

 

 

 

1,164,639

 

Diluted weighted average shares, in thousands

 

 

1,267,715

 

 

 

1,069,940

 

 

 

1,093,899

 

 

 

1,135,746

 

 

 

1,170,766

 

Cash dividends declared per share of common stock

 

$

1.390

 

 

$

1.340

 

 

$

1.240

 

 

$

1.165

 

 

$

1.075

 

Balance Sheet Data (at end of periods):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

 

53,224

 

 

 

15,196

 

 

 

15,402

 

 

 

16,557

 

 

 

16,254

 

Long-term debt (less current maturities)

 

 

16,941

 

 

 

4,633

 

 

 

5,099

 

 

 

5,035

 

 

 

3,206

 

Shareholders’ equity

 

 

18,252

 

 

 

4,522

 

 

 

5,167

 

 

 

5,257

 

 

 

6,251

 

Cash Flow Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash from operating activities

 

 

196

 

 

 

1,623

 

 

 

1,308

 

 

 

1,568

 

 

 

1,420

 

Net cash from (used in) investing activities

 

 

(10,005

)

 

 

(205

)

 

 

(113

)

 

 

(54

)

 

 

60

 

Net cash from (used) in financing activities

 

 

11,438

 

 

 

(1,918

)

 

 

(2,207

)

 

 

(971

)

 

 

(1,714

)

Net cash related to discontinued operations, net of tax

   benefit

 

 

 

 

 

25

 

 

 

 

 

 

 

 

 

 

Other Data:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ratio of earnings to fixed charges (8)

 

 

12.0

 

 

 

8.7

 

 

 

11.3

 

 

 

9.1

 

 

 

10.6

 

 

(1)

Net sales and cost of products sold exclude excise taxes of $4,209 million, $3,625 million, $3,730 million, $3,923 million and $4,107 million for the years ended December 31, 2015, 2014, 2013, 2012 and 2011, respectively.

(2)

Includes restructuring and/or asset impairment charges of $99 million and $149 million for the years ended December 31, 2015 and 2012, respectively.

(3)

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

(4)

Includes NPM Adjustment credits of $297 million, $345 million and $483 million for the years ended December 31, 2015, 2014 and 2013, respectively. In addition, 2015 includes $93 million for the partial recognition of the 2003 NPM Adjustment.

(5)

Includes MTM Adjustment of $246 million, $452 million, $329 million and $145 million for the years ended December 31, 2015, 2014, 2012 and 2011, respectively.

(6)

Includes Gain on Divestiture of $3,181 million for the year ended December 31, 2015.

(7)

Reflects impact of the Merger and Divestiture. See Item 8, note 2 to consolidated financial statements.

(8)

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.

 

 

30


 

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, 2015 compared with 2014, and 2014 compared with 2013. The statements of financial position and results of operations contained in the consolidated financial statements reflect the results of the Merger, Divestiture and related transactions. 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, 2015 and 2014, and for each of the years in the three-year period ended December 31, 2015.

Overview and Business Initiatives

On June 12, 2015, RAI completed the Merger, Divestiture and BAT Share Purchase. For additional information on these transactions, see Merger, Divestiture and related transactions below.

On January 13, 2016, RAI, through the Sellers, completed the sale of the international rights to the NATURAL AMERICAN SPIRIT brand name and associated trademarks, along with the international companies that distribute and market the brand outside the United States to JTI Holding, a subsidiary of JTI, in an all-cash transaction with a value of approximately $5 billion. For additional information on the transaction, see Item 8, note 4 and note 22 to consolidated financial statements.

RAI’s reportable operating segments are RJR Tobacco, Santa Fe and American Snuff. The RJR Tobacco segment consists principally of the primary operations of R. J. Reynolds Tobacco Company. The Santa Fe segment consists of the domestic operations of SFNTC. The American Snuff segment consists of the primary operations of American Snuff Co. Included in All Other, among other RAI subsidiaries, are RJR Vapor, Niconovum USA, Inc., Niconovum AB, and until their sale on January 13, 2016, as described below, SFRTI and various foreign subsidiaries affiliated with SFRTI. 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 shifts in consumer preferences, RAI’s strategy continues to focus on transforming tobacco to deliver sustainable earnings growth, strong cash flow and enhanced long-term shareholder value. This transformation strategy includes growing the core cigarette and moist-snuff businesses, focusing on innovation and engaging with adult tobacco consumers, 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 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 three of the top four best-selling cigarettes in the United States: NEWPORT, CAMEL and PALL MALL. These brands, and its other brands, including DORAL, MISTY and CAPRI, are manufactured in a variety of styles and marketed in the United States. As part of its total tobacco strategy, RJR Tobacco offers a smoke-free tobacco product, CAMEL Snus. RJR Tobacco 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 also manages the super-premium cigarette brands, DUNHILL and STATE EXPRESS 555, which are licensed from BAT.

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

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.

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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 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 in 2004 or the Merger. The U.S. cigarette market is a mature market in which overall adult 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.

RJR Tobacco’s cigarette brand portfolio strategy is based upon two brand categories: drive and other. The drive brands consist of two premium brands, NEWPORT and CAMEL, and the largest traditional value brand, PALL MALL. Although these three brands are managed for long-term market share and profit growth, NEWPORT and CAMEL will continue to receive the most significant equity support. The other brand category includes the premium brand, CAPRI, and the value brands, DORAL and MISTY, along with other smaller brands, all of which receive limited marketing support and 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 drive brands while managing the other brands for long-term sustainability and profitability. Consistent with that strategy, RJR Tobacco continues to evaluate some of its non-core cigarette styles for potential elimination.

RJR Tobacco’s portfolio also includes CAMEL Snus, a smoke-free, heat-treated tobacco product sold in individual pouches that provide 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. Competition among the major cigarette manufacturers continues to be highly competitive and includes product innovation and expansion into smoke-free tobacco categories.

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.

Santa Fe

Santa Fe competes in the U.S. cigarette market with its Natural American Spirit brand, which is the fastest growing super-premium cigarette brand and is a top 10 best-selling 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.

American Snuff

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

In contrast to the declining U.S. cigarette market, U.S. moist snuff retail volumes grew approximately 2.5% in 2015. 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.

32


 

All Other

RJR Vapor is a manufacturer and marketer of VUSE Digital Vapor Cigarette. The national expansion of VUSE began in 2014, and was completed in early 2015. VUSE is now the top-selling vapor product in convenience/gas stores, and its innovative digital technology is designed to deliver a consistent flavor and vapor experience.

During 2015, RAI announced that certain of its operating companies consolidated manufacturing operations for the VUSE Digital Vapor Cigarette, which should generate manufacturing and cost efficiencies. In addition to in-house production at RJR Tobacco’s manufacturing facility in Tobaccoville, North Carolina, certain production of VUSE cartridges was previously performed for RJR Vapor at a contractor’s facility in Kansas. Effective September 30, 2015, all production of VUSE cartridges occurs at the Tobaccoville facility, pursuant to a services agreement between RJR Tobacco and RJR Vapor.

Niconovum USA, Inc. was in lead markets in Iowa and Nebraska with ZONNIC, a nicotine replacement therapy gum, until September 2014 when it began its national expansion. ZONNIC is now available in many retail outlets across the United States. Niconovum AB is a marketer of nicotine replacement therapy products in Sweden under the ZONNIC brand name.

SFRTI and various foreign subsidiaries affiliated with SFRTI distribute the NATURAL AMERICAN SPIRIT brand outside the United States. On January 13, 2016, RAI, through the Sellers, completed the sale of the international rights to the NATURAL AMERICAN SPIRIT brand name and associated trademarks, along with the international companies that distribute and market the brand outside the United States to JTI Holding, a subsidiary of JTI, in an all-cash transaction with a value of approximately $5 billion.

Merger, Divestiture and BAT Share Purchase

Overview

On July 15, 2014, RAI, Merger Sub and Lorillard entered into the Merger Agreement, pursuant to which RAI agreed to acquire Lorillard in a cash and stock transaction.

On July 15, 2014, RAI entered into the Asset Purchase Agreement and Lorillard entered into the Transfer Agreement, in each case with Imperial Sub and for certain provisions of the Asset Purchase Agreement and as guarantor of certain obligations of Imperial Sub, Imperial, pursuant to which Imperial Sub agreed to acquire certain assets and assume certain liabilities of certain affiliates of each of RAI and Lorillard.

Merger

On June 12, 2015, the Merger was completed, with Merger Sub merging with and into Lorillard and Lorillard surviving as a wholly owned subsidiary of RAI. Pursuant to the Merger Agreement, each share of Lorillard common stock (other than treasury shares held by Lorillard and any shares of Lorillard common stock owned by any Lorillard subsidiary, RAI or Merger Sub) was converted into the right to receive (1) 0.2909 of a share of RAI common stock, prior to giving effect to the stock split, plus (2) $50.50 in cash (the foregoing collectively referred to as the Merger Consideration). RAI issued 104,706,847 shares of RAI common stock, prior to giving effect to the stock split, to Lorillard shareholders in the Merger.

As a part of the Merger, RAI acquired the premium cigarette brand, NEWPORT, which is the top selling menthol and second largest selling cigarette brand overall in the United States. In addition to NEWPORT, RAI acquired three additional brand families marketed under the KENT, TRUE and OLD GOLD brand names. With the addition of the NEWPORT brand, RAI's operating companies have brand portfolios that reflect diversification and strength across product categories and across geographies. It is expected that the transaction will provide RAI with additional resources to invest in innovation, R&D and its operating companies’ brands.

Divestiture

On June 12, 2015, the Divestiture was completed and Imperial Sub acquired the cigarette brands WINSTON, KOOL and SALEM, previously owned by RAI subsidiaries and included in the RJR Tobacco segment, as well as the cigarette brand MAVERICK and the “e-vapor” brand blu (including SKYCIG), previously owned by Lorillard subsidiaries, and other assets and certain liabilities, including inventory, fixed assets and employee benefit plans, for an aggregate purchase price of approximately $7.1 billion.

33


 

BAT Share Purchase and Other

Concurrently with the completion of the Merger and Divestiture and pursuant to the Subscription Agreement, BAT indirectly (through a wholly owned subsidiary) purchased 77,680,259 shares of RAI common stock, prior to giving effect to the stock split, for approximately $4.7 billion, which was sufficient for BAT and its subsidiaries collectively to maintain their approximately 42% beneficial ownership in RAI. Upon completion of the transactions on June 12, 2015, BAT and its subsidiaries collectively owned 301,014,278 shares, prior to giving effect to the stock split, or approximately 42%, of RAI’s outstanding common stock.

RAI financed the cash portion of the Merger Consideration and related fees and expenses with (1) the net proceeds from a public offering of $9 billion aggregate principal amount of newly issued RAI senior notes, (2) the proceeds from the Divestiture, (3) the proceeds from the BAT Share Purchase and (4) available cash. Transaction related costs of $54 million and $38 million, for the years ended December 31, 2015 and 2014, respectively, were included in selling, general and administrative expenses in RAI’s consolidated statements of income.

For additional information on the Merger, Divestiture and BAT Share Purchase, see Item 8, note 2 to consolidated financial statements.

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.

Business Combination

RAI accounts for business combination transactions in accordance with the Financial Accounting Standards Board, referred to as FASB, Accounting Standards Codification 805, Business Combinations, referred to as ASC 805. RAI allocates the cost of an acquisition to the assets acquired and liabilities assumed based on their fair values as of the acquisition date. Any excess of the purchase price over the estimated fair value of net assets acquired is recorded as goodwill. Determining the fair value of these items requires management’s judgment and may require utilization of independent valuation experts to assist such valuations. These valuations involve the use of significant estimates and assumptions with respect to the timing and amounts of future cash flows, discount rates, market prices, and asset lives, among other items. The judgments made in the determination of the estimated fair value of the assets acquired and the liabilities assumed as well as the estimated useful life of each asset and the duration of each liability can materially impact the financial statements in periods after the acquisition, such as depreciation, amortization, or in certain situations, impairment charges.

The fair value of acquired intangible assets measured on a nonrecurring basis, was determined based on inputs that are unobservable and significant to the overall fair value measurement. As such, acquired intangible assets are classified as Level 3. RAI engaged the services of a third party valuation expert to assist in determining the fair value of acquired trademarks and customer lists. The acquired trademarks and customer lists were valued utilizing the income approach and were based on a discounted cash flow valuation model. This approach utilized unobservable factors, such as royalty rate, projected revenues and a discount rate applied to the estimated cash flows. The determination of the discount rate was based on a cost of equity model, using a risk-free rate, adjusted by a stock beta-adjusted risk premium and size premium.

The fair value of acquired long-term debt was determined based on significant inputs that are observable either directly or indirectly, and are quoted prices for similar instruments in active markets or quoted prices for identical or similar instruments in markets that are not active. As such, acquired long-term debt is classified as Level 2. RAI engaged the services of a financial institution in determining the fair value of acquired long-term debt. The acquired long-term debt was valued utilizing market quotes, credit spreads and discounted cash flows, as appropriate. RAI performed its own independent valuation to assess the reasonableness of that calculated by the financial institution.

As a market participant, RAI determined the fair value of inventories and property, plant and equipment utilizing internal resources and external experts.  The fair value of finished goods inventories was determined using selling price less estimated costs to dispose.  The fair value of other inventories, primarily leaf tobacco acquired, was based on recent costs for similar inventory purchased by RAI and its subsidiaries or historical cost as appropriate.  To fair value property, plant and equipment, which consisted

34


 

primarily of machinery used in the manufacture of cigarettes, RAI utilized internal engineering resources and external vendor experts familiar with pricing for similar machinery on the secondary market.  The fair value of long-term retirement benefits represents the funded status of the employee benefit plans assumed by RAI in the Merger.  RAI engaged its actuaries to determine the fair value of the projected benefit obligations at the date of the Merger utilizing management’s assumptions and estimates relative to the benefit plans acquired.  For the fair value of benefit plan assets, an independent valuation expert was engaged, in addition to internal treasury resources, to project the fair value of the benefit plan assets at the Merger date.

For further information related to accounting for the Merger and Divestiture, see Item 8, note 2 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.

Reynolds Defendants 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 in their pending cases and valid defenses to all actions and intend to defend all actions vigorously. RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against Reynolds Defendants 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 certain Engle Progeny cases described in “— Litigation Affecting the Cigarette Industry — Engle and Engle Progeny Cases” in Item 8, note 13 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 Reynolds Defendants. Any unfavorable outcome of such actions could have a material adverse effect on the consolidated results of operations, cash flows or financial position of RAI or its subsidiaries.

For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see Item 8, note 13 to consolidated financial statements.

State Settlement Agreements

RJR Tobacco (itself, and as successor by merger to Lorillard Tobacco) and SFNTC are participants in the MSA, and RJR Tobacco (itself, and as successor by merger to Lorillard 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, operating profit and inflation. Since relative market share is based on cigarette shipments, the best estimate of the allocation of charges to RJR Tobacco and SFNTC 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 information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see “— Litigation Affecting the Cigarette Industry — Health-Care Cost Recovery Cases — State Settlement Agreements” and “— State Settlement Agreements — Enforcement and Validity; Adjustments” in Item 8, note 13 to consolidated financial statements.

Pension and Postretirement Benefits

RAI sponsors a number of non-contributory defined benefit pension plans covering most of the employees of RAI and certain of its subsidiaries. RAI and a subsidiary provide certain health and life insurance benefits for most of their retired employees and their dependents. These benefits are generally no longer provided to employees hired on or after January 1, 2004.

35


 

Because pension and other postretirement obligations ultimately will be settled in future periods, the determination of annual benefit cost (credit) 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.

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. Actuarial gains and losses are immediately recognized in the operating results in the year in which they occur, to the extent the gains and losses are in excess of 10% of the greater of the fair value of plan assets or benefit obligations, referred to as the corridor. Actuarial gains and losses outside the corridor are recognized annually as of December 31, or when a plan is 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.

Assumed discount rate and asset return are the most critical assumptions and their respective sensitivity to change can 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 2015 net periodic benefit cost

 

$

25

 

 

$

5

 

 

$

(35

)

 

$

(7

)

Effect on December 31, 2015, projected benefit obligation

   and accumulated postretirement benefit obligation

 

 

(678

)

 

 

(108

)

 

 

826

 

 

 

129

 

 

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 2015 net periodic benefit cost

 

$

(55

)

 

$

(2

)

 

$

55

 

 

$

2

 

 

For additional information relating to pension and postretirement benefits, see Item 8, note 16 to consolidated financial statements.

Intangible Assets

Intangible assets include goodwill, trademarks and other intangible assets. The determination of fair value involves considerable estimates and judgment. Goodwill, trademarks and other intangible assets with indefinite lives are tested annually for impairment in the fourth quarter.

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

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

36


 

development of a discount rate result in the application of a higher discount rate. The aggregate fair value of RAI’s operating units’ trademarks and other intangible assets at December 31, 2015, was substantially in excess of their aggregate carrying value. However, at December 31, 2015, as a result of the Merger, the individual fair values of four trademarks were less than 15% in excess of their respective carrying values. The aggregate carrying value of these four trademarks was $27.2 billion at December 31, 2015.

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. For information related to intangible assets, see Item 8, note 4 to consolidated financial statements.

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.

For information on assets and liabilities recorded at fair value, see Item 8, notes 3, 12 and 16 to consolidated financial statements.

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. For additional information on income taxes, see Item 8, note 10 to consolidated financial statements.

Recently Issued Accounting Pronouncements

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

 

 

37


 

Results of Operations

The results of operations below reflect the Merger and Divestiture that occurred on June 12, 2015.  As a result, for 2015, RJR Tobacco’s net sales and operating income include results of operations for the WINSTON, KOOL and SALEM brands only for the period of January 1, 2015 through June 11, 2015, and include results of operations for the NEWPORT, KENT, OLD GOLD and TRUE brands since the date of acquisition.  

 

 

 

For the Twelve Months Ended December 31,

 

 

 

 

2015

 

 

2014

 

 

% Change

 

 

2013

 

 

% Change

 

 

Net sales: (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

RJR Tobacco

 

$

8,634

 

 

$

6,767

 

 

 

27.6

%

 

$

6,728

 

 

 

0.6

%

 

Santa Fe

 

 

818

 

 

 

658

 

 

 

24.3

%

 

 

572

 

 

 

15.0

%

 

American Snuff

 

 

855

 

 

 

783

 

 

 

9.2

%

 

 

745

 

 

 

5.1

%

 

All Other

 

 

368

 

 

 

263

 

 

 

39.9

%

 

 

191

 

 

 

37.7

%

 

Net sales

 

 

10,675

 

 

 

8,471

 

 

 

26.0

%

 

 

8,236

 

 

 

2.9

%

 

Cost of products sold (1)(2)

 

 

4,688

 

 

 

4,058

 

 

 

15.5

%

 

 

3,678

 

 

 

10.3

%

 

Selling, general and administrative expenses

 

 

2,098

 

 

 

1,871

 

 

 

12.1

%

 

 

1,389

 

 

 

34.7

%

 

Gain on Divestiture

 

 

(3,181

)

 

 

 

 

NM

 

(3)

 

 

 

 

 

 

Amortization expense

 

 

18

 

 

 

11

 

 

 

63.6

%

 

 

5

 

 

NM

 

(3)

Asset impairment and exit charges

 

 

99

 

 

 

 

 

NM

 

(3)

 

 

 

 

 

 

Trademark and other intangible asset impairment

   charges

 

 

 

 

 

 

 

NM

 

(3)

 

32

 

 

NM

 

(3)

Operating income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

RJR Tobacco

 

 

3,359

 

 

 

2,173

 

 

 

54.6

%

 

 

2,587

 

 

 

(16.0

)%

 

Santa Fe

 

 

449

 

 

 

337

 

 

 

33.2

%

 

 

280

 

 

 

20.4

%

 

American Snuff

 

 

502

 

 

 

438

 

 

 

14.6

%

 

 

420

 

 

 

4.3

%

 

All Other

 

 

(265

)

 

 

(234

)

 

 

13.2

%

 

 

(70

)

 

NM

 

(3)

Gain on Divestiture

 

 

3,181

 

 

 

 

 

NM

 

(3)

 

 

 

 

 

 

Corporate expense

 

 

(273

)

 

 

(183

)

 

 

49.2

%

 

 

(85

)

 

NM

 

(3)

Operating income

 

$

6,953

 

 

$

2,531

 

 

NM

 

(3)

$

3,132

 

 

 

(19.2

)%

 

 

(1)

Excludes excise taxes of:

 

 

 

2015

 

 

2014

 

 

2013

 

RJR Tobacco

 

$

3,590

 

 

$

3,068

 

 

$

3,231

 

Santa Fe

 

 

254

 

 

 

211

 

 

 

193

 

American Snuff

 

 

54

 

 

 

53

 

 

 

52

 

All Other

 

 

311

 

 

 

293

 

 

 

254

 

 

 

$

4,209

 

 

$

3,625

 

 

$

3,730

 

 

(2)

See below for further information related to State Settlement Agreements, federal tobacco buyout and FDA user fees 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.

 

 

38


 

2015 Compared with 2014

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,

 

 

 

2015

 

 

2014

 

 

% Change

 

RJR Tobacco:

 

 

 

 

 

 

 

 

 

 

 

 

Drive brands:

 

 

 

 

 

 

 

 

 

 

 

 

NEWPORT

 

 

18.9

 

 

 

 

 

NM (2)

 

CAMEL

 

 

20.8

 

 

 

20.9

 

 

 

(0.5

)%

PALL MALL

 

 

19.9

 

 

 

20.6

 

 

 

(3.4

)%

 

 

 

59.5

 

 

 

41.5

 

 

 

43.5

%

Other brands

 

 

11.8

 

 

 

19.5

 

 

 

(39.4

)%

Total RJR Tobacco domestic cigarette shipment volume

 

 

71.3

 

 

 

61.0