10-K 1 d838194d10k.htm 10-K 10-K
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-K

 

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

For the fiscal year ended December 31, 2014

OR

 

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

For the Transition Period From                      to                     

Commission File Number: 001-34097

Lorillard, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware   13-1911176

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

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

(Address of principal executive offices) (Zip Code)

(336) 335-7000

(Registrant’s telephone number, including area code)

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

 

Title of Each Class

 

Name of Each Exchange on Which Registered

Common Stock, $0.01 par value   New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x     No  ¨

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

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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

 

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

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

The aggregate market value of voting and non-voting common equity of the registrant held by nonaffiliates of the registrant as of June 30, 2014 was $22.0 billion.

 

Class

 

Outstanding at February 6, 2015

Common Stock, $0.01 par value   360,047,231 shares

DOCUMENTS INCORPORATED BY REFERENCE:

The information required by this item will be contained in our proxy statement for our 2015 Annual Meeting of Shareholders to be filed pursuant to Section 14 of the Exchange Act, and is incorporated herein by reference.

 

 

 


Table of Contents

TABLE OF CONTENTS

 

         Page  

INTRODUCTORY NOTE

     ii   
PART I        2   
Item 1.  

BUSINESS

     2   
Item 1A.  

RISK FACTORS

     12   
Item 1B.  

UNRESOLVED STAFF COMMENTS

     35   
Item 2.  

PROPERTIES

     35   
Item 3.  

LEGAL PROCEEDINGS

     35   
Item 4.  

MINE SAFETY DISCLOSURES

     35   

PART II

       36   
Item 5.  

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

     36   
Item 6.  

SELECTED FINANCIAL DATA

     38   
Item 7.  

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

     40   
Item 7A.  

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     64   
Item 8.  

FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

     66   
Item 9.  

CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

     135   
Item 9A.  

CONTROLS AND PROCEDURES

     135   
Item 9B.  

OTHER INFORMATION

     138   

PART III

       138   
Item 10.  

DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

     138   
Item 11.  

EXECUTIVE COMPENSATION

     138   
Item 12.  

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

     138   
Item 13.  

CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE

     138   
Item 14.  

PRINCIPAL ACCOUNTANT FEES AND SERVICES

     138   

PART IV

       139   
Item 15.  

EXHIBITS AND FINANCIAL STATEMENT SCHEDULES

     139   

SIGNATURES

     144   

 

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INTRODUCTORY NOTE

On July 15, 2014, Lorillard, Inc. announced that it had entered into a merger agreement with Reynolds American Inc. (“RAI”) and a wholly owned subsidiary of RAI (the “Merger”). Unless stated otherwise, all forward-looking information contained in this report does not take into account or give any effect to the impact of the proposed merger. For additional details regarding the proposed merger, see Note 24 to our consolidated financial statements, “Merger Agreement and Merger-Related Litigation,” contained in Part II, Item 8, of this report, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in Part II, Item 7, of this report and “Risk Factors” contained in Part I, Item 1A, of this report.

 

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Unless otherwise indicated or the context otherwise requires, references to “Lorillard”, “we,” “us” and “our” refer to Lorillard, Inc., a Delaware corporation, and its subsidiaries. “Lorillard, Inc.” refers solely to the parent company and “Lorillard Tobacco” refers solely to Lorillard Tobacco Company, the principal subsidiary of Lorillard, Inc. “LOEC” or “blu eCigs” refers to LOEC, Inc.(d/b/a blu eCigs), a subsidiary of Lorillard, Inc. “Cygnet,” “SKYCIG” or “blu(U.K.)” refers to Cygnet UK Trading Limited, trading as SKYCIG or blu (U.K.), a subsidiary of Lorillard, Inc.

FORWARD-LOOKING STATEMENTS

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

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

the continuing decline in volume in the domestic cigarette industry;

 

   

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

 

   

general economic and business conditions;

 

   

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

 

   

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

 

   

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

 

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the risk of fire, violent weather, disasters or other interruptions adversely affecting our supply chain, including our and our suppliers’ production, storage and other facilities;

 

   

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

 

   

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

 

   

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

 

   

the closing of any contemplated transactions and agreements.

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

PART I

 

Item 1. BUSINESS

Overview

Lorillard is the third largest manufacturer of cigarettes in the United States. Founded in 1760, Lorillard is the oldest continuously operating tobacco company in the United States. Newport, our flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette brand overall in the United States based on gross units sold in 2014. The Newport brand, which includes both menthol and non-menthol product offerings, accounted for approximately 86.5% of our consolidated net sales for the fiscal year ended December 31, 2014. In addition to the Newport brand, our product line has four additional brand families marketed under the Kent, True, Maverick, and Old Gold brand names. These five brands include 45 different product offerings which vary in price, taste, flavor, length and packaging. In 2014, we shipped 39.0 billion cigarettes, all of which were sold in the United States and certain U.S. possessions and territories. Lorillard, through its other subsidiaries, is also a leading global electronic cigarette company, marketed under the blu eCigs brand. Newport, Kent, True, Maverick, Old Gold, blu eCigs and SKYCIG are the registered trademarks of Lorillard and its subsidiaries. We sold substantially all of our major cigarette trademarks outside of the United States in 1977. We maintain our headquarters and manufacture all of our traditional cigarette products in Greensboro, North Carolina.

We produce cigarettes for both the premium and discount segments of the domestic cigarette market. We do not compete in a subcategory of the discount segment that we identify as the deep discount segment. Premium brands are well known, established brands marketed at higher retail prices. Discount brands are generally less well recognized brands marketed at lower retail prices. We define the deep discount subcategory to include brands sold at the lowest retail prices. Deep discount cigarettes are typically manufactured by smaller companies, relative to us and other major U.S. manufacturers, many of which have no, or significantly lower, payment obligations under the Master Settlement Agreement among major tobacco manufacturers and 46 states and various other governments and jurisdictions (the “MSA”) and the settlements of similar claims brought by Mississippi, Florida, Texas and Minnesota, collectively the “State Settlement Agreements”.

On July 15, 2014, Lorillard Inc., Reynolds American Inc., a North Carolina corporation (“RAI”), and Lantern Acquisition Co., a Delaware corporation and a wholly owned subsidiary of RAI (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which, subject to the satisfaction or waiver of certain conditions, Merger Sub will merge with and into Lorillard Inc. (the “Merger”), with Lorillard Inc. surviving as a wholly owned subsidiary of RAI. Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Recent Developments” contained in Part II, Item 7, of this report for additional information.

 

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Advertising and Sales Promotion

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

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

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

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

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

prohibiting payments for cigarette placement in various media; and

 

   

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

In June 2009, the federal Family Smoking Prevention and Tobacco Control Act (the “FSPTCA”) was enacted granting authority over the regulation of certain tobacco products to the FDA, excluding electronic cigarettes. Pursuant to the FSPTCA, the FDA reissued a set of marketing and sales restrictions originally

 

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promulgated in 1995 as part of an unsuccessful effort by the agency to assert jurisdiction over certain tobacco products. The FSPTCA also contains other restrictions, some of which may be more stringent than those found in the original 1995 FDA rule, affecting the advertising, marketing and sale of cigarette products. See the section entitled “Legislation and Regulation” below for additional information concerning the marketing and sales provisions of the FSPTCA. In addition, many states, cities and counties have enacted legislation or regulations further restricting cigarette advertising, marketing and sales promotions, and others may do so in the future. We cannot predict the impact of such initiatives on our marketing and sales efforts.

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

Electronic cigarettes are generally less regulated than cigarettes. Accordingly, a wider variety of marketing programs are available. The predominant forms of advertising and promotion in the electronic cigarette industry are television, print advertising, sampling events and web based advertising. blu eCigs requires all purchasers of their electronic cigarettes to be at least 18 years of age in both the U.S. and U.K. During 2012, the FDA indicated that it intends to regulate electronic cigarettes under the FSPTCA through the issuance of deeming regulations that would include electronic cigarettes under the definition of a “tobacco product” under the FSPTCA subject to the FDA’s jurisdiction. On April 25, 2014, FDA issued a proposed rule that would include electronic cigarettes under the definition of “tobacco product”, and opened a docket for public comment. As of February 6, 2015, the FDA has not issued a final rule on this matter.

Customers and Distribution

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

As of December 31, 2014, we had approximately 500 direct buying customers servicing more than 400,000 retail accounts for our cigarettes. We do not sell cigarettes directly to consumers. During 2014, 2013, and 2012, sales made by us to the McLane Company, Inc. comprised 29%, 29% and 29%, respectively, of our cigarette revenues. No other customer accounted for more than 10% of 2014, 2013 or 2012 cigarette revenues. We do not have any written sales agreements with our customers, including the McLane Company, Inc. that provide for any backlog orders.

Most of our customers buy cigarettes on a next-day-delivery basis. Customer orders are shipped from public distribution warehouses via third party carriers. We do not ship products directly to retail stores. In 2014, approximately 99% of our customers purchased cigarettes using electronic funds transfer, which provides immediate payment to us.

As of December 31, 2014, we had approximately 400 direct buying customers providing blu eCigs electronic cigarettes to approximately 176,000 retail accounts in the U.S. blu (U.K.) sells electronic cigarettes through retail outlets in the U.K. We also sell electronic cigarettes directly to adult consumers over the internet. We do not have any written sales agreements with our customers that provide for any backlog orders for electronic cigarettes. Customer orders are shipped primarily from a public distribution warehouse via third party carriers.

 

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Raw Materials and Manufacturing

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

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

We purchased approximately 80%, 86% and 90% of our leaf tobacco from 3, 4 and 4 suppliers in 2014, 2013 and 2012, respectively. If these suppliers become unwilling or unable to supply leaf tobacco to us, we believe that we can readily obtain high quality leaf tobacco from well-established, alternative industry sources. However, we believe that such high quality leaf tobacco may not be available at prices comparable to those we pay currently.

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

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

All raw materials used in the manufacture of our electronic cigarettes, with the exception of the liquid flavorings used by blu eCigs in the U.S., are produced by various suppliers located in Asia. The liquid flavorings used in our blu eCigs electronic cigarettes products in the U.S., which have varieties with and without nicotine, are manufactured in the U.S. and exported to Asian based manufacturers for assembly. All of our electronic cigarettes are manufactured and assembled in Asia and imported to the United States for blu eCigs and United Kingdom for blu (U.K.).

Research and Development

We have an experienced research and development team that continuously evaluates new products and line extensions and assesses new technologies and scientific advancements to be able to respond to marketplace demands and developing regulatory requirements. Our primary research and development facility is located in Greensboro, North Carolina, and we have an electronic cigarette research and development facility in Campbell, California. Our research and development efforts focus primarily on:

 

   

developing quality products that appeal to adult consumers;

 

   

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

 

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improving the quality and consistency of existing electronic cigarette products;

 

   

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

 

   

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

 

   

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

 

   

developing new, or modifying existing, products, processes, and analytical methods for cigarettes and electronic cigarettes to ensure high quality, accurate data, to promote quality control, and to comply with current and anticipated laws and regulations; and

 

   

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

Tobacco-related research activities include: the analysis of cigarette components, including cigarette paper, filters, tobacco and ingredients, including menthol; analysis of mainstream smoke; and modification of cigarette design. We employ advanced scientific equipment in our research efforts, including gas chromatographs, liquid chromatographs, and mass spectrometers coupled with gas and liquid chromatographs. We use this equipment to structurally identify and measure the amount of chemical compounds found in cigarette smoke and various tobaccos. These measurements allow us to better understand the relationship between the tobacco, cigarette construction, and the smoke yielded from cigarettes. In addition, advanced analytical instrumentation is utilized to develop, validate, and apply analytical methods to determine the chemical compositions of e-liquids, e-cigarette aerosols, and exhaled vapor. Also, advanced biological techniques are developed and used to test the biological impact of tobacco smoke and e-cigarette aerosols on cells and advance our understanding of potential biomarkers for disease risk.

Information Technology

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

Employees

As of December 31, 2014, we had approximately 2,900 full-time employees. As of that date, approximately 1,100 of those employees were represented by labor unions covered by two collective bargaining agreements. Local Union #317T Greensboro of the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union (AFL-CIO-CLC) represents workers at our Greensboro cigarette manufacturing plant. In August 2011, a new collective bargaining agreement covering this Union was approved, which expires in September 2015. Workers at our Danville, Virginia tobacco storage facility are also represented by Local Union #317T Danville

 

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of the Bakery, Confectionery, Tobacco Workers and Grain Millers International Union (AFL-CIO-CLC). In March 2012, a new collective bargaining agreement covering Local Union #317T of Danville was approved, which expires in April 2016. We have historically had an amicable relationship with the unions representing our employees.

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

Intellectual Property

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

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

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

Competition

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

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

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

Please read the sections entitled “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Business Environment” and “—Selected Industry and Domestic Cigarette Retail Market Share Data” beginning on pages 47 and 51, respectively, for additional information.

Legislation and Regulation

Our business operations are subject to a variety of federal, state and local laws and regulations governing, among other things, the research, development and manufacture of cigarettes and electronic cigarettes; the

 

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development of new tobacco products; the publication of health warnings on cigarette packaging and advertising; the marketing and sale of tobacco products; restrictions on the use of tobacco products in public places; and fire safety standards. From time to time, new legislation and regulations are proposed and reports are published by government sponsored committees and others recommending additional regulation of tobacco products.

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

Federal Regulation

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

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

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

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

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

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

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

 

   

prohibit all tobacco advertising and promotion;

 

   

authorize the establishment of various anti-smoking education programs;

 

   

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

 

   

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

 

   

direct the placement of advertising of tobacco products;

 

   

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

 

   

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

 

   

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

 

   

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

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

 

   

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

 

   

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

 

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

 

   

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

 

   

bans the distribution of free samples of cigarettes;

 

   

requires the disclosure of cigarette ingredients and additives;

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

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

During 2012, the FDA indicated that it intends to regulate electronic cigarettes under the FSPTCA through the issuance of deeming regulations that would include electronic cigarettes under the definition of a “tobacco product” under the FSPTCA subject to the FDA’s jurisdiction. On April 25, 2014, FDA issued a proposed rule that would include electronic cigarettes under the definition of “tobacco product”, and opened a docket for public comment. As of February 6, 2015, the FDA had not issued its final regulation on this matter. We cannot predict the scope of such regulations or the impact they may have on our electronic cigarette business, though if enacted, they could have a material adverse effect on our electronic cigarette business in the future.

Environmental Tobacco Smoke

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

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

 

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General also addressed the health risks of ETS in the 2010 Report of the Surgeon General on “How Tobacco Smoke Causes Disease: The Biology and Behavioral Basis for Smoking-Attributable Disease” (“2010 Surgeon General Report”).

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

State and Local Regulation

Many state, local and municipal governments and agencies, as well as private businesses, have adopted legislation, regulations or policies which prohibit or restrict, or are intended to discourage the use of cigarettes and electronic cigarettes, including legislation, regulations or policies prohibiting or restricting smoking in various places such as public buildings and facilities, stores, restaurants and bars and on airline flights and in the workplace.

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

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

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

Excise Taxes and Assessments

Cigarettes are subject to substantial federal, state and local excise taxes in the United States and, in general, such taxes have been increasing. Effective April 1, 2009, the federal excise tax on cigarettes increased to $50.33 per thousand cigarettes (or $1.0066 per pack of 20 cigarettes) from $19.50 per thousand cigarettes (or $0.39 per pack of 20 cigarettes). State excise taxes, which are levied upon and paid by the distributors, are also in effect in the fifty states, the District of Columbia and many municipalities. During 2014, there were two state excise tax increases, $0.13 per pack implemented in the state of Oregon and $0.13 per pack implemented in the state of Vermont, as well as municipal excise tax increases that included a $2.00 per pack increase in Philadelphia, Pennsylvania, a $0.50 per pack increase in the City of Chicago, Illinois, and a $0.04 per pack excise tax increase in the District of Columbia. For the twelve months ended December 31, 2014, the combined state and municipal taxes ranged from $0.17 to $6.16 per pack of cigarettes.

A federal law enacted in October 2004 repealed the federal supply management program for tobacco growers and compensated tobacco quota holders and growers with payments to be funded by an assessment on tobacco manufacturers and importers. Cigarette manufacturers and importers were responsible for paying 88.2% of a $10.14 billion payment to tobacco quota holders and growers over a ten-year period which expired in the third quarter of 2014. The law provides that payments were based on shipments for domestic consumption.

 

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

Separation Agreement with Loews Corporation

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

Indemnification Provisions

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

 

   

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

 

   

certain tax matters, as discussed below;

 

   

any other activities in which we may engage;

 

   

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

 

   

any breach by us of the Separation Agreement;

 

   

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

 

   

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

 

   

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

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

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

 

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

 

   

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

 

   

any breach by Loews of the Separation Agreement;

 

   

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

 

   

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

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

Available Information

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

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

 

Item 1A. RISK FACTORS

Risks Related to our Pending Merger with Reynolds American Inc.

The completion of the Merger is subject to certain conditions, including, among others, regulatory approval and the absence of legal restraints prohibiting the completion of the Merger. Each party’s obligation to consummate the Merger is also subject to the accuracy of the representations and warranties of the other party (subject to certain qualifications and exceptions) and the performance in all material respects of the other party’s covenants under the Merger Agreement, including, with respect to us, certain covenants regarding operation of our business prior to completion of the Merger. As a result of these conditions, we cannot assure you that the Merger will be completed or that, if completed, it will be exactly on the terms set forth in the Merger Agreement. If the Merger is not completed for any reason, we expect that we would continue to be managed by our current management, under the direction of our board of directors.

If the proposed Merger is not completed, our stock price will likely fall to the extent that the current market price of our common stock reflects an assumption that a transaction will be completed. In addition, the failure of

 

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the proposed Merger to be completed may result in negative publicity and/or a negative impression of us in the investment community and may affect our relationship with employees, customers and other partners in the business community.

The Merger process could adversely affect our business, stock price, reputation and results of operations.

Our efforts to complete the Merger could cause substantial disruptions in our business, which could have an adverse effect on our financial results. Among other things, uncertainty as to whether a transaction will be completed with RAI may affect our ability to recruit prospective employees or to retain and motivate existing employees. Employee retention may be particularly challenging while the Merger is pending, because employees may experience uncertainty about their future roles with RAI or Imperial, as the case may be.

Uncertainty as to our future could adversely affect our business, reputation and our relationship with existing customers and suppliers and potential customers and suppliers. For example, customers, suppliers and others that deal with us could defer decisions concerning working with us, or seek to change existing business relationships with us. Further, a substantial amount of the attention of management and employees is being directed toward completion of the Merger and thus is being diverted from our day-to-day operations because matters related to the Merger require substantial commitments of time and resources.

While the Merger Agreement is in effect, we are subject to restrictions on our business activities.

While the Merger Agreement is in effect, we are subject to restrictions on our business activities and must generally operate our business in the ordinary course in all material respects (subject to certain exceptions). These restrictions could prevent us from pursuing attractive business opportunities that arise prior to the completion of the Merger and are generally outside the ordinary course of business, and otherwise have a material adverse effect on our future results of operations or financial condition.

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

Some plaintiffs in our litigation and constituencies, including the FDA and other public health agencies, have claimed or expressed concerns that mentholated cigarettes may pose greater health risks and may impact public health more than non-mentholated cigarettes, including concerns that mentholated cigarettes may make it easier to start smoking and harder to quit, and may seek restrictions or a ban on the production and sale of mentholated cigarettes. For example, in 2014 the European Union adopted a ban on the sale of characterizing flavors in cigarettes, including menthol, which will become effective in 2022. Any ban or material limitation on the use of menthol in cigarettes would materially adversely affect our results of operations, cash flow and financial condition.

Following the passage of the Family Smoking Prevention and Tobacco Control Act (the “FSPTCA”) in June 2009, the FDA established the Tobacco Products Scientific Advisory Committee (the “TPSAC”) to evaluate, among other things, “the impact of the use of menthol in cigarettes on the public health, including such use among children, African-Americans, Hispanics, and other racial and ethnic minorities.” In addition, the FSPTCA permits the FDA to impose restrictions regarding the use of menthol in cigarettes, including a ban, if those restrictions would be appropriate for the public health. The TPSAC or the Menthol Report Subcommittee held meetings on March 30-31, 2010, July 15-16, 2010, September 27, 2010, October 7, 2010, November 18, 2010, January 10-11, 2011, February 10-11, 2011, March 2, 2011, March 17-18, 2011 and July 21, 2011 to consider the issues surrounding the use of menthol in cigarettes. At the March 18, 2011 meeting, TPSAC presented its report and recommendations on menthol. The report’s findings included that menthol likely increases experimentation and regular smoking, menthol likely increases the likelihood and degree of addiction for youth smokers, non-white menthol smokers (particularly African-Americans) are less likely to quit smoking and are less responsive to certain cessation medications, and that consumers continue to believe that smoking

 

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menthol cigarettes is less harmful than smoking non-menthol cigarettes as a result of the cigarette industry’s historical marketing. TPSAC’s overall recommendation to the FDA was that “[r]emoval of menthol cigarettes from the marketplace would benefit public health in the United States.” At the July 21, 2011 meeting, TPSAC considered revisions to its report, and the voting members unanimously approved the final report for submission to the FDA with no change in its recommendation.

On June 27, 2011, the FDA provided a progress report on its review of the science related to menthol cigarettes. In the June 2011 update, the FDA stated that “[e]xperts within the FDA Center for Tobacco Products are conducting an independent review of the science related to the impact [of menthol] in cigarettes on public health …” The FDA stated that it would submit its draft independent review of menthol science to an external peer review panel in July 2011. On January 26, 2012, the FDA provided a second progress report on its review of the science related to menthol cigarettes. In its January 2012 update, the FDA stated that “FDA submitted its report to external scientists for peer review, and the agency is revising its report based on their feedback.” On July 23, 2013, the FDA made available its preliminary scientific evaluation (“PSE”) of public health issues related to the use of menthol in cigarettes and peer review comments thereto. Although the FDA PSE found that menthol in cigarettes is not associated with increased smoke toxicity, increased levels of biomarkers of exposure or increased disease risk, the evaluation concluded that menthol in cigarettes is likely associated with increased initiation and progression to regular cigarette smoking, increased dependence, reduced success of smoking cessation, especially among African American menthol smokers, altered physiological responses to tobacco smoke and particular patterns of smoking. In the preliminary scientific evaluation, the FDA concluded that menthol cigarettes likely pose a public health risk above that seen with non-menthol cigarettes. The FDA also issued an Advance Notice of Proposed Rulemaking (“ANPRM”) seeking comments on the PSE and requesting additional information related to potential regulatory options it might consider for the regulation of menthol. The FDA requested comments regarding, among other things, information on potential product standards for levels of menthol in cigarettes; the timeframe for compliance with any product standard enacted; whether a stepped approach to lowering or removing menthol from cigarettes would be appropriate; whether sales, distribution, advertising or promotion restrictions are appropriate; and evidence, including public health impact, of any potential illicit market in menthol cigarettes should they no longer be available. In addition, the FDA announced that it is funding new research on, among other things, the differences between menthol and nonmenthol cigarettes to obtain information to assist FDA in making informed decisions related to potential regulation of menthol in cigarettes. The FDA established a 60-day comment period for the ANPRM and PSE, and said it will consider all comments and other information submitted to determine what, if any, regulatory action is appropriate. On September 11, 2013, the FDA extended the comment period for an additional 60 days to November 22, 2013. On November 21, 2013, the Company provided comments on the ANPRM and PSE to the FDA. If the FDA determines that regulation of menthol is warranted, the FDA could promulgate regulations that, among other things, could result in a ban on or restrictions on the use of menthol in cigarettes.

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

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

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

 

   

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

 

 

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

 

   

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

 

   

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

 

   

requires the disclosure of cigarette ingredients and additives;

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

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

In addition, products introduced on or after March 22, 2011 require pre-market approval by the FDA which may be subject to similar or more restrictive procedures. One component of our strategic plan is the introduction of new cigarette products in adjacent market segments, in which we do not have a significant presence. We have submitted a number of requests for approval of substantially equivalent new products with the FDA. Although we believe that the statutory language of the FSPTCA suggests the pre-market approval process should take 90 days for substantially equivalent new products, the FDA has approved only two substantially equivalent new product applications by us on June 25, 2013 (after more than 20 months of review). We believe our ability to execute our strategic plan has been negatively impacted by the delay in the FDA’s new product approval process.

Pursuant to the FSPTCA, the FDA may also undertake various investigative and enforcement actions, including facility inspections, requests for documentation and other information, other examinations and investigations, seeking injunctive relief, money penalties and product withdrawals, recalls and seizures. Any of these FDA actions could result in significant costs to our businesses or otherwise have a material adverse effect on our financial position, cash flows and results of operations.

 

 

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As of February 6, 2015, Lorillard Tobacco is a defendant in approximately 6,228 product liability cases, including approximately 636 cases in which Lorillard, Inc. is a co-defendant. Lorillard, Inc. is a defendant in one case in which Lorillard Tobacco is not a defendant. In addition to the product liability cases, Lorillard Tobacco and, in some instances, Lorillard, Inc., are defendants in Filter Cases, Tobacco-Related Antitrust Cases, and MSA-Related Cases. These cases, which are extremely costly to defend, could result in substantial judgments against Lorillard Tobacco and/or Lorillard, Inc.

Numerous legal actions, proceedings and claims arising out of the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of cigarettes are pending against Lorillard Tobacco and Lorillard, Inc., and it is likely that similar claims will continue to be filed for the foreseeable future. Lorillard Tobacco is a defendant in 61 Filter cases. Lorillard, Inc. is a co-defendant in two of the 61 Filter Cases that are pending against Lorillard Tobacco. Lorillard, Inc. is also a defendant in one additional Filter case in which Lorillard Tobacco is not a defendant. Lorillard Tobacco is a defendant in one Tobacco-Related Antitrust case. Lorillard, Inc. is not a defendant in this case. In addition, several cases have been filed against Lorillard Tobacco and other tobacco companies challenging certain provisions of the MSA among major tobacco manufacturers and 46 states and various other governments and jurisdictions, and state statutes promulgated to carry out and enforce the MSA.

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

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

In December 2010, a Massachusetts jury awarded damages, including punitive damages, from Lorillard Tobacco in a Conventional Product Liability Case, Evans v. Lorillard Tobacco Company (Superior Court, Suffolk County, Massachusetts). In September 2011, the court reduced the compensatory damages awarded to the estate of a deceased smoker to $25 million and reduced the award to the deceased smoker’s son to $10 million. The court declined to reduce the jury’s award of $81 million in punitive damages. In December 2011, the court entered a final judgment that awarded $35 million in compensatory damages, $81 million in punitive damages, approximately $2.6 million in attorneys’ fees and costs, and interest on the damages awards at the rate of 12% per year from the date the case was filed in 2004. On June 11, 2013, the Massachusetts Supreme Judicial Court affirmed the compensatory damages award but remanded the case to the trial court for a new trial on the issue of punitive damages, finding that the jury was inadequately instructed regarding the application of various theories of negligence. Lorillard Tobacco filed a petition for rehearing, which was denied on July 26, 2013. In September 2013, plaintiff filed a motion seeking immediate entry of judgment on the compensatory damages award. At a status conference on September 17, 2013, the trial judge rejected defendant’s proposed procedures for retrial of plaintiff’s claims. Lorillard Tobacco incurred a charge of $79 million, including $35 million for compensatory damages plus statutory interest of 12% per year since June 28, 2004. This amount was paid in October 2013, and the case has been dismissed in its entirety and is now concluded.

On July 30, 2014, a verdict was returned in Major v. R.J. Reynolds Tobacco Company, et al. (California Superior Court, Los Angeles County), a case in which plaintiff alleged that the smoker’s injuries were caused by asbestos fiber and tobacco smoke inhalation. Lorillard Tobacco was the sole defendant at trial. The jury awarded plaintiff $2,736,700 in economic compensatory damages and $15,000,000 in non-economic compensatory

 

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damages, for a total compensatory damages award of $17,736,700. Punitive damages were not at issue in this trial. The jury apportioned 50% of the fault for the smoker’s injuries to the smoker, 17% to Lorillard Tobacco, and 33% to exposure to cigarettes manufactured by companies other than Lorillard Tobacco. The jury found that exposure to asbestos was not a substantial factor in the smoker’s injuries. On August 25, 2014, the Court entered judgment awarding plaintiff $2,550,000 in non-economic damages (which represents Lorillard Tobacco’s 17% share as found by the jury) and the amount of $1,368,350 in economic damages (under California law, Lorillard Tobacco is responsible for the amount of economic damages that the jury found was the fault of anyone other than plaintiff, not just its 17% share), for a total award against Lorillard Tobacco of $3,918,350. On September 17, 2014, Lorillard Tobacco filed a motion for a new trial and a motion for judgment notwithstanding the verdict, which the Court denied on October 28, 2014. On November 17, 2014, the Court granted in part and denied in part plaintiff’s motion for trial court costs and pre-judgment interest on the damages award, determining that pre-judgment interest accrued over an approximately 5 year period, excluding an approximately 6 year period during which the case was dismissed prior to re-filing. On November 26, 2014, Lorillard Tobacco noticed an appeal to the California Second District. Court of Appeal from the final judgment awarding compensatory damages and the order granting in part trial court costs and pre-judgment interest. Plaintiff has also noticed an appeal from the order denying in part pre-judgment interest.

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

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

The 2006 ruling by the Florida Supreme Court in Engle also permitted members of the Engle class to file individual claims, including claims for punitive damages. The Florida Supreme Court held that these individual plaintiffs are entitled to rely on a number of the jury’s findings in favor of the plaintiffs in the first phase of the Engle trial. These findings included that smoking cigarettes causes a number of diseases; that cigarettes are addictive or dependence-producing; and that the defendants, including Lorillard Tobacco and Lorillard, Inc., were negligent, breached express and implied warranties, placed cigarettes on the market that were defective and unreasonably dangerous, and concealed or conspired to conceal the risks of smoking. Lorillard Tobacco is a defendant in approximately 3,611 cases pending in various state and federal courts in Florida that were filed by members of the Engle class (the “Engle Progeny Cases”), including 633 cases in which Lorillard, Inc. is a co-defendant. Lorillard, Inc. is a defendant in one Engle Progeny case in which Lorillard Tobacco is not a defendant.

As of February 6, 2015, trial was underway in two Engle Progeny Cases in which Lorillard Tobacco.is a defendant: Caprio v. R.J. Reynolds Tobacco Company, et al. (State Court, Broward County, Florida) and Landau v. R.J. Reynolds Tobacco Company, et al. (Federal Court, Middle District, Jacksonville, Florida). Lorillard, Inc. is not a defendant in either of these trials. As of February 6, 2015, Lorillard Tobacco and Lorillard, Inc. are defendants in Engle Progeny Cases that have been placed on courts’ 2015 trial calendars or in which specific trial dates have been set. Trial schedules are subject to change and it is not possible to predict how many of the Engle Progeny Cases pending against Lorillard Tobacco or Lorillard, Inc. will be tried in 2015. It also is not possible to predict whether some courts will implement procedures that consolidate multiple Engle Progeny Cases for trial.

 

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

As of February 6, 2015, Lorillard has been a defendant in twenty-one Engle Progeny Cases tried to a verdict. Plaintiffs in seventeen Engle Progeny Cases were awarded compensatory damages from Lorillard Tobacco. In sixteen of these cases the damages were awarded by the jury, and in one case the court entered an order following trial that awarded plaintiff compensatory damages. In four of the seventeen cases, plaintiffs were awarded punitive damages from Lorillard Tobacco. Lorillard, Inc. was a defendant in one of these seventeen cases at the time of verdict. The seventeen cases are listed below in the order in which the verdicts were returned:

 

   

In Mrozek v. Lorillard Tobacco Company (Circuit Court, Fourth Judicial Circuit, Duval County, Florida), the jury awarded plaintiff a total of $6 million in compensatory damages and $11.3 million in punitive damages in March 2011. The jury apportioned 35% of the fault for the smoker’s injuries to the smoker and 65% to Lorillard Tobacco. The final judgment entered by the trial court reflected the jury’s verdict and awarded plaintiff $3,900,588 in compensatory damages and $11,300,000 in punitive damages plus the applicable statutory rates of annual interest. In December 2012, the Florida First District Court of Appeal affirmed the final judgment awarding compensatory and punitive damages and Lorillard Tobacco’s motion for rehearing of the appellate court opinion was denied in February 2013. In March 2013, Lorillard Tobacco filed a notice with the Florida Supreme Court seeking review of the appellate court decision. On February 13, 2014, the Florida Supreme Court declined to grant review of this case. In March 2014, Lorillard Tobacco amended the bond necessary to maintain a stay on payment of the final judgment. On March 28, 2014, Lorillard Tobacco filed a petition with the United States Supreme Court, seeking review of the due process issue, and requested that the petition be held and resolved in the same manner as the Duke, Walker, and Brown cases, also pending before the United States Supreme Court. On June 9, 2014, the United States Supreme Court denied the petitions seeking review. The trial court announced on June 25, 2014 that it had granted Lorillard Tobacco’s motion to determine the applicable rates of post-judgment interest that were in dispute. On June 27, 2014, Lorillard Tobacco made a payment of $17,500,197 to satisfy the final judgment awarding compensatory and punitive damages and post-judgment interest. On July 25, 2014, the court entered an order confirming satisfaction of judgment. On July 28, 2014, plaintiff appealed the order determining the rate of post-judgment interest payable on the final judgment, and that appeal remained pending as of February 6, 2015. The Florida First District Court of Appeal provisionally granted plaintiff’s motion for intermediate appellate court attorneys’ fees, ruling that the trial court is authorized to award appellate fees if the trial court determines entitlement to attorneys’ fees. In June 2013, the trial court granted plaintiff’s motion for entitlement to trial court attorneys’ costs and fees and also determined that plaintiff was entitled to intermediate appellate court attorneys’ fees. As of February 6, 2015, the trial court had not determined the amount of trial court or intermediate appellate court fees to award. On February 13, 2014, the Florida Supreme Court provisionally granted plaintiff’s motion for attorneys’ fees in connection with the appeal to the Florida Supreme Court in the amount of $2,500, conditioned on the trial court’s determination of entitlement.

 

   

In Tullo v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida), the jury awarded plaintiff a total of $4.5 million in compensatory damages in April 2011. The jury assessed 45% of the fault to the smoker, 5% to Lorillard Tobacco and 50% to other defendants. The jury did not award punitive damages to the plaintiff. The court entered a final judgment that awarded plaintiff $225,000 in compensatory damages from Lorillard Tobacco plus 6% annual interest. Defendants noticed an appeal from the final judgment to the Florida Fourth District Court of Appeal. In August 2013, the Florida Fourth District Court of Appeal affirmed the final judgment. On October 16, 2013, defendants filed a notice with the Florida Supreme Court seeking review of the appellate court decision. On March 10, 2014, the trial court entered an order confirming that Lorillard Tobacco had satisfied the judgment awarding compensatory damages and post-judgment interest for an amount totaling approximately $263,400. On March 18, 2014, Lorillard Tobacco filed a notice of voluntary dismissal of their petition seeking review of the Florida Supreme Court and the Court entered an order dismissing the petition for review as to Lorillard Tobacco on May 21, 2014. The

 

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Florida Supreme Court declined to accept review of the petition as to the other defendants. Plaintiff is not entitled to recover trial or appellate fees from Lorillard Tobacco. As of February 6, 2015, the trial court had not determined the amount of trial or appellate court costs to award.

 

   

In Sulcer v. Lorillard Tobacco Company, et al. (Circuit Court, First Judicial Circuit, Escambia County, Florida), in April 2011, the jury awarded $225,000 in compensatory damages to the plaintiff and it assessed 95% of the fault for the smoker’s injuries to the smoker with 5% allocated to Lorillard Tobacco. The jury did not award punitive damages to the plaintiff. The court entered a final judgment that incorporated the jury’s determination of the parties’ fault and awarded plaintiff $11,250 in compensatory damages. Lorillard Tobacco paid approximately $246,000 to resolve the damages verdict, costs and fees. Following this payment, Sulcer was concluded.

 

   

In Jewett v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Fourth Judicial Circuit, Duval County, Florida), the jury awarded the estate of the decedent $692,981 in compensatory damages and awarded the plaintiff $400,000 for loss of companionship in May 2011. The jury assessed 70% of the responsibility for the decedent’s injuries to the decedent, 20% to R.J. Reynolds and 10% to Lorillard Tobacco. The jury did not award punitive damages to the plaintiff. The final judgment entered by the trial court reflected the jury’s verdict and awarded plaintiff a total of $109,298 from Lorillard Tobacco plus 6% annual interest. In November 2012, the Florida First District Court of Appeal reversed the judgment awarding compensatory damages and ordered the case returned to the trial court for a new trial. In January 2013, the appellate court denied a motion filed by the plaintiff for rehearing of the decision reversing the judgment. Both the plaintiff and defendants filed notices with the Florida Supreme Court seeking review of the appellate court decision. On February 14, 2014, the Florida Supreme Court declined to grant review of this case. As of February 6, 2015, a new trial date had not been set.

 

   

In Weingart v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida), in July 2011, the jury determined that the decedent did not sustain any compensatory damages from the defendants, including Lorillard Tobacco, and it returned a verdict for the defendants that punitive damages were not warranted. The jury assessed 91% of the fault for the decedent’s injuries to the decedent, 3% to Lorillard Tobacco and 3% to each of the other two defendants. Following trial, the court granted in part a motion by the plaintiff to award damages, and it tentatively awarded plaintiff $150,000 in compensatory damages. The court entered a final judgment that applied the jury’s comparative fault determinations to the court’s award of compensatory damages. The final judgment awarded plaintiff $4,500 from Lorillard Tobacco. Defendants noticed an appeal to the Florida Fourth District Court of Appeal from the order that awarded compensatory damages to the plaintiff and amended their notice of appeal to address the final judgment. On February 13, 2013, the Florida Fourth District Court of Appeal affirmed the final judgment awarding compensatory damages. Defendants filed a notice with the Florida Supreme Court seeking review of this decision. In March 2012, the trial court entered a judgment against the defendants for costs with Lorillard Tobacco’s share amounting to $43,081 plus 4.75% annual interest. Defendants noticed an appeal from this costs judgment. In June 2013, all defendants satisfied both the final judgment awarding compensatory damages and the costs judgment, with Lorillard Tobacco’s share amounting to approximately $50,000. Defendants’ petition for Florida Supreme Court review and the appeal from the costs judgment have been dismissed. This case is now concluded.

 

   

In Sury v. R.J. Reynolds Tobacco Company, et al., (Circuit Court, Fourth Judicial Circuit, Duval County, Florida), in November 2011, the jury awarded plaintiff $1,000,000 in compensatory damages and assessed 60% of the responsibility for the decedent’s injuries to the decedent, 20% to Lorillard Tobacco and 20% to R.J. Reynolds. The jury returned a verdict for the defendants regarding whether punitive damages were warranted. In March 2012, the court entered a final judgment against

 

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defendants in the amount of $1,000,000, jointly and severally, plus 4.75% annual interest, declining to apply the jury’s comparative fault findings to causes of action alleging intentional conduct. On June 24, 2013, the Florida First District Court of Appeal affirmed the final judgment. Defendants’ motion for rehearing of this decision with the Florida First District Court of Appeal was denied in August 2013. The Florida Supreme Court declined review of the intermediate appellate court decision in January 2014. On March 28, 2014, defendants filed a petition with the United States Supreme Court, seeking review of the due process issue, and requested that the petition be held and resolved in the same manner as the Duke, Walker, and Brown cases, also pending before the United States Supreme Court. On June 9, 2014, the United States Supreme Court denied the petitions seeking review. On June 19, 2014, Lorillard Tobacco made a payment of $1,659,674 to satisfy the final judgment awarding compensatory damages plus post judgment interest, trial level attorneys’ fees and costs, and Florida Supreme Court fees. The Court entered an order confirming satisfaction of judgment on July 24, 2014. In June 2013, the First District Court of Appeal determined that plaintiff was entitled to attorneys’ fees in connection with the appeal to the First District Court of Appeal and directed the trial court to determine the amount. As of February 6, 2015, the trial court had not determined the amount.

 

   

In Alexander v. Lorillard Tobacco Company, et al. (Circuit Court, Eleventh Judicial Circuit, Miami-Dade County, Florida) the jury awarded plaintiff $20,000,000 in compensatory damages and $25,000,000 in punitive damages in February and March 2012. Lorillard Tobacco is the only defendant in this case. The jury apportioned 20% of the fault for the smoker’s injuries to the smoker and 80% to Lorillard Tobacco. In March 2012, the court entered a final judgment that applied the jury’s comparative fault determination to the court’s award of compensatory damages, awarding the plaintiff $16,000,000 in compensatory damages and $25,000,000 in punitive damages from Lorillard Tobacco. In May 2012, the court granted a motion by Lorillard Tobacco to lower the amount of compensatory damages and reduced the amount awarded to $10,000,000 from Lorillard Tobacco. Other post-trial motions challenging the verdict were denied. The court entered an amended final judgment that applied the jury’s comparative fault determination to the court’s award of compensatory damages, awarding the plaintiff $8,000,000 in compensatory damages and $25,000,000 in punitive damages. The court also awarded plaintiff post-judgment interest (based on a statutory rate) on the compensatory and punitive damages. Lorillard Tobacco noticed an appeal from the amended final judgment to the Florida Third District Court of Appeal. On September 4, 2013, the Florida Third District Court of Appeal affirmed the amended final judgment awarding compensatory and punitive damages. Lorillard Tobacco’s motion for rehearing of this decision with the Florida Third District Court of Appeal was denied in October 2013. Lorillard Tobacco filed a petition with the Florida Supreme Court seeking review of the intermediate appellate court decision in November 2013, and this petition was denied on September 9, 2014. On September 23, 2014, Lorillard Tobacco made a payment of $38,960,916 to resolve all damages, costs and fees, and post-judgment interest. Plaintiff filed a satisfaction of judgment on September 29, 2014 and the Court confirmed satisfaction of judgment on October 3, 2014. This case is now concluded.

 

   

In Calloway v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Seventeenth Judicial Circuit, Broward County, Florida), the jury awarded plaintiff and a daughter of the decedent a total of $20,500,000 in compensatory damages in May 2012. The jury apportioned 20.5% of the fault for the smoker’s injuries to the smoker, 27% to R.J. Reynolds, 25% to Philip Morris, 18% to Lorillard Tobacco, and 9.5% to Liggett. The jury awarded $12,600,000 in punitive damages from Lorillard Tobacco and $42,250,000 from the other defendants, for a total punitive damages award of $54,850,000. In August 2012, the court granted a post-trial motion by the defendants and lowered the compensatory damages award to $16,100,000. The court also ruled that the jury’s finding on the plaintiff’s percentage of comparative fault would not be applied to reduce the compensatory damage award because the jury found in favor of the plaintiff on her claims alleging intentional conduct. In August 2012, the court entered final judgment against defendants in the amount of $16,100,000 in compensatory damages, jointly and severally, and $54,850,000 in punitive damages. Lorillard Tobacco is liable for $12,600,000 of the total punitive damages award. The court also awarded plaintiff post-

 

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judgment interest (based on a statutory rate) on the compensatory and punitive damages, which totaled approximately $2.0 million as of February 6, 2015 based on the jury-apportioned fault for Lorillard Tobacco. The final judgment also granted plaintiff’s application for trial court costs and attorneys’ fees, but as of February 6, 2015, the trial court had not awarded an amount. Defendants have noticed an appeal from the final judgment to the Florida Fourth District Court of Appeal. On March 31, 2014, plaintiff filed a motion with the Florida Fourth District Court of Appeal seeking attorneys’ fees in connection with the appeal to the Fourth District. As of February 6, 2015, the Florida Fourth District Court of Appeal had not ruled on this motion.

 

   

In Evers v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Thirteenth Judicial Circuit, Hillsborough County, Florida), the jury awarded plaintiff and the estate of the decedent a total of $3,230,000 in compensatory damages in February 2013. The jury apportioned 31% of the fault for the smoker’s injuries to the smoker, 60% to R.J. Reynolds and 9% to Lorillard Tobacco. The jury found that punitive damages against Lorillard Tobacco were not warranted and awarded $12,362,042 in punitive damages from R.J. Reynolds Tobacco Company. The Court granted a post-trial motion by R.J. Reynolds for a directed verdict on punitive damages and, as a result, the jury’s punitive damages award was set aside. The Court denied a motion filed by the plaintiff to reconsider the directed verdict. At a post-trial hearing, the plaintiff waived entitlement to the jury’s loss of services award which amounted to $280,000 of the total compensatory damages award. In May 2013, the court entered a final judgment that applied the jury’s comparative fault determinations and awarded plaintiff and the estate of the decedent $2,035,500 in compensatory damages ($265,500 from Lorillard Tobacco), plus the statutory rate of interest. Plaintiff and defendants have both appealed the final judgment to the Florida Second District Court of Appeal. Plaintiff also filed a motion for entitlement to trial attorneys’ fees and costs. As of February 6, 2015, the trial court had not ruled on this motion. On May 23, 2014, plaintiff filed a motion with the Florida Second District Court of Appeal seeking attorneys’ fees in connection with the appeal to the Second District. As of February 6, 2015, the Florida Second District Court of Appeal had not ruled on this motion.

 

   

In Cohen v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida), the jury awarded plaintiff and the estate of the decedent a total of $2,055,050 in compensatory damages in May 2013. The jury apportioned 40% of the fault for the smoker’s injuries to the smoker, 30% to R.J. Reynolds, 20% to Lorillard Tobacco, and 10% to Liggett. The jury found that punitive damages were not warranted against any of the defendants. On May 6, 2013, the Court entered final judgment against defendants in the amount of $1,233,030 ($411,010 from Lorillard Tobacco) plus 4.75% annual interest. On July 10, 2013, the Court entered an order granting defendants’ motion for a new trial based on the plaintiff’s improper arguments during closing. This order effectively vacated the final judgment. Plaintiff and defendants have both appealed the order granting the motion for new trial to the Florida Fourth District Court of Appeal.

 

   

In Ruffo v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Eleventh Judicial Circuit, Miami-Dade County, Florida), the jury awarded plaintiff $1,500,000 in compensatory damages in May 2013. The jury apportioned 85% of the fault for the smoker’s injuries to the smoker, 12% to Philip Morris, and 3% to Lorillard Tobacco. Defendants’ post-trial motions challenging the verdict were denied. On October 4, 2013, the Court entered a final judgment against defendants that applied the jury’s comparative fault determinations and awarded plaintiff $225,000 in compensatory damages ($45,000 from Lorillard Tobacco) plus the statutory rate of interest, which is currently 4.75%. Defendants noticed an appeal from the final judgment to the Florida Third District Court of Appeal. On May 12, 2014, the trial court entered an order confirming that Lorillard Tobacco had satisfied the judgment awarding compensatory damages and post-judgment interest for an amount totaling $46,857.43. On May 9, 2014, the Florida Third District Court of Appeal entered an order recognizing Lorillard Tobacco’s voluntary dismissal of their appeal to the final judgment. On November 19, 2014, the Florida Third District Court of Appeal affirmed the final judgment as to Philip Morris. Plaintiff filed a motion with the trial court seeking entitlement to attorneys’ costs and fees. In April 2014, the trial court

 

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denied this motion. Plaintiff filed a notice of appeal to the Florida Third District Court of Appeal from the order denying attorneys’ fees and costs. On November 19, 2014, the Florida Third District Court of Appeal affirmed the trial court’s order denying attorneys’ fees and costs.

 

   

In Gafney v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida), the jury awarded plaintiff a total of $5,800,000 in compensatory damages in September 2013. The jury apportioned 34% of the fault for the smoker’s injuries to the smoker, 33% to R.J. Reynolds, and 33% to Lorillard Tobacco. Lorillard, Inc. was also a defendant in this trial but damages and comparative fault were not assessed separately for Lorillard, Inc. Because the jury found in favor of the defendants on the claims alleging intentional conduct, the plaintiff was not entitled to punitive damages. On September 26, 2013, the Court entered a final judgment that applied the jury’s comparative fault determinations and awarded the plaintiff a total of $3,828,000 in compensatory damages ($1,914,000 from Lorillard Tobacco), plus the statutory rate of interest. Defendants’ post-trial motions challenging the verdict were denied in November 2013. Defendants have noticed an appeal from the final judgment to the Florida Fourth District Court of Appeal. Plaintiff has filed a motion with the trial court seeking entitlement to attorneys’ fees and costs. As of February 6, 2015, the trial court had not ruled on this motion. On January 13, 2015, plaintiff filed a motion with the Florida Fourth District Court of Appeal seeking attorneys’ fees in connection with the appeal to the Fourth District. As of February 6, 2015, the Florida Fourth District Court of Appeal had not ruled on this motion.

 

   

In Jacobson v. R.J. Reynolds Tobacco Company, et al. (Federal Court, Southern District, Miami, Florida), the jury returned a verdict in favor of the defendants on October 29, 2013. The Court entered final judgment in favor of the defendants on October 30, 2013. Plaintiff filed a motion for new trial which was denied in January 2014. On February 10, 2014, the Court entered an order granting Lorillard’s motion for attorneys’ fees and costs. Lorillard has agreed not to enforce its right to fees and costs in exchange for plaintiff’s agreement not to pursue an appeal of the verdict. This case is concluded.

 

   

In Chamberlain v. R. J. Reynolds Tobacco Company, et al. (Federal Court, Middle District, Jacksonville, Florida) the jury returned a verdict in favor of the defendants on November 15, 2013. The Court entered final judgment in favor of the defendants on November 20, 2013. Plaintiff’s motion for new trial was denied on April 25, 2014. On June 27, 2014, plaintiff filed a notice of appeal from the final judgment with the Eleventh Circuit Court of Appeals. On December 3, 2014, the Eleventh Circuit Court of Appeals dismissed the appeal from the final judgment, ruling that the filing date was past the deadline to appeal.

 

   

In Burkhart v. R.J. Reynolds Tobacco Company, et al. (Federal Court, Middle District, Jacksonville, Florida), the jury awarded plaintiff a total of $5,000,000 in compensatory damages on May 15, 2014. The jury apportioned 50% of the fault for the smoker’s injuries to the smoker, 25% to R.J. Reynolds, 15% to Philip Morris, and 10% to Lorillard Tobacco. The jury awarded $500,000 in punitive damages from Lorillard Tobacco and $2,000,000 from the other defendants for a total punitive damages award of $2,500,000. The Court ruled that the jury’s finding on the plaintiff’s percentage of comparative fault would not be applied to reduce the compensatory damage award because the jury found in favor of the plaintiff on her claims alleging intentional conduct. On June 11, 2014, the Court entered a final judgment against defendants in the amount of $5,000,000 in compensatory damages, jointly and severally, and $2,500,000 ($500,000 from Lorillard Tobacco) in punitive damages, plus the statutory rate of interest. The Court denied defendants post-trial motions challenging the verdict. On October 10, 2014, defendants filed a notice of appeal from the final judgment with the Eleventh Circuit Court of Appeals. The final judgment also granted plaintiff entitlement to trial court costs, but as of February 6, 2015, the trial court had not awarded an amount. Plaintiff’s motion for attorneys’ fees and prevailing party costs was denied.

 

   

In Harris v. R.J. Reynolds Tobacco Company, et al. (Federal Court, Middle District, Jacksonville, Florida), on July 31, 2014, the jury found that one of the smoker’s alleged Engle qualifying diseases did not manifest prior to the cut-off period for membership in the Engle class, and that the smoker’s

 

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other alleged Engle qualifying disease was not caused by the smoker’s addiction to cigarettes containing nicotine. However, the jury awarded compensatory damages on plaintiff’s survival and wrongful death claims in the total amount of $1,726,650. The jury apportioned 60% of the fault for the smoker’s injuries to the smoker, 15% to Philip Morris, 15% to R.J. Reynolds, and 10% to Lorillard Tobacco, in connection with plaintiff’s survival claims. The jury apportioned 70% of the fault for the smoker’s injuries to the smoker, 10% to Philip Morris, 10% to R.J. Reynolds, and 10% to Lorillard Tobacco, in connection with plaintiff’s wrongful death claims. Because the jury found in favor of the defendants on the claims alleging intentional conduct, the plaintiff was not entitled to punitive damages. On August 13, 2014, defendants filed a motion for entry of judgment in favor of all defendants, arguing that the jury’s findings establish that the smoker was not an Engle class member. On December 17, 2014, the Court denied defendants’ motion. On December 18, 2014, the Court entered final judgment, awarding $1,726,650 in compensatory damages in a lump sum against all defendants. The jury’s comparative fault determinations were not applied despite the jury’s finding in favor of the defendants on the claims alleging intentional conduct. On January 15, 2015, defendants filed additional post-trial motions challenging the verdict and the final judgment. Plaintiff does not oppose applying the jury’s comparative fault determination to the final judgment. On January 2, 2015, the plaintiff filed a motion for attorneys’ fees and costs, which defendants have opposed. As of February 6, 2015, the Court had not ruled on this motion.

 

   

In Irimi v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Seventeenth Judicial Circuit, Broward County, Florida), the jury awarded plaintiff a total of $3,123,437 in compensatory damages on August 28, 2014. The jury apportioned 70% of the fault for the smoker’s injuries to the smoker, 14.5% to Lorillard Tobacco, 14.5% to R.J. Reynolds, and 1% to Liggett. Because the jury found in favor of the defendants on the claims alleging intentional conduct, the plaintiff was not entitled to punitive damages. Defendants filed post-trial motions challenging the verdict and plaintiff filed a motion for a new trial on the issue of entitlement to punitive damages. On December 18, 2014, the Court entered a final judgment that applied the jury’s comparative fault determinations and awarded the plaintiff a total of $937,031 in compensatory damages ($452,898 from Lorillard Tobacco), plus the statutory rate of interest. On January 27, 2015, the Court entered an order granting defendants’ motion for a new trial based on improper jury selection procedures, which effectively vacates the final judgment. Plaintiff filed a motion for rehearing on February 4, 2015.

 

   

In Lourie v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Thirteenth Judicial Circuit, Hillsborough County, Florida), the jury awarded plaintiff and a son of the decedent a total of $1,371,549 in compensatory damages on October 10, 2014. The jury apportioned 63% of the fault for the smoker’s injuries to the smoker, 27% to Philip Morris, 7% to Lorillard Tobacco, and 3% to R.J. Reynolds. The jury found that punitive damages were not warranted against any of the defendants. The Court denied defendants’ post-trial motions challenging the verdict. On November 6, 2014, the Court entered a final judgment that applied the jury’s comparative fault determinations and awarded plaintiff and a son of the decedent a total of $507,473 in compensatory damages ($96,008 from Lorillard Tobacco), plus the statutory rate of interest. Defendants have noticed an appeal from the final judgment to the Florida Second District Court of Appeal. On November 10, 2014, plaintiff filed a motion for attorneys’ fees and costs. As of February 6, 2015, the Court had not ruled on this motion.

 

   

In Perrotto v. R.J. Reynolds Tobacco Company, et al. (Circuit Court, Fifteenth Judicial Circuit, Palm Beach County, Florida), the jury awarded plaintiff a total of $4,087,339 in compensatory damages on November 21, 2014. The jury apportioned 49% of the fault for the smoker’s injuries to the smoker, 25% to Philip Morris, 20% to R.J. Reynolds, 6% to Lorillard Tobacco, and 0% to Liggett. Because the jury found in favor of the defendants on the claims alleging intentional conduct, the plaintiff was not entitled to punitive damages. On December 4, 2014, the Court entered a final judgment that applied the jury’s comparative fault determinations and awarded the plaintiff a total of $2,084,545 in compensatory damages ($245,240 from Lorillard Tobacco), plus the statutory rate of interest. Defendants have filed post-trial motions challenging the verdict, and the plaintiff has filed a post-trial motion seeking a new trial on entitlement to punitive damages. Plaintiff also filed a motion for

 

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attorneys’ fees and costs. As of February 6, 2015, the Court had not ruled on these motions. On December 31, 2014, the plaintiff filed a petition with the Florida Fourth District Court of Appeal seeking to disqualify the trial judge from further consideration of this case.

Since the Florida Supreme Court issued its 2006 ruling, through February 6, 2015, verdicts have been returned in 132 Engle Progeny Cases in which neither Lorillard Tobacco nor Lorillard, Inc. were defendants. Juries awarded compensatory damages and punitive damages in 44 of these trials. In 43 of those 44 trials, the amount of punitive damages awarded totaled approximately $862.1 million and ranged from $20,000 to $244 million. In July 2014, punitive damages of $23.6 billion were awarded in one of these cases. In that case, the Court granted in part a post-trial motion filed by the defendant and reduced the punitive damages to approximately $17 million. As of February 6, 2015, this award was subject to challenge through post-trial motions and the appellate process. In 35 of the trials, juries awarded only compensatory damages. In the 51 other trials, juries found in favor of the defendants. In some of the trials decided in the defendants’ favor, plaintiffs have filed motions challenging the verdicts and in some cases, appeals from final judgments are pending before various Florida circuit and intermediate appellate courts. As of February 6, 2015, one verdict in favor of the defendants has been reversed on appeal and returned to the trial court for a new trial on all issues. It is not possible to predict the final outcome of this litigation.

Various intermediate state and federal Florida appellate courts have issued rulings that address the scope of the preclusive effect of the findings from the first phase of the Engle trial, including whether those findings relieve plaintiffs from the burden of proving certain legal elements of their claims. The Florida Supreme Court granted review in the Douglas case, in which a verdict awarding compensatory damages to the plaintiff was affirmed by an intermediate state Florida appellate court, to address the issue of whether a tobacco manufacturer’s due process rights are violated by reliance upon the Engle Phase I findings. On March 14, 2013, the Florida Supreme Court ruled that application of the Engle Phase I findings to establish certain elements of plaintiffs’ claims is not a violation of the Engle defendants’ due process rights. In order to prevail on either strict liability or negligence claims, the Court found that plaintiffs must establish (i) membership in the Engle class; (ii) that addiction to smoking the Engle defendants’ cigarettes containing nicotine was a legal cause of the injuries alleged and (iii) damages. On August 12, 2013, defendants filed a petition with the United States Supreme Court seeking review of the Florida Supreme Court’s decision. This petition for review was denied on October 7, 2013. The due process issue was also on appeal in the United States Court of Appeals for the Eleventh Circuit in two cases that had been consolidated for appeal: Duke and Walker. On September 6, 2013, the United States Court of Appeals for the Eleventh Court affirmed the verdicts in these cases, holding that the judgment of the Florida Supreme Court in Douglas should be given full faith and credit, and that deference to the decision in Douglas does not violate the due process rights of the defendant. The defendant filed a petition for rehearing of the decision in Duke and Walker with the United States Court of Appeals for the Eleventh Circuit in October 2013. On October 31, 2013, the United States Court of Appeals for the Eleventh Circuit vacated and reconsidered its original opinion. The Court entered a new opinion that is substantively similar to the first with the exception that the Court now discusses giving full faith and credit to the Engle decision, as interpreted in Douglas. On November 7, 2013, the Court denied defendant’s petition for rehearing. On November 7, 2013, the defendant filed a second petition seeking review of the October 31, 2013 opinion. On January 6, 2014, the Court denied this petition. On March 28, 2014, the defendant in Duke and Walker filed a petition with the United States Supreme Court seeking to answer the question of whether the Engle Phase I findings can be applied to establish certain elements of plaintiffs’ claims. On the same date, defendants filed similar petitions in the Brown case (an appeal from a Florida state court trial), as well as in eight other state court cases, including two cases in which Lorillard Tobacco is a defendant (Mrozek and Sury). The defendants requested that these petitions be held pending disposition of the Duke, Walker, and Brown cases, and resolved in a similar manner. On June 9, 2014, the United States Supreme Court declined to accept review of the Duke, Walker, and Brown cases. On the same date, the United States Supreme Court declined to accept review of the eight other state court cases, including Mrozek and Sury, discussed above.

 

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In connection with the Engle Progeny Cases, Lorillard and various other tobacco manufacturing defendants face various legal issues that could materially affect the outcome of the Engle cases. These legal issues include, but are not limited to, the application of the statute of limitations and statute of repose, the ability of an Engle plaintiff to pursue a claim against defendants that did not manufacture or market the cigarettes plaintiff smoked, the constitutionality of a cap on the amount of a bond necessary to obtain an automatic stay of a post-trial judgment, whether Engle class members may pursue an award of punitive damages based on claims of negligence or strict liability, and whether a judgment based on a claim of intentional conduct should be reduced by a jury’s findings on comparative fault. Various intermediate Florida appellate courts and Florida Federal Courts have issued rulings on these issues.

In certain cases, trial courts have entered final judgments that define defendants’ liability as joint and several. Four of these judgments have been affirmed by intermediate Florida appellate courts, including one case in which Lorillard Tobacco was a defendant. In such cases, Lorillard Tobacco may face the risk of liability for the entire amount of the judgment even if a percentage of fault was allocated to other defendants, in the event that one or more co-defendants decline or otherwise fail to pay their proportionate or jury-allocated share of a judgment. Also, the presumptive respective share of each joint and several judgment debtor is pro rata, and not proportional to the amount of fault attributable to each defendant by the jury. As a result, Lorillard Tobacco under certain circumstances may have to pay more than their proportionate share of any judgment-related amount.

The judgment entered in the U.S. Government Case, while not final in all respects, could restrict or limit our defenses in other litigation.

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

In 2009, a three-judge panel of the U.S. Court of Appeals for the District of Columbia Circuit upheld substantially all of the District Court’s final judgment and remedial order. In June 2010, the U.S. Supreme Court denied the parties’ petitions seeking review of the case. The case was remanded to the District Court, for implementation of the Court of Appeals’ directions in its 2009 ruling and for entry of an amended final judgment. As of February 6, 2015, the District Court had not entered the amended final judgment addressing all of the directions from the Court of Appeals, although, as described above, it had entered its order setting forth the language of the corrective statements and the consent order regarding implementation of the corrective statements. Defendants’ appeal from the orders regarding the corrective statements is pending.

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

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

In December 2008, the United States Supreme Court issued a decision that neither the Federal Cigarette Labeling and Advertising Act nor the Federal Trade Commission’s regulation of cigarettes’ tar and nicotine

 

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disclosures preempts (or bars) some of plaintiffs’ claims. The decision also more broadly addresses the scope of preemption based on the Federal Cigarette Labeling and Advertising Act, and could significantly limit cigarette manufacturers’ arguments that certain of plaintiffs’ other claims in smoking and health litigation, including claims based on the alleged concealment of information with respect to the hazards of smoking, are preempted.

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

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

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

The Surgeon General also addressed the health risks to non-smokers from exposure to ETS in the 2010 Surgeon General Report and in the 2014 Surgeon General Report. These reports could form the basis of additional litigation against cigarette manufacturers, including us. The reports have been and in the future could be used to support litigation against us or other cigarette manufacturers. It also is possible that the Surgeon General’s report could result in additional restrictions placed on cigarette smoking or in additional regulations placed on the manufacture or sale of cigarettes. It is possible that such additional restrictions or regulations could result in a decrease in cigarette sales in the United States, including sales of our brands. These developments may have a material adverse effect on our financial condition, results of operations, and cash flows.

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

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

 

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Under the State Settlement Agreements, we paid $1.364 billion in 2014 and estimate that we will pay between $1.450 billion and $1.500 billion in 2015, primarily based on 2014 estimated industry volume. Annual payments under the State Settlement Agreements are required to be paid in perpetuity and are based, among other things, on our domestic market share and unit volume of domestic shipments, with respect to the MSA, in the year preceding the year in which payment is due, and, with respect to the Initial State Settlements, in the year in which payment is due.

Amounts due under the State Settlement Agreements are impacted by a number of factors, including industry volume, market share and industry operating profits. In the fourth quarter 2011, RAI, the parent of RJR Tobacco, announced a change to a mark-to-market pension accounting method. Such method of accounting for pension and postretirement benefits results in the recognition of actuarial gains and losses on pension and postretirement plan assets or benefit obligations in the year it is incurred to the extent such gains and losses are in excess of 10% of the greater of the fair value of the plan assets or the plan’s benefit obligation, referred to as the corridor, rather than amortized over the average future service period of the active employees in such plans. As a result of the change to mark-to-market pension accounting announced by RAI, the industry operating profits as defined in the State Settlement Agreements may be impacted positively or negatively in any given year. For example, in 2012 and 2014 RAI’s mark-to-market pension adjustment resulted in $8 million and $11 million reductions in our obligations under the State Settlement Agreements, respectively. It is possible that our State Settlement Agreement obligations, results of operations, cash flows and financial position could be materially adversely affected by RAI’s mark-to-market adjustments or other factors impacting industry operating profits in the future.

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

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

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

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

 

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

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

Our principal competitors are the two other major U.S. cigarette manufacturers, Philip Morris and RJR Tobacco. We also compete against numerous other smaller manufacturers or importers of cigarettes. If our major competitors were to significantly increase the level of price discounts offered to consumers, we could respond by increasing price discounts, which could have a materially adverse effect on our profitability and results of operations.

Electronic cigarettes, having been recently introduced to market, are at an early stage of development and are evolving rapidly. Competition in the electronic cigarette industry is intense. We compete with many companies in the market for electronic cigarettes and the nature of our competitors is varied as the market is highly fragmented and the barriers to entry into the business are low. For instance, our competitors include large companies, such as Philip Morris and RJR Tobacco, as well as smaller companies with similar product offerings. The method of distribution for many competing companies is predominately over the internet, with only a small number of competitors currently having a significant presence at retail. Our future sales and any future profits in our electronic cigarette business are substantially dependent upon the acceptance and use of electronic cigarettes by adult smokers. Our ability to generate future sales will be dependent on a number of factors, many of which are beyond our control, including the pricing of competing products, overall demand for our products, changes in consumer preferences, market competition and government regulation. We may not be able to adapt as the electronic cigarette industry and customer demand evolves, whether attributable to regulatory constraints or requirements or our failure to respond in a timely and/or effective manner to new technologies, customer preferences, changing market conditions or new developments in our industry, which could have a material adverse effect on our electronic cigarette business.

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

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

 

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

On April 25, 2014, the FDA released proposed rules that would extend its regulatory authority to electronic cigarettes and certain other tobacco products under the FSPTCA. We preliminarily note that the proposed rules would require that electronic cigarette manufacturers (i) register with the FDA and report electronic cigarette product and ingredient listings; (ii) market new electronic cigarette products only after FDA review; (iii) only make direct and implied claims of reduced risk if the FDA confirms that scientific evidence supports the claim and that marketing the electronic cigarette product will benefit public health as a whole; (iv) not distribute free samples; (v) implement minimum age and identification restrictions to prevent sales to individuals under age 18; (vi) include health warnings; and (vii) not sell electronic cigarettes in vending machines, unless in a facility that never admits youth. The proposed regulation was subject to a 75-day public comment period, which was extended by the FDA to August 8, 2014, following which the FDA was to finalize the proposed regulation. On August 7, 2014, Lorillard filed comments to the proposed rules. It is not known how long this regulatory process to finalize and implement the rules may take. Accordingly, although we cannot predict the content of any final rules of the proposed or future regulation or the impact they may have, if enacted they could have a material adverse effect on our electronic cigarette business.

In the European Union (“EU”), the Tobacco Products Directive (“TPD”) regulates the content, manufacture, marketing and labeling of tobacco products. An amendment of the TPD was adopted, and became effective in May of 2014, which provides for detailed premarket notification requirements for electronic cigarettes and places certain classes of electronic cigarettes under the authority of medicinals regulations in EU member states. The Tobacco Products Directive must be transposed into national legislation by member states by May 20, 2016. Depending on the TPD implementation at a national level, certain sales and marketing restrictions on electronic cigarettes may be applicable in the United Kingdom, and this could result in a decrease in sales of our electronic cigarettes in the United Kingdom and have a material adverse effect on our electronic cigarette business in the future.

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

In addition to the regulation of our business by the FDA, our business, results of operations or financial condition could be adversely affected by new or future legal requirements imposed by federal, state, local and foreign legislative or regulatory initiatives, including but not limited to those relating to health care reform, climate change and environmental matters. For example, the health care reform legislation, which was signed into law in March 2010, resulted in the repeal of $2 million of future tax deductions for Medicare Part D subsidies for our retiree drug benefits and could impact our accounting for retiree medical benefits, employer-sponsored medical plans and related matters in future periods. However, the extent of that impact, if any, cannot be determined until regulations are promulgated and additional interpretations of the health care law are available. In addition, blu (U.K.) is based in the United Kingdom and we manufacture electronic cigarettes in Asia, which may present unique challenges and increase our exposure to the risks associated with foreign operations, including compliance with the legal requirements imposed by foreign legislative or regulatory initiatives. New legislation or regulations may result in increased costs directly for our compliance or indirectly to the extent such requirements increase the prices of goods and services because of increased costs or reduced availability. We cannot predict whether such legislative or regulatory initiatives will result in significant changes to existing laws and regulations and/or whether any changes in such laws or regulations will have a material adverse effect on our business, results of operations or financial condition.

Sales of cigarettes are subject to substantial federal, state and local excise taxes, which could be extended to electronic cigarettes.

The federal excise tax on cigarettes was last increased on April 1, 2009 from $0.39 per pack to $1.0066 per pack to finance health insurance for children. The President’s fiscal year 2016 federal budget plan included a

 

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proposal to further increase the federal excise tax on cigarettes by $0.94 per pack to fund early childhood education. For the twelve months ended December 31, 2014, combined state and local excise taxes ranged from $0.17 to $6.16 per pack of cigarettes. Various states and localities have raised the excise tax on cigarettes substantially in recent years. During 2014, there were two state excise tax increases, $0.13 per pack implemented in the state of Oregon and $0.13 per pack implemented in the state of Vermont, as well as municipal excise tax increases that included a $2.00 per pack increase in Philadelphia, Pennsylvania, a $0.50 per pack increase in the City of Chicago, Illinois and a $0.04 per pack excise tax increase in the District of Columbia.

It is our expectation that several states will propose further increases in 2015 and in subsequent years. We believe that increases in excise and similar taxes have had an adverse impact on sales of cigarettes. In addition, we believe that the 2009 increase in the federal excise tax, and possible future increases, the extent of which cannot be predicted, compounded by poor economic conditions, could result in further volume declines for the cigarette industry, including us, and an increased sales shift toward lower priced discount cigarettes rather than premium brands.

Presently the sale of electronic cigarettes is not subject to federal, state and local excise taxes to the same extent as the sale of cigarettes and other tobacco products, all of which have faced significant increases in the amount of taxes collected on their sales. Should any excise taxes be broadly imposed on electronic cigarettes similar to those levied against cigarettes and other tobacco products, such imposition of taxes may have a material adverse effect on the demand for our electronic cigarettes, as consumers may be unwilling to pay the increased costs.

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

Although we conduct business in Puerto Rico, Guam and the U.S. Virgin Islands, our cigarette business in the 50 states of the United States (the “domestic cigarette market”) is currently our only significant business and has generally been contracting. We do not have foreign cigarette sales that could offset these effects, as we sold the international rights to substantially all of our cigarette brands, including Newport, in 1977. As a result of price increases, restrictions on advertising and promotions, increases in regulation and excise taxes, health concerns, a decline in the social acceptability of smoking, increased pressure from anti-tobacco groups and other factors, industry-wide domestic cigarette shipments have decreased at a compound annual rate of approximately 3.9% during the period 2004 through 2014. Industry-wide domestic cigarette shipments decreased by an estimated 3.2% for 2014 compared to 2013, 4.6% for 2013 compared to 2012 and 2.3% for 2012 compared to 2011. We expect the domestic cigarette market to continue to contract, which could have a material adverse effect on our results of operation and financial condition.

We derive most of our revenue from one brand.

Our largest selling brand, Newport, accounted for approximately 86.5% of our consolidated net sales for 2014. Our principal strategic plan revolves around the marketing and sales promotion in support of the Newport brand. We cannot ensure that we will continue to successfully implement our strategic plan with respect to Newport or that implementation of our strategic plan will result in the maintenance, growth or profitability of the Newport brand.

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

Since 1998, the cigarette market has been increasingly price competitive due to the impact of, among other things, higher state and local excise taxes and the market share of deep discount brands. In response to these and other competitor actions and pricing pressures, we have engaged in the significant use of promotions and sales incentives. The cost of these measures could have a material adverse impact on our business. We regularly review the results of our promotional spending activities and adjust our promotional spending programs in an

 

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effort to maintain our competitive position. Accordingly, unit sales volume and sales promotion costs in any period are not necessarily indicative of sales and costs that may be realized in subsequent periods.

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

The loss of any of our key employees could adversely affect our business. As a tobacco company, we may experience difficulty in identifying and hiring qualified executives and other personnel in some areas of our business. This difficulty is primarily attributable to the health and social issues associated with the tobacco industry. The loss of services of any key personnel or our inability to attract and hire personnel with requisite skills could restrict our ability to develop new products, enhance existing products in a timely manner, sell products or manage our business effectively. These factors could have a material adverse effect on our results of operations and financial condition.

Increased restrictions on the sale and/or use of cigarettes and electronic cigarettes in public places could adversely affect our sales volume, revenue and profitability.

In recent years, states and many local and municipal governments and agencies, as well as private businesses, in the United States have adopted legislation, regulations or policies which prohibit, restrict, or discourage the sale, marketing and/or use of cigarettes and electronic cigarettes; the use of cigarettes and electronic cigarettes in public buildings and facilities, stores, restaurants and bars; and smoking on airline flights and in the workplace. In addition, smoking in virtually all enclosed public places and workplaces is now prohibited by law throughout the United Kingdom. Other similar laws and regulations are currently under consideration and may be enacted by state and local governments in the United States or in the United Kingdom in the future. Although we have no empirical evidence of the effect of such restrictions, we believe that restrictions on smoking in public and other places may lead to a decrease in the number of people who smoke or a decrease in the number of cigarettes smoked by smokers. Increased restrictions on smoking in public and other places may have caused a decrease, and may continue to cause a decrease in the volume of cigarettes that would otherwise be sold by us absent such restrictions, which may have a material adverse effect on our sales volume, revenue and profits. At present, several local governments have considered and, in some cases imposed, similar restrictions on the use of electronic cigarettes. Should foreign, federal, state, local or municipal governments, agencies or regulators or private industry likewise restrict the sale, marketing and/or use of electronic cigarettes in public and other places, such restrictions may lead to a similar decrease in the volume of electronic cigarettes that would otherwise be sold by us absent such restrictions, which may have an adverse effect on our electronic cigarette business.

Our business may face additional international governmental actions aimed at cigarettes and other tobacco products.

There are a number of international regulatory developments relating to cigarettes that could impact our domestic cigarette business and/or our electronic cigarette business. The tobacco industry expects significant regulatory developments to take place over the next few years, driven principally by the World Health Organization’s Framework Convention on Tobacco Control (“FCTC”), which entered into force in February 2005. As of February 6, 2015, 177 countries, including the United Kingdom, have become parties to the FCTC. While the United States is a signatory of the FCTC, it is not currently a party to the agreement, as the agreement has not been submitted to, or ratified by, the United States Senate. The FCTC is the first international public health treaty on tobacco and its objective is to establish a global agenda for tobacco regulation with the purpose of reducing initiation of tobacco use and encouraging cessation. Regulatory initiatives that have been proposed, introduced or enacted include:

 

   

the levying of substantial and increasing tax and duty charges;

 

   

restrictions or bans on advertising, marketing and sponsorship;

 

   

the display of larger health warnings, graphic health warnings and other labeling requirements;

 

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restrictions on packaging design, including the use of colors and generic packaging;

 

   

restrictions or bans on the display of tobacco product packaging at the point of sale, and restrictions or bans on cigarette vending machines;

 

   

requirements regarding testing, disclosure and performance standards for tar, nicotine, carbon monoxide and other smoke constituents levels;

 

   

requirements regarding testing, disclosure and use of tobacco product ingredients;

 

   

increased restrictions on smoking in public and work places and, in some instances, in private places and outdoors;

 

   

elimination of duty free allowances for travelers; and

 

   

encouraging litigation against tobacco companies.

If electronic cigarettes are subject to one or more significant regulatory initiatives enacted under the FCTC, our electronic cigarette business could be materially and adversely affected.

Electronic cigarettes are not generally recognized as less harmful than cigarettes at this time.

Notwithstanding the potential harm reduction attributes of electronic cigarettes, the public health community is split on whether electronic cigarettes are less harmful than cigarettes. In addition, many public health advocates believe that electronic cigarettes provide a gateway to the normalization of smoking. Because long-term clinical studies about the safety and efficacy of electronic cigarettes will likely be required to address these public health concerns and a robust body of science on electronic cigarettes emissions is not available at this time, legislative, regulatory and other efforts to limit the sale, marketing and use of electronic cigarettes may continue or accelerate, which could have a material adverse effect on our electronic cigarette business.

Expanding our operations internationally poses additional risks to our business.

We are primarily engaged in business activities in the United States, but we do engage in certain international business activities, primarily related to electronic cigarettes, and are subject to various United States and foreign laws and regulations, such as the U. S. Foreign Corrupt Practices Act, U.K. Bribery Act and other laws prohibiting bribery and corruption. We operate our blu (U.K.) business and market its products in the United Kingdom and manufacture our electronic cigarettes in Asia. Our business or financial performance may be adversely affected due to the risks of doing business internationally, including but not limited to the following: economic and political instability; supply chain disruptions; unfavorable changes in tariffs or export and import restrictions; and failure to comply with foreign laws and regulations. If any of these events were to materialize, they could lead to disruption of our electronic cigarette business, significant expenditures and/or damage to our reputation, and could harm our reputation or have a material adverse effect on our financial position, results of operations, or cash flows.

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

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

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

We purchased approximately 80%, 86% and 90% of our leaf tobacco from 3, 4 and 4 suppliers in 2014, 2013 and 2012, respectively. If these suppliers become unwilling or unable to supply leaf tobacco to us, we

 

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

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

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

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

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

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

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

 

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

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

 

   

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

 

   

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

 

   

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

 

   

limitations on the right of shareholders to remove directors.

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

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

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

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

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

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

 

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transferee or successor agrees to be bound by these indemnification obligations. In addition, we could face substantial charges for indemnification payments to Loews, which could have a material adverse effect on our cash flows, financial condition and results of operations.

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

 

Item 1B. UNRESOLVED STAFF COMMENTS

None.

 

Item 2. PROPERTIES

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

Our principal properties are owned in fee and generally we own all of the machinery we use. We believe that our properties and machinery are in generally good condition. We lease sales offices in major cities throughout the United States, a cold-storage facility and satellite data center in Greensboro and warehousing space in 17 public distribution warehouses located throughout the United States.

We lease an office for headquarters, marketing and administrative personnel in our blu eCigs electronic cigarettes business in Charlotte, North Carolina as well as an office for product development in Campbell, California. We also lease a warehouse with shipping and receiving areas totaling approximately 13,500 square feet in Charlotte, North Carolina that is used for the fulfillment of consumer orders over the internet.

We lease two offices for headquarters, marketing and administrative personnel in our blu (U.K.) electronic cigarettes business in Edinburgh, Scotland and Birmingham, England. We also lease a warehouse with shipping and receiving areas totaling approximately 10,000 square feet in Edinburgh, Scotland that is used for the fulfillment of customer and consumer orders.

 

Item 3. LEGAL PROCEEDINGS

Information regarding legal proceedings is set forth in Note 23, “Legal Proceedings,” to our Consolidated Financial Statements included in Part II, Item 8 of this report, which is incorporated herein by reference.

 

Item 4. MINE SAFETY DISCLOSURES

None.

 

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PART II

 

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

Our Common Stock began trading “regular way” on the NYSE under the symbol “LO” on June 10, 2008. There were 78 shareholders of record as of February 6, 2015. This figure excludes any estimate of the indeterminate number of beneficial holders whose shares may be held of record by brokerage firms and clearing agencies. The following table presents the high and low sales prices of our Common Stock on the NYSE as well as cash dividends declared per share during the fiscal quarters indicated:

 

Common Stock Market Price

   Price per Share      Cash
Dividends
Declared

Per Share
 
   High      Low     

2014

        

Fourth Quarter

   $ 64.06       $ 58.00       $ 0.6150   

Third Quarter

     67.22         59.03         0.6150   

Second Quarter

     65.18         52.24         0.6150   

First Quarter

     55.26         47.31         0.6150   

2013

        

Fourth Quarter

   $ 53.00       $ 44.18       $ 0.5500   

Third Quarter

     46.53         41.86         0.5500   

Second Quarter

     44.92         40.33         0.5500   

First Quarter

     42.41         37.98         0.5500   

Dividend Policy

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

In 2014, we paid cash dividends of $224 million, $222 million, $221 million and $222 million on March 10, 2014, June 10, 2014, September 10, 2014 and December 10, 2014, respectively. In 2013, we paid cash dividends of $209 million, $208 million, $204 million and $202 million on March 11, 2013, June 10, 2013, September 10, 2013 and December 10, 2013, respectively. In 2012, we paid cash dividends of $202 million, $203 million, $203 million and $199 million on March 9, 2012, June 11, 2012, September 10, 2012 and December 10, 2012, respectively.

Stock Split

In the fourth quarter of 2012, the Board of Directors declared a three-for-one split of the Company’s common stock. The record date of the stock split was December 14, 2012 and the additional shares were distributed January 15, 2013. All shares and per share amounts for all prior periods presented in this filing have been adjusted for the stock split.

 

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Performance Graph

The following graph compares the cumulative total shareholder return on our Common Stock from December 31, 2009 to December 31, 2014 with the comparable cumulative return of (i) the S&P 500 Index and (ii) the S&P Tobacco Index. The graph assumes $100 was invested on December 31, 2009 in our Common Stock and in each of the indices and assumes that all cash dividends are reinvested. The table below the graph shows the dollar value of those investments as of the dates in the graph. The comparisons in the graph are required by the SEC and are not intended to forecast or be indicative of future performance of our Common Stock.

 

 

LOGO

 

    12/31/09     06/30/10     12/31/10     06/30/11     12/31/11     06/30/12     12/31/12     06/30/13     12/31/13     06/30/14     12/31/14  

Lorillard Common Stock

    100.00        92.17        108.09        147.47        158.10        187.50        169.97        196.11        232.97        286.85        302.12   

S&P 500 Index

    100.00        93.35        115.06        122.00        117.49        128.64        136.30        155.14        180.44        193.32        205.14   

S&P 500 Tobacco Index

    100.00        99.45        127.70        148.13        174.20        200.62        192.36        210.39        224.98        239.10        256.05   

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

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

During the fourth quarter of 2014, the Company has not repurchased any shares of our Common Stock.

Recent Sales of Unregistered Securities

During the period covered by this annual report, the Company has not sold any unregistered securities.

 

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Item 6. SELECTED FINANCIAL DATA

The following table includes our selected historical consolidated financial information as of the dates and for the periods indicated. The selected historical consolidated financial information as of and for the years ended December 31, 2010 through 2014 have been derived from our audited financial statements. You should read the following selected historical consolidated financial data in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our consolidated financial statements and related notes appearing herein.

 

     Years Ended December 31,  
(In millions, except per share data)    2014     2013     2012     2011     2010  

Results of Operations:

          

Net sales (1)

   $ 6,990      $ 6,950      $ 6,623      $ 6,466      $ 5,932   

Cost of sales (1)

     4,252        4,231        4,241        4,123        3,809   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Gross profit

     2,738        2,719        2,382        2,343        2,123   

Selling, general and administrative

     630        665        504        451        398   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (2)

     2,108        2,054        1,878        1,892        1,725   

Investment income (3)

     7        2        4        3        4   

Interest expense

     (179     (172     (154     (125     (94
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Income before income taxes

     1,936        1,884        1,728        1,770        1,635   

Income taxes (4)

     749        704        629        654        606   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 1,187      $ 1,180      $ 1,099      $ 1,116      $ 1,029   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Diluted weighted average number of shares outstanding

     360.76        373.71        390.13        418.06        455.19   

Diluted earnings per share

   $ 3.28      $ 3.15      $ 2.81      $ 2.66      $ 2.25   

Dividends per share

   $ 2.46      $ 2.20      $ 2.07      $ 1.73      $ 1.42   

Ratio of earnings to fixed charges

     11.8        12.0        12.2        15.2        18.4   

Segment data:

          

Net sales

          

Cigarettes (1)

   $ 6,825      $ 6,720      $ 6,562      $ 6,466      $ 5,932   

Electronic cigarettes

     165        230        61        —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   $ 6,990      $ 6,950      $ 6,623      $ 6,466      $ 5,932   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Operating income (loss)

          

Cigarettes

   $ 2,180      $ 2,054      $ 1,877      $ 1,892      $ 1,725   

Electronic cigarettes

     (72     —          1        —          —     
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 
   $ 2,108      $ 2,054      $ 1,878      $ 1,892      $ 1,725   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Includes excise taxes of $1,938, $1,978, $1,987, $2,014 and $1,879 million, respectively.
(2)

2014 includes a $27 million favorable impact of the 2003 non-participating manufacturer award as a result of the September 2013 arbitration panel determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers. 2014 also includes a $14 million favorable impact of the reduction in Lorillard’s MSA payments as a result of the settlement with two more states in June 2014 to resolve certain MSA payment adjustment disputes approved by the arbitration panel in March 2013. 2014 also includes a $11 million favorable impact of the mark-to-market pension adjustment recorded by Reynolds American in the fourth quarter of 2014. 2014 also includes a $23 million unfavorable impact on administrative expenses resulting from amortization of the fair value ascribed to the SKYCIG brand that is being amortized over an estimated life of 18 months beginning October 1, 2013, after which amortization charges related to the brand will cease. 2014 also includes $26 million in costs related to the RAI merger agreement included in selling, general and administrative expenses. 2014 also includes $39 million in costs to satisfy the Alexander final judgment including statutory interest and related fees included in selling,

 

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  general and administrative expenses. 2014 also includes a $2 million unfavorable impact of the resolution of the SKYCIG purchase price dispute. Lastly, 2014 includes an $8 million favorable impact of the fair value adjustment to the blu (U.K.) earn out liability included in selling, general and administrative expenses. 2013 includes a $155 million favorable impact on Lorillard’s tobacco settlement expense included in cost of sales related to the reduction in Lorillard’s MSA payments as a result of the settlement with certain states to resolve certain MSA payment adjustment disputes in March 2013. 2013 also includes $79 million, $20 million and $22 million unfavorable impacts on administrative expenses resulting from accrued costs related to compensatory damages and statutory interest to dismiss the Evans case, accrued costs related to estimated costs to comply with the U.S. Government Case and accrued costs related to compensatory damages, punitive damages, statutory interest and attorneys’ fees related to certain Engle Progeny Cases, respectively. Lastly, 2013 includes $4 million and $6 million unfavorable impacts on administrative expenses resulting from expenses incurred in conjunction with the acquisition of SKYCIG and amortization of the fair value ascribed to the SKYCIG brand that is being amortized over an estimated life of 18 months beginning October 1, 2013, after which amortization charges related to the brand will cease. 2012 includes a $6 million unfavorable impact on administrative expenses resulting from the acquisition of blu eCigs on April 24, 2012. 2012 also includes a $7 million unfavorable impact on tobacco settlement expense resulting from a competitor’s adjustments to its 2001-2005 operating income and restructuring charges. See further discussion under Results of Operations in Management’s Discussion and Analysis of Financial Condition and Results of Operations.
(3) Includes interest income of $7 million, $2 million, $4 million, $3 million and $4 million. $4 million of 2014 interest income is related to the 2013 NPM arbitration award and the Missouri and Pennsylvania court rulings in the second quarter of 2014.
(4) 2014 includes a $11 million unfavorable impact of an income tax valuation allowance recorded related to blu (U.K.) deferred tax assets.

 

     December 31,  

(In millions)

   2014     2013     2012     2011     2010  

Financial Position:

          

Current assets

   $ 2,634      $ 2,736      $ 2,777      $ 2,564      $ 2,935   

Total assets

     3,508        3,536        3,396        3,008        3,296   

Current liabilities

     1,583        1,651        1,601        1,485        1,426   

Long-term debt

     3,561        3,560        3,111        2,595        1,769   

Total liabilities

     5,690        5,600        5,173        4,521        3,521   

Shareholders’ deficit

     (2,182     (2,064     (1,777     (1,513     (225

 

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

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

Overview

Lorillard has two reportable segments, Cigarettes and Electronic Cigarettes.

The Cigarettes segment consists principally of the operations of Lorillard, Inc., Lorillard Tobacco and related entities. Lorillard Tobacco is the third largest manufacturer of cigarettes in the United States. Founded in 1760, Lorillard Tobacco is the oldest continuously operating tobacco company in the United States. Newport, Lorillard’s flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette overall in the United States based on gross units sold during the years ended December 31, 2014 and 2013. In addition to the Newport brand, the Lorillard product line has four additional brand families marketed under the Kent, True, Maverick and Old Gold brand names. These five cigarette brands include 45 different product offerings which vary in price, taste, flavor, length and packaging.

The Electronic Cigarettes segment consists of the operations of LOEC (d/b/a blu eCigs), Cygnet (t/a blu (U.K.)) and related entities. blu eCigs is a leading electronic cigarette company in the United States. Lorillard acquired the blu eCigs brand and other assets used in the manufacture, distribution, development, research, marketing, advertising and sale of electronic cigarettes on April 24, 2012. Lorillard acquired certain assets and operations of SKYCIG (now t/a blu (U.K.), a United Kingdom based electronic cigarette business, on October 1, 2013.

Recent Developments

On July 15, 2014, the Company, Reynolds American Inc., a North Carolina corporation (“RAI”), and Lantern Acquisition Co., a Delaware corporation and a wholly owned subsidiary of RAI (“Merger Sub”), entered into an Agreement and Plan of Merger (the “Merger Agreement”), pursuant to which, subject to the satisfaction or waiver of certain conditions, Merger Sub will merge with and into the Company (the “Merger”), with the Company surviving as a wholly owned subsidiary of RAI. At the effective time of the Merger, each share of Company common stock (other than treasury stock held by the Company or owned by a subsidiary of the Company, RAI or Merger Sub and shares owned by shareholders of the Company who have properly made and not withdrawn a demand for appraisal rights) will be converted into the right to receive a unit consisting of (i) $50.50 per share in cash and (ii) 0.2909 fully paid and non-assessable shares of common stock of RAI. On January 28, 2015, the Company’s shareholders adopted the Merger Agreement, and RAI’s shareholders approved the issuance of RAI common stock in the Merger. The transaction remains subject to regulatory approval and the additional customary closing conditions contained in the Merger Agreement. Although no assurance can be given if and when the transaction will be completed because it remains subject to regulatory approval and the additional customary closing conditions, the transaction is expected to close in the first half of 2015.

In connection with the Merger Agreement, on July 15, 2014, RAI and Lignum-2, L.L.C., a wholly owned subsidiary of Imperial Tobacco Group PLC (“Imperial”), which subsequently changed its name to ITG Brands, LLC (“Imperial Sub”), entered into an asset purchase agreement, pursuant to which Imperial Sub has agreed to

 

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purchase, immediately following the completion of the Merger, the Kool, Salem, Winston, Maverick and blu eCigs brands and certain other assets for a total consideration of $7.1 billion in cash (subject to certain adjustments). Also, on July 15, 2014, in connection with the asset purchase, the Company and Imperial Sub entered into a Transfer Agreement, pursuant to which Imperial Sub agreed to acquire certain assets owned by the Company, including its manufacturing and R&D facilities in Greensboro, N.C., and approximately 2,900 employees. On January 28, 2015, the shareholders of Imperial approved the asset purchase.

Critical Accounting Policies and Estimates

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

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

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

 

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Goodwill and Intangible Assets

The acquisitions of blu eCigs on April 24, 2012 and SKYCIG on October 1, 2013 resulted in the recording of goodwill, trademarks and other intangible assets. Upon acquisition, the purchase price was first allocated to identifiable assets and liabilities, including trademarks and trade names and other intangible assets, and the remainder of the purchase price was recorded as goodwill. Our blu eCigs trademark and trade name and goodwill recorded as a part of the blu eCigs reporting unit are considered indefinite lived intangible assets and as such are not amortized. Our SKYCIG trademark recorded as part of the blu (U.K.) reporting unit has an estimated useful life of 18 months and is being amortized over that life on a straight line basis starting on the date of acquisition (October 1, 2013). Our SKYCIG goodwill, also recorded as part of the blu (U.K.) reporting unit, is considered an indefinite lived intangible asset. Both the blu eCigs and blu (U.K.) reporting units are components of our Electronic Cigarettes reporting segment. We test indefinite lived intangible assets recorded as part of our blu eCigs reporting unit for impairment as of November 1 of each year and our blu (U.K.) reporting unit as of September 1 of each year and more frequently if indicators of impairment exist.

Goodwill Valuations

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

In arriving at the fair value of a reporting unit, we utilize a combination of the income and market approaches. The income approach uses a reporting unit’s projection of estimated operating results and cash flows that is discounted using a weighted average cost of capital that is determined based on current market conditions. The projection uses management’s best estimates of economic and market conditions over the projected period including growth rates in sales, costs and number of units, estimates of future expected changes in operating margins and cash expenditures. Other estimates and assumptions include terminal value growth rates, future estimates of capital expenditures and changes in future working capital requirements. The market approach estimates fair value by applying cash flow multiples to the reporting unit’s operating performance. The multiples are derived from comparable publicly traded companies with similar operating and investment characteristics. Finally, we consider the implied control premium and conclude whether the implied control premium is reasonable based on other recent market transactions. Determining the fair value of a reporting unit involves the use of significant estimates and assumptions and we believe the estimates and assumptions used in our blu eCigs and blu (U.K.) goodwill impairment testing are reasonable. The fair value of the blu eCigs reporting unit determined using the approach discussed above was greater than its carrying value, but was not substantially in excess of carrying value as of November 1, 2014, the date of our last impairment test for that reporting unit. The fair value of the blu (U.K.) reporting unit was substantially in excess of carrying value as of September 1, 2014, the date of the last impairment test for that reporting unit. Therefore, no impairment was determined to exist for our blu eCigs or blu (U.K.) reporting units. Differences in key estimates of economic and market conditions over the projection period, which are discussed above, that are used in the calculations of the fair values of our reporting units could differ in comparison to actual future results. Potential events or changes in circumstances that could negatively affect the fair values of our reporting units include increased price competition, a decrease in demand for our products, changes in consumer preferences, market competition and government regulation, and could result in future impairment charges. See Note 6 to our consolidated financial statements beginning on page 80 for information regarding the amount of goodwill allocated to each reporting unit.

 

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Intangible Asset Valuations

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

Based on our impairment testing performed as of November 1, 2014, the estimated fair value of the blu eCigs trademark and trade name was substantially in excess of its carrying value, and, therefore, no impairment was determined to exist.

For additional information about goodwill and intangible asset valuations, see Notes 1 and 6 to our consolidated financial statements beginning on page 73.

Revenue Recognition

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

Tobacco Settlement Costs

In 1998, Lorillard Tobacco, Philip Morris, RJR Tobacco and Brown & Williamson Tobacco Corporation (now an affiliate of RJR Tobacco) (the “Original Participating Manufacturers”) entered into the MSA with 46 states and various other governments and jurisdictions to settle asserted and unasserted health care cost recovery and other claims. We and certain other U.S. tobacco product manufacturers had previously settled similar claims brought by Mississippi, Florida, Texas and Minnesota (which are referred to as the “Initial State Settlements”, and together with the MSA, are referred to as the “State Settlement Agreements”). Our portion of ongoing adjusted settlement payments and legal fees is based on our relative share of the settling manufacturers’ domestic cigarette shipments, with respect to the MSA, in the year preceding that in which the payment is due, and, with respect to the Initial State Settlements, in the year in which payment is due. We record our portion of ongoing adjusted settlement payments as part of cost of sales as product is shipped. Please read “State Settlement Agreements” beginning on page 61 for additional information.

Tobacco and Other Litigation

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

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

We establish accruals in accordance with Accounting Standards Codification Topic 450, Contingencies (“ASC 450”), when a material litigation liability is both probable and can be reasonably estimated. There are a number of factors impacting our ability to estimate the possible loss or a range of loss, including the specific facts of each matter; the legal theories proffered by plaintiffs and legal defenses available to us; the wide-ranging

 

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outcomes reached in similar cases; differing procedural and substantive laws in the various jurisdictions in which lawsuits have been filed, including whether punitive damages may be pursued or are permissible; the degree of specificity in a plaintiff’s complaint; the history of the case and whether discovery has been completed; plaintiffs’ history of use of our cigarettes relative to those of the other defendants; the attribution of damages, if any, among multiple defendants; the application of contributory and/or comparative negligence to the allocation of damage awards among plaintiffs and defendants; the likelihood of settlements for de minimis amounts prior to trial; the likelihood of success at trial; the likelihood of success on appeal; and the impact of current and pending state and federal appellate decisions. It has been our experience and is our continued expectation that the above complexities and uncertainties will not be clarified until the late stages of litigation. For those reasonably possible loss contingencies for which an estimate of the possible loss or range of loss cannot be made, we disclose the nature of the litigation and any developments as appropriate.

We monitor the status of all outstanding litigation on an ongoing basis in order to determine the probability of loss and assess whether an estimate of the possible loss or range of loss can be determined. In evaluating litigation, we consider, among other things, the nature of the claims; the jurisdiction in which the claims have been filed and the law and case law developed in that jurisdiction; the experience of plaintiffs’ counsel in this type of litigation; the parties’ respective litigation strategies; the stage of the proceedings; the outcome of the matters at trial or on appeal; the type and amount of damages claimed by plaintiffs; the outcomes and damage awards, if any, for similar matters brought against us and/or the tobacco industry; and the possibility and likelihood of success on appeal. Our assessment of a possible loss or range of loss is based on our assessment of the final outcome of the litigation upon the conclusion of all appeals.

We record provisions in the consolidated financial statements for pending litigation when we determine that it is probable that a loss has been incurred and the amount of loss can be reasonably estimated. Except for the impact of the State Settlement Agreements as described above, the U.S. Government Case and certain Engle Progeny Cases (See Note 23 “Legal Proceedings,” to our consolidated financial statements beginning on page 111), while it is reasonably possible that a loss has been incurred, (i) we have concluded that it is not probable that a loss has been incurred in any material pending litigation against us, (ii) we are unable to estimate the possible loss or range of loss that could result from an unfavorable outcome in any material pending litigation due to the many variables, uncertainties and complexities described above, and (iii) accordingly, we have not provided any amounts in the consolidated financial statements for possible losses related to material pending litigation. It is possible that our results of operations or cash flows in a particular quarterly or annual period or our financial position could be materially adversely affected by an unfavorable outcome or settlement of certain pending or future litigation or an inability to secure bonds where required to stay the execution of judgments on appeal.

Defense costs associated with product liability claims are a significant component of our selling, general and administrative expenses and are accrued as incurred. Defense costs may increase in future periods, in part, as a result of the Engle Progeny Cases as described in Note 23, “Legal Proceedings,” to our consolidated financial statements beginning on page 111. Numerous factors affect product liability defense costs in any given period. The principal factors are as follows:

 

   

the number and types of cases filed;

 

   

the number of cases tried and appealed;

 

   

the development of the law;

 

   

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

 

   

litigation strategy and tactics.

Please read Note 23, “Legal Proceedings,” to our consolidated financial statements beginning on page 111 for detailed information regarding tobacco litigation affecting us.

 

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Pension and Postretirement Benefit Obligations

A significant portion of our plan assets, classified in U.S. Equity Securities, Absolute Return Hedge Funds, Equity Hedge Funds, Private Equity, Private Real Assets and Fixed Income Securities, are invested in private investment funds and do not have readily determinable market values given the specific investment structures involved and the nature of the underlying investments. These investments are valued based on their respective net asset value (“NAV”) per share (or its equivalent) as a practical expedient to estimate fair value due to the absence of readily available market prices and are classified in Level 3.

NAVs or their equivalent for private investment funds are provided by the respective investment sponsors or investment advisers and are subsequently reviewed and approved by management. For those investments reported on a one-quarter lagged basis (primarily Private Equity and Private Real Assets) we adjust reported external valuations for subsequent cash flows and significant events.

See Note 16, “Retirement Plans,” to our consolidated financial statements beginning on page 89 for additional discussion of the inputs used to determine fair value for each significant asset class or category.

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

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

The salary growth assumption reflects our long-term actual experience and future and near-term outlook. Long-term return on plan assets is determined based on historical portfolio results, asset allocations and management’s expectation of the future economic environment. Our major assumptions are set forth in Note 16 to our Consolidated Financial Statements beginning on page 89.

Assumptions regarding future mortality experience are set based on published statistics from the Society of Actuaries with adjustments deemed appropriate based on the demographics of each plan. Specifically for the hourly pension and postretirement medical plans, a table constructed of blue collar employees only was used. An allowance for improvements in longevity is made using continuous mortality improvement rates with a long-term trend of 1.00 per cent per annum.

Health care cost trend rates are developed using a national health care trend survey. The survey gathers information of trend expectations for the coming year from various insurers and benefit managers. These trends are broken out by drug and medical, as well as by pre/post Medicare and type of coverage (e.g. PPO, HMO, POS). We selected plans that most closely match Lorillard’s benefits and blended the drug trend into the corresponding medical trend to create the composite pre and post Medicare initial trends. The ultimate trend is developed based on a building block approach which considers CPI, GDP, and Technology growth.

The changes in the funded status and accumulated other comprehensive loss related to pension and other postretirement benefits during 2014 are primarily a result of implementing a new set of mortality tables issued by

 

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the Society of Actuaries in October 2014 and lower discount rates. The Society of Actuaries reviews and updates mortality rates every 10 to 15 years. We monitor mortality table updates made by the Society of Actuaries when determining assumptions regarding future mortality experience for pension and postretirement benefits. See Note 16, “Retirement Plans,” to our Consolidated Financial Statements beginning on page 89 for additional discussion of the changes in the funded status and accumulated other comprehensive loss related to pension and other postretirement benefits.

For 2014, hypothetical changes in the assumptions we used for the pension plans would have had the following impact on our pension expense:

 

   

A decrease of 25 basis points in the long-term rate of return would have increased our pension expense by approximately $3 million;

 

   

A decrease of 25 basis points in the discount rate would have increased our pension expense by approximately $3 million;

 

   

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

 

   

An increase of 1 year in the future mortality experience would have increased our pension expense and other postretirement benefits expense by approximately $6 million and $1 million, respectively; and

 

   

An increase of 1 percent in healthcare cost trend rates would have increased our other postretirement benefits expense by $1 million.

Income Taxes

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

Inventories

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

Recent Accounting Pronouncements

Please read “Recently adopted accounting pronouncements” in Note 1 of the Notes to Consolidated Financial Statements beginning on page 73.

 

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Business Environment

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

 

   

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

 

   

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

 

   

The domestic cigarette market, in which we conduct our only significant cigarette business, continues to contract. As a result of price increases, restrictions on advertising, promotions and smoking in public and private facilities, increases in regulation and excise taxes, health concerns, a decline in the social acceptability of smoking, increased pressure from anti-tobacco groups and other factors, domestic cigarette shipments have decreased at a compound rate of approximately 3.9% from 2004 through 2014.

 

   

Increases in cigarette prices since 1998 have led to an increase in the volume of discount and, specifically, deep discount cigarettes. Cigarette price increases have been driven by increases in federal, state and local excise taxes and by manufacturer price increases. Price increases have led, and continue to lead, to high levels of discounting and other promotional activities for premium brands. Deep discount brands have grown from an estimated domestic shipment share in 1998 of less than 2.0% to an estimated share of 13.0% for the twelve months ended December 31, 2014, and continue to be a significant competitive factor in the domestic cigarette market. We do not have sufficient empirical data to determine whether the increased price of cigarettes has deterred consumers from starting to smoke or encouraged them to quit smoking, but it is likely that increased prices may have had an adverse effect on consumption and may continue to do so.

 

   

The tobacco industry is subject to substantial and increasing regulation. In June 2009, the Family Smoking Prevention and Tobacco Control Act (the “FSPTCA”) was enacted granting the FDA authority to regulate tobacco products. The FDA could promulgate regulations that, among other things, could result in a ban on or restrict the use of menthol in cigarettes. The law imposes and will impose new restrictions on the manner in which cigarettes can be advertised and marketed, requires larger and more severe health warnings on cigarette packaging, permits restriction of the level of tar and nicotine contained in or yielded by cigarettes and may alter the way cigarette products are developed and manufactured.

 

   

Pursuant to the terms of the FSPTCA, the FDA established the Tobacco Products Scientific Advisory Committee (the “TPSAC”) to evaluate, among other things, the impact of the use of menthol in cigarettes on the public health. In March 2011, the TPSAC issued its report to the FDA (the “TPSAC Menthol Report”) stating that “removal of menthol cigarettes from the marketplace would benefit

 

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public health.” On June 27, 2011, the FDA provided a progress report on its review of the science related to menthol cigarettes. In that update, the FDA stated that “[e]xperts within the FDA Center for Tobacco Products are conducting an independent review of the science related to the impact [of menthol] in cigarettes on public health …” On July 21, 2011, TPSAC considered revisions to its report, and the voting members unanimously approved the final report for submission to the FDA with no change in its recommendation. On January 26, 2012, the FDA stated that its independent review had been submitted to the peer review panel and comments had been received from the panel on the report. On July 23, 2013, the FDA made available its preliminary scientific evaluation (“PSE”) of public health issues related to the use of menthol in cigarettes and peer review comments thereto. In the PSE, the FDA concluded that menthol cigarettes likely pose a public health risk above that seen with nonmenthol cigarettes. The FDA also acknowledged that it needed additional information on the impact of menthol in cigarettes. Accordingly, the FDA issued an Advance Notice of Proposed Rulemaking (“ANPRM”) seeking comments on the PSE and requesting additional information related to potential regulatory options it might consider for the regulation of menthol. In addition, the FDA announced that it is funding new research on, among other things, the differences between menthol and nonmenthol cigarettes to obtain information to assist FDA in making informed decisions related to potential regulation of menthol in cigarettes. The FDA established a 60-day comment period for the ANPRM and PSE, and said it will consider all comments and other information submitted to determine what, if any, regulatory action is appropriate. On September 11, 2013, the FDA extended the comment period for an additional 60 days to November 22, 2013. On November 21, 2013, the Company provided comments on the ANPRM and PSE to the FDA. As discussed further below, in July 2014 the U.S. District Court for the District of Columbia enjoined the FDA (i) to reconstitute the TPSAC membership so that it complies with the applicable ethics laws and (ii) from relying on or using the TPSAC Menthol Report in any manner, which may impact the FDA’s timing and process relating to the regulation of the use of menthol in cigarettes.

 

   

In August 2009, we, along with RJR Tobacco, other tobacco manufacturers and a tobacco retailer, filed a lawsuit in the U.S. District Court for the Western District of Kentucky against the FDA challenging the constitutionality of certain restrictions on speech included in the FSPTCA. These restrictions on speech include, among others, bans on the use of color and graphics in certain tobacco product advertising, limits on the right to make truthful statements regarding modified risk tobacco products, a prohibition on making certain statements about the FDA’s regulation of tobacco products, restrictions on the placement of outdoor advertising, a ban on certain promotions offering gifts in consideration for the purchase of tobacco products, a ban on brand name sponsorship of events and the sale of brand name merchandise, and a ban on the distribution of product samples. The suit also challenges the law’s requirement for extensive graphic warning labels on all packaging and advertising. The complaint seeks a judgment (i) declaring that such provisions of the law violate the First and/or Fifth Amendments of the U.S. Constitution and (ii) enjoining the FDA from enforcing the unconstitutional provisions of the law. On January 4, 2010, the district court issued an order (a) striking down the provisions of the law that banned the use of color and graphics in certain tobacco product advertising and prohibited tobacco manufacturers from making certain statements about the FDA’s regulation of tobacco products and (b) upholding the remaining challenged advertising provisions. Both sides appealed the district court’s ruling to the Sixth Circuit Court of Appeals, and on March 19, 2012, the Sixth Circuit issued an opinion (i) affirming the district court’s decision upholding the FSPTCA’s restrictions on marketing modified-risk tobacco products, bans on event sponsorship, branding nontobacco merchandise and free sampling; (ii) affirming the district court’s decision upholding the FSPTCA’s requirement that tobacco manufacturers reserve significant packaging space for graphic health warnings; (iii) affirming the district court’s decision striking down the FSPTCA’s restriction of tobacco advertising, in most instances, to black and white text; (iv) reversing the district court’s decision upholding the FSPTCA’s restriction on statements regarding the relative safety of tobacco products based on FDA regulation and its decision upholding the FSPTCA’s ban on tobacco continuity programs in most instances. Plaintiffs’ motion for rehearing en banc was denied, and Plaintiffs filed a

 

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petition for certiorari with the U.S. Supreme Court on October 30, 2012. The government declined to seek a petition for certiorari to the U.S. Supreme Court. The government did not appeal the part of the Court of Appeal’s ruling striking the FSPTCA’s restriction of tobacco advertising to black and white text. On April 22, 2013, the U.S. Supreme Court denied plaintiffs’ petition for certiorari.

 

   

In February 2011, we, along with RJR Tobacco, filed a lawsuit in the U.S. District Court for the District of Columbia against the FDA challenging the composition of the TPSAC because of the FDA’s appointment of certain voting members with significant financial conflicts of interest. We believe these members are financially biased because they regularly testify as expert witnesses against tobacco-product manufacturers, and because they are paid consultants for pharmaceutical companies that develop and market smoking-cessation products. The suit similarly challenges the presence of certain conflicted individuals on the Constituents Subcommittee of the TPSAC. The complaint seeks a judgment (i) declaring that, among other things, the appointment of the conflicted individuals to the TPSAC (and its Constituents Subcommittee) was arbitrary, capricious, an abuse of discretion, and otherwise not in compliance with the law because it prevented the TPSAC from preparing a report that was unbiased and untainted by conflicts of interest, and (ii) enjoining the FDA from, among other things, relying on the TPSAC’s Menthol Report. The FDA filed a motion to dismiss this action which the court denied in August 2012. In October 2012, the FDA filed its answer to the amended complaint. The parties completed the briefing for summary judgment motions on September 20, 2013. On July 21, 2014, the District Court denied defendants’ motion for summary judgment and granted, in part, our motion for summary judgment entering an order enjoining the FDA (i) to reconstitute the TPSAC membership so that it complies with the applicable ethics laws and (ii) from relying on or using the TPSAC Menthol Report in any manner. The FDA appealed the decision on September 18, 2014 and the D.C. Circuit Court of Appeals scheduled the briefing to conclude in the first half of 2015.

 

   

In August 2011, we, along with RJR Tobacco and several other tobacco manufacturers, filed a lawsuit in the U.S. District Court for the District of Columbia against the FDA challenging the constitutionality of certain regulations requiring specific graphic warning labels on all packaging and advertising. The Complaint seeks a judgment (i) declaring that the regulations violate the First Amendment; (ii) declaring that the regulations violate various provisions of the Administrative Procedure Act; (iii) declaring that the textual and graphic warnings required under the FSPTCA shall become effective 15 months after the FDA issues regulations that are permissible under the U.S. Constitution and federal law; and (iv) preliminarily and permanently enjoining enforcement of the regulations. Plaintiffs moved for a preliminary injunction, and after full briefing and oral argument, the district court granted plaintiffs’ motion. Plaintiffs also moved in the district court for summary judgment in their favor and after full briefing and oral argument, the district court granted that motion too. The FDA appealed both decisions to the D.C. Circuit Court of Appeals, which consolidated the appeals and heard oral argument on April 10, 2012. On August 24, 2012, the D.C. Circuit Court of Appeals affirmed the lower court’s judgment that the graphic warnings were unconstitutional, vacated the regulations and remanded them to the FDA. On October 9, 2012, the FDA filed a motion with the Court of Appeals for rehearing or rehearing en banc. That motion was denied on December 5, 2012. On March 19, 2013, the government announced that it would not seek review by the U.S. Supreme Court.

 

   

Electronic cigarettes are generally less regulated than cigarettes. However, on April 25, 2014, the FDA released proposed rules that would extend its regulatory authority to electronic cigarettes and certain other tobacco products under the FSPTCA. We are in the process of reviewing and analyzing the proposed rules and their impact on our electronic cigarette business. We preliminarily note that the proposed rules would require that electronic cigarette manufacturers (i) register with the FDA and report electronic cigarette product and ingredient listings; (ii) market new electronic cigarette products only after FDA review; (iii) only make direct and implied claims of reduced risk if the FDA confirms that scientific evidence supports the claim and that marketing the electronic cigarette product will benefit public health as a whole; (iv) not distribute free samples; (v) implement minimum age and identification restrictions to prevent sales to individuals under age 18; (vi) include a health warning;

 

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and (vii) not sell electronic cigarettes in vending machines, unless in a facility that never admits youth. The proposed regulation will be subject to a 75-day public comment period, which was extended by the FDA to August 8, 2014, following which the FDA will finalize the proposed regulation. On August 7, 2014, Lorillard filed comments to the proposed rules. It is not known how long this regulatory process to finalize and implement the rules may take. Accordingly, although we cannot predict the content of any final rules of the proposed or future regulation or the impact they may have, if enacted they could have a material adverse effect on our electronic cigarette business.

 

   

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

 

   

Substantial federal, state and local excise taxes are reflected in the retail price of cigarettes. In 2014, the federal excise tax was $1.0066 per pack and combined state and local excise taxes ranged from $0.17 to $6.16 per pack. During 2014, there were two state excise tax increases, $0.13 per pack implemented in the state of Oregon and $0.13 per pack implemented in the state of Vermont, as well as a municipal excise tax increases that included a $2.00 per pack increase in Philadelphia, Pennsylvania, a $0.50 per pack increase in the City of Chicago, Illinois and a $0.04 per pack excise tax increase in the District of Columbia. On June 21, 2010, the New York state legislature approved a $1.60 per pack state excise tax increase that was implemented on July 1, 2010. The federal excise tax on cigarettes increased by $0.6166 per pack to $1.0066 per pack, effective April 1, 2009, to finance health insurance for children. The fiscal year 2015 federal budget plan included a proposal to further increase the federal excise tax on cigarettes by $0.94 per pack to fund early childhood education, and it is our expectation that several states will propose further increases in 2015 and in subsequent years. It is likely that increases in excise and similar taxes have had an adverse impact on sales of cigarettes and that the most recent increase and future increases, the extent of which cannot be predicted, could result in further volume declines for the cigarette industry, including us, and an increased sales shift toward deep discount cigarettes rather than premium brands. In addition, we and other cigarette manufacturers and importers are required to pay an assessment under a federal law designed to fund payments to tobacco quota holders and growers and are required to pay an annual user fee to the FDA.

 

   

The domestic market for cigarettes is highly competitive. Competition is primarily based on a brand’s taste; quality; price, including the level of discounting and other promotional activities which became more intense in 2012 and continued in 2013 and 2014; positioning; consumer loyalty; and retail display. Our principal competitors are the two other major U.S. cigarette manufacturers, Philip Morris USA and RJR Tobacco. We also compete with numerous other smaller manufacturers and importers of cigarettes, including deep discount cigarette manufacturers. We believe our ability to compete even more effectively has been restrained in some marketing areas as a result of retail merchandising contracts offered by Philip Morris USA and RJR Tobacco which limit the retail shelf space available to our brands. As a result, in some retail locations we are limited in competitively supporting our promotional programs, which may constrain sales.

 

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The following table presents selected Lorillard and industry cigarette shipment data for the years ended December 31, 2014, 2013 and 2012:

Selected Industry Data

 

     Year Ended December 31,  
(Volume in billions)    2014      2013      2012  

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

     38.535         39.325         39.491   

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

     264.612         273.262         286.468   

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

     86.3%         85.8%         85.0%   

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

     85.6%         85.0%         84.1%   

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

     88.6%         88.3%         87.8%   

 

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

The following table presents selected Lorillard and industry retail market share data for the years ended December 31, 2014, 2013 and 2012, based on Lorillard’s proprietary retail shipment database administered by MSAI, which reflects shipments from wholesalers to retailers.

Selected Domestic Cigarette Retail Market Share Data(1)

 

     Year Ended December 31,  
       2014         2013         2012    

Lorillard’s share of the retail market

     15.1     14.8     14.3

Lorillard’s share of the premium market

     17.6     17.3     16.6

Lorillard’s share of the menthol market (2)

     40.3     40.2     39.3

Newport’s share of the retail market

     12.9     12.6     12.0

Newport’s share of the premium market

     17.5     17.1     16.4

Newport’s share of the menthol market (2)

     37.1     37.0     36.1

Total menthol segment market share for the industry (2)

     31.7     31.4     31.1

Total discount segment market share for the industry

     26.1     26.5     26.7

 

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

The market for electronic cigarettes is evolving at a very fast pace and is very fragmented, with many companies competing with similar product offerings. In the competition for retail presence, blu eCigs has begun the process of differentiating itself from the competition with unique technology, impactful displays and point of sale materials. According to Nielsen, blu’s domestic all-outlet dollar market share of electronic cigarettes

 

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decreased 8.7 share points to 33.4% for the 52 weeks ending December 27, 2014 versus the year ago 52 week period. The method of distribution for many competing companies is predominately over the internet, with only a small number of competitors currently having a significant presence at retail, although certain competitors are in the midst of new national product launches, which have been supported by aggressive introductory “free trial” promotional programs.

blu Domestic Retail Electronic Cigarette Dollar Market Share Data(3)

13 Week Reporting Periods Ended:

 

March 23, 2013

     35.3

June 22, 2013

     42.0

September 28, 2013

     44.7

December 21, 2013

     45.0

March 15, 2014

     44.2

July 5, 2014

     39.3

September 27, 2014

     28.3

December 27, 2014

     23.6

 

(3) Based on Nielsen, ScanTrack Database—All Outlets Combined.

Income Statement Captions

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

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

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

Investment income includes interest and dividend income, realized gains and losses on sale of investments.

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

 

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Results of Operations

Year ended December 31, 2014 Compared to the Year ended December 31, 2013

Lorillard Consolidated Results

 

     2014      2013  
     (In millions)  

Net sales (including excise taxes of $1,938 and $1,978)

   $ 6,990       $ 6,950   

Cost of sales (including excise taxes of $1,938 and $1,978)

     4,252         4,231   
  

 

 

    

 

 

 

Gross profit

     2,738         2,719   

Selling, general and administrative

     630         665   
  

 

 

    

 

 

 

Operating income

     2,108         2,054   

Investment income

     7         2   

Interest expense

     (179      (172
  

 

 

    

 

 

 

Income before income taxes

     1,936         1,884   

Income taxes

     749         704   
  

 

 

    

 

 

 

Net income

   $ 1,187       $ 1,180   
  

 

 

    

 

 

 

Cigarettes Segment Results

 

     2014      2013  
     (In millions)  

Net sales (including excise taxes of $1,938 and $1,978)

   $ 6,825       $ 6,720   

Cost of sales (including excise taxes of $1,938 and $1,978)

     4,125         4,071   
  

 

 

    

 

 

 

Gross profit

     2,700         2,649   

Selling, general and administrative

     520         595   
  

 

 

    

 

 

 

Operating income

   $ 2,180       $ 2,054   
  

 

 

    

 

 

 

Net sales. Cigarette net sales increased by $105 million, or 1.6%, from $6.720 billion in 2013 to $6.825 billion in 2014. Net sales increased $264 million due to higher average unit prices reflecting price increases in November 2013, May 2014 and November 2014, partially offset by lower unit sales volume of $159 million (including $40 million of federal excise tax).

Total Lorillard wholesale cigarette unit volume, which includes Puerto Rico and U.S. Possessions, decreased 2.3% for 2014 compared to the corresponding period of 2013. Puerto Rico and U.S. Possessions declined 23.1% compared to a year ago period, reflecting the negative impact of the July 2013 $1.00 per pack excise tax increase in Puerto Rico. Domestic wholesale cigarette unit volume, which excludes Puerto Rico and U.S. Possessions, decreased 2.0% for 2014 compared to the corresponding period of 2013. The Company estimates total cigarette industry domestic wholesale shipments decreased approximately 3.2% for 2014 compared to 2013.

Total wholesale unit volume, including Puerto Rico and U.S. Possessions, for Newport, the Company’s flagship brand, decreased 1.8% for 2014 compared to 2013. Domestic wholesale cigarette unit volume for Newport, which excludes Puerto Rico and U.S. Possessions, decreased 1.4% for 2014 versus year ago. Domestic wholesale shipments for Maverick, the Company’s leading discount brand, decreased 4.9% for 2014 compared to 2013.

Based on Lorillard’s proprietary retail shipment database administered by Management Science Associates, Inc., which measures shipments from wholesale to retail, Lorillard’s 2014 domestic retail market share increased

 

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0.3 share point versus year ago to 15.1%. Newport’s domestic retail market share reached 12.9%, an increase of 0.3 share point compared to 2013. Lorillard’s domestic retail share of the menthol market increased 0.1 share point to 40.3% for 2014. Gains in Newport’s domestic retail market share were primarily attributable to the continued strengthening of Newport Menthol in its core geographies, continued success in expansion markets and volume growth from Newport Non-Menthol.

Cost of sales. Cost of sales increased by $54 million, or 1.3%, from $4.071 billion in 2013 to $4.125 billion in 2014. The increase in cost of sales is primarily due to higher expenses related to the State Settlement Agreements ($117 million), higher raw material costs, primarily tobacco and wrapping materials ($16 million) and higher Food and Drug Administration fees ($6 million), partially offset by lower unit sales volume ($53 million, including $40 million of federal excise tax), a lower Federal Assessment for Tobacco Growers ($28 million) resulting from the expiration of the assessment on September 30, 2014 and lower indirect manufacturing costs ($4 million). We recorded pre-tax charges for our obligations under the State Settlement Agreements of $1.358 billion and $1.241 billion for the years ended December 31, 2014 and 2013, respectively, an increase of $117 million. The $117 million increase is due primarily to the absence of the $154 million favorable impact on Lorillard’s tobacco settlement expense of the settlement to resolve certain MSA payment adjustment disputes approved by the arbitration panel in March 2013, the inflation adjustment of $38 million, the $17 million unfavorable impact of higher market share and other adjustments ($3 million), partially offset by the $43 million favorable impact of the volume adjustment related to lower Original Participating Manufacturer volume, the favorable impact of $27 million on Lorillard’s tobacco settlement expense in 2014 related to the 2003 non-participating manufacturer arbitration award as a result of the September 2013 arbitration panel determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers, the $14 million favorable impact of the reduction in Lorillard’s MSA payments as a result of the settlement with two more states in June 2014 and the $11 million favorable impact of RAI’s mark-to-market pension accounting adjustment in the fourth quarter of 2014.

Selling, general and administrative. Selling, general and administrative expenses decreased $75 million, or 12.6%, from $595 million in 2013 to $520 million in 2014. The decrease in 2014 is primarily due to the absence of the $20 million in estimated costs to comply with or otherwise resolve the U.S. Government Case judgment incurred in the first quarter of 2013, $79 million in accrued costs related to compensatory damages and statutory interest to dismiss the Evans case incurred in the third quarter of 2013, $22 million of costs related to certain Engle Progeny cases incurred in the fourth quarter of 2013, $8 million in lower benefits related expenses, $10 million in lower litigation related expenses and $6 million in lower promotional expenses related to Newport Menthol, partially offset by $39 million in costs to satisfy the Alexander judgment including statutory interest and fees and $26 million in costs related to the agreement to merge with RAI.

Electronic Cigarettes Segment Results

 

     2014*      2013*  
     (In millions)  

Net sales

   $ 165       $ 230   

Cost of sales

     127         160   
  

 

 

    

 

 

 

Gross profit

     38         70   

Selling, general and administrative

     110         70   
  

 

 

    

 

 

 

Operating income (loss)

   $ (72    $  —     
  

 

 

    

 

 

 

 

* Results for the year ended December 31, 2014 provided above are not comparable to the results for the year ended December 31, 2013 as Lorillard purchased SKYCIG on October 1, 2013.

Net sales. Net sales for the Electronic Cigarettes segment were $165 million for 2014, compared to $230 million for 2013. The decline in sales of blu eCigs in the U.S. of $70 million versus year ago reflects a decrease

 

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in unit volume of products sold in 2014 of $95 million as well as the estimated $11 million mix impact of a lower price on rechargeable kits that were introduced in 2013. The decrease in unit volume was partially offset by sales from 2014 product launches, including sales of the new blu eCigs PLUS+ kit and tank products of $20 million and cherry disposable products of $16 million. 2013 was also favorably impacted by significant pipeline inventory as the brand was in its initial phase of national expansion. blu (U.K.) was acquired on October 1, 2013 and generated $9 million in net sales during 2014 as compared to $4 million in 2013.

Based on the Nielsen ScanTrack Database, blu’s domestic all-outlet dollar market share of electronic cigarettes was 33.4% for the 52 weeks ending December 27, 2014, compared to 42.1% in 2013. Based on Nielsen ScanTrack data in the U.K., blu (U.K.)’s all-outlet dollar market share of electronic cigarettes was 5.7% for the 52 week period ending January 3, 2015—after successfully re-branding the Company’s e-cigarette product offerings as “blu” in the second quarter of 2014.

Cost of sales. Cost of sales for the Electronic Cigarettes segment was $127 million for the year ended December 31, 2014, compared to $160 million for the year ended December 31, 2013.

Gross profit. Gross profit was $38 million, or 23.0% of net sales, for 2014. This compares to gross profit of $70 million, or 30.4% of net sales, for 2013. Gross profit and gross profit margin for 2014 at blu eCigs in the U.S. were negatively impacted by a decline in unit volumes ($45 million), the mix impact of the lower priced rechargeable kits ($7 million) and higher retail distribution costs ($7 million), partially offset by the new blu eCigs PLUS+ kit and tank and cherry disposable product launches ($18 million) and decreased product costs ($21 million). Gross profit and gross profit margin for the years ended December 31, 2014 and 2013 also included supply chain related charges of approximately $8 million and $5 million, respectively. Gross profit and gross profit margin for 2014 at blu (U.K.) were negatively impacted primarily by higher retail distribution costs of $4 million.

Selling, general and administrative. Selling, general and administrative costs were $110 million for the year ended December 31, 2014, compared to $70 million for the year ended December 31, 2013. Selling, general and administrative costs in 2014 include incremental investment to build the blu brand in the U.S. as well as to launch the blu brand in the U.K. Selling, general and administrative costs for the year ended December 31, 2014 also include $23 million of amortization related to the SKYCIG brand, partially offset by a fair value adjustment to the blu (U.K.) earn out liability of $8 million. The fair value ascribed to the SKYCIG brand in connection with the acquisition of £20 million (approximately $32 million at December 31, 2014 exchange rates) is being amortized over an estimated life of 18 months beginning October 1, 2013 after which amortization charges related to the brand will cease.

Operating income/(loss). The Electronic Cigarettes segment had an operating loss of $(72) million for the year ended December 31, 2014, compared to no operating income for the year ended December 31, 2013. blu (U.K.)’s operating losses were $(49) million for the year ended December 31, 2014 and $(7) million for the year ended December 31, 2013.

Lorillard Consolidated Results

Investment income (loss). Investment income increased $5 million for 2014 compared to 2013 and reflects $4 million of interest income related to the 2003 non-participating manufacturer arbitration award.

Interest expense. Interest expense increased $7 million in 2014, compared to 2013, and reflects interest on the 2023 Notes (defined below) issued in the second quarter of 2013.

Income taxes. Income taxes increased $45 million, or 6.4%, from $704 million for the year ended December 31, 2013 to $749 million for the year ended December 31, 2014. The change reflects an increase in income before income taxes of $52 million, or 2.8%, and an increase in the effective tax rate from 37.4% to

 

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38.7% for the year ended December 31, 2013 and 2014, respectively. The rate increase is mainly due to non-deductible merger related expenses, United Kingdom foreign tax rate differences that negatively impacted the tax rate and a valuation allowance recorded related to blu (U.K.) deferred tax assets in 2014.

Year ended December 31, 2013 Compared to the Year ended December 31, 2012

Lorillard Consolidated Results

 

     2013      2012  
     (In millions)  

Net sales (including excise taxes of $1,978 and $1,987)

   $ 6,950       $ 6,623   

Cost of sales (including excise taxes of $1,978 and $1,987)

     4,231         4,241   
  

 

 

    

 

 

 

Gross profit

     2,719         2,382   

Selling, general and administrative

     665         504   
  

 

 

    

 

 

 

Operating income

     2,054         1,878   

Investment income

     2         4   

Interest expense

     (172      (154
  

 

 

    

 

 

 

Income before income taxes

     1,884         1,728   

Income taxes

     704         629   
  

 

 

    

 

 

 

Net income

   $ 1,180       $ 1,099   
  

 

 

    

 

 

 

Cigarettes Segment Results

 

     2013      2012  
     (In millions)  

Net sales (including excise taxes of $1,978 and $1,987)

   $ 6,720       $ 6,562   

Cost of sales (including excise taxes of $1,978 and $1,987)

     4,071         4,201   
  

 

 

    

 

 

 

Gross profit

     2,649         2,361   

Selling, general and administrative

     595         484   
  

 

 

    

 

 

 

Operating income

   $ 2,054       $ 1,877   
  

 

 

    

 

 

 

Net sales. Cigarette net sales increased by $158 million, or 2.4%, from $6.562 billion in 2012 to $6.720 billion in 2013. Net sales increased $191 million due to higher average unit prices reflecting price increases in June and December 2012 and June and November 2013, partially offset by lower unit sales volume of $33 million (including $9 million of federal excise tax).

Total Lorillard wholesale cigarette unit volume, which includes Puerto Rico and U.S. Possessions, decreased 0.5% for 2013 compared to the corresponding period of 2012. Lorillard’s domestic wholesale cigarette unit volume, which excludes Puerto Rico and U.S. Possessions, also decreased 0.4% for 2013, compared to 2012. Lorillard implemented control measures to limit fluctuations in wholesale inventory in advance of anticipated price increases. These control measures have a positive impact on the business in the long term, but had a negative impact on year on year comparisons in the fourth quarter. This compares favorably to total cigarette industry domestic wholesale shipments which decreased approximately 4% for 2013 compared to 2012, after adjusting for the impact of changes in wholesale inventory patterns.

Total wholesale unit volume for Newport, the Company’s flagship brand, increased 0.6% for 2013 compared to 2012. Domestic wholesale cigarette unit volume for Newport, which excludes Puerto Rico and U.S. Possessions increased 0.7% for 2013 compared to 2012. Domestic wholesale shipments for Maverick, the Company’s leading discount brand, decreased 5.3% for 2013 compared to 2012.

 

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Based on Lorillard’s proprietary retail shipment database administered by MSAI, Lorillard’s domestic retail market share once again posted strong gains in 2013, increasing 0.5 share point to 14.8%. Newport’s domestic retail market share reached 12.6% for 2013, an increase of 0.6 share point versus year ago. Lorillard’s domestic retail share of the menthol market reached 40.2% for 2013, an increase of 0.9 share point compared to year ago. Gains in Newport’s domestic retail market share were primarily attributable to the continued strengthening of Newport Menthol in its core geographies, continued success in expansion markets and the volume impact resulting from the introduction of Newport Smooth Select in the second quarter of 2013 and, to a lesser extent, Newport Non-Menthol Gold in the fourth quarter of 2013.

Cost of sales. Cost of sales decreased by $130 million, or 3.1%, from $4.201 billion in 2012 to $4.071 billion in 2013. The decrease in cost of sales is primarily due to lower expenses related to the State Settlement Agreements ($138 million) and lower unit sales volume ($12 million, including $9 million of federal excise tax), partially offset by higher raw material costs, primarily tobacco and wrapping materials ($12 million), higher Food and Drug Administration fees ($6 million) and a higher Federal Assessment for Tobacco Growers ($2 million). We recorded pre-tax charges for our obligations under the State Settlement Agreements of $1.241 billion and $1.379 billion for the years ended December 31, 2013 and 2012, respectively, a decrease of $138 million. The $138 million decrease is due primarily to the favorable impact of the reduction in Lorillard’s MSA payments on Lorillard’s tobacco settlement expense in 2013 of $177 million as a result of the settlement with some states to resolve certain MSA payment adjustment disputes approved by the arbitration panel in March 2013, offset partially by the impact of the inflation adjustment ($37 million) and a $22 million unfavorable impact of the industry Volume Adjustment Offset under the State Settlement Agreements associated with the settlement.

Selling, general and administrative. Selling, general and administrative expenses increased $111 million, or 22.9%, from $484 million in 2012 to $595 million in 2013. The increase in 2013 is primarily due to $79 million in accrued costs related to compensatory damages and statutory interest to dismiss the Evans case, $20 million in estimated costs to comply with the U.S. Government Case and $22 million related to compensatory damages, punitive damages, statutory interest and attorneys’ fees in certain Engle Progeny Cases, offset partially by lower legal defense costs related to Engle Progeny litigation.

Electronic Cigarettes Segment Results

 

     2013*      2012*  
     (In millions)  

Net sales

   $ 230       $ 61   

Cost of sales

     160         40   
  

 

 

    

 

 

 

Gross profit

     70         21   

Selling, general and administrative

     70         20   
  

 

 

    

 

 

 

Operating income

   $  —         $ 1   
  

 

 

    

 

 

 

 

* Results for the year ended December 31, 2012 provided above are not comparable to the results for the year ended December 31, 2013 as Lorillard purchased blu eCigs on April 24, 2012 and SKYCIG on October 1, 2013.

Net sales. Net sales for the Electronic Cigarettes segment were $230 million for the year ended December 31, 2013, compared to $61 million for the year ended December 31, 2012. Strong sales of blu eCigs resulted from significant brand building activities highlighted by a national television advertising campaign, expansion of retail distribution into a total of over 136,000 retail outlets, the launch of new, lower priced rechargeable kits and strong repeat purchases. SKYCIG, based in the U.K., was acquired on October 1, 2013 and generated $4 million in net sales during 2013.

 

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According to Lorillard’s proprietary retail shipment database administered by MSAI, blu eCigs emerged as the category leader with domestic retail market share of the electronic cigarettes market of approximately 47% for 2013.

Cost of sales. Cost of sales for the Electronic Cigarettes segment was $160 million for the year ended December 31, 2013, compared to $40 million for the year ended December 31, 2012.

Gross profit. Gross profit was $70 million, or 30.4% of net sales, for the year ended December 31, 2013, compared to $21 million, or 34.4% of net sales, for the year ended December 31, 2012. Gross profit and gross profit margin for the year ended December 31, 2013 were negatively impacted by the change in product offering arising from the introduction of our new, lower priced rechargeable kit that began shipping to wholesale late in the second quarter of 2013 as well as higher promotional costs. Gross profit and gross profit margin for the year ended December 31, 2013 also included a supply chain related charge of $5 million which was partially offset by ongoing product cost reductions.

Selling, general and administrative. Selling, general and administrative costs were $70 million for the year ended December 31, 2013, compared to $20 million for the year ended December 31, 2012. Selling, general and administrative costs include marketing and administrative costs associated with the blu eCigs’ national retail roll-out as well as $4 million of costs at SKYCIG. Selling, general and administrative costs in 2013 also include $6 million of amortization related to the SKYCIG brand. The fair value ascribed to the SKYCIG brand in connection with the acquisition of $33 million is being amortized over an estimated life of 18 months beginning October 1, 2013 after which amortization charges related to the brand will cease.

Operating income. The Electronic Cigarettes segment had no operating income for the year ended December 31, 2013, compared to $1 million for the year ended December 31, 2012. SKYCIG’s operating loss was $7 million for the year ended December 31, 2013.

Lorillard Consolidated Results

Interest expense Interest expense increased $18 million in 2013, compared to 2012, and reflects interest on the 2017 Notes and the 2023 Notes (defined below) issued in the third quarter of 2012 and the second quarter of 2013, respectively.

Income taxes. Income taxes increased $75 million or 11.9%, from $629 million in 2012 to $704 million in 2013. The change reflects the increase in income before income taxes of $156 million in 2013 or 9.0% and an increase in the effective tax rate from 36.4% to 37.4% for the years ended December 31, 2012 and 2013, respectively. The increase was primarily driven by an increase in state income taxes and a decrease in the manufacturers’ deduction.

Liquidity and Capital Resources

Our cash and cash equivalents of $1.308 billion at December 31, 2014 were invested in prime money market funds.

Our short-term and long-term investments totaled $324 million and $167 million as of December 31, 2014, respectively. Short-term and long-term investments consist of investment grade debt securities, all of which are classified as available for sale.

Cash Flows

Cash flow from operating activities. The principal source of liquidity for our business and operating needs is internally generated funds from our operations. We generated net cash flow from operations of $1.329 billion for

 

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2014 compared to $1.192 billion for 2013. The increased net cash flow in 2014 primarily reflects the increase in net income, a decrease in inventory, a decrease in pension and post-retirement contributions and an increase in depreciation and amortization, partially offset by a decrease in accounts payable and accrued liabilities, a decrease in accrued settlement costs and higher tax payments. Net cash flow from operations was $1.192 billion for 2013, compared to $1.170 billion for 2012. The increased net cash flow in 2013 primarily reflects the increase in net income and a lower increase in inventory, partially offset by a lower increase in accounts payable and accrued expenses and higher tax payments.

Cash flow from investing activities. Our cash flows from investing activities used cash of $282 million for 2014, which consisted of $654 million used for the purchases of investments and $41 million for additions to plant and equipment, partially offset by $244 million received for sales of investments and $169 received for maturities of investments. This compares to $358 million of cash used for investing activities in 2013, which consisted of $276 million used for the purchases of investments, $62 million for additions to plant and equipment and $46 million for the acquisition of SKYCIG, partially offset by $3 million received for sales of investments and $23 million received for maturities of investments.

Our investing activities used cash of $358 million for the twelve months ended December 31, 2013 compared to $209 million for 2012. The increase in cash used by investing activities in 2013 is due primarily to the purchase of investments totaling $276 million, partially offset by lower cash used for business acquisitions and capital expenditures and sales and maturities of investments totaling $26 million.

Capital expenditures were $41, $62 million and $74 million for 2014, 2013 and 2012, respectively. The expenditures were primarily for the modernization of manufacturing equipment. Our capital expenditures for 2015 are forecast to be between $45 million and $50 million.

Cash flow from financing activities. Our cash flow from operations has exceeded our working capital and capital expenditure requirements in each of the years ended December 31, 2014, 2013 and 2012. In 2012, we paid cash dividends of $202 million, $203 million, $203 million and $199 million on March 9, 2012, June 11, 2012, September 10, 2012 and December 10, 2012, respectively. In 2013, we paid cash dividends of $209 million, $208 million, $204 million and $202 million on March 11, 2013, June 10, 2013, September 10, 2013 and December 10, 2013, respectively. In 2014, we paid cash dividends of $224 million, $222 million, $221 million and $222 million on March 10, 2014, June 10, 2014, September 10, 2014 and December 10, 2014, respectively.

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

In May 2013, Lorillard Tobacco issued $500 million aggregate principal amount of 3.750% unsecured senior notes due May 20, 2023 (the “2023 Notes”) pursuant to the Indenture and the Fifth Supplemental Indenture, dated May 20, 2013. The net proceeds from the issuance were used for the repurchase of our common stock.

Lorillard Tobacco is the principal, wholly owned operating subsidiary of Lorillard, Inc., and the $750 million aggregate principal amount of 8.125% senior notes issued in June 2009 and due 2019 (the “2019 Notes”), $750 million aggregate principal amount of 6.875% senior notes due 2020, $250 million aggregate principal amount of 8.125% senior notes due 2040, $500 million aggregate principal amount of 3.500% Notes due 2016, 2017 Notes, 2023 Notes, 2040 Notes and $250 million aggregate principal amount of 7.000% Notes due 2041 (together, the “Notes”) are unconditionally guaranteed in full on a senior unsecured basis by Lorillard, Inc.

The interest rate payable on the 2019 Notes is subject to incremental increases from 0.25% to 2.00% in the event either Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”) or both

 

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Moody’s and S&P downgrade the 2019 Notes below investment grade (Baa3 and BBB- for Moody’s and S&P, respectively). As of December 31, 2014, our debt ratings were Baa2 and BBB- with Moody’s and S&P, respectively, both of which are investment grade.

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

As of June 4, 2014, the Company completed its $1 billion repurchase program announced in March 2013 and amended in May 2013. As a result of the Merger Agreement, we have suspended any further share repurchase activity. In 2014, we paid a total of $314 million for share repurchases that were funded from available cash balances. In 2013 and 2012, share repurchases of $795 million and $578 million, respectively, were funded by debt issuances of $500 million in each of 2013 and 2012 as well as available cash balances.

Liquidity

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

The rate of return on our pension assets in 2014 was a positive 8.4%. Our pension expense was approximately $4 million in 2014 and we anticipate pension expense of approximately $25 million in 2015. We contributed $1 million to our pension plans in 2014 and anticipate a contribution of $1 million in 2015.

We believe that it is appropriate for a company of our size and financial characteristics to have a prudent level of debt as a component of our capital structure in order to reduce our total cost of capital and improve total shareholder returns. Accordingly, we raised $500 million and $500 million of debt financing in 2013 and 2012, respectively. As a result of the pending merger agreement with RAI, we have suspended any further debt financing. Should the merger not be completed, we expect that we would seek to raise additional debt financing in the future, although the structure, timing and amount of such indebtedness has not yet been determined and will depend on a number of factors, including, but not limited to the prevailing credit and interest rate environment, our cash requirements, and other business, financial and tax considerations. The proceeds of any such debt financing may be used to fund stock repurchases, acquisitions, dividends or for other general corporate purposes. We presently have no commitments or agreements with or from any third party regarding any debt financing transactions and no assurance can be given that we will ultimately pursue any debt financing or, if pursued, that we will be able to obtain debt financing at the suggested levels or on attractive terms.

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

 

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

There were no borrowings under the Revolver during 2012, 2013 or 2014.

State Settlement Agreements

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

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

 

   

inflation;

 

   

aggregate volume of Original Participating Manufacturers cigarette shipments;

 

   

other Original Participating Manufacturers and our market share; and

 

   

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

The inflation adjustment increases payments on a compounded annual basis by the greater of 3.0% or the actual total percentage change in the consumer price index for the preceding year. The inflation adjustment is measured starting with inflation for 1999. The volume adjustment increases or decreases payments based on the increase or decrease in the total number of cigarettes shipped in or to the 50 U.S. states, the District of Columbia and Puerto Rico by the Original Participating Manufacturers during the preceding year compared to the 1997 base year shipments. If volume has increased, the volume adjustment would increase the annual payment by the same percentage as the number of cigarettes shipped exceeds the 1997 base number. If volume has decreased, the volume adjustment would decrease the annual payment by 98.0% of the percentage reduction in volume. In addition, downward adjustments to the annual payments for changes in volume may, subject to specified conditions and exceptions, be reduced in the event of an increase in the Original Participating Manufacturers aggregate operating income from domestic sales of cigarettes over base year levels established in the State Settlement Agreements, adjusted for inflation. Any adjustments resulting from increases in operating income would be allocated among those Original Participating Manufacturers who have had increases.

During 2014, we paid $1.4 billion under the State Settlement Agreements, primarily based on 2013 volume. Included in the above number was $93 million we deposited in an interest-bearing escrow account (“Disputed Payments Account”) in accordance with procedures established in the MSA pending resolution of a claim by us and the other Original Participating Manufacturers that they are entitled to reduce their MSA payments based on a loss of market share to non-participating manufacturers. Most of the states that are parties to the MSA are disputing the availability of the reduction and we believe that this dispute will ultimately be resolved by judicial

 

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and arbitration proceedings. Our $93 million deposit in escrow is based upon the Original Participating Manufacturers collective loss of market share in 2011 that resulted in a reduction of $88 million and for adjustments related to escrow payments for other years. In April of 2013, 2012, 2011, 2010, 2009, 2008, 2007 and 2006, we had previously deposited $119 million, $106 million, $104 million, $83 million, $73 million, $72 million, $111 million and $109 million, respectively, in the Disputed Payments Account discussed above, which were based on losses of market share in 2010, 2009, 2008, 2007, 2006, 2005, 2004 and 2003 to non-participating manufacturers. In February 2009, we directed the release of $72 million from the Disputed Payments Account to the MSA states. This amount related to the loss of market share in 2005 and this release was pursuant to an Agreement Regarding Arbitration that we and the other Participating Manufacturers entered into with certain MSA states. In April 2013, October 2013, April 2014 and June 2014, we directed the release of $298 million, $22 million, $40 million and $12 million, respectively, from the Disputed Payments Account to the signatory states to the settlement that resolved the disputes involving MSA payment adjustments relating to non-participating manufacturers, as further discussed below. In addition, in April 2014, we directed the release of $62 million from the Disputed Payments Account to Lorillard Tobacco associated with the 2003 arbitration award, as further discussed below. We and the other Original Participating Manufacturers have the right to claim additional reductions of MSA payments in subsequent years under provisions of the MSA.

On December 17, 2012, the Participating Manufacturers, including Lorillard Tobacco, agreed to settle with 17 states and the District of Columbia and Puerto Rico disputes under the MSA involving payment adjustments relating to non-participating manufacturers. The Participating Manufacturers presented the settlement to the arbitration panel responsible for adjudicating the 2003 NPM adjustment dispute with a request that the panel enter it as a partial settlement and award. On March 12, 2013, the arbitration panel issued a Stipulated Partial Settlement and Award that directed the Independent Auditor under the MSA to implement the settlement provisions involved, thereby allowing the settlement to proceed. Since the panel’s ruling, one additional state joined the settlement on April 12, 2013, two additional states joined the settlement on May 24, 2013, one additional state joined the settlement on June 10, 2014 and one additional state joined the settlement on June 26, 2014.

The settlement resolves the claims for the years 2003 through 2012 and puts in place a new method for calculating this adjustment beginning in 2013. Under the terms of the settlement, Lorillard Tobacco and other Participating Manufacturers will receive credits against their future MSA payments over six years, and the signatory states will be entitled to receive their allocable share of the amounts currently being held in escrow resulting from these disputes. Lorillard Tobacco currently expects to receive credits over six years of approximately $254 million on its outstanding claims, with $165 million having occurred in April 2013, $36 million in April 2014 (including $14 million received in April 2014 related to the 2003 NPM Adjustment award from the two states that joined the settlement in June 2014), and approximately $53 million over the following five years. The estimate is subject to change depending upon a number of factors included in the calculation of the credit.

Based on the terms of the settlement, during the first quarter of 2013 Lorillard Tobacco recorded a reduction in its State Settlements liability and expense of $165 million and reduced its April 15, 2013 MSA Annual Payment by the same amount. The reduction was partially offset by an increase of $21 million in the State Settlements liability and expense related to the industry Volume Adjustment Offset associated with the increase in the industry aggregate operating income under the agreements with the previously settled states. During the second quarter of 2013 Lorillard Tobacco recorded a reduction in its State Settlements liability and expense of $12 million as a result of the two additional states joining the settlement. The reduction was partially offset by an increase of $1 million in the State Settlements liability and expense related to the industry Volume Adjustment Offset associated with the increase in the industry aggregate operating income under agreements with the previously settled states. During the second quarter of 2014, Lorillard Tobacco recorded a reduction in its State Settlements liability and expense of $14 million as a result of the two additional states joining the settlement.

 

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Lorillard Tobacco will continue to pursue these claims against those states that have not settled. Fourteen states that have not joined the settlement have taken action in state court to prevent the settlement from proceeding or to seek other relief related to the settlement. As of February 6, 2015, claims in eight states remain pending as three states withdrew their opposition; one state’s challenge was denied and not appealed; and, as noted above, two additional states joined the settlement and indefinitely stayed their challenges. Two of the states also unsuccessfully sought to preliminarily enjoin the implementation of the settlement. There is no assurance that such attempts will be resolved favorably to the Company.

On September 11, 2013, the arbitration panel responsible for adjudicating the 2003 NPM adjustment dispute issued a determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers. The six non-diligent states included Indiana, Kentucky, Missouri, New Mexico, Maryland, and Pennsylvania. Nine other states that did not participate in the settlement were considered by the arbitration panel because the OPMs contested the states’ diligence as well. The arbitration panel found those nine states diligent. As a result of the panel’s ruling, the OPMs are entitled to receive $458 million, plus interest and earnings, with Lorillard Tobacco’s share of the principal amount totaling $47 million. The six non-diligent states filed motions in their state courts to vacate the arbitration panel’s non-diligence findings, although two of the states subsequently joined the settlement and agreed to indefinitely stay their challenges. On March 31, 2014, the MSA Independent Auditor issued final calculations for the April 2014 MSA payments that implement the 2003 NPM Adjustment in that fashion.

On April 10, 2014, the MSA court in Pennsylvania issued its rulings on that state’s motion to vacate the arbitration panel’s rulings with respect to that state. The court upheld the arbitration panel’s non-diligence finding for that state. However, the court also ruled that the states that signed the settlement and had been contested in the 2003 NPM Adjustment arbitration would be deemed non-diligent for purposes of calculating that state’s share of the 2003 NPM Adjustment. The OPM’s appealed this ruling. The MSA Independent Auditor on April 14, 2014 issued revised final calculations for the April 2014 MSA payments that implement the Pennsylvania court’s ruling. The ruling was reflected as an increase of $12 million in Lorillard Tobacco’s April 15, 2014 MSA payment, and resulted in an increase to Lorillard Tobacco’s State Settlement liability and expense of $9 million during the second quarter of 2014.

On May 2, 2014, the MSA court in Missouri issued a ruling similar to Pennsylvania, which the OPMs appealed. On June 23, 2014, the MSA Independent Auditor issued revised final calculations for the April 2014 MSA payments that implement the Missouri ruling. The ruling was reflected as an increase in Lorillard Tobacco’s State Settlements liability and expense of $4 million during the second quarter of 2014.

On July 22, 2014, the MSA Independent Auditor issued revised final calculations for the April 2014 MSA payments requiring payment of a portion of the DPA earnings to the states that did not settle, which Lorillard has disputed and paid $2 million into the DPA pending its resolution.

On July 23, the MSA court in Maryland issued a ruling that denied Maryland’s motions to vacate the settlement and the arbitration panel’s non-diligent determination against Maryland for the 2003 NPM Adjustment. Maryland has appealed the ruling.

Based on the terms of the award, and subsequent events, Lorillard Tobacco recorded in 2014 a reduction in its State Settlements liability and expense of $34 million and recorded $5 million as an increase to investment income related to interest earned on the proceeds from the 2003 NPM Adjustment award, including funds paid into and released from the Disputed Payments Account (“DPA”). The reduction was partially offset by an increase of $6 million in the State Settlements liability and expense related to the industry Volume Adjustment Offset associated with the increase in the industry aggregate operating income under the agreements with the previously settled states.

In addition, in connection with the MSA, the Original Participating Manufacturers entered into an agreement to establish a $5.2 billion trust fund payable between 1999 and 2010 to compensate the tobacco

 

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growing communities in 14 states (the “Trust”). Payments to the Trust ended in 2005 as a result of an assessment imposed under a federal law, enacted in 2004, repealing the federal supply management program for tobacco growers. Under the law, tobacco quota holders and growers were compensated over 10 years with payments totaling $10.1 billion, funded by an assessment on tobacco manufacturers and importers. Payments under the law to qualifying tobacco quota holders and growers commenced in 2005 and are now complete. Lorillard Tobacco’s final payment was made on September 30, 2014. Lorillard recorded pretax charges for its obligations under the law of $92 million, $120 million and $118 million for the years ended December 31, 2014, 2013 and 2012, respectively.

Contractual Cash Payment Obligations

The following table presents the contractual cash payment obligations of Lorillard as of December 31, 2014:

 

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

Senior notes

   $ 3,500       $  —         $ 1,000       $ 1,500       $ 1,000   

Interest payments related to notes

     1,742         198         537         210         797   

Contractual purchase obligations

     62         62         —           —           —     

Leaf purchase obligations

     85         85         —           —           —     

Operating lease obligations

     5         2         2         1         —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 5,394       $ 347       $ 1,539       $ 1,711       $ 1,797   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

As of December 31, 2014, we do not believe that we will make any payments in the next twelve months related to gross unrecognized tax benefits. We cannot make a reasonably reliable estimate of the amount of liabilities for unrecognized tax benefits that may result in cash settlements for periods beyond twelve months.

As previously discussed, we have entered into the State Settlement Agreements which impose a stream of future payment obligations on us and the other major U.S. cigarette manufacturers. Our portion of ongoing adjusted settlement payments, including fees to settling plaintiffs’ attorneys, are based on a number of factors which are described above. Our cash payment under the State Settlement Agreements in 2014 amounted to $1.36 billion, net of the NPM settlement credit of $37 million, and we estimate our cash payments in 2015 under the State Settlement Agreements will be between $1.45 billion and $1.50 billion, primarily based on 2014 estimated industry volume. Payment obligations are not incurred until the related sales occur and therefore are not reflected in the above table. The 2014 cash payments include the favorable impact of the release from the DPA on April 15, 2014 of $62 million as a result of the September 2013 arbitration panel determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers.

Off-Balance Sheet Arrangements – None.

 

Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We invest in financial instruments that involve market risk. Our measure of market risk exposure represents an estimate of the change in fair value of our financial instruments. Market risk exposure is presented below for each class of financial instrument we held at December 31, 2014, assuming immediate adverse market movements of the magnitude described below. We believe that the rate of adverse market movement represents a measure of exposure to loss under hypothetically assumed adverse conditions. The estimated market risk exposure represents the hypothetical loss to future earnings and does not represent the maximum possible loss nor any expected actual loss, even under adverse conditions, because actual adverse fluctuations would likely differ. In addition, since our investment portfolio is subject to change based on our portfolio management strategy as well as in response to changes in the market, these estimates are not necessarily indicative of the

 

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actual results which may occur. The market risk exposure represents the potential loss in carrying value and pretax impact to future earnings caused by the hypothetical change in price.

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

Interest rate risk. Our cash and cash equivalents consist of money market funds with major financial institutions. Our short and long-term investments are made up of available-for-sale securities which include corporate debt securities, U.S. Government agency obligations, commercial paper and international government obligations. All of our investments are exposed to fluctuations in interest rates. A sensitivity analysis, based on a hypothetical 1% increase or decrease in interest rates on our average 2014 investments, would cause an increase or decrease in pretax income of approximately $18 million for 2014.

Our debt is denominated in US Dollars and has been issued at a fixed rate. In September 2009, we entered into interest rate swap agreements for a total notional amount of $750 million to hedge changes in fair value of the Notes due to changes in the designated benchmark interest rate. Changes in the fair value of the derivative are recorded in earnings along with offsetting adjustments to the carrying amount of the hedged debt. A sensitivity analysis, based on a hypothetical 1% change in LIBOR, would cause an increase or decrease in pretax income of approximately $8 million for 2014.

Liquidity risk. We may be forced to cash settle all or a portion of our derivative contracts before the expiration date if our debt rating is downgraded below Ba2 by Moody’s or BB by S&P. This could have a negative impact on our cash position. Early cash settlement would result in the timing of our hedge settlement not being matched to the cash settlement of the debt. As of December 31, 2014 our Moody’s debt rating was Baa2, and our S&P debt rating was BBB-, both of which are above the ratings at which settlement of our derivative contracts would be required. See Note 13 to our consolidated financial statements for additional information on derivatives.

 

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Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

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

 

     Page
No.
 

Report of Independent Registered Public Accounting Firm

     67   

Consolidated Balance Sheets

     68   

Consolidated Statements of Income

     69   

Consolidated Statements of Comprehensive Income

     70   

Consolidated Statements of Shareholders’ Deficit

     71   

Consolidated Statements of Cash Flows

     72   

Notes to Consolidated Financial Statements

     73   

 

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REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

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

Greensboro, North Carolina

We have audited the accompanying consolidated balance sheets of Lorillard, Inc. and subsidiaries (the “Company”) as of December 31, 2014 and 2013, and the related consolidated statements of income, comprehensive income, shareholders’ deficit, and cash flows for each of the three years in the period ended December 31, 2014. Our audits also included the financial statement schedule listed in the Index at Item 15. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on the consolidated financial statements and financial statement schedule based on our audits.

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

In our opinion, such consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2014 and 2013, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2014, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2014, based on the criteria established in Internal Control — Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 11, 2015 expressed an unqualified opinion on the Company’s internal control over financial reporting.

 

 

LOGO

Raleigh, North Carolina

February 11, 2015

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

     December 31,  
(In millions, except share and per share data)    2014     2013  

ASSETS:

    

Cash and cash equivalents

   $ 1,308      $ 1,454   

Short-term investments

     324        157   

Accounts receivable, less allowances of $2 and $3

     13        19   

Other receivables

     35        29   

Inventories

     404        499   

Deferred income taxes

     522        555   

Other current assets

     28        23   
  

 

 

   

 

 

 

Total current assets

     2,634        2,736   

Plant and equipment, net

     308        316   

Long-term investments

     167        93   

Goodwill

     100        102   

Intangible assets, net

     63        87   

Deferred income taxes

     142        51   

Other assets

     94        151   
  

 

 

   

 

 

 

Total assets

   $ 3,508      $ 3,536   
  

 

 

   

 

 

 

LIABILITIES AND SHAREHOLDERS’ DEFICIT:

    

Accounts and drafts payable

   $ 31      $ 42   

Accrued liabilities

     357        377   

Settlement costs

     1,187        1,224   

Income taxes

     8        8   
  

 

 

   

 

 

 

Total current liabilities

     1,583        1,651   

Long-term debt

     3,561        3,560   

Postretirement pension, medical and life insurance benefits

     473        305   

Other liabilities

     73        84   
  

 

 

   

 

 

 

Total liabilities

     5,690        5,600   
  

 

 

   

 

 

 

Commitments and Contingent Liabilities

    

Shareholders’ Deficit:

    

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

     —          —     

Common stock:

    

Authorized—600 million shares; par value—$0.01 per share

    

Issued—383 million and 382 million shares (outstanding 360 million and 365 million shares)

     4        4   

Additional paid-in capital

     287        256   

Accumulated deficit

     (1,140     (1,438

Accumulated other comprehensive loss

     (263     (130

Treasury stock at cost, 23 million and 17 million shares

     (1,070     (756
  

 

 

   

 

 

 

Total shareholders’ deficit

     (2,182     (2,064
  

 

 

   

 

 

 

Total liabilities and shareholders’ deficit

   $ 3,508      $ 3,536   
  

 

 

   

 

 

 

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

 

     Year Ended December 31,  
(In millions, except per share data)    2014     2013     2012  

Net sales (including excise taxes of $1,938, $1,978 and $1,987)

   $ 6,990      $ 6,950      $ 6,623   

Cost of sales (including excise taxes of $1,938, $1,978 and $1,987)

     4,252        4,231        4,241   
  

 

 

   

 

 

   

 

 

 

Gross profit

     2,738        2,719        2,382   

Selling, general and administrative

     630        665        504   
  

 

 

   

 

 

   

 

 

 

Operating income

     2,108        2,054        1,878   

Investment income

     7        2        4   

Interest expense

     (179     (172     (154
  

 

 

   

 

 

   

 

 

 

Income before income taxes

     1,936        1,884        1,728   

Income taxes

     749        704        629   
  

 

 

   

 

 

   

 

 

 

Net income

   $ 1,187      $ 1,180      $ 1,099   
  

 

 

   

 

 

   

 

 

 

Earnings per share:

      

Basic

   $ 3.29      $ 3.15      $ 2.82   

Diluted

   $ 3.28      $ 3.15      $ 2.81   

Weighted average number of shares outstanding:

      

Basic

     360.14        372.96        389.27   

Diluted

     360.76        373.71        390.13   

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

 

     Year Ended December 31,  
(In millions)    2014     2013      2012  

Net income

   $ 1,187      $ 1,180       $ 1,099   

Other comprehensive income (loss), net of tax:

       

Defined benefit retirement plans gain (loss), net of tax expense (benefit) of $(86), $41 and $(4)

     (130     110         (13

Foreign currency translation gain (loss), net of tax expense (benefit) of $(1), $- and $-

     (3     1         —     
  

 

 

   

 

 

    

 

 

 

Other comprehensive income (loss)

     (133     111         (13
  

 

 

   

 

 

    

 

 

 

Comprehensive income

   $ 1,054      $ 1,291       $ 1,086   
  

 

 

   

 

 

    

 

 

 

 

 

 

 

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ DEFICIT

 

     Common
Stock
    Additional
Paid-in
Capital
    Retained
Earnings
(Accumulated
Deficit)
    Accumulated
Other
Comprehensive
Loss
    Treasury
Stock
    Total
Share-
Holders’
Deficit
 
(In millions, except per share data)                                     

Balance, December 31, 2011

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

Net income

         1,099            1,099   

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

           (13       (13

Dividends paid ($2.07 per share)

         (807         (807

Share repurchases

             (578     (578

Share-based compensation

       35              35   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2012

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

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

         1,180            1,180   

Other comprehensive income, net of tax expense of $41

           111          111   

Dividends paid ($2.20 per share)

         (823         (823

Retirement of treasury shares

     (1     (82     (4,146       4,229        —     

Share repurchases

             (795     (795

Share-based compensation

       27              27   

Excess tax benefit on share-based compensation

       13              13   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2013

   $ 4      $ 256      $ (1,438   $ (130   $ (756   $ (2,064
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

         1,187            1,187   

Other comprehensive loss, net of tax benefit of $(87)

           (133       (133

Dividends paid ($2.46 per share)

         (889         (889

Share repurchases

             (314     (314

Share-based compensation

       22              22   

Excess tax benefit on share-based compensation

       9              9   
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, December 31, 2014

   $ 4      $ 287      $ (1,140   $ (263   $ (1,070   $ (2,182
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

 

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

     Year Ended December 31,  
     2014     2013     2012  
     (In millions)  

Cash flows from operating activities:

  

Net income

   $ 1,187      $ 1,180      $ 1,099   

Adjustments to reconcile to net cash provided by operating activities:

      

Depreciation and amortization

     72        50        39   

Pension, health and life insurance contributions

     (11     (44     (43

Pension, health and life insurance benefits expense

     18        36        44   

Deferred income tax provision (benefit)

     27        (42     (11

Share-based compensation

     20        18        20   

Excess tax benefits from share-based arrangements

     (9     (13     (11

Changes in fair value of earn out liability

     (8     —          —     

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

      

Accounts and other receivables

     9        (7     (8

Inventories

     95        (89     (118

Accounts payable and accrued liabilities

     (29     20        64   

Settlement costs

     (37     41        32   

Income taxes

     (1     36        59   

Other current assets

     (3     3        5   

Other assets

     (1     3        (1
  

 

 

   

 

 

   

 

 

 

Net cash provided by operating activities

     1,329        1,192        1,170   
  

 

 

   

 

 

   

 

 

 

Cash flows from investing activities:

      

Purchase of investments

     (654     (276     —     

Business acquisitions

     —          (46     (135

Additions to plant and equipment

     (41     (62     (74

Sales of investments

     244        3        —     

Maturities of investments

     169        23        —     
  

 

 

   

 

 

   

 

 

 

Net cash used in investing activities

     (282     (358     (209
  

 

 

   

 

 

   

 

 

 

Cash flows from financing activities:

      

Proceeds from issuance of long-term debt

     —          500        500   

Dividends paid

     (889     (823     (807

Shares repurchased

     (314     (795     (578

Debt issuance costs

     —          (4     (5

Proceeds from exercise of stock options

     2        9        5   

Excess tax benefits from share-based arrangements

     9        13        10   
  

 

 

   

 

 

   

 

 

 

Net cash used in financing activities

     (1,192     (1,100     (875
  

 

 

   

 

 

   

 

 

 

Effect of foreign currency rate changes on cash and cash equivalents

     (1     —          —     
  

 

 

   

 

 

   

 

 

 

Change in cash and cash equivalents

     (146     (266     86   

Cash and cash equivalents, beginning of year

     1,454        1,720        1,634   
  

 

 

   

 

 

   

 

 

 

Cash and cash equivalents, end of year

   $ 1,308      $ 1,454      $ 1,720   
  

 

 

   

 

 

   

 

 

 

Cash paid for income taxes

   $ 724      $ 712      $ 580   

Cash paid for interest, net of cash received from interest rate swaps of $25 in 2014, $24 in 2013 and $24 in 2012

   $ 174      $ 164      $ 144   

See Notes to Consolidated Financial Statements

 

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LORILLARD, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

1.    Significant Accounting Policies

Basis of presentation—Lorillard, Inc., through certain of its subsidiaries, is engaged in the manufacture and sale of cigarettes and electronic cigarettes. Lorillard Tobacco Company’s principal cigarette products are marketed under the brand names of Newport, Kent, True, Maverick and Old Gold with substantially all of its sales in the United States of America. On April 24, 2012 Lorillard acquired blu eCigs, an electronic cigarette brand in the U.S. On October 1, 2013, Lorillard acquired the assets and operations of SKYCIG, now trading as blu (U.K.), a United Kingdom-based electronic cigarette business. Newport, Kent, True, Maverick, Old Gold, blu eCigs and SKYCIG are the registered trademarks of Lorillard, Inc. and its subsidiaries.

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

The Company has two reportable segments – Cigarettes and Electronic Cigarettes. The Cigarettes segment consists principally of the operations of Lorillard Tobacco Company (“Lorillard Tobacco” or “Issuer”) and related entities. The Electronic Cigarettes segment consists of the operations of LOEC, Inc. (d/b/a blu eCigs), (“LOEC” or “blu eCigs”), Cygnet U.K. Trading Limited (t/a SKYCIG or blu (U.K.)) (“Cygnet”, “SKYCIG” or “blu (U.K.)”) and related entities.

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

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

Short-term and Long-term Investments—Our short-term and long-term investments consist of investment grade debt securities, all of which are classified as available for sale. Available for sale securities are recorded at fair value, and unrealized holding gains and losses are recorded, net of tax, as a component of accumulated other comprehensive income. Available for sale securities with remaining maturities of less than one year and those identified by management at the time of purchase to be used to fund operations within one year are classified as short-term. All other available for sale securities are classified as long-term. Unrealized losses are charged against net earnings when a decline in fair value is determined to be other than temporary. We review several factors to determine whether a loss is other than temporary, such as the length and extent of the fair value decline, the financial condition and near term prospects of the issuer, and whether we have the intent to sell or will likely be required to sell before the anticipated recovery of the securities, which may be at maturity. Realized gains and losses are accounted for using the specific identification method, and are recorded as a component of investment income in the accompanying consolidated statements of income. Purchases and sales are recorded on a trade date basis.

Inventories—Cigarette inventories (including leaf tobacco, manufactured stock and materials and supplies) are valued at the lower of cost, determined on a last-in, first-out (“LIFO”) basis, or market. A significant portion of leaf tobacco on hand will not be sold or used within one year, due to the duration of the aging process. All

 

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inventory of leaf tobacco, including the portion that has an operating cycle that exceeds 12 months, is classified as a current asset as is a generally recognized trade practice. Electronic cigarette inventories are valued at the lower of cost, determined on a first-in, first-out (“FIFO”) basis, or market and are included in manufactured stock.

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

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

Business Combinations—Lorillard utilizes the acquisition method in accounting for business combinations whereby the amount of purchase price that exceeds the fair value of the acquired assets and assumed liabilities is allocated to goodwill. Lorillard recognizes intangible assets apart from goodwill if they arise from contractual or other legal rights, or if they are capable of being separated or divided from the acquired entity and sold, transferred, licensed, rented or exchanged. Assumptions and estimates are used in determining the fair value of assets acquired and liabilities assumed in a business combination. Valuation of intangible assets acquired requires that we use significant judgment in determining fair value, whether such intangibles are amortizable and, if the asset is amortizable, the period and the method by which the intangible asset will be amortized. On April 24, 2012, the Company acquired blu eCigs and other assets used in the manufacture, distribution, development, research, marketing, advertising, and sale of electronic cigarettes. On October 1, 2013, the Company acquired certain of the assets and operations of SKYCIG, a United Kingdom based electronic cigarette business. Changes in the initial assumptions could lead to changes in amortization or impairment charges recorded in our Consolidated Financial Statements. See Notes 2 and 6 to the Consolidated Financial Statements for additional disclosure about the acquisitions and the purchase price allocations.

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

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

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

 

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Foreign Currency Translation—Foreign currency denominated assets and liabilities of a foreign subsidiary are translated into United States dollars at exchange rates existing at the respective balance sheet dates. Translation adjustments resulting from fluctuations in exchange rates are recorded as a separate component of other comprehensive income (loss) within shareholders’ deficit. The results of operations of foreign subsidiaries are translated at the average exchange rates during the respective periods. Gains and losses resulting from foreign currency transactions are included in net earnings.

Revenue recognition—Revenue from product sales, net of sales incentives, is recognized at the time ownership of the goods transfers to customers and collectability is reasonably assured. Federal excise taxes are recognized on a gross basis, and are reflected in both net sales and cost of sales. Sales incentives include retail price discounts, coupons and retail display allowances and are recorded as a reduction of revenue based on amounts estimated as due to customers and consumers at the end of a period based primarily on use and redemption rates. Sales to one customer represented 29%, 29% and 29% of Lorillard’s revenues in 2014, 2013 and 2012, respectively. Our largest selling brand, Newport, accounted for approximately 86.5%, 85.4% and 87.0% of consolidated net sales of Lorillard in 2014, 2013 and 2012, respectively.

Cost of sales—Cost of sales includes federal excise taxes, leaf tobacco cost, wrapping and casing material, manufacturing labor and production salaries, wages and overhead, research and development costs, distribution, other manufacturing costs, State Settlement Agreement expenses, the federal assessment for tobacco growers, Food and Drug Administration fees, promotional product expenses and electronic cigarette raw materials and manufacturing costs. Promotional product expenses include the cost, including excise taxes, of the free portion of “buy some get some free” promotions. We purchased approximately 80%, 86% and 90% of our leaf tobacco from 3, 4 and 4 suppliers in 2014, 2013 and 2012, respectively.

Advertising and marketing costs—Advertising costs are recorded as expense in the year incurred. Marketing and advertising costs that include such items as direct mail, advertising, agency fees and point of sale materials are included in selling, general and administrative expenses. Advertising expense was $87 million, $84 million and $54 million for the years ended December 31, 2014, 2013 and 2012, respectively.

Research and development costs—Research and development costs are recorded as expense as incurred, are included in cost of sales and amounted to $25 million, $21 million and $20 million for each of the years ended December 31, 2014, 2013 and 2012, respectively.

Tobacco settlement costs—Lorillard recorded charges of $1.358 billion, $1.241 billion and $1.379 billion for the years ended December 31, 2014, 2013 and 2012, respectively, to accrue its obligations under the State Settlement Agreements (see Note 23). Lorillard’s portion of ongoing adjusted settlement payments and legal fees is based on its share of total domestic cigarette shipments in that year. Accordingly, Lorillard records its portion of ongoing adjusted settlement payments as part of cost of sales as the related sales occur. Payments are made annually and are generally due in April of the year following the accrual of costs. The settlement cost liability on the consolidated balance sheets represents the unpaid portion of the Company’s obligations under the State Settlement Agreements.

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

Legal costs and loss contingencies—Legal costs are expensed as incurred and amounted to $144 million, $146 million and $160 million for the years ended December 31, 2014, 2013 and 2012, respectively. Lorillard establishes accruals in accordance with Accounting Standards Codification Topic 450, Contingencies (“ASC 450”), when a loss contingency is both probable and can be reasonably estimated as a charge to selling, general

 

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and administrative expense. There are a number of factors impacting Lorillard’s ability to estimate the possible loss or a range of loss, including the specific facts of each matter; the legal theories proffered by plaintiffs and legal defenses available to Lorillard Tobacco and Lorillard, Inc.; the wide-ranging outcomes reached in similar cases; differing procedural and substantive laws in the various jurisdictions in which lawsuits have been filed, including whether punitive damages may be pursued or are permissible; the degree of specificity in a plaintiff’s complaint; the history of the case and whether discovery has been completed; plaintiffs’ history of use of Lorillard Tobacco’s cigarettes relative to those of the other defendants; the attribution of damages, if any, among multiple defendants; the application of contributory and/or comparative negligence to the allocation of damage awards among plaintiffs and defendants; the likelihood of settlements for de minimis amounts prior to trial; the likelihood of success at trial; the likelihood of success on appeal; and the impact of current and pending state and federal appellate decisions. It has been Lorillard’s experience and is its continued expectation that the above complexities and uncertainties will not be clarified until the late stages of litigation. For those reasonably possible loss contingencies for which an estimate of the possible loss or range of loss cannot be made, Lorillard discloses the nature of the litigation and any developments as appropriate. See Note 23 for a description of loss contingencies.

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

Recently adopted accounting pronouncements—In July 2012, the FASB issued ASU 2012-02 “Intangibles – Goodwill and Other (Topic 350): Testing Indefinite-Lived Intangible Asset for Impairment.” ASU 2012-02 gives an entity the option to first assess qualitative factors to determine whether the existence of events or circumstances indicates that it is more likely than not that indefinite-lived intangible assets other than goodwill are impaired, before being required to complete a quantitative impairment test. If an entity concludes, after assessing the totality of qualitative factors, that it is more likely than not that the indefinite-lived intangible assets are not impaired, then it is not required to complete a quantitative impairment test whereby the fair value of the indefinite-lived intangible asset would be determined and compared with the carrying amount of the intangible asset. The amendments in this update are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012, and early adoption is permitted. The adoption of ASU 2012-02 did not have a material impact on Lorillard’s financial position or results of operations.

In February 2013, the FASB issued ASU 2013-02 “Comprehensive Income (Topic 220) – Reporting of Amounts Reclassified out of Accumulated Other Comprehensive Income.” ASU 2013-02 requires an entity to provide information about amounts reclassified out of accumulated other comprehensive income. An entity is also required to present either on the face of the financial statements or in the footnotes, significant items reclassified out of accumulated other comprehensive income by the respective line items of net income, but only if the item reclassified is required under U.S. GAAP to be reclassified to net income in its entirety. For other items that are not required under U.S. GAAP to be reclassified to net income in their entirety, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts. This standard is effective for public entities prospectively for reporting periods beginning after December 15, 2012. The adoption of ASU 2013-02 did not have any impact on Lorillard’s financial position or results of operations, but resulted in disclosure of additional information about amounts reclassified out of accumulated other comprehensive income. For additional information, see Note 19, “Accumulated Other Comprehensive Loss.”

 

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Accounting Pronouncements not yet adopted. In May 2014, the FASB issued ASU 2014-09 “Revenue from Contracts with Customers (Topic 606).” ASU 2014-09, which was a joint project of the FASB and IASB, clarifies the principles for recognizing revenue and provides a common revenue standard under U.S. GAAP and International Financial Reporting Standards that removes inconsistencies and weaknesses in existing revenue requirements; provides a more robust framework for addressing revenue issues; improves comparability of revenue recognition practices across entities, industries, jurisdictions and capital markets; provides more useful information to users of financial statements through improved disclosure requirements; and simplifies the preparation of financial statements by reducing the number of requirements to which an entity must refer. The guidance in this proposed update affects any entity that enters into contracts with customers unless those contracts are in the scope of other standards (for example, insurance contracts or lease contracts). The core principle of this update is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. To achieve that core principle, an entity applies the following steps: identify the contract(s) with a customer; identify the separate performance obligations in the contract; determine the transaction price; allocate the transaction price to the separate performance obligations in the contract; and recognize revenue when (or as) the entity satisfies a performance obligation. The amendments in this update are effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early application is not permitted. We have not yet determined the potential effects on Lorillard’s financial position or results of operations, if any.

In August 2014, the FASB issued ASU 2014-15 “Presentation of Financial Statements – Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern.” ASU 2014-15 requires an entity’s management to evaluate whether there are conditions or events that raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. Management’s evaluation should be based on relevant conditions and events that are known at the date that the financial statements are issued. This update is effective for annual periods beginning after December 15, 2016. Early application is permitted. We are still evaluating the potential effects on Lorillard’s financial position or results of operations, if any.

2.    Acquisitions

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

The results of operations of blu eCigs are included in our consolidated financial statements beginning as of April 24, 2012. Lorillard’s consolidated revenues include $155 million, $226 million and $61 million of sales of blu eCigs during the years ended 2014, 2013 and 2012, respectively. blu eCigs had operating income (loss) of $(23) million, $7 million and $1 million during the years ended 2014, 2013 and 2012, respectively. Lorillard incurred $6 million of acquisition-related expenses during 2012.

 

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

 

Assets acquired:

  

Current assets:

  

Accounts receivable

   $ 2   

Inventories

     15   
  

 

 

 

Total current assets

     17   
  

 

 

 

Goodwill

     64   

Intangible assets

     58   
  

 

 

 

Total assets

     139   
  

 

 

 

Liabilities assumed:

  

Current liabilities:

  

Accounts and drafts payable

     4   
  

 

 

 

Purchase price

   $ 135   
  

 

 

 

On October 1, 2013, Lorillard acquired certain assets and operations of SKYCIG, now trading as blu (U.K.), a United Kingdom (“UK”)-based electronic cigarette (e-cigarette) business for approximately £28 million (approximately $46 million) in cash paid at closing and contingent consideration of up to an additional £30 million (approximately $47 million at December 31, 2014 exchange rates) to be paid in 2016 based on the achievement of certain financial performance benchmarks.

The results of operations of SKYCIG, now trading as blu (U.K.), are included in our consolidated financial statements beginning as of October 1, 2013. Lorillard’s consolidated revenues include $9 million and $4 million of sales of blu (U.K.) during the years ended 2014 and 2013, respectively. blu (U.K.) had operating losses of $49 million and $7 million during the years ended 2014 and 2013, respectively. Lorillard incurred $4 million of acquisition-related expenses during 2013.

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

 

Assets acquired:

  

Current assets:

  

Accounts receivable

   $ 2   

Goodwill

     38   

Intangible assets

     35   
  

 

 

 

Total assets

     75   
  

 

 

 

Liabilities assumed:

  

Current liabilities:

  

Accounts and drafts payable

     3   

Accrued liabilities

     1   
  

 

 

 

Total current liabilities

     4   
  

 

 

 

Earn out liability

     25   
  

 

 

 

Purchase price

   $ 46   
  

 

 

 

 

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3.    Inventories

Cigarette inventories (including leaf tobacco, manufactured stock and materials and supplies) are valued at the lower of cost, determined on a LIFO basis, or market. Electronic cigarette inventories of $51 million and $85 million included in manufactured stock as of December 31, 2014 and 2013, respectively, are valued at the lower of cost, determined on a FIFO basis, or market. Inventories consisted of the following:

 

     December 31,  
     2014      2013  
     (In millions)  

Leaf tobacco

   $ 305       $ 349   

Manufactured stock

     93         143   

Materials and supplies

     6         7   
  

 

 

    

 

 

 

Total

   $ 404       $ 499   
  

 

 

    

 

 

 

If the average cost method of accounting was used for inventories valued on a LIFO basis, inventories would be greater by approximately $283 million and $264 million at December 31, 2014 and 2013, respectively. During 2014, inventory quantities were reduced. This reduction resulted in liquidation of LIFO inventory layers, the effect of which decreased cost of sales by approximately $1 million. There were no inventory decrements in 2013 or 2012.

4.    Other Current Assets

Other current assets were as follows:

 

     December 31,  
     2014      2013  
     (In millions)  

Appeal bonds

   $ 17       $ 7   

Deposits

     2         2   

Other current assets

     9         14   
  

 

 

    

 

 

 

Total

   $ 28       $ 23   
  

 

 

    

 

 

 

5.    Plant and Equipment, Net

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

 

     December 31,  
     2014     2013  
     (In millions)  

Land

   $ 3     $ 3  

Buildings

     108        104   

Equipment

     700        684   
  

 

 

   

 

 

 

Total

     811        791   

Accumulated depreciation

     (503     (475
  

 

 

   

 

 

 

Plant and equipment, net

   $ 308      $ 316   
  

 

 

   

 

 

 

Depreciation expense was $50 million, $44 million and $39 million for 2014, 2013 and 2012, respectively.

 

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6.    Goodwill and Intangible Assets

On April 24, 2012, Lorillard completed the acquisition of blu eCigs. For additional information, see Note 2, “Acquisitions.” The purchase price allocation includes $64 million of goodwill and $58 million of intangible assets, $57 million of which is an indefinite lived intangible asset consisting of the blu eCigs trademark and trade name.

We evaluated our goodwill and indefinite lived intangible assets recorded as a part of the blu eCigs reporting unit for impairment as of November 1, 2014. Based on the results of our impairment analysis, no impairment of the blu eCigs goodwill or the blu eCigs trademark or trade name was determined to exist.

There were no changes in blu eCigs goodwill or the blu eCigs trademark and trade name during the year ended December 31, 2014.

On October 1, 2013, Lorillard completed the acquisition of SKYCIG, now trading as blu (U.K.). For additional information, see Note 2, “Acquisitions.” The purchase price allocation includes $38 million of goodwill and $35 million of intangible assets, $33 million of which is the fair value ascribed to the SKYCIG trademark and trade name. The fair value ascribed to the SKYCIG trademark and trade name in connection with the acquisition is being amortized over an estimated life of 18 months, beginning October 1, 2013, after which amortization charges related to the trademark and trade name will cease.

We evaluated our goodwill recorded as part of the blu (U.K.) reporting unit for impairment as of September 1, 2014. Based on the results of our impairment analysis, no impairment of the blu (U.K.) goodwill was determined to exist.

All goodwill and intangible assets have been recorded as a part of our blu eCigs and blu (U.K.) reporting units, both of which are components of our Electronic Cigarettes reporting segment.

There were no changes in blu (U.K.) goodwill during the year ended December 31, 2014, other than the impact of foreign currency translation.

Intangible Assets

 

     Weighted
Average
Amortization
Period
   Cost      Foreign
Currency
Translation
    Accumulated
Amortization
     Net
Carrying
Amount
 
(Dollars in millions)                                

Amortizable intangible assets:

             

blu eCigs Non-compete Agreement and Technology

   5 years    $ 1       $ —        $ 1       $ —     

SKYCIG Non-compete Agreement and Customer List

   5 years      2         —          1         1   

SKYCIG trademark and trade name

   18 months      33         (2     26         5   
             

 

 

 

Amortizable intangible assets, net

                6   

Indefinite-lived intangible assets:

             

blu eCigs trademark and trade name

                57   
             

 

 

 

Intangible assets, net

              $ 63   
             

 

 

 

Intangible assets are amortized using the straight-line method. The aggregate amortization expense for the years ended December 31, 2014 and 2013 were $23 million and $7 million, respectively.

 

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7.    Other Assets

Other assets were as follows:

 

     December 31,  
     2014      2013  
     (In millions)  

Debt issuance costs, net

   $ 22       $ 26   

Interest rate swap

     61         60   

Prepaid pension

     —           55   

Other prepaid assets

     11         10   
  

 

 

    

 

 

 

Total

   $ 94       $ 151   
  

 

 

    

 

 

 

8.    Accrued Liabilities

Accrued liabilities were as follows:

 

     December 31,  
     2014      2013  
     (In millions)  

Legal fees

   $ 25       $ 29   

Salaries and other compensation

     21         20   

Medical and other employee benefit plans

     29         30   

Consumer rebates

     85         78   

Sales promotion

     26         29   

Accrued vendor charges

     3         3   

Excise and other taxes

     73         57   

Accrued interest

     34         34   

Litigation related accruals

     22         42   

Other accrued liabilities

     39         55   
  

 

 

    

 

 

 

Total

   $ 357       $ 377   
  

 

 

    

 

 

 

9.    Commitments

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

 

     December 31, 2014  
     (In millions)  

2015

   $ 2.4   

2016

     1.5   

2017

     0.9   

2018

     0.5   

2019

     0.3   
  

 

 

 

Net Minimum lease payments

   $ 5.6   
  

 

 

 

Rental expense for all operating leases was $6 million, $5 million and $4 million for 2014, 2013 and 2012, respectively.

At December 31, 2014, Lorillard Tobacco had contractual obligations to purchase leaf tobacco between January 1, 2015 and December 31, 2015 of approximately $85 million.

 

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At December 31, 2014, Lorillard Tobacco had other contractual purchase obligations of approximately $53 million. These purchase obligations related primarily to agreements to purchase machinery between January 1, 2015 and December 31, 2015.

At December 31, 2014, blu eCigs had contractual purchase obligations of approximately $9 million. These purchase obligations related primarily to agreements to purchase inventory between January 1, 2015 and December 31, 2015.

At December 31, 2014, blu (U.K.) did not have any contractual purchase obligations.

10.    Fair Value

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

 

   

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

 

   

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

 

   

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

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

Assets and liabilities measured at fair value on a recurring basis at December 31, 2014 were as follows:

 

(In millions)    Level 1      Level 2      Level 3      Total  

Cash and Cash Equivalents:

           

Prime money market funds

   $ 1,308       $ —         $ —         $ 1,308   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total cash and cash equivalents

   $ 1,308       $ —         $ —         $ 1,308   
  

 

 

    

 

 

    

 

 

    

 

 

 

Short-term investments:

           

Corporate debt securities

   $ —         $ 201       $ —         $ 201   

U.S. Government agency obligations

     —           45         —           45   

Commercial paper

     —           33         —           33   

International government obligations

     —           45         —           45   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total short-term investments

   $ —         $ 324       $ —         $ 324   
  

 

 

    

 

 

    

 

 

    

 

 

 

Long-term investments:

           

Corporate debt securities

   $ —         $ 109       $ —         $ 109   

U.S. Government agency obligations

     —           58         —           58   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total long-term investments

   $ —         $ 167       $ —         $ 167   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative Asset:

           

Interest rate swaps — fixed to floating rate

   $ —         $ 61       $ —         $ 61   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other liabilities:

           

blu (U.K.) earn out liability

   $ —         $ —         $ 17       $ 17   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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Assets and liabilities measured at fair value on a recurring basis at December 31, 2013 were as follows:

 

(In millions)    Level 1      Level 2      Level 3      Total  

Cash and Cash Equivalents:

           

Prime money market funds

   $ 1,454       $ —         $ —         $ 1,454   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total cash and cash equivalents

   $ 1,454       $ —         $ —         $ 1,454   
  

 

 

    

 

 

    

 

 

    

 

 

 

Short-term investments:

           

Corporate debt securities

   $ —         $ 63       $ —         $ 63   

U.S. Government agency obligations

     —           59         —           59   

Commercial paper

     —           22         —           22   

International government obligations

     —           13         —           13   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total short-term investments

   $ —         $ 157          $ 157   
  

 

 

    

 

 

    

 

 

    

 

 

 

Long-term investments:

           

Corporate debt securities

   $ —         $ 86       $ —         $ 86   

U.S. Government agency obligations

     —           7         —           7   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total long-term investments

   $ —         $ 93       $ —         $ 93   
  

 

 

    

 

 

    

 

 

    

 

 

 

Derivative Asset:

           

Interest rate swaps — fixed to floating rate

   $ —         $ 60       $ —         $ 60   
  

 

 

    

 

 

    

 

 

    

 

 

 

Other liabilities:

           

blu (U.K.) earn out liability

   $ —         $ —         $ 25       $ 25   
  

 

 

    

 

 

    

 

 

    

 

 

 

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

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

Short-term and long-term investments include corporate debt securities, U.S. Government agency obligations, commercial paper and international government obligations. The fair value of corporate debt securities, U.S. Government agency obligations, commercial paper and international government obligations, classified as Level 2, utilized quoted prices for identical assets in less active markets or quoted prices for similar assets in active markets. Short-term investments mature within one year of the balance sheet date. Long-term investments mature within one to three years of the balance sheet date.

There were no transfers between levels within the fair value hierarchy. There were no Level 3 purchases, sales, issuances or settlements of these assets and liabilities for the years ended 2014 and 2013.

Proceeds from sales of available for sale securities were $244 million and $3 million for the twelve months ended December 31, 2014 and 2013, respectively. Proceeds from maturities of available for sale securities were $169 million and $23 million for the twelve months ended December 31, 2014 and 2013, respectively. For the twelve months ended December 31, 2014, realized gains and losses on sales, maturities and calls of available for sale securities were not material. The difference between the amortized cost basis and the fair value of major security types was not material as of December 31, 2014 or 2013. There was no other than temporary impairment recognized in accumulated other comprehensive income for the years ended December 31, 2014 or 2013 and total gains for securities with net gains in accumulated other comprehensive income and total losses for securities with net losses in accumulated other comprehensive income were not material as of December 31, 2014 or 2013. Short term investments as of December 31, 2014 and 2013 mature within one year. Long term investments as of December 31, 2014 and 2013 mature within one to five years.

 

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The fair value of the blu (U.K.) earn out liability (the “Earn Out”), classified as Level 3 was determined utilizing a discounted cash flows approach using various probability-weighted blu (U.K.) 2015 financial performance scenarios, upon which the ultimate earn out liability to be paid in 2016 will be based. Significant unobservable inputs used in calculating the fair value of the Earn Out include various blu (U.K.) financial performance scenarios, the probability of achieving those scenarios, and the discount rate. Based upon this calculation, the fair value of the Earn Out was determined to be £15 million, approximately $25 million, as of the date of the acquisition (October 1, 2013). The amount of the Earn Out that will be ultimately paid in 2016 could range from £0 to £30 million (approximately $0 to $47 million at December 31, 2014 exchange rates). We reviewed the fair value of the Earn Out as of December 31, 2014. Based on the results of our analysis, we reduced the Earn Out to approximately £11 million (approximately $17 million at December 31, 2014 exchange rates). Changes in the fair value of the Earn Out are recorded as a component of selling, general and administrative expenses of the Electronic Cigarettes segment. See note 2, “Acquisitions” for additional information related to the acquisition of SKYCIG.

11.    Credit Agreement

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

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

As of December 31, 2014, Lorillard was in compliance with all financial covenants and there were no borrowings under the Revolver.

12.    Long-Term Debt

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

 

     December 31,
2014
     December 31,
2013
 
     (In millions)  

2016 Notes—3.500% Notes due 2016

   $ 500       $ 500   

2017 Notes—2.300% Notes due 2017

     500         500   

2019 Notes—8.125% Notes due 2019

     811         810   

2020 Notes—6.875% Notes due 2020

     750         750   

2023 Notes—3.750% Notes due 2023

     500         500   

2040 Notes—8.125% Notes due 2040

     250         250   

2041 Notes—7.000% Notes due 2041

     250         250   
  

 

 

    

 

 

 

Total long-term debt

   $ 3,561       $ 3,560   
  

 

 

    

 

 

 

 

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

In May 2013, Lorillard Tobacco issued $500 million aggregate principal amount of 3.750% unsecured senior notes due May 20, 2023 (the “2023 Notes”) pursuant to the Indenture and the Fifth Supplemental Indenture, dated May 20, 2013. The net proceeds from the issuance were used for the repurchase of the Company’s common stock.

Lorillard Tobacco is the principal, 100% owned operating subsidiary of the Company, and the $750 million aggregate principal amount of 8.125% senior notes issued in June 2009 and due 2019 (the “2019 Notes”); the $750 million aggregate principal amount of 6.875% senior notes due 2020 (the “2020 Notes”) and $250 million aggregate principal amount of 8.125% senior notes due 2040 (the “2040 Notes”), each issued in April 2010; the 2017 Notes; the 2023 Notes; and the $500 million aggregate principal amount of 3.500% Notes due 2016 (the “2016 Notes”), and $250 million aggregate principal amount of 7.000% Notes due 2041 (the “2041 Notes”), each issued in August 2011 (together, the “Notes”) are unconditionally guaranteed on a senior unsecured basis by the Company.

The interest rate payable on the 2019 Notes is subject to incremental increases from 0.25% to 2.00% in the event either Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Ratings Services (“S&P”) or both Moody’s and S&P downgrade the 2019 Notes below investment grade (Baa3 and BBB- for Moody’s and S&P, respectively). As of December 31, 2014, our debt ratings were Baa2 and BBB- with Moody’s and S&P, respectively, both of which are investment grade.

Upon the occurrence of a change of control triggering event, Lorillard Tobacco would be required to make an offer to repurchase the Notes at a price equal to 101% of the aggregate principal amount of the Notes, plus accrued interest. A “change of control triggering event” occurs when there is both a “change of control” (as defined in the Supplemental Indentures) and the Notes cease to be rated investment grade by both Moody’s and S&P within 60 days of the occurrence of a change of control or public announcement of the intention to effect a change of control. The Notes are not entitled to any sinking fund and are not redeemable prior to maturity. The Notes contain covenants that restrict liens and sale and leaseback transactions, subject to a limited exception. At December 31, 2014 and December 31, 2013, the carrying value of the Notes was $3.561 billion and $3.560 billion, respectively, and the estimated fair value was $3.984 billion and $3.872 billion, respectively. The fair value of the Notes is based on market pricing. The fair value of the Notes, classified as Level 1, utilized quoted prices in active markets.

13.    Derivative Instruments

In September 2009, Lorillard Tobacco entered into interest rate swap agreements, which the Company guaranteed, with a total notional amount of $750 million to modify its exposure to interest rate risk by effectively converting the interest rate payable on the 2019 Notes from a fixed rate to a floating rate. Under the agreements, Lorillard Tobacco receives interest based on a fixed rate of 8.125% and pays interest based on a floating one-month LIBOR rate plus a spread of 4.625%. The variable rates were 4.779% and 4.793% as of December 31, 2014 and 2013, respectively. The agreements expire in June 2019. The interest rate swap agreements qualify for hedge accounting and were designated as fair value hedges. Under the swap agreements, Lorillard Tobacco receives a fixed rate settlement and pays a variable rate settlement with the difference recorded in interest expense. That difference reduced interest expense by $25 million in 2014 and $24 million in 2013 and 2012.

For derivatives designated as fair value hedges, which relate entirely to hedges of long-term debt, changes in the fair value of the derivatives are recorded in other assets or other liabilities with an offsetting adjustment to the carrying amount of the hedged debt. At December 31, 2014 and 2013, the adjusted carrying amounts of the hedged debt were $811 million and $810 million, respectively and the amounts included in other assets were $61 million and $60 million, respectively.

 

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If our debt rating is downgraded below Ba2 by Moody’s or BB by S&P, the swap agreements will terminate and we will be required to settle them in cash before their expiration date. As of December 31, 2014, our debt ratings were Baa2 and BBB- with Moody’s and S&P, respectively, both of which are above the ratings at which settlement of our derivative contracts would be required.

14.    Earnings Per Share

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

 

     Year Ended
December 31,
 
     2014     2013     2012  
     (In millions)  

Numerator:

      

Net income, as reported

   $ 1,187      $ 1,180      $ 1,099   

Less: Net income attributable to participating securities

     (4