RJ REYNOLDS TOBACCO HOLDINGS INC - 10-Q Quarterly Report

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


(Mark One)
[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

		For the quarterly period ended September 30, 2003

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: 1-6388

(RJRTH LOGO)

(Exact name of registrant as specified in its charter)


Delaware		56-0950247
(State or other jurisdiction of		(I.R.S. Employer Identification Number)
incorporation or organization)

401 North Main Street

Winston-Salem, NC 27102-2866

(Address of principal executive offices) (Zip Code)

(336) 741-5500

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed from last report)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). YES þ NO o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of the latest practicable date: 84,630,268 shares of common stock, par value $.01 per share, as of October 15, 2003

INDEX


		Page

Part I — Financial Information

Item 1.	Financial Statements
	Condensed Consolidated Statements of Income (Unaudited) — Three Months and Nine Months Ended September 30, 2003 and 2002		3
	Condensed Consolidated Statements of Cash Flows (Unaudited) — Nine Months Ended September 30, 2003 and 2002		4
	Condensed Consolidated Balance Sheets — September 30, 2003 (Unaudited) and December 31, 2002		5
	Notes to Condensed Consolidated Financial Statements (Unaudited)		6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		50

Item 3.	Quantitative and Qualitative Disclosures about Market Risk		69

Item 4.	Controls and Procedures		70

Part II — Other Information

Item 1.	Legal Proceedings		70

Item 6.	Exhibits and Reports on Form 8-K		71

Signature			72

PART I — Financial Information

Item 1. Financial Statements

R.J. REYNOLDS TOBACCO HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Millions, Except Per Share Amounts)

(Unaudited)



				For the Three						For the Nine
				Months Ended						Months Ended
				September 30,						September 30,

				2003			2002			2003			2002

Net sales¹				$	1,384		$	1,585		$	4,033		$	4,805
Costs and expenses:
	Cost of products sold^1,2				814			985			2,418			2,843
	Selling, general and administrative expenses				313			348			1,028			1,041
	Restructuring and impairment charges				310			—			365			—
	Goodwill and trademark impairment charges				3,590			—			3,590			—

		Operating income (loss)			(3,643	)		252			(3,368	)		921
Interest and debt expense					25			38			90			110
Interest income					(6	)		(16	)		(23	)		(44	)
Other (income) expense, net					2			2			(4	)		7

		Income (loss) before income taxes			(3,664	)		228			(3,431	)		848
Provision for (benefit from) income taxes					(213	)		89			(121	)		331

		Income (loss) before cumulative effect of accounting change			(3,451	)		139			(3,310	)		517
Cumulative effect of accounting change, net of $328 of income taxes					—			—			—			(502	)

			Net income (loss)	$	(3,451	)	$	139		$	(3,310	)	$	15

Basic income (loss) per share:
	Income (loss) before cumulative effect of accounting change			$	(41.31	)	$	1.58		$	(39.55	)	$	5.76
	Cumulative effect of accounting change				—			—			—			(5.59	)

			Net income (loss)	$	(41.31	)	$	1.58		$	(39.55	)	$	0.17

Diluted income (loss) per share:
	Income (loss) before cumulative effect of accounting change			$	(41.31	)	$	1.56		$	(39.55	)	$	5.64
	Cumulative effect of accounting change				—			—			—			(5.48	)

			Net income (loss)	$	(41.31	)	$	1.56		$	(39.55	)	$	0.16

Dividends declared per share				$	0.95		$	0.95		$	2.85		$	2.775

¹ Excludes excise taxes of $405 million and $457 million for the three months ended September 30, 2003 and 2002, respectively, and $1.2 billion and $1.3 billion for the nine months ended September 30, 2003 and 2002, respectively.

² Includes settlement expense of $500 million and $655 million for the three months ended September 30, 2003 and 2002, respectively, and $1.5 billion and $1.9 billion for the nine months ended September 30, 2003 and 2002, respectively.

See Notes to Condensed Consolidated Financial Statements

R.J. REYNOLDS TOBACCO HOLDINGS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Millions)

(Unaudited)



			For the Nine Months
			Ended September 30,

			2003			2002

Cash flows from (used in) operating activities:
	Net income (loss)		$	(3,310	)	$	15
	Adjustments to reconcile to net cash flows from (used in) operating activities:
		Cumulative effect of accounting change, net of income taxes		—			502
		Depreciation and amortization		118			109
		Goodwill and trademark impairment charges		3,590			—
		Restructuring and impairment charges, net of cash payment		319			—
		Deferred income tax expense (benefit)		(308	)		76
		Other working capital items, net of acquisition		79			(23	)
		Tobacco settlement and related expenses		8			471
		Long-term retirement benefits		107			57
		Other, net		4			(108	)

		Net cash flows from operating activities		607			1,099

Cash flows from (used in) investing activities:
	Capital expenditures			(35	)		(66	)
	Acquisition, net of cash acquired			(9	)		(339	)
	Purchases of short-term investments			(4	)		(504	)
	Proceeds from sale of short-term investments			492			—
	Increases in equity investments			(20	)		—
	Proceeds from the sale of business			6			—
	Other, net			1			17

		Net cash flows from (used in) investing activities		431			(892	)

Cash flows from (used in) financing activities:
	Repurchase of common stock			(72	)		(398	)
	Repayment of long-term debt			(741	)		—
	Dividends paid on common stock			(243	)		(250	)
	Proceeds from exercise of stock options			2			38
	Proceeds from issuance of long-term debt			—			745
	Other, net			—			—

		Net cash flows from (used in) financing activities		(1,054	)		135

Net change in cash and cash equivalents				(16	)		342
Cash and cash equivalents at beginning of period				1,584			2,020

Cash and cash equivalents at end of period			$	1,568		$	2,362

Income taxes paid, net of refunds			$	34		$	(49	)
Interest paid			$	77		$	81
Tobacco settlement and related expense payments			$	1,445		$	1,429

See Notes to Condensed Consolidated Financial Statements

R.J. REYNOLDS TOBACCO HOLDINGS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(Dollars in Millions)


			September 30,			December 31,
			2003			2002

			(Unaudited)
Assets
Current assets:
	Cash and cash equivalents		$	1,568		$	1,584
	Short-term investments			107			595
	Accounts and notes receivable, net of allowance			74			96
	Inventories			649			762
	Deferred income taxes			562			588
	Other current assets			139			289
	Assets held for sale			89			78

		Total current assets		3,188			3,992
Property, plant and equipment, net of accumulated depreciation				891			940
Trademarks, net of accumulated amortization				1,759			2,085
Goodwill, net of accumulated amortization				3,835			7,090
Other assets and deferred charges				508			544

			$	10,181		$	14,651

Liabilities and stockholders’ equity
Current liabilities:
	Accounts payable		$	47		$	60
	Tobacco settlement and related accruals			1,553			1,543
	Accrued liabilities and other			915			1,075
	Current maturities of long-term debt			56			741
	Liabilities related to assets held for sale			11			8

		Total current liabilities		2,582			3,427
Long-term debt (less current maturities)				1,692			1,755
Deferred income taxes				911			1,236
Long-term retirement benefits				1,363			1,176
Other noncurrent liabilities				531			341
Commitments and contingencies
Stockholders’ equity:
	Common stock (shares issued: 2003 — 115,886,311; 2002 — 115,413,501)			1			1
	Paid-in capital			7,420			7,401
	Retained earnings (accumulated deficit)			(2,333	)		1,217
	Accumulated other comprehensive loss			(600	)		(598	)
	Unamortized restricted stock			(22	)		(19	)

				4,466			8,002
	Less treasury stock (shares: 2003 — 31,255,386; 2002 — 29,365,197), at cost			(1,364	)		(1,286	)

		Total stockholders’ equity		3,102			6,716

			$	10,181		$	14,651

See Notes to Condensed Consolidated Financial Statements

Notes to Condensed Consolidated Financial Statements (Unaudited)

Note 1 — Summary of Significant Accounting Policies

Basis of Presentation

The condensed consolidated financial statements include the accounts of R.J. Reynolds Tobacco Holdings, Inc., referred to as RJR, and its wholly owned subsidiaries. RJR’s wholly owned subsidiaries include its operating subsidiaries, R.J. Reynolds Tobacco Company, referred to as RJR Tobacco, and Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe. RJR also wholly owns RJR Acquisition Corp.

The equity method is used to account for investments in businesses that RJR does not control, but has the ability to significantly influence operating and financial policies. The cost method is used to account for investments in which RJR does not have the ability to significantly influence operating and financial policies. All material intercompany balances have been eliminated. We have no investments in entities greater than 20% that we account for by the cost method, and we have no investments in non-consolidated entities greater than 50% that we account for by the equity method.

The accompanying unaudited, interim condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and, in management’s opinion, contain all adjustments, consisting only of normal recurring items, necessary for a fair statement of the results for the periods presented. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. For interim reporting purposes, certain costs and expenses are charged to operations in proportion to the estimated total annual amount expected to be incurred primarily based on sales volumes. The results for the interim period ended September 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.

The condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and related footnotes, which appear in RJR’s Annual Report on Form 10-K for the year ended December 31, 2002. For comparability, certain reclassifications were made to conform prior periods to the current presentation format.

All dollar amounts are presented in millions unless otherwise noted.

Accounting for Returned Goods

During the second quarter of 2003, RJR Tobacco announced a revision of its policy related to returned goods. Previously, RJR Tobacco accepted all damaged and out-of-code-date products. Under its revised policy, RJR Tobacco will accept only returns of unintentionally damaged products. During the second quarter of 2003, all retail returns other than unintentionally damaged products were suspended. Returns other than unintentionally damaged products shipped from wholesalers under the previous return policy, were last accepted during the third quarter of 2003.

At June 30, 2003, the reserve for returned goods consisted of (a) an estimate of returns for unintentionally damaged product and (b) an estimate of returned goods from wholesalers under the previous policy. These estimates resulted in a $54 million reduction of the reserve for returned goods balance as of June 30, 2003, having the effect of increasing net sales $54 million. The change in the estimate of the reserve for returned goods was made in the second quarter, as that is the period that RJR Tobacco’s policy change was effected and announced to its customers. Additionally, returned goods expense was $39 million lower during the third quarter of 2003, for a total of $93 million during the nine months ended September 30, 2003. The change in the returned goods policy benefited net income $0.28 per basic and diluted share during the third quarter of 2003, and $0.67 per basic and diluted share during the nine months ended September 30, 2003.

Notes to Condensed Consolidated Financial Statements (Unaudited) (Continued)

Merchandising Fixtures

Beginning in the fourth quarter of 2002, in response to changes in industry retail display, RJR Tobacco began replacing significant portions of its merchandising fixtures on an accelerated basis that resulted in accelerated amortization. During the second quarter of 2003, it became evident that the scope, extent and timing of competitors’ similar replacement actions were reduced significantly from RJR Tobacco’s original expectations. As a result, RJR Tobacco re-evaluated its practices related to replacement of merchandising fixtures, and determined to reduce significantly any further replacement of its merchandising fixtures and to continue to utilize its current merchandising fixtures to leverage related display opportunities with its customers. Accordingly, the service lives of those fixtures targeted for near-term replacement, which were shortened in the fourth quarter of 2002, have been extended to their original service life. Additionally, the percentage salvageable is higher than previously estimated. As a result, there was no additional book value to amortize on an accelerated basis. Accordingly, RJR Tobacco ceased accelerated amortization. Amortization of merchandising fixtures during the first nine months of 2003 was $55 million, of which $21 million was accelerated amortization. During the first nine months of 2002, amortization expense was $42 million. The change in estimate and resulting accelerated amortization adversely impacted net income $0.15 per basic and diluted share during the nine months ended September 30, 2003.

Goodwill and Trademarks

RJR tests goodwill and trademarks for impairment in accordance with the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 142 on an annual basis or more frequently if events and circumstances indicate that the asset might be impaired. In response to competitive changes in the tobacco industry, RJR Tobacco initiated comprehensive changes in its strategies and cost structure that resulted in a restructuring primarily during the third quarter of 2003. In conjunction with these events, RJR Tobacco tested its trademarks and goodwill for impairment.

The trademark impairment testing indicated that impairment occurred on certain of RJR Tobacco’s brands, primarily WINSTON and DORAL, reflecting RJR Tobacco’s decision in the third quarter of 2003 to limit investment in these brands in an effort to optimize profitability. Accordingly, RJR Tobacco recorded an impairment charge of $326 million, $197 million after tax, based on the excess of the brands’ carrying values over their fair values, determined using the present value of estimated future cash flows assuming a discount rate of 10.5%. This discount rate was determined by adjusting the RJR Tobacco enterprise discount rate by an appropriate risk premium to reflect an asset group risk. This impairment charge is included in goodwill and trademark impairment charges in the condensed consolidated income statements for the periods ended September 30, 2003, as a decrease in the carrying value of trademarks in the condensed consolidated balance sheet as of September 30, 2003, and had no impact on cash flows.

The changes in the carrying amount of trademarks during the nine months ended September 30, 2003 were:


		RJR
		Tobacco			Santa Fe		Consolidated

Balance as of January 1, 2003.		$	1,930		$	155	$	2,085
	Impairment		(326	)		—		(326	)

Balance as of September 30, 2003		$	1,604


¹	Excludes excise taxes of $405 million and $457 million for the three months ended September 30, 2003 and 2002, respectively, and $1.2 billion and $1.3 billion for the nine months ended September 30, 2003 and 2002, respectively.

²	Includes settlement expense of $500 million and $655 million for the three months ended September 30, 2003 and 2002, respectively, and $1.5 billion and $1.9 billion for the nine months ended September 30, 2003 and 2002, respectively.