ProShares Ultra 7-10 Year Treasury
Q2 2008 Earnings Call Transcript

Published:

  • Operator:
    Welcome to the second quarter 2008 UST, Inc. earnings conference call. (Operator Instructions). I would now like to turn the presentation over to your host for today's call, Mark Rozelle, Vice President, [Investor Relations].
  • Mark Rozelle:
    For those who have not seen the release, it is available on our website under the Investor Relations section. This presentation is being webcast live and is available on playback mode. The audio will is also available on our website in an MP3 format, which can be downloaded to a player such as an iPod. Hosting the call will be Murray Kessler, Chairman and CEO of UST. Also joining us with remarks today will be Dan Butler, President of our U.S. Smokeless Tobacco subsidiary, and Ray Silcock, our CFO. At the end of our prepared remarks, Murray and the team will take your questions. In order to help you understand the company and its results, we will be making some forward-looking statements. Accordingly, it is possible that our actual results may differ from the predictions we make today. Additional information regarding factors that could make such a difference appear in our Safe Harbor statement included in our public filings. We will also be discussing non-GAAP financial measures on this call. A complete reconciliation of GAAP to non-GAAP financial measures can be found in our press release, which we issued this morning and, as I mentioned, is available on our website. I will now turn the call over to Murray.
  • Murray S. Kessler:
    Despite a challenging U.S. economy, a significant mid-quarter spike in gasoline prices, and a meaningful increase in smokeless competitive activity, UST exceeded our internal and publicly-stated earnings expectations for the quarter. For the quarter net sales increased 3% versus a year ago, GAAP diluted EPS increased 8% versus a year ago to $0.94 per share, and adjusted diluted EPS increased 5.6% to $0.95, which is above our guidance of approximately 4% EPS growth. A strong earnings performance was the result of a) continued over-delivery of project momentum cost savings, which helped improve operating margins for both smokeless tobacco and wine, b) spectacular wine division results with net sales up 25% and operating profit up 30%, and c) lower shares outstanding, a result of our increased share repurchase activity over the last 12 months. Of note, this strong earnings performance also came despite our premium smokeless tobacco business performing below our expectations for the quarter. So let me provide you my perspective on the premium smokeless volume results. Volume for April and May was solid and on track for our expectations and relative to what we’ve seen over the last year and a half. All of the shortfall occurred in June and all of it occurred in one geographic area. That area, which is characteristically in the Southeast portion of the country, is a lower per capital income and high price value development area, but to be clear, it has nothing to do with the competitive test market in Atlanta where our premium business continues to post growth. What we do attribute the June shortfall to is a significant increase in gasoline prices that drove the average price of gasoline well over $4.00 a gallon, a new threshold. In the area of the country where our business was negatively affected the cost of gasoline now represents as much as 16% of total per capita income. Second, our own promotional timing which also affected the June performance as our brands were off buy-down in June, similar to years in the past, and three, heightened competitive activity in the form of new product launches and I think more significantly, much higher levels of competitive promotional support at the lower end of the market, perhaps taking advantage of our promotional timing. The combined effect of outer reduction and support in the face of higher competitive activity and higher gasoline prices caused the shortfall. From our perspective, we can address these issues but there wasn’t enough time to adjust in the month of June. The promotional timing issue is easily addressed. We need to simply be less predictable. From a support-level prospective, as I’ve said all along, we had anticipated this type of issue and retained and level of flexible spending to deal with it. Although to be clear, we have reset our expectations of the environment we will be operating in for the balance of this year into 2009. As we believe the level of flexible funds that we maintained and which are now being deployed to address the current external environment are sufficient, we are reiterating our previous adjusted earnings guidance of $3.65, with a range of $3.60 to $3.70 and a total shareholder return of 10%. We believe this is another good example of our expanded tool box at work. With that I will turn the call over to Ray Silcock, our Chief Financial Officer, who will cover second quarter financial results in more detail, and Dan Butler, President of U.S. Smokeless Tobacco Company, who will review operational results.
  • Raymond P. Silcock:
    As you have seen from this morning’s earnings release and just heard from Murray, the company continues to exceed its earnings commitments despite the challenging economic environment. Strong Wine results combined with a continued savings from Project Momentum and other cost-improvement efforts helped offset lower than expected premium Smokeless Tobacco volume caused by a soft economy, rising gas prices, and sharply competitive activity. We remain on track to deliver our earnings goals for the year. Before taking you through our Q2 performance in more detail, I would like, as usual, to remind you that I will be referring to adjusted results in my comments this morning. Reconciliations of adjusted results to comparable GAAP measures, along with the rational for why we believe their use is appropriate, are included in this morning’s press release, which is available on our websites. Sales for the second quarter amounted to $506.2 million, an increase of 3% from the same quarter last year. While reported operating income increased 4.4%, to $237.7 million. On an adjusted basis, operating income amounted to $240.5 million, a 2.5% increase over prior year. Reported net earnings for the quarter decreased slightly to $139.7 million, $141.4 million on an adjusted basis principally as a result of higher interest expense related to the increased debt we took on to fund our share repurchase program. GAAP diluted earnings per share were $0.94 for the quarter, or $0.95 per share on an adjusted basis, a 5.6% increase versus prior year adjusted EPS. Note that the 2007 adjustments were $0.02 of restructuring and $0.01 from the sale of our previous headquarters while the 2008 adjustment was $0.01 and resulted from our modifying a pre-existing anti-trust litigations settlement in Wisconsin where we experienced higher than anticipated consumer participation in our coupon program. Turning to our Smokeless Tobacco business, smokeless net can volume grew 1.3% in the second quarter but net sales of $393.7 million were down 1.3% from the same quarter last year, a reduction in net revenue of $0.07 per can to $2.24. This reduction in revenue per can was principally due to the higher growth this quarter of our price-value brands, which were up 9.7% as compared to our premium brands, which declined 0.3%. Increased promotional spending versus the same period last year also adversely impacted our revenue per can. Smokeless Tobacco adjusted operating profit of $228.9 million was up 0.8% as compared to the same quarter prior year. This amounted to a 120 basis point improvement in operating margin versus last year, bringing our operating margin for the quarter just ended to 58.1% and was primarily due to lower SA&A expense, which more than offset the impact of lower net sales in the quarter. Second quarter SA&A was down, primarily due to the continued benefit from Project Momentum as our heightened focus on productivity helped us compete effectively in an increasingly difficult environment and continues to have a strong positive impact on our earnings. In fact, since Project Momentum’s inception in 2006, we have achieved an annual savings rate of $117 million, a significant proportion of which is from the Smokeless Tobacco business. Project Momentum savings from the Smokeless Tobacco business, from reduced corporate expense, and from the Winery, all helped contribute to the company’s overall 5.5% reduction in SA&A this quarter. They also helped offset higher input costs, generally energy related, which we estimate will amount to between $0.02 and $0.03 for the entire year. Of note, we are still on target to reach more than $150 million in annual savings from the Project Momentum initiative by the end of next year. Moving on to the Winery, we had yet another truly outstanding quarter in that business. Case volume was up 20% as compared to the same period last year to 1.5 million cases with net sales increasing 24.7% to $99.1 million. The Winery’s performance was broad-based. We had strong growth across our entire portfolio of brands including Chateau Ste. Michelle, Columbia Crest, Red Diamond, and Erath. Market share increased in the quarter as our strong brands and superior quality wines were recognized by leading wine publications including Robert Parker’s Wine Advocate and The Wine Spectator. As we noted in the earnings release, we received more than 35 ratings of 90 and higher, including a 97 rating for our 2006 Chateau Ste. Michelle late-harvest white Riesling, and a 94 for the 2005 Casolari. Casolari is our vineyard and winery joint venture with Piero Antinori and is based in the state of Washington. We also benefited this quarter from the addition of Stag’s Leap Wine Cellars, which we acquired in September last year. Winery gross profit was $35.2 million in the quarter, an increase of 31% as compared to the same quarter last year. This strong advance in Winery profit was driven by an improved product mix, including Stag’s Leap Wine Cellars and also benefited from higher pricing. These factors, combined with our ongoing focus on cost improvement, helped increase gross margin by 170 basis points to 35.5%. Operating margin roses 60 basis points to 15%. Higher prices, primarily from an increase in the size of our sales force to support expanded distribution, and the impact of adding Stag’s Leap Wine Cellars, offset a portion of the gross margin improvement. For all other operations, principally our international business, net sales were up 5.2% in the second quarter as compared to prior year, to a total of $13.4 million. All other operations operating profit was down 16.9% versus last year to $4.1 million. The decline in operating profit was primarily due to the recent $2.00 per can excise tax increase in Canada. This necessitated our adding to the reserve for returned goods there, since the dollar cost of replacing returned cans, following this increase, will go up $2.00. The excise tax increase is expected to impact UST’s earnings this year by about $0.01 a share and is already included in our earnings guidance. We also continued to use our strong financial position to buy back stock in the second quarter of 2008. We bought 1.3 million shares for $66.8 million, bringing our repurchases for 2008 to 3.7 million shares for a total of $198.7 million, an average price per share of $53.95. It remains our intent to purchase approximately $100 million worth more of stock this year to bring our total stock repurchase to $300 million. I would like to turn now to 2008 earnings guidance. As noted in the press release, we are confirming our earnings guidance for the year. However, in light of our revised view of the external environment, which includes overall economic weakness, rapidly rising gas prices and competitive discounting, we now plan on spending back all our first half earnings over delivery, and some of our 2008 earnings flexibility as well, in order to shore up our Smokeless Tobacco premium volume in the second half of the year, as well as to offset the impact of the Canadian tax increase, and to cover some of the $0.02 to $0.03 per share of import cost increases. So, our strong earnings this quarter notwithstanding, we are still expecting to achieve adjusted earnings per share this year of $3.65, up 5.5% from 2007, with a range of $3.60 to $3.70. To be clear, while I’m sure you can do the math yourselves, the second half of the year is expected to be up approximately 2% to 3%, as compared to last year. So in summary, with a total 5.5% EPS growth versus prior year and a planned dividend payout of $2.52, approximately a 4.5% yield, we remain confident of reaching our shareholder return goal of 10% in 2008. With that I will turn the call to Dan Butler, President of the U.S. Smokeless Tobacco Company.
  • Daniel Butler:
    As Ray noted, the Smokeless Tobacco segment delivered underlying operating growth of 0.8+% versus the prior year as operating margin increased 120 basis points to 58.1% against a net sales decline of 1.3%. Net sales declined despite an overall increase in volume of 1.3% and premium volume was essentially flat and price value volume grew nearly 10%, impacting mix. Continued cost management and savings resulting from Project Momentum initiatives, fueled the growth in operating income and margins. I would first like to provide some color on our volume results for the quarter. Total net can volume for the second quarter was up 1.3% versus year ago, marking 10 consecutive quarters of overall growth. USSTC premium volume was essentially flat, at (0.03%), below our expectations for the quarter. In price value, USSTC volume growth accelerated to 9.7%, behind continued solid growth on both the Red Seal and Husky brands. While our premium volume trends for the quarter did not meet our expectations, it is important to understand that the shortfall is largely due to both timing and geography. From a timing perspective the slow down in our premium volume came during the month of June. In fact, for the first nine weeks of the second quarter, premium volume was up 1.3% versus the prior year. Geographically, the weakness was primarily felt in only one of our five sales regions. That region is characterized by lower average household income and strong price value development. In the remaining four regions, USSTC premium volume grew 1.2% for the quarter, in line with the trends we’ve seen since 2006. We believe the slow down in June is related to several factors. The first is promotional scheduling. As Murray noted, we came off a scheduled buy-down flight at the end of May. Second was an uncharacteristically sharp increase in competitive promotional activity in June that occurred just at the time that we came off deal. For perspective, during the month of June competitive promotional volume was more than double the average level. Thirdly, the rapid run-up in gasoline prices to over $4.00 a gallon that impacted consumers, particularly on and following the Memorial Day holiday. As we have said, we have maintained the financial flexibility to enable us to adjust promotional spending, scheduling, and regional programming. We have already made plan adjustments for the back half of the year, which should return our premium volume to growth as the year progresses. While the second quarter as challenging, we are encouraged that in the majority of the country we continue to deliver solid premium volume growth. Underlying that growth was the exceptional performance of Copenhagen and Skoal pouches, which again posted solid double-digit growth nationally despite strong competitive activity and the launch of new price value pouch products. We expect our pouch growth to accelerate in the third quarter behind the launch of Skoal Straight Pouches, which I will expand upon in moment. On the price value side, USSTC volume growth rate increased in the second quarter behind trends on both Red Seal and Husky. Now for further perspective on volume, I will turn to RAD-SVT data, which is our measure of consumer take-away. I will be reporting on the RAD-SVT results for the full 26-week period ended June 14, 2008. Starting with the category, moist smokeless tobacco category volume growth accelerated to 7.6% versus year ago. Total USSTC volume grew 1.7% versus year ago and USSTC volume share for the period was 57.9%, down 3.4% versus year ago. Importantly, from a revenue standpoint, total USSTC dollar share continues to be very strong at 70%, driven by our leading premium brands, Copenhagen and Skoal. As you know, RAD-SVT reports shipments from wholesale to retail and is therefore impacted by new product pipeline sales and promotional products shifted to retail. Both category growth and USSTC reported share were somewhat impacted by pipeline volume associated with new competitive price value launches and a very significant increase in promotional activity on existing competitive SKUs at the end of the period. This promotional activity, which we believe pushed significant inventory into the trade, may have also put pressure on our shipments as customers worked to manage their cash flow and inventory investments. It will take time to determine how strongly that heavy promotional volume pulled through. Regarding new products, the coming months will provide more clarity on the ongoing source of volume, although past experience and early results suggest that price value items will force volume, primarily from existing price value brands. Now I will turn to performance by segment. The overall premium segment grew 0.6% versus year ago and represent 52.7% of category volume for the period. USSTC premium volume increased 0.3% and our share of the segment was essentially flat at 90.7%. Similar to what we saw in shipments, RAD-SVT indicates that our premium volume challenge is largely confined to a handful of contiguous states. Excluding those states, the remainder of the country, which constitutes the vast majority of our volume, was up 1.2% for the period. Turning to price value, segment volume grew 16.5%, somewhat higher than recent trends, reflecting the previously mentioned new product and promotional activity. The price value segment represented 47.2% of category volume. USSTC price value volume growth increased 8.6% versus year ago and USSTC share of the price value segment was 21.4%. Our Husky brand again grew faster than the segment, while Red Seal continues to deliver mid-single digit growth. As a reminder, while Red Seal is classified as a price value brand for RAD-SVT reporting purposes, we think of it more as a mid-price brand, since it wholesales for nearly 60% more than the leading price value brand. We are very pleased with the solid growth that we have achieved on Red Seal in the last several quarters. So there are several important take-aways from the shipment in RAD-SVT results. First, with oil and gas prices at record levels and economic pressures mounting, the Smokeless tobacco category continues to be a stellar performer within total Tobacco and more broadly, in the consumer packaged goods industry. Second, economic factors were combined in the second quarter with intense competitive activity, which included the launch of a new competitive price value brand, several new SKUs from existing brands, and a spike in promotional activity at the end of the quarter, at levels well above what we’ve typically seen. Third, despite these factors USSTC premium brands have held up well, although we clearly need to adjust our plans to return premium volume to growth in the back half of the year. We are committed to sustaining strong performance in a heightened competitive environment and an increasingly challenging economy. Therefore, as we have in the past, we are taking advantage of our financial flexibilities to adjust our plans and address these issues head on. Looking ahead, we remain committed and optimistic about delivering sustainable premium volume growth in 2008 and the long term. Our optimism traces to our proven business strategy of growing the MST categories by converting adult smokers to smokeless tobacco. In an environment of increased smoking restrictions and increased social pressure on smoker, we believe that strong category growth is sustainable for many years to come. A key component of growing the category to benefit our business is to build our premium brands and continue to lead innovation in the category. To that end we are currently executing a strong integrated consumer promotion for the Skoal brand and on August 4th we will launch Skoal Straight Pouches nationally. The pouch segment continues to grow at double-digit growth rates, is a proven success in attracting new-to-category adult consumers, primarily smokers. The straight flavor segment is the largest in the category after natural and wintergreen, representing 10% of category volume and it consistently grows faster than the category. Furthermore, it is the only major flavor segment not currently represented in the portion pack format. This represents a clear portfolio opportunity for Skoal and its premium innovation will be supported with advertising, point-of-sale consumer sampling, direct mail, trade promotion, and in-store merchandising. We are confident that this exciting new item will provide added fuel for the growth of the category, the portion pack segment, and our Skoal brand. Also on the innovation front, I would like to update you on our approach to the spit-free pouch segment. As we detailed in the past, the concept of a spit-free pouch always scored well with potential adult consumers but the challenge has been to create meaningful awareness and trials and encourage consumers to adopt a new and unfamiliar behavior. In market performance of various test continue to generate only modest share and we have seen no significant change in that performance over the last quarter. Having said that, we believe that it makes sense of us to continue to evolve our brand and product offering and continue to gather learning. To that end, in the coming weeks we will discontinue Skoal Dry in the Austin and Louisville test markets and will launch a limited test market for new Skoal Snoose. This product is the evolution of Skoal Dry that we discussed in our investor conference last December. We have optimized the flavors, the pouch size, the package format, and branding. In blind consumer testing, new Skoal Snoose demonstrated overall preference and stronger overall liking than Skoal Dry and the leading competitive Snoose products. Again, we view Snoose as a challenging and long-term proposition and we are scaling our investment appropriately to efficiently maximize our learning. To be clear, we don’t expect Skoal Snoose, or competitive Snoose products, to meaningfully impact our results in the near future, but we will continue to monitor the segment and we have the capability to scale up rapidly if the market indicates a value-creating opportunity for our shareholders. So, in summary, while we did not meet our expectations for the second quarter, we are optimistic about our business for the back half of the year. We have brand-building promotions planned for the third and fourth quarter and we have made appropriate tactical adjustments to our plan to address the regional and competitive issues that confronted us in Q2. We look forward to the added contribution from Skoal Straight Pouches, which began shipping in August and we remain committed to delivering long-term, sustainable premium volume growth. With that I will turn the call back to our CEO and Chairman, Murray Kessler.
  • Murray S. Kessler:
    So to sum up, in the context of the current U.S. economic headwinds, I believe our business has held up well, especially when compared to the U.S. cigarette market and frankly, to most other CPG categories. Importantly, we have reaffirmed our guidance for the year, even though we are increasing promotional spending to support premium smokeless volume, are absorbing about $0.01 in adverse impact from a significant excise tax increase in Canada, and are also absorbing about $0.02 to $0.03 of higher input costs. I believe we continue to meet or exceed earnings for commitments for a number of reasons. First and foremost, we have tremendous brands with high consumer loyalty. Second, we compete in growing categories that have long-term secular trends that favor both the smokeless tobacco and premium wine categories. Third, our expanded business model provides for a level of earnings flexibility, and finally, I am fortunate to have talented and dedicated employees throughout our organization that continue to meet challenges head on, drive innovation, and deliver superior execution. And with that, we will open it up for Q&A.
  • Operator:
    (Operator Instructions) Your first question comes from Nik Modi with UBS Securities.
  • Nik Modi:
    On the convenience store traffic front, can you just share some perspective on what you guys are seeing. It seems like the category still held at a pretty healthy clip. And then another question on Skoal Wintergreen Edge, can you just give us an update there? And then for Ray on cost savings up side, any thoughts on projects that you guys are reviewing right now?
  • Daniel Butler:
    Regarding c-store traffic, we get conflicting signals on that. I do get industry data on in-store sales, excluding gasoline, and after years of, I would say, strong mid-single-digit growth on in-store sales dollars versus prior years, in the last three months that growth rate has sort of flattened out. So I think the industry is feeling pressure and I think another important dynamic in the c-store industry is just the profit pressures they’re feeling because despite higher gasoline prices their fuel margins are not growing, their credit card fees are increasing, so their profitability as an industry is actually down fairly significantly. And I think that plays to how they manage cash and inventory in the store. Regarding Skoal Edge, we launched that at the end of the first quarter. It was a piece of the promotional spending that you saw in our second quarter this year. Because it was entering into the wintergreen segment, which already has a number of strong competitors who wanted to make strong investments to drive trial, so there was a fair amount of promotional activity, pretty deep discounts, to drive trial. We have seen great response from retailers, we met our distribution objectives, consumer response has been strong, and we feel very good that it appears to be highly incremental and has not impacted our score wintergreen business. So we feel like we’re in good shape.
  • Raymond P. Silcock:
    We are already at that about $117 million annual rate because, you know, we are close to achieving the goal we set ourselves for the year. And while we’re always looking for opportunities, we only have a modest amount built into the balance of the year.
  • Operator:
    Your next question comes from July Hong with Goldman Sachs.
  • Judy Hong:
    Have you seen any signs, as you increase support in the regions that you’ve seen premium volume pressure, whether your trends are positively responding to increase support as well as any changes to the competitive activity after June?
  • Murray S. Kessler:
    The reality of it is, number one, I wouldn’t give you a response of what’s happening in the third quarter. But from a practical standpoint, you know, we got sort of caught with our pants down a little bit in the month of June. We were coming off buy-down, within a similar timing to last year, and from my perspective, it’s not the one factor or the other. It’s not necessarily just gasoline prices or there was new product activity. We knew those things. It was a sharp increase in gasoline prices, a very significant increase in competitive promotional activity, and in order to respond to that, you know, you tend to be out, you know, our buy-down period starts back up probably toward the end of July and in order to get into retailers and make those adjustment, even though we made the adjustments very quickly, you know, they will come as time goes on and as the quarter proceeds. You don’t just flip the switch and it changes in 24 hours.
  • Judy Hong:
    So if you look at regions where the dynamics are similar to kind of the Southeast regions, you know, household income lower, higher price value penetration, what’s happening in those regions, both from a competitive standpoint as well as from a consumer standpoint?
  • Daniel Butler:
    Clearly there are more than just a handful of states that are categorized by lower unemployment, but I think the area where you’re seeing it is where a piece of it is price value development historically has been stronger there and it was where we saw a lot of focus on competitive promotional activity. But just to be clear, there are a number of places in the country, including some where the economy is pressure, where we are performing exceptionally well. So I think we have, the good news about this is you have a problem you can get your arms around and it’s a fairly focused area and we understand what the issues are and we develop things to address it.
  • Judy Hong:
    I’m just trying to understand how much of this issue really is more limited to this particular region and we really don’t see this issue broadening out to other parts of the country, again, from a consumer standpoint, or if you are going to see even more competitive activity emerging in those markets and that you have to continue to increase spending to really protect your share in those regions as well.
  • Murray S. Kessler:
    It’s a fair question but you need time for us to play out. You know, right now we don’t see a lot of pull-through. You know, you and I have had this conversation in the past about Nielsen. I’m not a big fan of the Nielsen data because for our category it covers just a small percentage of the volume. You know, it’s 30% to 40% of the volume. But it’s the sort of the cleanest, purest read on consumer take-away. We didn’t see a downturn at all during the month of June in consumer take-away. So I think we need a little bit more time to even see if that increased promotional activity fell through. Because it was a lot of volume in a pre-packed kind of a format, just shipped into wholesale. So you’ve got to find out first whether it’s just affected inventories and whether it really even, in fact, affected true consumption trend, before you decide whether it’s going to broaden out to other areas. It was just a lot of volume shipped in, and most of it shipped into the Southeast.
  • Judy Hong:
    And just clarification just in terms of your re-affirmation of guidance in relations to what you had projected previously. Basically you are spending more, previously you had anticipated some of the Project Momentum savings to really flow to the bottom line. Now more of that is just going to get reinvested back into supporting these premium brands?
  • Murray S. Kessler:
    What I think is I’ve been very clear that we had talked about holding some flexible funds because we were going into what we saw was a changing external environment with our eyes wide open and because of that I think that explained the difference why the analysts were further ahead of us on our estimate, because we were holding those funds. And I’ve said that every place I’ve gone and in every call, that our business was holding up well but we were concerned with what was happening with the economy and we were going to stick with our forecast. So, in effect, you know, we had the money set aside in case this happened. Had we gone a little further, and we weren’t seeing any change, we would be raising our guidance right now. But you know, we were just well prepared for it. So, it’s not like we’re generating additional savings, we just had a pot set aside in case this happened because it made sense and it was a prudent thing to do. And that’s why we’re protecting our earnings and we’re even doing a little more than I thought because we also covered that Canadian tax excise increase and about $0.02 or $0.03 of additional energy-related costs.
  • Judy Hong:
    If I look at your second quarter of 2007, your premium volume that you reported last year is about .6 million units higher than what you reported today, so I’m just trying to reconcile what that difference is.
  • Murray S. Kessler:
    The difference is, and it’s immaterial and total, but it’s the reason your numbers don’t exactly match. We have a very, very small regional brand called Rooster, which we tried about a year and a half ago to reposition. It was kind of a mid-tier price and we tried to reposition it as a premium brand. That was a failed effort. And it’s a tiny regional brand that has a loyal consumer following and rather than shut that down we repositioned that as a price value brand. So that small amount of volume, for both years, just moved from the premium category to the PB brand. I guess the learning there is even when it’s up it’s hard to launch a premium brand into the category. It just doesn’t work. So that’s the difference.
  • Judy Hong:
    So going forward if we were to kind of think about the base number for premium in the third and the fourth quarters, should we adjust those numbers down by a similar amount as we saw in the second quarter?
  • Murray S. Kessler:
    Yes, I don’t know the exact number but Mark will be able to help you. But, yes, that is correct. Last year’s third and fourth quarter premium number will be slightly lower because we moved the Rooster brand. You know, it’s tiny but it does mess up your model a little bit, I guess.
  • Operator:
    Your next question comes from Felippe Goossens with Credit Suisse.
  • Filippe Goossens:
    My first question is both for Murray and Ray. Ray, for the last couple of quarters you have alluded to the very strong performance of your Wine business. You’ve also stated in the past, particularly Murray has stated this, that it is part of many of the tools that you have in your tool kit as to deliver shareholders’ value. Yet, the fact that you stress the solid performance of that Wine business, should we read into that that Wine perhaps is becoming a little bit more important in your overall portfolio going forward?
  • Raymond P. Silcock:
    I think Wine is a growing business and because it is growing at a faster rate than the Smokeless Tobacco business it is being a larger piece of our portfolio but it is still a modest amount and it still represents, in terms of total earnings for the company, it represents a modest proportion. However, I think the point that was being made this morning was that the Winery division had a really spectacular quarter, despite the economic circumstances, and continues to perform extremely well.
  • Murray S. Kessler:
    We’ve always been clear, we like the Wine business and we view it as clear. We’ve been it for 25-30 years and at the rate it’s running it’s going to be 20% to 25% of the company’s sales by the end of the year. So it’s an important business and it’s performing spectacularly.
  • Filippe Goossens:
    Then, Murray, historically you have kind of downplayed the relevance of gas prices on the Smokeless business. Needless to say, over the last quarter the magnitude, as well as the velocity, of the price increases were unprecedented. Based on the data that you have currently available, would you say that the price elasticity of the demand is perhaps starting to change a little bit for Tobacco as well?
  • Murray S. Kessler:
    It’s hard to tease apart, they all hit at the same time, right? The gasoline prices had gone up into the mid-$3.00s sometime last year then came back down to the mid-$2.00s and then earlier in the year got back up to the $3.00 level and we kind of knew that going into the year and that’s why we set aside some flexible funds. But we didn’t see any impact to our business. I think Dan, on the last conference call, had classified that that was not a price they had not seen before and sort of they had gotten used to it to some extent. What you had happened this quarter was a whole new threshold going up another dollar up to the mid-$4.00s. But it’s still very hard, on a short amount of time, since this happened within weeks ago, to say that it was the spike in gasoline prices. It makes sense because the worst hit markets are where total gasoline, if you look at it as a percentage of per capita income, is the highest. I mean it’s up to 15% to 17% of total per capita income in some of these states we’re talking about. Having said that, there are other states that have just as poor per capital income and our volume grew during the quarter. So if I’m leaning to the thing that changed the most, it’s not the competitive new products, they have a lot to prove to say that they’re going to be incremental. They’ve sold, but if you look at sort of the incrementality of those brands, I think there’s a, from my perspective, we would have been fine with just that, again I’m not sure we’re seeing a lot of incrementality relative to what their previous businesses were. The part that changed the most was a very significant increase in promotional support. And we have to gauge that. Was that tactical, was that defensive, is that ongoing and if it’s ongoing how do we respond to that going forward? But in general, the beauty of our plans is they’re state-by-state plans and we adjust and we sort of know what it takes and we’re confident that we have the right mix right now. We just need to quickly adjust and it takes a little bit of time.
  • Filippe Goossens:
    The 7.6% category growth, definitely better than what was expected. If you were to tease out the impact the promotional activity that Murray just referred to, how do you think the category growth would have been? The reason I am asking this question is this morning Imperial put out a trading update and they basically said within the U.S. cigarette market they thought that the overall category performance was again moving towards the long-term historical trend. In other words, improving somewhat from what we’ve seen recently. So I’m just trying to see if there’s any change in the overall outlook for product category when compared to the dynamics in the cigarette markets.
  • Daniel Butler:
    Well, I don’t know about relative to cigarettes. I can tell you the 7.6% we reported, as I mentioned, I think that was impacted by pipeline fill for a new competitive brand and some new competitive SKUs and I think it was about equally impacted by a promotional push in the last four-week period of that 26-week RAD period. So, when you’re doing those types of pre-pack promotions like Murray talked about, you sell them and you push them out to retail and then it takes some time for them to pull through. Well, RAD is measuring the push out to retail. So, to make a long story short, if you take out the combined impact of new product pipeline volume and the above-normal amount of promotional volume we saw at the end of the period, we think the category growth probably would have been closer to 6.5% as opposed to the 7.6% that was reported. And that’s pretty much in line with what we’ve seen more recently. Now we’re half way into the year the category is up 7.6% for the 26 weeks and we now believe full-year category growth is probably going to be 6% to 7% versus the 5% to 6% that we had previously forecasted.
  • Filippe Goossens:
    The $0.01 to $0.02 from higher input costs, all of that is distribution related?
  • Raymond P. Silcock:
    Not all of it. A significant portion of it is some of it’s related to increased plastics costs for our cans, for example. But a significant portion of the increase is due to energy and arguably most of the increase is related to oil price increases.
  • Operator:
    Your next question comes from David Adelman with Morgan Stanley.
  • David Adelman:
    First, can you quantify the magnitude of your intended second half promotional spending increase?
  • Murray S. Kessler:
    I don’t think we would do that for competitive reasons, but it’s not our intent to engage in some kind of price war. It’s to go back to where we were, to make the adjustment so that premium volume is growing in line with sort of our steady-state plan that we’ve been working on over the past few years.
  • David Adelman:
    And the secondly, how do you assess the risk or the possibility that if the current market trends continue for some period, that the premium segment becomes almost marginalized with consumers? Discount is now over 47% of volume.
  • Murray S. Kessler:
    I still say, I’ve probably worked on 20 consumer packaged goods categories and we’re still low. I mean, as a percentage of total volume that’s promoted, we’re much lower than the cigarette category, we’re much lower than most of the categories I’ve ever worked on in my career. We’re getting up to kind of normal levels. I think we’re sort of the typical average promotional brand to be up at around 47% is probably a more normative level and I’ve worked on brands that are as high as 70% to 80%. So I don’t think we’re in that kind of state. We’ve just come from a period of time where we enjoyed a number of years where we were so far below the average and in a more competitive market we’re behaving a little more like a typical CPG brand.
  • David Adelman:
    I’m sorry, Murray, I mean it in a different way. I think you were referring to the percentage of your volume that you’re doing some type of promotion on. I mean something else. I just meant that 47% of the categories total volume now is discount brands. In the last quarter alone I think discount share was up sequentially 150 basis points. Granted there’s some unusual dynamics going on in the market place. You probably aren’t going to have incrementally this level of new product and competitive activity at the low end. But do you think there’s an issue there that the premium category, over time, could, I don’t want to exaggerate and say become a niche element of the category, but how do you think about those issues? And also, how do you think about the need to be substantially more promotional at an obvious adverse impact to profitability in the short term to retain premium share where it is?
  • Daniel Butler:
    I think the good news is we compete in a growing category and thank goodness that continues to be the focus of the company. Because we’re not talking about declines in our volume, even in our toughest state here, our volume was flat. Your notion of the different categories, the categories are starting to break out into different price segments, too. You’ll have price segments that around $3.00, there’s like 7 or 8 share points of that category with Red Seal that are much closer to a premium price product than they are to a price to the sub-value products. And you would probably feel differently if I added the 7 points to the premium side but we have brands that we’re counting in premium that sell below Red Seal, like the Snoose product. I think that’s always a good question, but our challenge is to continue to grow our business and in 85% of the country, in sort of the worst set of circumstances, we continue to do that. We just need to adjust for that 15%.
  • David Adelman:
    And then lastly, on the Wine business, what’s the risk that the economy starts affecting that segment, particularly on the restaurant side?
  • Murray S. Kessler:
    I think it has started to affect the restaurant side. I think you are getting a little bit of channel shifting there. But the beauty of our brands, we have wonderfully spectacular brands like Stag’s Leap and Casolari, they’re very high-end, but the core positioning of Ste. Michelle Wine Estates, the beauty of it is it actually is favored by this current economy because we are an incredibly highly-rated brand at a great value. So you’re looking at the Columbia Crest and Chateau Ste. Michelle line, you’re buying 90-rated bottles of wine for $11 to $13. I think that’s helping to accelerate sales and drive sales. We’re on almost every best-value rating chart there is.
  • Operator:
    Your next question comes from Christine Farkas with Merrill Lynch.
  • Christine Farkas:
    Back to the regional dynamics. With an understanding that the Southeast consumer may feel especially squeezed and that promotions there in that region are probably higher in general than you see across the rest of the country, did you see a step up there in promotions beyond what occurred across the country? Was it highly skewed to that region or were they just more sensitive to promotions?
  • Daniel Butler:
    I think the answer is yes, the promotional activity that we saw, and it was a national phenomenon but it was very disproportionate in that segment of the country. And that’s also sort of spending behind where price value share is higher for those brands. It was competitive promotions on both medium and price value brands but it was multiple brands that all hit about the same time, so from a competitive, promotional standpoint it was a little bit of a perfect storm. But yes, it was disproportionate increase in the Southeast and represented a very significant portion of total category volume in the month of June.
  • Christine Farkas:
    And I don’t expect you to give guidance or comments about the third quarter, but as you moved into July and some of these inventory factors may or may not have reversed, can you talk a little bit about what you might see, given some adjustments to your own program and inventory moving through the trade? Are you seeing some reversal of those trends?
  • Murray S. Kessler:
    Yes, for sure. But without being specific, but I also don’t want to set expectations that, as I said earlier to somebody’s question, that this is a switch we just flip. So we would be more conservative to say it was flat in the second quarter, it will be kind of flattish in the third quarter and we’ll get it going as the year progresses. And it’s so hard for me to say that. I tend to take a conservative look on things. But we have adjusted our plans, they will get up and running, and we should be back into growth as the year goes on.
  • Christine Farkas:
    And some brands that are out there now that are positioning themselves or calling themselves premium but really discounting to a much lower level, do you get the sense that those price levels are more permanent or will they actually ultimately come back to the premium level pricing?
  • Daniel Butler:
    Other than Kodiak, which is the other real true premium brand out there, and they’re promoting and trying to put life back into that brand, but the ones I’m referring to are on tiny cat markets. I made a comment in my actual formal comments that I didn’t want anybody to mistake that what happened in the Southeast had anything to do with Atlanta. Our volume grew and grew at a normal level in that one test market despite that product being way down. So it certainly has nothing to do with that. And a number of the Snoose products have taken their prices down as well and are well below the price of Red Seal as an example, which is a high-margin brand growing faster than category at this point.
  • Christine Farkas:
    And back on Canada and I know you’ve absorbed the $2.00 in Can excise tax there. I just want to understand that you do intend to take pricing up in Canada to offset that hit?
  • Murray S. Kessler:
    Yes, it is a federal excise tax so it hits our costs and if definitely will be passed through. It will result in a $2.00 increase per can. It’s an unfortunate tax increase that we continue to argue our case with the Finance Minister. We think it’s terribly unfair because in essence it’s an air tax. They haven’t officially raised the tax but they’ve put in a minimum can size so they’re just taxing you for product that doesn’t even exist. We’re in a 15 gram can in Canada and I the tax as been set as 50 grams. So you’re paying tax on 50 grams of tobacco but you’re only selling 15 grams. Again, we think that’s terribly unfair, it obviously raises the price a couple of dollars and we had a second quarter impact of that on the returned goods allotment accrual we have to establish for that because we’ll be taking them it at the higher price. But going forward the $0.01 that Ray is primarily talking about is the volume impact, it’s just a small portion of our business.
  • Operator:
    Your next question comes from Ann Gurkin with Davenport & Co.
  • Ann Gurkin:
    Just a couple of questions. You actually have reserved extra funds to use against the competitive environment. Do you have anything left in your war chest, tool box, after what you’ve talked about today?
  • Murray S. Kessler:
    We obviously do by the nature or the way we have some upside, where there’s downside there’s upside and we haven’t changed the range. Yeah, there’s room to make additional adjustments.
  • Ann Gurkin:
    Where are you producing Snoose?
  • Murray S. Kessler:
    Same place we produced it before.
  • Ann Gurkin:
    What is your outlook for the premium volume in the second half of the year?
  • Murray S. Kessler:
    I think we’re saying right now, I guess at the end of the first half now it’s closer to 1% growth. We’re calling it about 1% for the year at this point. If I had to guess, it would probably be a little less than that in the third quarter and a little more than that in the fourth quarter. Taking out the extra week last year in the fourth quarter.
  • Operator:
    Your next question comes from Sanket Patel with Greenlight Capital.
  • Sanket Patel:
    If look at your earnings guidance for the year and back out what you’ve achieved in the first half it implies $1.86 for the second half of the year. Can you help us understand what we should expect for the third quarter versus the fourth quarter.
  • Murray S. Kessler:
    We don’t provide guidance by quarter.
  • Sanket Patel:
    Is there any reason to believe that I should not assume like a rough split between the two?
  • Murray S. Kessler:
    The only slight variation, and I’m not sure there is a reason there would be much difference but one slight caveat is that last year was an unusual year where we had a 53rd week. But having said that I think your way of thinking about it is correct.
  • Sanket Patel:
    Dan, you mentioned the competitors that increased promotional sales in June. Can you tell us which competitor that was and what their activity has been like so far in July?
  • Daniel Butler:
    I think that’s probably a better question to ask them but it was not just one competitor, it was several different brands and a lot of activity. And I don’t have market place data for July yet.
  • Murray S. Kessler:
    It doesn’t help us anecdotally what we hear. When we are able to dissect that is when we get the July raw data and the August raw data and we don’t have that yet.
  • Sanket Patel:
    Was it new competitors in the market place or just existing competitors increasing promotional sales?
  • Murray S. Kessler:
    June was a story, basically, of existing brands coming back in and promoting hard. And as I said, the impact of that on the reported numbers in the quarter was about equal to the impact of new brands that were introduced in the mid-part of the first half of the year. So you had about equal impact, I would say, from competitive new product pipeline volume on the raw results as well as competitive promotional volume at the very end of the period.
  • Sanket Patel:
    Dan, I was wondering what the average lag between sell-into-retail and then sell-to-the-final-customer is for the product?
  • Daniel Butler:
    I think that depends on how compelling the value and the consumer proposition and the branding is. You know, sometimes you can push, and we’ve seen in this category a lot of times, people will come in with very low priced brands, unknown brands, and push out a whole lot of promotional volume and it sits there. If you’ve got a good brand and good value proposition, it can move through fairly quickly. But it’s not something measured in days. It takes weeks or if it’s bad it can take months.
  • Sanket Patel:
    What do you think your corporate average is?
  • Murray S. Kessler:
    Our promotional sells through very quickly but we have to schedule them. To put this in perspective, the amount of volume promoted, it’s a resist-type of tactic versus buy-downs which pull through on existing every day shelf stock. It’s more than we would typically do in our biggest promoter period and we’re a big brand. We’re more than half that category so it was a big number. So we are very cognizant of selling brands or promotions that would sell through very quickly because we have dated product, especially when it’s Copenhagen, which is a 30-day dated product. So, in general, our promotions tend to sell through within a week or two. They’re set up to go broadly and sell through very quickly so they don’t disturb our regular stock. It’s hard to say. This was a lot of promotion.
  • Operator:
    Your last question comes from Andrew Kieley with Deutsche Bank.
  • Andrew Kieley:
    Murray, on the competitor promotions can you tell us, did you really start to see a pick up in June or was it sort of throughout the quarter that you noticed a pick up?
  • Murray S. Kessler:
    All June.
  • Andrew Kieley:
    Just in June?
  • Murray S. Kessler:
    Right. But the new product activity was throughout the quarter. Again, when you’re trying to dissect it, we were doing fine with the competitive new product activity. That wasn’t disrupting our business at all. It was a very big push in June. But having said that, so was this hike in gasoline prices and so was our own promotional timing.
  • Andrew Kieley:
    Were there any specific new competitor products that you saw sort of siphoning off premium consumers or was it more just the broad-based price discounting? Were there any one or two new competitive products that really had an impact?
  • Murray S. Kessler:
    Nothing that we hadn’t seen. These new products that had rolled out had done it in waves. They had initial markets. Nothing behaved unusually different. And again, I’m not here to talk about our competitors’ brands but it didn’t look like a whole lot of incrementality to the PB segment from those. As Dan said, if you pull out that pipeline volume that really hit towards the end of the quarter I think you see some different numbers. The question is how much did that affect us versus gasoline prices and some of the other factors.
  • Andrew Kieley:
    On some of the newer products that you’re going to be launching like the newer pouch products and Edge, any reason for us to expect a big margin differential on those kinds of products versus the traditional Skoal or Copenhagen product?
  • Murray S. Kessler:
    No. And you point out pouch and it’s actually an interesting one to look at because we had a lot of competitive new product activity in pouches and our pouch business accelerated back up to double digits in the second quarter so clearly our brands performed well through that.
  • Andrew Kieley:
    Ray, could you give, on the Wine business, the organic growth, if we strip out the Stag’s Leap, what the volume was or what the revenue was.
  • Raymond P. Silcock:
    The net sales growth, excluding Stag’s Leap, was 20%.
  • Operator:
    There are no further questions.
  • Murray S. Kessler:
    Thank you for your continuing interest in UST and we look forward to talking to you at the end of the third quarter.

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