ProShares Ultra 7-10 Year Treasury
Q3 2008 Earnings Call Transcript

Published: 24 Oct 2008

[Operator:]

Welcome to the third 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 of Investor Relations.

[Mark Rozelle:]

Good morning and thank you for joining us as we discuss our third quarter results. 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 is also available on our website in MP3 format. Hosting the call will be Murray Kessler, Chairman and CEO of UST. Also joining us today will be Ray Silcock, our CFO. At the end of our prepared remarks, Murray and Ray will take your questions. Murray will make a few comments on the status of the agreement announced on September 8, 2008, for Altria to acquire all outstanding shares of UST for $69.50 per share. Other than that, we do not plan on further discussing or answering questions concerning the agreement. The purpose of this call is to review third quarter 2008 results and we ask that all questions be focused on this. 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 also encourage you to read the Other Information section in our release. We will be discussing non-GAAP financial measures in this call. A complete reconciliation of GAAP to non-GAAP financial measures can be found in our press release, which we issued this morning, which I mentioned is available on our website. And just one more thing before we get started. In connection with the proposed acquisition, UST intends to file with the SEC in the coming weeks a proxy statement on Schedule 14-A. Investors and shareholders are encouraged to read UST’s proxy statements and all relevant documents filed with the SEC because they will contain important information about the proposed transaction. I will now turn the call over to Murray.

[Murray S. Kessler:]

Good morning and thank you for participating in UST’s third quarter 2008 earnings call. Given the big news of the quarter, the pending acquisition of our company by Altria, today’s call will be structured a bit differently than our usual call format. I will handle the call and comments in what may be my last opportunity to do so. I am pleased to say that we have good news to report, not just on the progress of the transaction, but also on the continuing good performance of our business, particularly in the face of unprecedented economic head winds. While I will be leading the call, I speak on behalf of my entire team in thanking you for the support you have shown us as shareholders these past few years. But now on to the quarter. As announced on September 8, 2008, we are being acquired by Altria for $69.50 per share. As you heard from Altria yesterday during their conference call, the process for completing the transaction is proceeding smoothly. We have received federal regulatory approval, Altria has committed financing in place, and a special meeting of UST shareholders will be held on December 4, 2008. Assuming shareholder approval at that meeting, Altria expects the transaction to close during the first full week of January 2009 and no later than January 7. I will not be commenting any further on the transaction during this conference call. Details of the transaction are, however, available in the definitive proxy statement which we will mail next week. A preliminary proxy was filed and is available on the SEC website. Where I will be focusing my comments this morning is on business results. In the face of the increased competitive activity, strong economic head winds, higher gasoline prices, the suspension of our share repurchase program, and distraction associated with this transaction, I am very pleased to report that UST

[Operator:]

(Operator Instructions) Your first question comes from Judy Hong – Goldman Sachs.

[Judy Hong:]

Murray, you talked about the sequential improvement in the premium brands as the quarter progressed with your incremental promotional spending. How sustainable do you think is that sequential improvement, especially as we see lower consumer confidence and just the more distressed the conditions for the consumers in the U.S. and whether you are taking any additional proactive steps to provide more value to the consumers.

[Murray S. Kessler:]

Gasoline prices is always something that we track very closely and that is coming down dramatically. As we’re sitting here on the call, it’s down $4 today or something, the price of oil. So that’s gone back to retail good news. I think a second one is that a lot of these competitive new product introductions we faced in the beginning of the year, that challenged us with pipeline and some competitive trial, are all starting to lapse. So if you add up all those new product launches, they probably represented 5 or 6 share points and one of the incremental differences versus a year ago, and if you get into the fourth quarter, that more than cuts in half and as you get into the first quarter it goes down again. But on an ongoing level of performance of those, they haven’t continued to grow. They were kind of one-shot, they got a level of share, and if anything they’ve tailored off since then in the aggregate. So I think that competitive new product pressure that was on us is going to subside significantly. And from our own standpoint, we stepped up the flexible funds significantly in the third quarter and made sure we had stronger programs in place in the fourth quarter and deployed all of those. So we will have stronger promotion plans in the fourth quarter versus year ago. And our PDL to price increases. The gap is closing again, as well. So, you put all those together, and but for the consumer confidence, I would say we were set to have some really very positive growth. But I’m pretty optimistic that we have real strong plans in place going into the fourth quarter.

[Judy Hong:]

And if I look at your PV brands they were up only 3% or so in the quarter, I’m just wondering if you can address what’s happening within your PV brand portfolio as to whether the emphasis on the premium in the quarter sort of left an emphasis on your price value brands in the quarter.

[Murray S. Kessler:]

It is possibly some of that but I think the big issue, Red Seal growth is the same rate now in the third quarter that it did in the second quarter. The issue was Husky and this time last year, if you remember Dan saying that we were putting additional emphasis on Husky. We did a huge distribution drive and built in a lot of distribution and rolled it out in a more national way to be more competitive. And I think that’s part of what’s going on here, is you’ve got some inventory comparisons. If you look at just RAD for quarter, and I don’t know if you noticed, but I gave you just pure quarterly RAD versus that longer 26-week period, and I did it on purpose. So you see the RAD numbers, which aren’t affected by these pipeline and certain timings to the same extent, you see real strong growth on premium and acceleration and sequential share gains during the quarter. And that’s because, I think, that in between the summer delivery, last year we launched new Copenhagen in the last few weeks of September, it was a very late quarter launch, so all the pipeline build was sort of incremental in the category, and I don’t know if you remember or not, but last year we had like 2.5% premium volume growth and very strong price value growth, but if you explore that in the third quarter, and Dan got up on the call and said that underlying we think it’s about 1 point to 1.5 points less than that, it’s more like 1.5% to 1.6% growth on our incremental programs. And I didn’t adjust for any of those. But, to me, what’s really going on with the business is what RAD is saying right now, that our total business take-away consumers, is around less than 2% and premium is a little more than 1%.

[Judy Hong:]

And then in terms of Snus, I know previously you’ve been a little bit reluctant to comment on Snus making any meaningful inroads in the near term. You’ve got Reynolds now rolling out Camel Snus nationwide. Do you think that they’re beginning to gain some traction, maybe faster than you expected? What are your thoughts there for Snus, generally?

[Murray S. Kessler:]

Our Snus test, we put it in and in selected customers it’s doing fine. I haven’t seen any change in trend that would change the opinions I’ve given you in the past. So they obviously see the numbers different than me but it still remains a very tiny piece of the category and I don’t see it building significantly in original markets in any material way. So I’m not saying it can’t over time, I’ve always been a believer, but no, there are no breakthroughs going on right now.

[Operator:]

Your next question comes from David Adelman – Morgan Stanley & Co.

[David Adelman:]

I wanted to ask you three things. First, but for the pending acquisition, would you have promoted during this quarter at a level that generated a 7% year-on-year operating profit decline in the smokeless business?

[Murray S. Kessler:]

I think to be very fair, I think the answer is yes, because here’s the way I see it. Three years ago we ended up sitting back and watching and not being aggressive, and you were one of the people who jumped all over me on that, and sat back and let it turn into a 4% or 5% volume decline over the course of the year, to the point we had to call off earnings and had to reset the entire business. Then we went to this new methodology of a state-by-state plan, being very quick and very proactive. And the result of that is we probably spent back a dime off of retail price over the quarter, somewhere around that, and if you do the math on, you came out into the second quarter growing around 1%. In order to end up flat last quarter you had to be declining 2% or 3% for that final month of June and going into July, and instantly through that investment we were able to correct it, get back the sequential share points that we had lost and get the business corrected rather than going through some major restructuring and pain. So I think that’s more about lessons learned and frankly, when I made the decision to do that spending, I had no idea whether we were going to sign the deal with Altria. We had to make that decision in June or July and we negotiated through the course of the summer and maybe it was going to happen and maybe it wasn’t, so I was making the decisions for the business.

[David Adelman:]

Secondly, help me understand something. Even in the second half of the quarter, when you were clearly spending at high levels, the per-can revenue shows that, the per-can profit shows that. You really only were getting back to premium volume growth and total shipment growth that you were generating without that level of higher promotional spending in the first quarter, and basically last year as well. So I’m just curious, is it because the economy is tougher and the competitive environment is tougher, is that why you’re not performing even then at a higher level than you were previously, in the absence of that higher promotional spend?

[Murray S. Kessler:]

I would say it would be the macro external environment and what was going on with the competition require a higher level of support. I am assuming you are talking about the RAD numbers, which have us about 1 point. The point being that you were growing 1.8 when you weren’t spending that kind of money, but gasoline was $1.50 cheaper a gallon. We had the launch of Red Man, the launch of Grizzly snuff, the launch of Grizzly pouches. So you had those three or four new products. I think it was an unusual period of time. But I don’t view that as a permanent change. I view that as there was a surge against us and we needed to respond with that and that’s not a level we need to maintain as an ongoing. It’s just thinking about it a little differently, to meet it very quickly.

[David Adelman:]

And then if you were not concerned about profitability, for a moment, and the goal and the objective was to generate on Skoal and Copenhagen market share growth, to outgrow the category, for a sustained period of time, how much do you think, on a weighted average national basis, you would need to bring down those products’ average pricing?

[Murray S. Kessler:]

I think Mike was very clear and very open saying that he has a plan in mind and that he will share that plan and we look forward, when we are allowed to, sitting down with them and working through with that plan because he stated that is his goal. But I think that when the transaction is complete he is going to come and share the operating plan with everybody and the good news is, based on the way this thing has progressed with the approvals, you’re not going to wait long.

[Operator:]

Your next question comes from Erik Bloomquist – J.P. Morgan.

[Erik Bloomquist:]

Just wondering if you could drill a little bit into performance of premium. Was there a divergence within Copenhagen and Skoal performance? And also within pouches? And secondly, I was curious if you’re seeing any particular change in terms of consumers, seeing more smokers adopting smokeless or if there’s any change in that dynamic with the category growth being a bit higher.

[Murray S. Kessler:]

Let me answer the Copenhagen/Skoal question. Every brand, so both Copenhagen, the poor portion of Copenhagen came back beautifully and grew nicely in the quarter. The same thing was true, our pouch business was one of the areas we focused on, some of the spending. If you remember, our pouch business slowed a little bit during the second quarter with the competitive new product pouch launches. Swedish Match launched pouches, Conwood launched pouches on both their premium and the PV. And we got back to very strong, I think we were near 20% pouch growth for the quarter, both on an underlying basis and close to that on a reported basis. Skoal came back strongly and our price value brands all responded well. The only one thing I will say is a little different is that the new launch Copenhagen, which Dan told you last time we were not thrilled with the results we’ve gotten from new Copenhagen. That one was a drag on the quarter because you had almost 2.0 million cans of pipeline last year, 1.5 million cans of pipeline last year, and the product hasn’t really performed up to its levels. So new Copenhagen dragged down the total Copenhagen franchise, but the core Copenhagen snuff, Copenhagen long-cut, Copenhagen pouches, were all up beautifully. And the second one was smokers. I have no additional data on smokers over the course of the quarter right now. We get all that usage and diary panel data at the end of the year.

[Erik Bloomquist:]

In terms of what’s happening with the new Copenhagen launch, is that something that we should expect continued promotion on to try and get that to where you think it should be or is that something you think has been necessarily impacted by the competitive launches and will just, as you anniversary those launches, you will see better results our of new Copenhagen?

[Murray S. Kessler:]

The new products, nothing has gone against new Copenhagen in the packaging. The question is, just like everybody else who has a hard time trying to launch a premium brand in difficulty in the compete, we had the same difficulty trying to launch in trying to launch a new premium brand. At the heart of it, I think Dan and the team, they’ve done a beautiful job building the brands and the investment and this was a creative idea but at the heart of it is Copenhagen is rugged, tough, authentic, natural, and I’m just not sure that Copenhagen consumers are willing to accept some flavors. But we’re selling some cans. It’s nothing compared to a new product like Copenhagen pouches, which modifies form and stays true to the core. And I think the good news that you’re also hearing on this call is despite some sort of discussions by some of my competitors relative to the success and the basic Copenhagen snuff category, the Copenhagen snuff business had a good quarter.

[Operator:]

Your next question comes from Christine Farkas – Merrill Lynch.

[Christine Farkas:]

I’m wondering if you can comment just a little bit about regional performance, particularly in the Southeast. Is that where you saw most of the rebound coming in the second half of the quarter?

[Murray S. Kessler:]

It was a broad scale acceleration and performance. That Southeast that I pointed out in the last quarter is a good question. It recovered. I think it would have recovered more because we spent a fair amount of resources down there. But then as it got towards the end of the quarter, that whole gasoline pipeline issue and the hurricanes cost us some inventory. Some of our key retailers, one of them actually shut down 50 to 70 stores in a key area for us, for two weeks. That whole Southeast border, there was no gasoline for a while. So it’s a little bit hard to read. The answer is, it recovered but there is still a drag on performance relative to the rest of the country and remains an area of focus because if I was reporting what the rest of the country did right now, that north of 70% which is growing strongly, you would be pretty pleased with how strong those numbers are.

[Christine Farkas:]

So you are suggesting that the drag from the Southeast is still pretty meaningful?

[Murray S. Kessler:]

Yes, I think that’s fair. It improved and I think it has improved more than the numbers we see, because of what happened with some disruption, so I’m optimistic that we have the right programs there and they have made some fundamental changes to the programming. But, yes, that’s a challenging part of the country. Those are high PV markets.

[Christine Farkas:]

It sounds like it’s difficult to quantify but how much would you say of this drag, per se, would be coming from hurricane disruption and overall economic factors, because we are seeing gasoline prices drop, as you have indicated, so perhaps that sensitivity would improve. But is there a way to quantify how much of the slowdown or the drag in the third quarter, although it sounds like it’s improving, is coming from those factors versus price gaps or other things?

[Murray S. Kessler:]

It’s hard. I would be guessing.

[Christine Farkas:]

With respect to your overall top line in the tobacco business, which was done sharper than we’ve seen in a long time, was the plan kind of done in one shot or as the quarter progressed you saw that the reactions was perhaps not as strong as you had hoped and you picked that up? I’m trying to figure out, as the quarter went through, did you find that your original plans were just not deep enough to recover the share from the second quarter?

[Murray S. Kessler:]

No, it was one shot, defensive. Remember, I didn’t have a lot of time to react because April and May were quite good for the company, June was off. You’ve got about a four-week lead time to get anything reflected at retail. So to be able to affect August and September, you get into one week, two week, three weeks, when we saw June was really an issue. We made a decision to go and to make sure we shored the business up. And that includes additional value packs in parts of the county, some promotions and things that will actually carry through into the fall as well. So, no, it was a defensive planned incremental activity that was very specific in nature. We had sequential share gains all summer long and it’s been a long time since we were actually increasing that share line every month.

[Christine Farkas:]

With respect to SG&A costs in the quarter, were there M&A-related costs that you could perhaps float for us or do you anticipate some of those in the fourth quarter?

[Raymond P. Silcock:]

We had costs related to the Altria acquisition. I think we disclosed approximately $7.1 million of costs in the quarter. There will be added costs when the transaction closes and those will be included in our fourth quarter results.

[Operator:]

Your next question comes from Nik Modi – UBS.

[Nik Modi:]

In terms of convenience store, just generally, did you notice traffic start picking up as the quarter went through and gas prices started to moderate substantially? The second question is the things that retail, this category is pretty inefficient in terms of only about 20% of the SKUs actually make most of the money in the category, I think it’s somewhere in the 70% to 80% of the total profit for the category at retail. How does the retailer think about that situation and do you think that they will become more efficient over time in terms of really shelving the fast-moving SKUs?

[Murray S. Kessler:]

We have spent a lot of time partnering with customers on category management. OTP is so profitable, you know this. You know this as well as I know this. That when you look at the total amount of space most convenience stores have dedicated to it, there is always the big accounts like sheets with really big sections, but you go into most gas stations, most convenience stores, you are talking about a rack with about 20 SKUs on it. And given the level of profitability and the incrementality of how loyal consumers are, whether it’s our brands or others, how loyal they are to their individual cut and flavor, they all make a lot of money. So over time will there be some rationalization? I guess that’s true with every category, but in my personal opinion, there needs to be more space dedicated to smokeless. And that’s still a significant, when you look at total tobacco and how much profitability and how much volume comes out of moist smokeless as a total category, I believe that it’s underspaced. Convenience store traffic. Were you at NACS? I went to NACS, I talked to a bunch of retailers. They were, at the time, all still stinging from the summer of gasoline prices being very high. The Southeast customers, obviously it was a concern because they didn’t even have gasoline at their pumps. But I didn’t hear definitive answers one way or another on traffic. We had a retailer advisory group at our place earlier in the summer and that answer was interesting that they thought traffic was pretty good because gasoline had gotten so high that people weren’t filling up a full tank anymore, they were coming in filling up a half of tank, so they were still seeing folks there. Dan’s not on the call today and he’s closer to that number than I am. I think we can get back with a definitive answer. But I think it had to suffer a little bit.

[Operator:]

Your next question comes from Ann Gurkin – Davenport & Company.

[Ann Gurkin:]

Do you expect any kind of distortion in inventory build in the fourth quarter?

[Murray S. Kessler:]

Let me talk to UST specifically. It is going to go up and down a little bit through the quarter because last year, if you recall at this time, Congress was considering, or had voted and passed, and [inaudible] bill that was passed on to the President for signature. And a number of wholesalers early in the quarter were trying to build a little bit of inventory because they knew the prices were going to go up and it was an opportunity to make some inside margin? And then he vetoed it and it sort of came right back out. So the good news is I think there will be some up and downs within the quarter, but I don’t see any major swings crossing the year.

[Ann Gurkin:]

And on wine, do you have an adequate supply of grapes for 2009, any issues on sourcing grapes?

[Murray S. Kessler:]

No.

[Operator:]

Your next question comes from Andrew Kieley – Deutsche Bank Securities.

[Andrew Kieley:]

How strong do you think brand equity is generally among the PV segment? Theoretically, if we saw price gaps on premium products next year narrow significantly, do you think that there’s brand equity in PV products that’s anywhere near premium, to keep consumers from leaving that segment?

[Murray S. Kessler:]

I think that the brand equity levels for Copenhagen and Skoal are extremely high and given a closure of price gap, if that’s the way it ultimately plays out, I think our brands will perform extremely well. Because brand loyalty aside for other brands, we have done our own quantitative and consumer studies that say that consumers are extremely loyal to our brands and would prefer to be consuming those products. And as an example, Copenhagen snuff, hands-down winner in blind taste tests, given a closer price, are going to want to dip Copenhagen. So I think our products are positioned beautifully for a potential significant investment.

[Andrew Kieley:]

Just reading through the proxy that you put out, it talks about a scenario of new innovative products. I was wondering if that’s anything revolutionary or new versus what you’ve talked about in the past, or if you can give any details on that.

[Murray S. Kessler:]

I’m trying to avoid comments on the transaction, but you’re just talking about in general when it talked about our internal valuation method of a scenario new products?

[Andrew Kieley:]

Exactly.

[Murray S. Kessler:]

I’ve been very clear with that. I think I said that when I stood up at the investor conference, etc. we were trying to wait to see how the regulatory front proceeded but that we were ready to go with innovative products. And nothing has changed in that regard. Obviously, given the transaction, I think we will wait to one, see how the regulatory environment persuades, and then also eventually show those new products to Altria and then we will decide what’s the appropriate next step. But I will stand behind what I’ve said on every conference call in the past, notwithstanding anything that’s been announced in the past few weeks. I don’t believe that any smokeless company has any technology that we don’t and that we couldn’t quickly be able to roll out or launch.

[Andrew Kieley:]

In the wine business, it’s safe to say you’re making some good distribution gains and that’s helping to drive the growth, but within the growth are you seeing any discernable trade down or weakness from consumers in that premium wine segment, that’s affecting things at all?

[Murray S. Kessler:]

Our wine segment? No. I think our wine brands are absolutely perfectly positioned for this economy. If you look at Columbia Crest and Ste. Michelle, especially Columbia Crest, you can buy a 90-rated bottle of wine for $8 to $10 versus having to pay $30 to $40 for a 90-rated bottle of wine. And we sell more 90-rated bottles of wine than any winery in the world. So I think going into this economy, the fact that Columbia Crest and Ste. Michelle consistently show up on every best value list in the country is partially why we are just roaring along through this economy.

[Operator:]

Your next question comes from Mark Cohen – Merrill Lynch.

[Mark Cohen:]

I know you don’t want to talk about the price gap answer to David’s question but maybe you can at least give us some tools to work with so we can understand the price elasticity. So can you put into perspective how much you reduced the average prices on Copenhagen and Skoal in the quarter and what the response of the brands were to those price reductions?

[Murray S. Kessler:]

Yes. I think our realization per can was down about $0.10 for the quarter, something like that. You could do that math on your own. And I think we were running, prior to that, about $0.04 or $0.05 down on just the general promotion. So call it an extra nickel at the wholesale level and you can figure out whatever that passes through to a consumer. And then I told you we came into June and July, the math has to work out that you were down in the 2% to 3% range and it got back up to the plus 1% or 2%, so you had almost a 4 point swing in trend.

[Mark Cohen:]

So it sounds like it’s incredibly sensitive.

[Murray S. Kessler:]

It’s more complicated than I just did but I think you saw a pretty darned good response for our investment this quarter.

[Operator:]

There are no further questions.

[Murray S. Kessler:]

Like I said, everything is proceeding smoothly. I just want to thank everybody for everything from their challenging questions and keeping us on our toes from an analyst community, from support from shareholders. We look forward to closing the deal in the first week of January, which we’re all on track for, and I can speak on behalf of my management team that we’re excited about joining the Altria team and making the acquisition a smash success for them. I think it’s going to do beautifully as part of their company. Thanks for all your support.

[Operator:]

This concludes today’s conference call.