ProShares Ultra 7-10 Year Treasury
Q2 2007 Earnings Call Transcript

Published: 27 Jul 2007

Operator:

Good day, ladies and gentlemen. And welcome to the second-quarter 2007 UST Inc. earnings conference call. My name is Tolisha and I will be your operator for today. At this time all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference (Operator Instructions). As a reminder this conference is being recorded for replay purposes. I would now like to turn the call over to your host for today, Mr. Mark Rozelle, Vice President, Investor Relations. Please proceed, Sir.
Mark Rozelle:

Thank you for joining us this morning as we discuss our second-quarter 2007 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 in playback mode. The audio will also the available on our web site in an MP3 format, which can be downloaded, to a player such as an iPod. Hosting the call will be Murray Kessler, President and CEO of UST. Also joining us with remarks today will be Jim Patracuolla, our Principal Accounting Officer, and Dan Butler, President of U.S. Smokeless Tobacco. 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 segment included in our public filing. We will also be discussing non-GAAP financial measures in this presentation. A complete reconciliation of GAAP to non-GAAP financial measures can be found in the press release we issued this morning. I will now turn the call over to Murray.
Murray Kessler:

Good morning. And thank you for participating end UST's second-quarter earnings call. In the second quarter UST once again continued to build momentum. From my perspective we had an excellent quarter. Importantly, the Company made progress on all of our strategic initiatives during the quarter including accelerating profitable volume growth, continued strong moist smokeless tobacco category growth; increasing the Company's competitiveness, state excise tax equity, Company wide innovation, project momentum cost savings, improving winery returns, building a world-class organization and rewarding shareholders. I will provide some perspective on each of these. Then Jim Patracuolla, our Principal Accounting Officer, will review overall financial results and Dan Butler, President of USSTC will review Smokeless Tobacco Company results in more detail. We'll take questions at the end of our prepared comments. So let's get right to the highlights. First once again UST grew at both top and bottomline in the second quarter. Net sales grew 3.9% versus a year ago and adjusted diluted EPS, as shown in the adjustment table of the release grew 8.4% versus a year ago to $0.90 per diluted share. Relative to our internal forecast, net sales came in slightly above expectations and adjusted diluted EPS was well above the 1% to 3% guidance, we had previously communicated. Second, UST's topline benefited from volume growth in all of our operations. Revenue at our Ste. Michelle Wine Estates subsidiary was up 28%, U.S. Smokeless Tobacco Company was flat and all other operations increased 8%. Robust winery sales reflect the incremental benefit of the Antinori distribution agreement and the Erath acquisition both completed mid last year combined with a 10% volume increase in our core business, which is attributed to continued innovation, distribution gains, and strong acclaim. Flat revenues on USSTC came behind a 1.5% increase in premium net unit volume and a 2.5% increase in total net unit volume, which was offset by planned additions in the premium-based loyalty program that continue to increase the Company's competitiveness. We are obviously pleased to see sustained premium volume growth above our 1% growth stated goal for the year. Third, the categories we compete in continue to show strong growth. Total moist smokeless tobacco category of growth for the 26 weeks ending June 16th per RAD-SVT was up 7.2%, slightly above our forecast. Total price value segment category growth has moderated, now growing around 15%. In the super and ultra premium wine segments combined, where we primarily compete, the category remained strong, growing around 13%. Worth noting within that segment our winery -- Ste. Michelle Wine Estates was the fastest growing top-10 winery during the quarter in the U.S. Fourth, one of the significant benefits of our strategic initiative is that USSTC has made significant progress in stabilizing its category share. USSTC total market share for the 26 weeks ending June 16th, 2007 was 61.2% basically flat versus the 61.3% for the 26 weeks ending February 24, 2007, we reported on at the end of the first quarter. In fact, USSTC market share has been essentially stable on a sequential four-week period basis since last October. While we continue to believe we will see some additional share going forward, the trends have improved dramatically providing further evidence that our premium loyalty plan has been effective. Fifth, we continue to have success on our state excise tax equity initiative. Delaware passed legislation converting moist smokeless tobacco from an ad-valorem to a weight-based tax structure during the quarter. This is the fifth state to convert to weight base in the last 12 months. Sixth, the big news on innovation for the quarter was the announcement of our new Cope subline, which will begin shipping in September. This initiative is designed to broaden the appeal of Copenhagen to more adult smokers. Dan, will provide details shortly. Seventh, project momentum cost savings continue to come in ahead of plan, contributing to our over delivery of earnings and improvement in operating margins in the second quarter. UST's adjusted operating margin increased from 44.4% in the first quarter to 47.7% in the second quarter. Smokeless tobacco adjusted operating margins were actually up 190 basis points year-over-year for the quarter. Based on our competence in delivering our original ongoing run rate of $100 million plus in savings and additional work done on identifying Phase II savings, we are raising the project momentum cost savings target by $50 million to $150 million plus still within the original three years. The additional savings will come in 2008 and 2009 and obviously, contribute to the Company's ability to deliver its 10% shareholder return goal on a consistent and sustainable basis over the long-term. Eighth, in regards to building our organizational strength, we also announced within the last few days that Ray Silcock has joined the Company as Senior Vice President and Chief Financial Officer effective August 6th. Ray is a seasoned professional having just recently completed the Swift transaction in his brief stint as CFO. He previously was CFO for seven years at Cott Corporation, where he helped build considerable shareholder value. Besides his strong accounting treasury and tax expertise, Ray brings particular strength and financial strategy to UST. I look forward to him being a true business partner going forward as we continue to build value for UST shareholders. Ninth, speaking of rewarding shareholders, the Company continued to return cash in the form of a strong dividend in share repurchases. During the quarter the Company repurchased $70 million of stock, which was a combination of our original $50 million guideline plus an additional $20 million from the $100 million we had added to this year's share repurchase program, utilizing the proceeds from the sale of our Greenwich headquarters building. We had originally communicated that we would be spending the additional $100 million in the back half of the year but decided to accelerate that timing as we believe the stock is a particularly good value, given the recent pullback that is clearly not related to our business fundamentals, which are obviously very good. After that report card on our key strategic priorities, I hope you can see why we are bullish on the business and remain confident in our ability to deliver consistent and sustainable growth over the long-term. We believe we are truly building momentum. Therefore, we are also once again raising our adjusted diluted EPS target and the range. Our new adjusted diluted EPS target is $3.35, an increase of $0.03 with a new range of $3.30 to $3.41. This projection still allows considerable financial flexibility to adjust to any meaningful changes in the competitive environment of which, to be clear, there have been none so far this year. So there is a potential for additional earnings upside. Having said that we're also considering several incremental brand-building investments that would even further build momentum on the smokeless tobacco business. So for now we would encourage you to stick with our $3.35 adjusted diluted EPS guidance. And with that I'll turn the call over to Jim Patracuolla, our Principal Accounting Officer.
Jim Patracuolla:

Thank you, Murray. And good morning, everyone. As Murray stated, the company continues to build momentum as it implements strategic plans, which are designed to deliver consistent and sustainable long-term volume driven profit growth. This is evidenced not only by the strong second-quarter financial results, but also by the fact that we are again raising guidance for the year. Before I begin taking you through the second-quarter results in more detail, I'd like to remind you that at times I will be referring to adjusted results in my comments. Reconciliations of adjusted or underlying figures to the comparable GAAP figures, as well as why we believe the use of such measures is appropriate is included in this morning's press release which, as Mark mentioned, is available on our website. Let's begin with UST's consolidated second-quarter results. GAAP net earnings increased 3.9% to $140 million and diluted earnings per share increased 4.8% to $0.87. GAAP results were affected by the following items, which negatively impacted diluted earnings per share by $0.03 during the quarter; $0.02 of restructuring charges associated with Project Momentum; and a $0.01 impact due to the amortization of imputed rent associated with the sale of our Greenwich headquarters building. As I noted last quarter, the charges related to be imputed rent are a byproduct of the structure of the sale of our Greenwich headquarters building. As you'll recall, the total consideration we received for the building, which was the basis for the after-tax gain of $66.5 million or $0.41 per diluted share recognized in the first quarter, included the sales price of the building of $130 million and the imputed fair market value of a below-market short-term lease of $6.7 million. Even though the company is not paying any rent to remain in its Greenwich headquarters until its September relocation to Stanford, the imputed portion of the consideration is effectively being accounted for as a prepaid rent and amortized to expense. Therefore the portion of the gain on the sale that was attributable to the imputed fair market value of the lease and this amortization expense will offset each other by the and of the third quarter. And the full-year impact from the sales transaction will be the $0.39 we previously communicated. The after-tax impact of the amortized rent in the second quarter was $1.8 million or $0.01 per diluted share. Excluding the restructuring charges and the imputed rent amortization, adjusted net earnings were up 7.1% to $144.2 million and diluted earnings per share were up 8.4% to $0.90, significantly ahead of the 1 to 3% increase noted in our previous guidance. These adjusted net earnings and diluted earnings per share increases were driven by and reflect overall net sales growth, increased operating profit in both the smokeless tobacco and wine segments, as well as our international smokeless operation, improved operating profit margins in the smokeless tobacco segment as a result of cost savings associated with Project Momentum, slightly lower operating profit margins in the wine segments reflect the increased promotional spend, a lower effective tax rate and lower net interest expense. These items were partially offset by higher unallocated corporate expenses. The increase in diluted earnings per share also reflects the positive impact of shares repurchased under the company's buyback program. Now I'll take you through each of these elements in a bit more detail. First, from a topline perspective net sales for the quarter were $491.3 million, up 3.9% compared to the second quarter of 2006 primarily driven by the wine segment. Smokeless tobacco segment net sales were flat as both a 1.5% increase in premium and a 2.5% increase in overall net unit volume offset the incremental costs associated with execution of the premium brand loyalty plan, focused on improving our competitiveness at retail. Dan will provide further detail on the second-quarter growth in smokeless unit volume later in the call. Turning to the winery. Net sales were up more than 28% on a 19.5% increase in premium case volume. This marks the third consecutive quarter of sales growth exceeding 20%. This strong growth was driven by the third-quarter 2006 additions to the portfolio Antinori and Erath and an 11% sales increase in the core brand. Turning to bottom line operating performance. On an adjusted basis, consolidated operating income for the second quarter was up 3.9% to $234.4 million, driven by and reflecting the impact of sales growth, a 1.1% increase in gross margin dollars and a lower SA&A expenses, much of which can be attributed to continuous savings for Project Momentum. Looking at the components of operating income, the smokeless tobacco segment's adjusted operating profit was up 3.4% to $227 million, driven by lower administrative spending primarily due to Project Momentum. Continued focus on cost management, which resulted in a 10% decline in administrative expenses has allowed the company to reallocate resources to grow premium unit volume and at the same time increase the adjusted operating profit margin by 190 basis points versus year ago to 56.9%. The wine segments operating profit increased 19.7% to $11.2 million on its continued strong topline growth; partially offset by higher costs associated with promotional spending behind the Antinori brands and increased headcount attributable to the expanded distribution of our wine. A combination of these factors led to a 1 percentage point decrease in operating margin to 14.1%. Operating profit for all other operations consisting of our international smokeless tobacco operations was up 26.4% to $4.9 million, driven by increased unit volume, foreign currency translation gains, and lower spending. Unallocated corporate expenses, as adjusted for the rent amortization, the final component of operating income increased $1.6 million to $8.8 million in the second quarter primarily resulting from additional charges recorded in connection with a previously announced separation in executive management. The organization continues its focus on identifying operational efficiencies and cost-savings opportunity under its Project Momentum initiative. As demonstrated by the operating income result the second quarter, as well as the six-month period, was favorably impacted by the cost savings attributable to Project Momentum. These savings were favorable to our plan as all initiatives are well into implementation. The company has also finalized plans on various other initiatives expected to generate $50 million in additional savings beyond the initial $100 million target we had committed to achieving. These savings are expected to be realized in 2008 and 2009 and will be generated from initiatives associated primarily with our manufacturing operations and our procurement function. The company anticipates it will record additional restructuring charges related to the $50 million in incremental savings in the range of $3 million to $5 million or approximately $0.02 per diluted share in 2007, and additional charges of approximately $1 million in 2008 which as you can see results in a very quick payback. The final component impacting net earnings comparison was income taxes. As I previously indicated the second quarter of 2007 was favorably impacted by a comparatively lower effective tax rate 36.1% versus 37.3% a year ago. As I indicated last quarter this lower rate was expected, and is primarily due to the scheduled increase in 2007 for the Federal deduction available for qualified domestic production activity. Furthermore, contributing to the company's diluted EPS growth was its share repurchase program. On our first-quarter call the company indicated that it planned to increase share repurchases by spending an incremental $100 million in the second half of the year, bringing the total investment and repurchases for 2007 to $300 million. As Murray mentioned, the company accelerated some of the additional share repurchases into the second quarter. As a result the company repurchased 1.3 million shares at a cost of $70 million. The company anticipates spending $180 million in share repurchases the remainder of the year. And we continue to anticipate that the share repurchase program will be increasingly accretive to EPS growth, because unexercised stock options represent only 2.5% of common shares outstanding and the company now primarily provides long-term equity compensation in the form of less dilutive restrictive shares. Turning to the balance sheet. Cash on hand and short-term investment at the end of the quarter were $344 million. The Company anticipates the cash balances to be lower in the third quarter as a result of the increased share repurchases and the payments due in connection with the California antitrust litigation settlement resolved in the first quarter. Looking forward to the balance of the year, we have raised our 2007 adjusted diluted EPS target in this case by $0.03 and adjusted to range. Full year adjusted diluted EPS is now targeted at $3.35 with a range of $3.30 to $3.41 per diluted share. This increased guidance is primarily a reflection of the improved smokeless tobacco premium net unit volume trend, stronger than anticipated wine results and the accelerated realization of cost savings under Project Momentum. With that I would like to turn the call over to Dan Butler, President of USSTC.
Dan Butler:

Thank you Jim, and good morning everyone. U.S. Smokeless Tobacco Company posted a strong quarter with underlying operating profit growth of 3.4% versus year ago. Results for the quarter exceeded our internal projections and were driven by continued solid volume growth on our premium brand and strong cost management related to Project Momentum. The highlights for the quarter was continued strong net unit volume performance for our smokeless products. Overall net unit volume for smokeless products was up 2.5% versus year ago, marking six consecutive quarters of overall growth. USSTC premium volume was up a strong 1.5%. As mentioned on our last call, we anticipated second-quarter volume growth to be a bit softer and third quarter a bit stronger due to a difference in the timing of the fourth of July holiday shipments versus last year. Our solid volume performance was delivered despite this timing shift, which occurred as anticipated, this bodes well for the outlook for volume for the second half, which I will discuss later. Now, let me provide a little more color on Q2 volume results. First as noted, premium net unit volume grew 1.5% versus year ago marking the fourth consecutive quarter of premium growth, and stronger than we had expected. This growth is particularly encouraging as comparative periods now reflect full implementation of the premium loyalty plan that began to gain traction early last year. Second, the Skoal brand was the primary driver of premium performance, with growth fueled by Skoal's citrus blend, which was introduced in Q1 in both long cut and pouch format. Third, the Copenhagen brand also posted positive results in the second quarter following a slight decline in Q1, which came as we lapsed the Q1 2006 launch of Copenhagen long cut straight and the associated pipeline volume. It's notable that both of our leading brands, Copenhagen and Skoal were up versus year ago on the second quarter, another indication of the breadth of our improvement. Fourth, our portion pack business, consisting of Cope and Skoal pouches plus Skoal Bandit continued continued to pose strong double-digit growth. The introduction of Skoal citrus pouches helped to fuel the momentum and Skoal Bandit, which was reintroduced in Q3 of last year, contributed with gains as well. As an easier to use, more discreet smokeless tobacco option, portion packs have been particularly appealing to smokers who switched to moist smokeless tobacco. Fifth on the price value side, USSTC growth accelerated to plus 8.6% in the quarter driven by solid growth on both of our PV brands, a strong double-digit increase on Husky and low single digit growth on Red Seal. As we've previously indicated we have increased competitive programming on our price value businesses; and we are pleased with our improving trend. Sixth and finally, we continue to see an increasingly strong contribution to our sales from new products that have been introduced in the last three years. Those products include several new Skoal long cut flavor and pouch SKUs, new and improved Bandit, Copenhagen long cut straight and the Husky sub price value line. In total, they contributed almost 14% of total can sales during the quarter. Now, let me turn to RAD-SVT data, which is our measure of consumer, take away. I will be reporting on RAD-SVT results for the full 26-week period ended June 16, 2007. Starting with the category total MST category volume growth continued at a very strong pace of plus 7.2% versus a year ago, in line with the growth we reported in Q1, and a little north of our full-year expectation of plus 5% to 6%. For U.S. Smokeless Tobacco company, I'm pleased to report volume growth across the board at stronger growth rates than we reported in Q1, stronger for total USSTC, stronger for USSTC premium, and stronger for USSTC price value brands. Total USSTC volume grew plus 3.2% versus a year ago and volume share was 61.2%, down 2.4 points versus year ago. The rate of year-over-year share decline continues to moderate and as indicated in Murray's comments our most recent 26-week share is essentially flat versus the 26 weeks ended February 24th which we reported on our last call. The progress in stabilizing our share is another clear sign that our premium loyalty plan is working as intended. From a revenue share standpoint, USSTC revenue share was 73%, a reflection of our leadership in the premium segment. Turning to the premium segment, total premium was up 1.4% versus year ago, representing 56.5% of category volume. USSTC premium volume increased plus 2.1% and our share of the premium segment increased plus 0.6 percentage points to 91%. The strength in our premium brands was broad-based with 36 states that represent 74% of our premium volume growing, and as we saw in our shipment both the Copenhagen and Skoal brands grew strongly during the period. Turning to price value, the total PV segment grew 15.8% versus year ago and represented 43.4% of category volume. PV segment growth has moderated versus recent history. Recall that segment growth is over 20% in the first half of last year and 26% in the full year of 2005. The growth trend moderated even further in the latter part of this 26-week period on both the percentage and an absolute basis versus year ago. Within the segment, total USSTC PV volume growth accelerated to plus 9.6% versus year ago for the 26-week period. Our low-priced Husky brand grew faster than the overall segment while Red Seal sustained its turnaround, delivering low single digit growth. USSTC's share of the total PV segment was 22.6% down 1.3 points versus year ago. So, to summarize key takeaways from the shipment and RAV results, first, with half a year behind us category growth continues to be robust with moist smokeless tobacco a leading growth category within consumer packaged goods. Our Company's commitment to attract adult smokers to the category and build our premium brands are fueling this growth. Second, both Copenhagen and Skoal are posting solid performance behind the investment in the premium loyalty plan and strong brand building. This performance is especially notable, as we have now lapsed the full implementation of the loyalty plan, which began in January of last year and gains traction during the year. Third, the total portion pack segment continues to pose solid double-digit growth driven by innovation and investments in the segment. Fueling continued growth in this segment is a key priority for continuing to convert adult smokers at a faster pace. Fourth, while the, PV segment continues to grow, the rate of growth is moderated as USSTC's premium brands loyalty is improving. Within price value we have committed to competing more effectively in 2007, and we are encouraged by our first-half results and our accelerating growth on both Red Seal and Husky. Fifth, and finally, new products are making an increasing contribution to our sales, fueled by the recent successful launch of the Copenhagen long cut straight, new and improved Skoal Bandit and Skoal citrus blend in long cut and pouches. These kinds of products add value and differentiate our premium brands from competition, and provide more approachable forms and flavors for adult smokers who are increasingly switching to smokeless tobacco. So given our broad based improvement in fundamentals we believe the outlook for the balance of the year is bright. Specifically, we expect category growth to remain strong although it is likely to moderate versus the 7% trend for the first half, as we lap very strong growth in the back calf of 2006. We believe that for the year the category growth will be at the high end of our previously estimated 5 to 6%. As the category outlook has strengthened, our share performance and premium volume trends have improved. We expect to see some modest share erosion for the rest of the year, but at a much lower rate than recent history. So despite the fact that we will now be lapping the premium growth posted in Q3 and Q4 of 2006, we are raising our full-year estimate for underlying premium volume growth from the 1% trend previously communicated to about 1.5%, not counting the extra billing day in December. Fueling our premium performance in the back half will be the launch of a new Copenhagen subline branded as Cope, the popular nickname of this iconic brand. The line will consist of two new items, Cope Smooth Hickory and Cope Whiskey Blend, as well as the rebranded Copenhagen long cut straight. This launch represents a logical and exciting extension for the Copenhagen brand, introducing subtle variances off of Copenhagen's signature, and distinctive natural flavor with a smoother, more approachable profile in the easier to use long cut style. The concept and the products tested extremely well and will enable the Copenhagen brand to more fully participate in the category growth driven by new to the category adults, primarily smokers. The products will begin shipping on September 17th and will be supported with a fully integrated advertising, sampling, direct marketing and merchandising plan. In summary, we are pleased with the sustained turnaround in our premium volume trends, the acceleration of our price value brands and the progress in stabilizing our category share. With strong brand building, continued innovation, and effective loyalty plans in place for the rest of year, we look forward to delivering full year top, and bottom line growth for U.S. Smokeless Tobacco company above our original expectations. With that I will turn the call back to our CEO, Murray Kessler.
Murray Kessler:

Thank you, Dan. As you can see UST is truly distinctly different. The categories we compete in are growing. Our top, and bottom lines are growing, through project momentum we continued to control costs, and we are returning all of our cash flow and more to our shareholders. Furthermore we continue to strengthen our organization and have a low litigation profile, as a result we believe UST is a compelling investment. We will now answer any questions you might have.
Operator:

(Operator Instructions) And our first question comes from the line of Filippe Goossens with Credit Suisse. Please proceed.
Filippe Goossens:

Yes, good morning, gentlemen, and congratulations on a strong performance here.
Murray Kessler:

Good morning, Filippe.
Filippe Goossens:

Good morning. My first question, Murray, can you give us an update in terms of your current thinking as it relates to the pending FDA and FET deals, and how that would affect your outlook for the remainder of this year and next year, please?
Murray Kessler:

Sure, let's do the FET bill first. The SCHIP bill was passed out of the Senate, I think we aligned with the industry that we're opposed to any tax increases, I think that bill from our perspective has a long way to go. The administration has certainly signaled a willingness to veto it. The Republican minority in the Senate has suggested they have sufficient votes to withhold a veto. So it's hard to actually forecast or predict that that is going to have an impact and if it did it certainly wouldn't be this year. The timing of that will take pretty much through the end of the session before anything would get implemented. Going a step beyond that, I would say that if something was to go through, while we are opposed to it, taxes and tobacco are part and parcel, and we would adjust our plans, and I don't think as I look at that bill right now it would have any material shift in our projections for a 10% shareholder return, as going forward on a consistent sustainable basis. As it relates to the FDA bill, I think, as we are in this conference call they are in the second round of the Committee hearings that started yesterday for the chairman's mark out of the Senate, and that bill also has a long way to go, it hasn't been considered in the House yet. Our position on the FDA, I think has been quite clear. We are opposed to the bill in the current form, but we're not opposed to the notion of regulation, if it's fair, and it recognizes the distinct different between smokeless tobacco, and cigarettes and allows us to compete fairly and there's a number of examples, as we stated in prior filings and communication. That bill also has not been considered by the House yet; it's got a long way to go. So right now we'll see how they play out. But we'd like to support FDA if they could or some type of legislation and regulation if they could make some meaningful changes and we'll continue to work through that process. And on the FET side, we opposed the tax increase.
Filippe Goossens:

Okay. Just coming back on the FET, Murray, what does the language of the bill look like right now, in terms of how smokeless would get taxed, would it be a similar percentage increase of your current rate or is it somewhat different?
Murray Kessler:

No. You're right; it's a similar percentage increase.
Filippe Goossens:

Okay. Second question, as it relates to the $50 million in incremental savings. How should we look at that number at this moment in terms of when, and how much of that could actually flow towards the bottom line or is it too early to tell? Are you in other words going to way to see what happens on the competitive side, before you're going to be making, or be willing to make some statement as it relates to how much of that can actually flow to the bottom line, as compared to reinvesting in the business?
Murray Kessler:

We will consider both. And I've been very clear that I wanted to increase the company's competitiveness, I wasn't satisfied with the company's level of growth not growing as fast as the category. We are making great progress on that. And then I gave a target that said 10% on a consistent sustainable basis over the long term and pretty much said we're going to deliver that number while at the same time increasing the companies competitiveness. And anything you are pretty much on volume as to what you'd see if we beat on volume we pass through to earnings. Now I have got to continue to monitor how we are progressing on that. Our share is obviously stabilizing, frankly faster than I even thought. We passed through; we were way ahead of our Project Momentum targets in the first half of the year. We raised our earnings guidance so far $0.05 this year, which is passing through a significant portion of that. But other than that, I would say it is wait and see. I'm not changing my outlook, which says 10% going forward other than the fact that we are now starting at a higher base because we raised guidance.
Filippe Goossens:

Then another follow-up on the FDA bill Murray, you have a whole bunch of new products in the pipeline. As a matter of fact in the past you've indicated or referred to the number of patents that you have applied for. Are you still pretty much bound by what happens with the FDA bill before you may launch some of the more innovative products perhaps? Or you might decide hey if this discussion takes too long we are going to go forward anyhow. And want to kind of build the first kind of first leader or whatever you want to call it position in the market with these new innovative products?
Murray Kessler:

Yeah. It's a good question. We had, it's not like we are on a hold yet anyway, remember I had said in the Investor Conference last December, that we were talking about the end of the year or the fourth quarter this year, the first quarter of next year to test one of those innovative new products. And I still think we're on track with that, you've got the FDA bill going along concurrently. So, it's kind of silly for me right now to predict where the FDA might come out how it relates, etcetera. As that happens, as we see what happens with the Senate and the House and potential legislation and see the progress of where we are for test markets, I will sure share with you what the status of that is. But right now they're sort of concurrent, there are two paths that are going on, one is not affecting the other today.
Filippe Goossens:

Okay. Then the final question Murray for this morning. Given the stepped-up activity on this new side by your two competitors. Are you changing at all your game plan with regard to your own solution test marketing programs?
Murray Kessler:

Dan, do you want to answer?
Dan Butler:

Good morning Filippe, it's Dan. I guess as a basic question of what it really means. Snus in our view really means discrete spit-free pouches and we've been testing that concept with Rebel and Skoal Dry and other things for a number of years. So we clearly have the technology and we've been gathering a lot of learning about this for some time. I think we and our competitors might think are all probably trying to optimize the product bundle and get that right and get the positioning right. We continue to learn from our test markets both in Denver with Rebel and our other two markets with Skoal Dry and we will make adjustments. We do think that there is a strong concept here. I think it's going to take some time, some education, awareness building and I expect it to be a slow build. At this point I would say none of those products are in the marketplace are off to a rapid vapid start. I believe it is going to be a long slow build but we are committed to the concept we think there's something there. The other thing I would say about snus is I don't view that at all as something that has a major impact on our core business. It is not traditional round can moist smokeless tobacco in all of the test markets. Ours and competitors, we have seen no impact on our core business and in fact have seen category growth accelerate, those are products that are really designed for and positioned to adult smokers that appears to be the source of volume. And I think with us and others making investments in building the awareness and the trial for these things will be good for the overall category.
Filippe Goossens:

Great. Thank you very much, gentlemen.
Murray Kessler:

Yes and I would just add to that Filippe, there's nothing we have seen from those competitive test markets that would dictate a change in our strategy. We will make the decisions that are right for our shareholders based on our ability to create value and launch winning products, that's always our model.
Filippe Goossens:

Great. Thanks, Murray.
Operator:

And our next question comes from the line of Judy Hong with Goldman Sachs. Please proceed.
Judy Hong:

Hi, everyone.
Murray Kessler:

Good morning Judy.
Judy Hong:

Hi Murray. I guess I just want to better understand your guidance for the second half of the year, you beat Q2 by, that you beat Q2 by $0.04 at the high end of, actually, I think the Q2 expectation. It looks like your guidance is going up only by $0.03 and the top end is only going up by $0.01. And Dan sounded pretty positive about the volume outlook for the rest of year. So, I'm wondering what's causing you a little bit of caution as far as earnings growth for the second half of the year is concerned?
Murray Kessler:

Well, we are not cautious. I mean Actually I think we beat it by $0.05 and we beat the first quarter by $0.02 and we raised the year by $0.05. We have made a decision in the second half in order to create some additional momentum to spend back about $0.02 additionally, not on trade support or price kind of programs, but primarily behind category growth brand building. And specifically there's a big piece of that in support of the new Cope launch. So, that's just a decision on our part. I also said at the end of my comment that I thought there was, that we had retained flexibility and there's some earnings upside. So, we are continuing to monitor the environment. We are looking at additional decisions, we don't want to spend imprudently. So, we will weigh all those factors in, but we are very bullish obviously on the second half of the year and the momentum we have on the business. As it relates to only going up a penny on the high side of the range, that's just because we knew we had Project Momentum savings that were significant so if you look at our original range we weren't in the middle. So as we've been taking some of those savings to the bottom line raising the target, you were eating into the higher end of the range, does that make sense?
Judy Hong:

Yes. I was just wondering if there's sort of the timing difference in terms of when you are recognizing the product, Project Momentum savings throughout the year. Is there any difference in terms of quarter-to-quarter, fluctuations there?
Murray Kessler:

No. I mean it's pretty evenly spread throughout the year. The original goal was, I think we had a $15 million run rate at the end of last year. We had budgeted $45 million with $20 million upside. We beat by $0.05, that's something like $13 million in additional operating profit, a portion of that, a good portion of that is Project Momentum. So, it's all coming in ahead of schedule. It's just been a home run initiative for us and fits right into our strategy on building momentum. But you shouldn't read anything negative in our estimates of the second half of the year. You should read this as UST having a very good year, retaining flexibility, raising volume, creating momentum, prepared for anything that might happen in the marketplace and potentially a little bit of above side.
Judy Hong:

Okay. And then secondly, just following up on the SCTE question, to the extent that the bill does get past in the current sort of proposal, as it looks in the Senate or from the House. Do you think that given that the cigarette practice prices could probably go up a lot more than smokeless tobacco, do you think that actually could bring more cigarette smokers into the smokeless category and that actually could end up being positive for you guys? And just from a price gap relative to PV standpoint that could narrow as a result of the price increases on both products or segments?
Murray Kessler:

Well, here I think that the latter half I think that the impact on the price gap between PV and premium would be very tiny. I'm not sure that would fundamentally change any dynamic in that segment. The cigarette question is an interesting question. I don't think we have a lot of experience with that. I've asked the same question myself and we are digging into it because you have, you have some experience in some state levels where those kinds of things have happened. For example, Texas, where cigarettes had a significantly bigger tax increase, but I haven't been able to model out yet, sort of how much you could attribute to one versus another and separate out. Because remember when we have increases we tend to adjust our plan accordingly. But it's an interesting point, but I think you would have to wait and see it play out.
Judy Hong:

Okay. And then just in terms of the competitive dynamics in the price value segment with the stepped-up promotional spending, or activity from year-end and some of the competitors. Can you just talk about your share performance within PV in the context of we stepped-up spending both from your end and some of your competitors?
Murray Kessler:

Well, I can comment on ours. I'm not going to talk too much about competitors, but I think, as I outlined the volume and the RAD results early on, I said Husky, was growing strong double-digit, it is, Husky gained share overall in the category and it gained share within price value. It grew faster than the segment overall. We told you these segment grew 15.8% for that 26-week period and Red Seal was up low single digits, which is what, if you recall, I think on several occasions we said that brand went through a few tough quarters, was declining. It's kind of a mid-tier brand; very profitable brand and we wanted to get it to a low level of sustainable growth in the low single digits, which is what we have achieved. So Red Seal is growing slower than the category and slower than PV so it is eating some share, but we are more than making that up on Husky.
Judy Hong:

Okay. And then just my final question on the snus products. I understand that it really hasn't had much impact on your business at the moment, but you sort of look out in the future and assuming that these products get rolled out in additional markets. Is it, your view is sort of the more likely scenario that the snus products, it could accelerate the category growth enough so that you have enough, you have more new users coming into the category. And you have enough volume to go around for both your premium and these new products. Or is it your view that the percentage of new users that are coming into the category there are switching to the snus as opposed to moist smokeless is relatively small? That it doesn't really impact your premium brands?
Murray Kessler:

I think that we see that that potential in the U.S. market would only be good news for UST. We are not worried at all about those products hurting our core MST business. Our ability to convert smokers. There's 45 million smokers and it takes a very little amount to convert to keep the growth going and we have been testing Rebel, then Skoal Dry almost seven years now and we continued despite even in the markets where we are testing those to do have tremendous success converting smokers with our core products. And we see nothing getting in that way, especially as we continue to evolve with pouches and products that appeal that are designed and appeal to smokers. So I just, we are not worried about those products. I know it gets a lot of press and there's been a lot of hype about it, but...
Judy Hong:

Yes and I guess I'm just trying to understand why you are not worried. Is it because you think you'll actually accelerate the category growth that you just have incremental new users coming into the category from cigarette category? Or you just don't think that these products will take off meaningfully that would impact your traditional moist snuff segment. And was it a combination of both?
Murray Kessler:

Both. And to be very clear we have test market data for seven years on the impact of this on our core business and the category. In all cases we have found that these dry spit free pouches do not source from the core business nor inhibit our ability to continue to grow the core businesses. In every case, including our competitor test markets, Copenhagen and Skoal grew, as fast if not faster than the rest of the country. So I'm not, I don't have to guess or speculate on what it might be. We have years and years of data now that suggests that we will be fine with our core businesses continue to be able to convert? And the second part is also true that, I said this in the past that these products were going to be a runaway success. I would have been national five years ago.
Judy Hong:

Okay. Thanks.
Operator:

And our next question comes from the line of Erik Bloomquist with J.P. Morgan. Please proceed.
Erik Bloomquist:

Hi. Good morning.
Dan Butler:

Good morning Erik.
Murray Kessler:

Well, Good afternoon to you.
Erik Bloomquist:

Yeah thank you. Couple of questions, one with respect to the new products you are launching the new Cope and also some of the patches that have been very successful. Do you have any different data in terms of the smoker conversion ratio? Are those converting smokers at a higher rate than the 10% we had seen historically?
Dan Butler:

Good morning, good afternoon Erik, its Dan. I have I guess a different sort of spin on that. What I would say is that for the couch product particularly, if we look at smoker conversion and what percent of smokers are using those products they way over index versus their presence in moist smokeless tobacco. So for instance pouches index is close to a 500 to smokers and our long cuts and long cut flavors are probably well over 200 in terms of an index, in terms of what percentage of new to category smokers are converting there. So they are very effective in new to category consumers, particularly smokers. They very disproportionately go to the patches especially and kind of secondly to the long cut.
Erik Bloomquist:

Second question is with respect to the announcement in terms of the state tax conversion from ad valorem to specific. Is there any impact from the conversion of Delaware that we might expect in the second half? Or is that too small? Then, secondly, are there other states that are on the bubble in terms of changing their tax structure?
Dan Butler:

There are always states on the bubble and it's hard to predict. But in total, you've had five states over the past 12 months and I think there's enough data on the first four states that would demonstrate that what we've said in the past is true. That state revenue department's benefit. The category continues to grow. It doesn't have a negative impact particularly on any individual competitor, but our share positions improve, and it puts it on a fair and equal basis when the subsidy is changed; Delaware doesn't change until January 1st I think.
Erik Bloomquist:

Okay, but in terms of what you are having to spend in terms of closing those price gaps. With the changes in the tax structure, I am assuming that means you have less you need to spend.
Murray Kessler:

Yeah. I think that question got asked to Dan at the last conference call as well; we haven't made any significant adjustments to our trade plan either way; last year when it implemented the premium loyalty plan. We did a lot of fine-tuning and adjusted it, this year sort of plan we've put in place and the amount of dollars we said is exactly what we're doing. Is that an opportunity over time as you got broader coverage, sure; but I also think you just probably have an opportunity within the entire trade plan; right now it's been a series of adjustments to get the gaps right, to get the volume growing, there's probably a Project Momentum efficiency opportunity in that big trade planning budget in years to come as well, where you start a little bit more optimization.
Erik Bloomquist:

Okay, great.
Murray Kessler:

And that could be a part of it.
Erik Bloomquist:

Okay, thank you, last question that is with respect to the incremental 50 million units today in Project Momentum; can you give us some broad guidance on where that is coming from, I mean what kind, where you are realizing those savings.
Murray Kessler:

Yeah. I think Jim in his comments said it was primarily manufacturing and procurement, but just think about it this way; that in the initial Project Momentum in the manufacturing side of the business. We put in a number of efforts to improve performance, right; so those types of performance enhancements are the ones you would typically expect, reductions and scrap, improved utilization, etcetera. As you improve utilization you free up line space, and that gives you a whole another set of opportunities in terms of scheduling shipping schedules between facilities. Working with logistics, outsourcing opportunities. And this Phase II folds into those types of categories, which needed the foundation of enhancing the performance and the plants before you could do it, and then it creates procurement opportunities and everything else along the way. But it's really just been a terrific project, that $150 million doesn't count the $100 million from the sale of the building and it doesn't count what we continue to get and we've seen since the start of this initiative is just a heightened awareness of making every dollar count within the company. And we are not counting in our $150 million, at this point probably millions of millions of dollars of just standing efficiency where people are being more prudent; if there is not a project attached to it we don't count it in this initiative.
Erik Bloomquist:

So on a qualitative basis you'd say the company is being far more efficient with the money they're spending and people have really bought into the program.
Murray Kessler:

Very much so.
Erik Bloomquist:

Great, thank you.
Operator:

And our next question comes from the line of Andrew Kieley with Deutsche Bank. Please proceed.
Andrew Kieley:

Good morning everyone.
Murray Kessler:

Good morning, Andrew.
Andrew Kieley:

Just first question on the discount segment; you guys are tapping growth in that segment pretty aggressively now; if we assume that strategy continues, and the high growth rates continue. How do you think a more aggressive stance by UST might impact the overall industry-pricing environment in that segment?
Dan Butler:

We are committed to competing more effectively in that segment that is clearly strong and legitimate, it is about 43% of the total category today, but when I say it we want to be more competitive in price value. It means we want to have a better share and a stronger participation in that segment where we are just a little over 22% a share; we are under shared in the segment. But as we do that and get more competitive in price value, we do not see that it increasingly sources volume from premium, it is really competition within that segment, and just like you are seeing our sequential market share in total start to stabilize partly due to our efforts in price value. We are also seeing sequentially over time that the overall shift from premium to price value is starting to slow. And I expect that in the future we are going to see that come into some level of equilibrium; so, I think the price value. You are seeing the total segment growth slow down; it used to be 30% a few years ago, to 25 to 20 to now 15. I think we are going to get to an equilibrium place, and we just want to have a strong competitive position within all segments. And remember the overarching umbrella and goal that we set up in the beginning of the year was not volume for volume's sake; I mean we are all about growing profitable volume.
Andrew Kieley:

All right, okay. Second question I had just I guess a more strategic question, given your fairly conservative leverage and a very solid credit rating you guys pay out a very high amount to shareholders through dividends and buybacks. How do think longer term about your ability to maybe use the balance sheet flexibility and potentially raise shareholder payouts.
Murray Kessler:

I've said in the past that, it's clear that we are not a highly leveraged company, I mean the ratios speak for themselves, and now that I was bringing in a new CFO. I wanted to go out on a path of getting a CFO that was sort of particularly strong in financial strategy, I think Ray is exactly that and he will be a partner in crafting that strategy going forward. And we will share sort of our points of view on that going forward. In the meantime, it's little but we did spend more cash than we earned this year back; so we are starting to be a little bit more aggressive already.
Andrew Kieley:

Okay, thanks.
Operator:

And now our next question comes from the line of David Adelman with Morgan Stanley. Please proceed.
David Adelman:

Good morning.
Murray Kessler:

Good morning, David.
David Adelman:

Murray, I am curious, how do you set the categories pricing power from here going forward, you obviously didn't take a premium price increase this year; arguably there's a higher level of competitive intent to be at the low end of the market now than there was six months ago. In part because of your behavior; how do you think things can involve from here?
Murray Kessler:

Well, I'll answer that question two ways; one, relative to UST, I'd say pricing flexibility as increased over the last year, and clearly there's sort of a demonstration across the industry on a focus on profitable volume growth; there's the price gaps from where we were a year ago. A year ago we were saying we had to get things back into line and reach an equilibrium to where we could grow again, and more recently, we've talked about stabilizing our market shares which are happening. So in an environment where the category is growing it's a more rational price market, and we've gotten those price gaps back into place where we can; one would argue that there's more pricing flexibility. Having said that, we didn't not take a price increase because we couldn't last year. We didn't take a price increase because we didn't need to relative to all the tools that we now have available to us, and you know that was part of my investment thesis when I presented it in December was this notion of putting more tools in UST's toolbox, so that we were, could get back to not just relying on pricing but growing volume, taking tough looks at cost, working our share repurchase program; accelerating growth in the winery; and all of those tools and we balanced each of those with an overarching goal, that says we want to consistently and sustainably deliver that 10%, and at the same time we're not satisfied with our volume not growing as fast in the category. So, I think we're purposely making decisions, but that doesn't mean tomorrow we couldn't take a price increase. It means that each one of those factors gets considered at the time. But if you ask me do I think we have more pricing flexibility or less than a year ago? I think given our share positions and the price gaps, we have more.
David Adelman:

Okay. And then, as a follow-up, Murray, how do you assess, not in the next six months, but over time, the risk of the emergence or the development of a pricing tier that has substantial volume and share at where the lowest price points in the marketplace are today? Because obviously, if you go back over a long period of time, Grizzly essentially developed as a brand at a price point at which -- years earlier -- Red Seal was priced. What's the risk that two or three years from now in your view that the emergence of a new lower-priced tier, because obviously you can be profitable at very low price points in this market and particularly with the prevailing tax structure?
Dan Butler:

Good morning, David. It's Dan. I do think the environment has changed versus where it was some years ago. The rate of pricing in the category has slowed considerably and the bottom line has -- I think it comes down to how are you delivering value to consumers? And I would tell you that at the low end, you've got brands in tier three today that are very strong and legitimate brands. They're not just low-priced cans of snuff. They're legitimate brands that deliver a compelling value to consumers. At $2.25 a can is a very good value for a quality product with a legitimate brand name on it, and I don't believe that there's a huge opportunity to deliver significant consumer value underneath that price umbrella, because on its face is a good and a fair value. Now having said that, there have been a number of folks who have tried to come in underneath that umbrella and none of those things has gained any traction, because you not only have to come in with a very compelling price point. But you're going up against a handful of pretty strong brands in the sub price value segment today. So I just don't think it's that easy. And I think the brands that are there today already represent a pretty compelling value.
David Adelman:

And you mentioned, Dan, at some point reaching an equilibrium between the aggregate price value segment and premium, where do you think price value share ultimately sort of crescendos?
Dan Butler:

That's a fair question. I don't really want to speculate on that here today other than to say that I think the rate of sequential share increase in price value over time recently has started to slow. And I do think that we're going to see that equilibrium in the, what we call it, relatively near future, and I'll decline to be much more specific than that.
David Adelman:

Do you think that there's a point where you get a level of either distribution or retail shelf space for price value products from this point, where it could put the premium category under incremental pressure? Or do you think realistically the products have brought enough distribution and brought enough visibility and retail that even if they were to gain another 5, 7, 8 share points cumulatively over time that that in and of itself wouldn't radically change the competitive set from where it is today?
Dan Butler:

Yeah. I think actually in the retail trade -- and we do a terrific job of working with customers and have pretty sophisticated category management tools. I think today versus a year ago there's a heightened understanding of category profitability. I think that a lot of sophisticated retailers are looking at their shelf sets and realizing that in the days of 30% price value growth, there was a lot of distribution build. That's what killed some of the growth was distribution build. All of the low fruit on that, I would say, has basically been taken and now people are taking stock of where they are and realizing in some cases they're actually over-SKUed in the low-priced, low margin end of the business. And they are sort of rebalancing their shelf sets and I think we have a very compelling category -- management category profitability story that will help to bring things into balance, I think in terms of the retail shelf set. So, I think most of the taking shelf space has already occurred.
David Adelman:

Okay. Thank you very much.
Murray Kessler:

Yeah, David and just two additions to Dan, I would say on the shelf space issue as well there is significant opportunity for the entire OTP set, which is growing across the board, relative to a much larger cigarette sections, ultimately over time. And you're seeing with all the heightened interest especially with cigarette manufacturers now showing interest in smokeless tobacco and validating the category growth story we've been talking about for the past few years that there's opportunity to increase in total OTP, and that's not theoretical. That's happening every day. And the only other point I would make on low-priced scenario that other low-priced brands come in, that's part of the reason why -- part of the way that happens is an unfair tax subsidy that is a structural cost advantage that's wrong, and it comes out of the Revenue Department's pockets and why we're so adamant and committed, no matter how long it takes, to converting to a specific or weight based tax structure over time.
David Adelman:

Okay. Thanks.
Operator:

And our next question comes from the line of Ann Gurkin with Davenport.
Ann Gurkin:

Good morning.
Murray Kessler:

Good morning, Ann.
Ann Gurkin:

Just wanted to ask about your raised outlook for premium moist smokeless growth and the biggest drivers, or the key driver, would it be the price value category slowing, higher promotions, are you stepping up promotions on your premiums in the back half, innovation? Can you help me understand kind of what's driving that increase? The biggest driver?
Dan Butler:

Good morning, Ann. It's Dan. I think what we're really looking at is continued category growth in the back half. We're looking at the trend we've actually been able to post in the first half; it's not about increasing promotional spend. The big increase in promotional spend and premium loyalty happened in 2006 was a little bit of upland increase this year. We're doing basically, exactly what we planned to do this year from a premium loyalty standpoint. We are making some increased investments in brand building, specifically the new Cope launch that we mentioned earlier. I think that's going to give us some top stand on our premium volume. And we are lapping tougher comps for the back half on premium. We were up .7% in the third quarter last year and 1.7% in the fourth and we expect to be 1.5% or thereabouts for the back half. So it's going to be growth on top of growth, but I believe with a growing category and stabilizing share and the kind of programming we have in place that we'll do that.
Ann Gurkin:

Great. And then, can you talk about sales at convenience stores in light of higher gas prices?
Dan Butler:

We haven't really seen an impact of gasoline prices this year. We saw a huge seasonal increase like we saw last year. It popped up to record highs. Actually in the last week for the first time most recently, we're a little bit below where we were a year ago. But I think the kind of sticker shock we saw the first couple of times this thing went over $3, we didn't seem to see this year.
Ann Gurkin:

All right. Great. Thank you very much.
Operator:

(Operator Instructions) And now our next question comes from the line of Michael Quan with UBS. Please proceed.
Michael Quan:

Good morning.
Murray Kessler:

Hello.
Operator:

Mr. Quan, your line is open.
Murray Kessler:

Maybe, we should go to the next question.
Michael Quan:

Yes, hi.
Dan Butler:

No, there we go.
Operator:

Looks like his line went out again. (Operator Instructions) Okay, and we do have our question coming from the line of Michael Quan with UBS. Please proceed, Mr. Quan.
Michael Quan:

Can you guys hear me now?
Dan Butler:

Yes.
Michael Quan:

Sorry. Actually I just want to say my question has been answered. Nice quarter.
Dan Butler:

Thanks. This is Nick, right?
Michael Quan:

Yeah, it is.
Dan Butler:

Okay.
Michael Quan:

Sorry, guys. I'm golfing right now. I knew you would have a good quarter, so I just wanted to get on and I was going to ask about the gas prices, but it's already been asked.
Dan Butler:

Okay.
Operator:

And there appears to be no additional questions at this time. I would now like to turn the call over to Mr. Kessler for any closing remarks.
Murray Kessler:

Thank you for your continuing interest in UST.
Operator:

This now concludes your presentation. You may now disconnect and have a wonderful day.

ProShares Ultra 7-10 Year Treasury Q2 2007 Earnings Call Transcript

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ProShares Ultra 7-10 Year Treasury
Q2 2007 Earnings Call Transcript