TMCnet News

LORILLARD, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.
[July 30, 2014]

LORILLARD, INC. - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations.


(Edgar Glimpses Via Acquire Media NewsEdge) The following discussion should be read in conjunction with our historical consolidated financial statements and the notes related to those financial statements included in this Quarterly Report on Form 10-Q for the quarter ended June 30, 2014 (the "Form 10-Q"). In addition to historical information, the following discussion contains forward-looking statements based on current expectations that involve risks and uncertainties. Investors are cautioned not to place undue reliance on these forward-looking statements. Statements preceded by, followed by or that otherwise include the words "believe," "expect," "anticipate," "intend," "project," "estimate," "plan," "may increase," "may fluctuate" and similar expressions or future or conditional verbs such as "will," "should," -46- -------------------------------------------------------------------------------- Table of Contents "would," "may" and "could" are generally forward-looking in nature and are not historical facts. Actual results and the timing of certain events may differ significantly from those projected in such forward-looking statements due to a number of factors, including those risk factors set forth in our Annual Report on Form 10-K for the year ended December 31, 2013 (the "Form 10-K") and those risk factors set forth in "Business Environment" below, in Part II, "Item 1A.



Risk Factors" and elsewhere in this Form 10-Q. Except for our ongoing obligations to disclose material information under the federal securities laws, we undertake no obligation to release publicly any revisions to any forward-looking statements, to report events or to report the occurrence of unanticipated events unless required by law. For any forward-looking statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. Our consolidated financial statements are prepared in conformity with accounting principles generally accepted in the United States ("GAAP").

The terms "Lorillard," "we," "our" and "us" refer to Lorillard, Inc., a Delaware corporation, and its subsidiaries. The terms "Lorillard, Inc." and the "Company" refer solely to the parent company and "Lorillard Tobacco" refers solely to Lorillard Tobacco Company, the principal subsidiary of Lorillard, Inc. The terms "LOEC" and "blu eCigs" refer to LOEC, Inc. (d/b/a blu eCigs), our U.S.


electronic cigarette subsidiary, and the terms "Cygnet", "SKYCIG" and "blu (U.K.)" refer to Cygnet U.K. Trading Limited (t/a SKYCIG or blu (U.K.)), our U.K. electronic cigarette subsidiary.

Overview Lorillard has two reportable segments, Cigarettes and Electronic Cigarettes.

The Cigarettes segment consists principally of the operations of Lorillard, Inc., Lorillard Tobacco and related entities. Lorillard Tobacco is the third largest manufacturer of cigarettes in the United States. Founded in 1760, Lorillard Tobacco is the oldest continuously operating tobacco company in the United States. Newport, Lorillard Tobacco's flagship premium cigarette brand, is the top selling menthol and second largest selling cigarette overall in the United States based on gross units sold in the first six months of 2014 and in the full year 2013. In addition to the Newport brand, the Lorillard Tobacco product line has four additional brand families marketed under the Kent, True, Maverick and Old Gold brand names. These five cigarette brands include 43 different product offerings which vary in price, taste, flavor, length and packaging.

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

Recent Developments On July 15, 2014, the Company, Reynolds American Inc., a North Carolina corporation ("RAI"), and Lantern Acquisition Co., a Delaware corporation and a wholly owned subsidiary of RAI ("Merger Sub"), entered into an Agreement and Plan of Merger (the "Merger Agreement"), pursuant to which, subject to the satisfaction or waiver of certain conditions, Merger Sub will merge with and into the Company (the "Merger"), with the Company surviving as a wholly owned subsidiary of RAI.

At the effective time of the Merger (the "Effective Time"), each share of Company common stock (other than treasury stock held by the Company or owned by a subsidiary of the Company, RAI or Merger Sub and shares owned by stockholders of the Company who have properly made and not withdrawn a demand for appraisal rights) will be converted into the right to receive a unit consisting of (i) $50.50 per share in cash and (ii) 0.2909 fully paid and non-assessable shares of common stock of RAI (the "Merger Consideration"). On the day of the announcement, the transaction implied an enterprise value of $27.4 billion, representing approximately 13 times Lorillard's 2013 EBITDA.

Pursuant to the Merger Agreement, at the Effective Time, each outstanding Company equity award (including stock options and stock appreciation rights), whether vested or unvested, will be cancelled in exchange for cash based on the Merger Consideration less, in the case of a stock option, the per share exercise price. In addition, each restricted stock unit and unvested share of restricted Company common stock will, immediately prior to the Effective Time, be converted into unrestricted shares of Company common stock and, at the Effective Time, converted into the right to receive the Merger Consideration.

-47--------------------------------------------------------------------------------- Table of Contents The completion of the Merger is subject to certain conditions, including, among others, (i) the adoption of the Merger Agreement by the Company's stockholders, (ii) the approval by RAI's shareholders of the issuance of RAI common stock in the Merger (the "Stock Issuance"), (iii) the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended, (iv) the absence of legal restraints prohibiting the completion of the Merger and (v) the effectiveness of the registration statement on Form S-4 to be filed by RAI with the Securities and Exchange Commission (the "SEC") and the approval for listing on the New York Stock Exchange of the RAI common stock to be issued in the Merger. In addition, RAI's obligation to complete the Merger is subject to the absence of any legal restraint under applicable antitrust laws that results in any prohibition or limitation on the ownership, control or operation of the businesses of the surviving corporation, RAI or their respective subsidiaries, which, individually or in the aggregate, would reasonably be expected to result in a Substantial Detriment (as defined in the Merger Agreement).

Each of the Company and RAI has made representations and warranties in the Merger Agreement. The Company and RAI have each also agreed to various covenants and agreements, including, among other things, to conduct their respective businesses in the ordinary course in all material respects during the period between the execution of the Merger Agreement and completion of the Merger and not to engage in certain kinds of transactions during this period.

The Merger Agreement contains certain termination rights for both the Company and RAI, including if the Merger is not completed on or before July 15, 2015 (which date will be automatically extended to January 15, 2016 if certain closing conditions related to antitrust matters have not been satisfied) and if the approval of the Company's stockholders or RAI's shareholders is not obtained. If the Merger Agreement is terminated in connection with the Company entering into an alternative acquisition agreement in respect of a superior proposal or making a change of recommendation, or in certain other circumstances, the Company must pay RAI a termination fee of $740 million. In the event the Merger Agreement is terminated by the Company due to a change of recommendation by RAI's board of directors, RAI will be obligated to pay the Company a termination fee of $740 million.

The foregoing description of the Merger and the Merger Agreement is qualified in its entirety by reference to the Merger Agreement, a copy of which is attached as Exhibit 2.1 to the Company's Current Report on Form 8-K filed with the SEC on July 15, 2014 and which is incorporated by reference herein.

In connection with the Merger Agreement, on July 15, 2014, RAI and Lignum-2, L.L.C. ("Imperial Sub"), a wholly owned subsidiary of Imperial Tobacco Group PLC ("Imperial"), entered into an asset purchase agreement (the "Asset Purchase Agreement"), pursuant to which Imperial Sub has agreed to purchase, immediately following the completion of the Merger, the Kool, Salem, Winston, Maverick and blu eCigs brands and certain other assets for a total consideration of $7.1 billion in cash (subject to certain adjustments). Also, on July 15, 2014, in connection with the asset sale, the Company and Imperial Sub entered into a Transfer Agreement, pursuant to which Imperial Sub agreed to acquire certain assets owned by the Company, including its manufacturing and R&D facilities in Greensboro, N.C., and approximately 2,900 employees.

The Company cannot give any assurance that the Merger and the other related transactions will be completed or that, if completed, they will be exactly on the terms as set forth in the Merger Agreement and the other related transaction agreements. The Company and RAI will file a joint proxy statement/prospectus with the SEC in connection with the proposed Merger, which will form a part of the registration statement on Form S-4 to be filed by RAI with the SEC to register the Stock Issuance.

Critical Accounting Policies and Estimates For a description of the critical accounting policies that require the use of significant judgments and estimates by management, refer to "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our Form 10-K filed with the Securities and Exchange Commission ("SEC") on February 21, 2014.

-48- -------------------------------------------------------------------------------- Table of Contents Business Environment Participants in the U.S. tobacco industry, including us, face a number of issues that have adversely affected their results of operations and financial condition in the past and will continue to do so, including: • A substantial volume of litigation seeking compensatory and punitive damages ranging into the billions of dollars, as well as equitable and injunctive relief, arising out of allegations of cancer andother health effects resulting from the use of cigarettes, addiction tosmoking or exposure to environmental tobacco smoke, including claims for economic damages relating to alleged misrepresentation concerning the use of descriptors such as "lights," as well as other alleged damages.

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

cigarette manufacturers as product is sold and place significant restrictions on our and their ability to market and sellcigarettes.

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

• Increases in cigarette prices since 1998 have led to an increase in the volume of discount and, specifically, deep discount cigarettes.

Cigarette price increases have been driven by increases infederal, state and local excise taxes and by manufacturer price increases. Price increases have led, and continue to lead, to high levels ofdiscounting and other promotional activities for premium brands. Deep discount brands have grown from an estimated domestic shipment share in 1998 of less than 2.0% to an estimated share of 12.5% for the threemonths ended June 30, 2014, and continue to be a significant competitivefactor in the domestic cigarette market. We do not have sufficient empirical data to determine whether the increased price of cigarettes hasdeterred consumers from starting to smoke or encouraged them to quitsmoking, but it is likely that increased prices may have had an adverseeffect on consumption and may continue to do so.

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

• Pursuant to the terms of the FSPTCA, the FDA established the Tobacco Products Scientific Advisory Committee (the "TPSAC") to evaluate, among other things, the impact of the use of menthol in cigarettes on the public health. In March 2011, the TPSAC issued its report to the FDA (the "TPSAC Menthol Report") stating that "removal of mentholcigarettes from the marketplace would benefit public health." On June 27, 2011, the FDA provided a progress report on its review of the sciencerelated to menthol cigarettes. In that update, the FDA stated that "[e]xperts within the FDA Center for Tobacco Products are conducting an independent review of the science related to the impact [of menthol] incigarettes on public health …" On July 21, 2011, TPSAC considered revisions to its report, and the voting members unanimously approved the final report for submission to the FDA with no change in its recommendation. On January 26, 2012, the FDA stated that its independent review had been submitted to the peer review panel and comments had been received from the panel on the report. On July 23, 2013, the FDA made available its preliminary scientific evaluation ("PSE") of public health issues related to -49- -------------------------------------------------------------------------------- Table of Contents the use of menthol in cigarettes and peer review comments thereto. In the PSE, the FDA concluded that menthol cigarettes likely pose a public health risk above that seen with nonmenthol cigarettes. The FDA also acknowledged that it needed additional information on the impact of menthol in cigarettes. Accordingly, the FDA issued an Advance Notice of Proposed Rulemaking ("ANPRM") seeking comments on the PSE and requesting additional information related to potential regulatory options it might consider for the regulation of menthol. In addition, the FDA announced that it is funding new research on, among other things, the differences between menthol and nonmenthol cigarettes to obtain information to assist FDA in making informed decisions related to potential regulation of menthol in cigarettes. The FDA established a 60-day comment period for the ANPRM and PSE, and said it will consider all comments and other information submitted to determine what, if any, regulatory action is appropriate. On September 11, 2013, the FDA extended the comment period for an additional 60 days to November 22, 2013. On November 21, 2013, the Company provided comments on the ANPRM and PSE to the FDA.

• In August 2009, we, along with RJR Tobacco, other tobacco manufacturers and a tobacco retailer, filed a lawsuit in the U.S. District Court for the Western District of Kentucky against the FDA challenging the constitutionality of certain restrictions on speech included in the FSPTCA. These restrictions on speech include, among others, bans on the use of color and graphics in certain tobacco productadvertising, limits on the right to make truthful statements regarding modified risk tobacco products, a prohibition on making certain statements about the FDA's regulation of tobacco products, restrictions on the placement of outdoor advertising, a ban on certain promotions offering gifts inconsideration for the purchase of tobacco products, a ban on brand namesponsorship of events and the sale of brand name merchandise, and a ban on the distribution of product samples. The suit also challenges the law's requirement for extensive graphic warning labels on all packaging and advertising. The complaint seeks a judgment (i) declaring that such provisions of the law violate the First and/or Fifth Amendments of the U.S. Constitution and (ii) enjoining the FDA from enforcing the unconstitutional provisions of the law. On January 4, 2010, thedistrict court issued an order (a) striking down the provisions of the law that banned the use of color and graphics in certain tobacco product advertising and prohibited tobacco manufacturers from making certain statements about the FDA's regulation of tobacco products and (b) upholding the remaining challenged advertising provisions. Both sides appealed the district court's ruling to the Sixth Circuit Court of Appeals, and on March 19, 2012, the Sixth Circuit issued anopinion (i) affirming the district court's decision upholding theFSPTCA's restrictions on marketing modified-risk tobacco products, bans on event sponsorship, branding nontobacco merchandise and free sampling; (ii) affirming the district court's decision upholding theFSPTCA's requirement that tobacco manufacturers reserve significantpackaging space for graphic health warnings; (iii) affirming the district court's decision striking down the FSPTCA's restriction of tobaccoadvertising, in most instances, to black and white text; (iv) reversing the district court's decision upholding the FSPTCA's restriction on statements regarding the relative safety of tobacco products based on FDA regulation and its decision upholding the FSPTCA's ban ontobacco continuity programs in most instances. Plaintiffs' motion for rehearing en banc was denied, and Plaintiffs filed a petition for certiorari with the U.S. Supreme Court on October 30, 2012. The governmentdeclined to seek a petition for certiorari to the U.S. Supreme Court. The government did not appeal the part of the Court of Appeal's ruling striking the FSPTCA's restriction of tobacco advertising to black and white text. On April 22, 2013, the U.S. Supreme Court denied plaintiffs' petition for certiorari.

• In February 2011, we, along with RJR Tobacco, filed a lawsuit in the U.S. District Court for the District of Columbia against the FDA challenging the composition of the TPSAC because of the FDA's appointment of certain voting members with significant financial conflicts of interest. We believe these members are financially biased because they regularly testify as expert witnesses against tobacco-product manufacturers, and because they are paidconsultants for pharmaceutical companies that develop and market smoking-cessation products. The suit similarly challenges the presence of certain conflicted individuals on the Constituents Subcommittee of the TPSAC.

The complaint seeks a judgment (i) declaring that, among other things, the appointment of the conflicted individuals to the TPSAC (and its Constituents Subcommittee) was arbitrary, capricious, an abuse of discretion, and otherwise not in compliance with the law because it prevented the TPSAC from preparing a report that was unbiased and untainted by conflicts of interest, and (ii) enjoining the FDA from, among other things, relying on the TPSAC's Menthol Report. TheFDA filed a motion to dismiss this action which the court denied in August 2012.

In October 2012, the FDA filed its answer to the amended complaint. The parties completed the briefing for summary judgment motions on September 20, 2013. On July 21, 2014, the District -50- -------------------------------------------------------------------------------- Table of Contents Court denied defendants' motion for summary judgment and granted, in part, our motion for summary judgment entering an order enjoining the FDA (i) to reconstitute the TPSAC membership so that it complies with the applicable ethics laws and (ii) from relying on or using the TPSAC Menthol Report in any manner. As of July 25, 2014, the time for the FDA to appeal this decision had not yet expired.

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

• Electronic cigarettes are generally less regulated than cigarettes.

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

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

• Substantial federal, state and local excise taxes are reflected in the retail price of cigarettes. In 2013, the federal excise tax was $1.0066 per pack and combined state and local excise taxes ranged from $0.17 to $5.85 per pack. During 2013, there were three state excise tax increases implemented including a $1.60 per pack increase in Minnesota, effective July 1, 2013 and a $1.00 per pack increase in Massachusetts, effective July 31, 2013. In addition, in 2012, New Hampshire passedlegislation that decreased the cigarette tax by $0.10 per pack, but provided for the tax to revert to the original amount if certain revenue goals were not reached. These goals were not reached and the tax increased by $0.10 per pack on August 1, 2013. There was also a tax increase in Cook County, Illinois of $1.00 per pack, effective March 1, 2013. On June 21, 2010, the New York state legislature approved a $1.60 per pack state excise tax increase that was implemented on July 1, 2010. The federal excise tax on cigarettes increased by -51- -------------------------------------------------------------------------------- Table of Contents $0.6166 per pack to $1.0066 per pack, effective April 1, 2009, to finance health insurance for children. For the six months ending June 2014, there was one state excise tax increase of $0.13 per pack implemented in the state of Oregon, as well as a $0.50 municipal excise tax increase in the City of Chicago, Illinois. It is likely that increases in excise and similar taxes have had an adverse impact on sales of cigarettes and that the most recent increase and future increases, the extent of which cannot be predicted, could result in further volume declines for the cigarette industry, including us, and an increased sales shift toward deep discount cigarettes rather than premium brands. In addition, we and other cigarette manufacturers and importers are required to pay an assessment under a federal law designed to fund payments to tobacco quota holders and growers and are required to pay an annual user fee to the FDA.

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

The following table presents selected Lorillard and industry cigarette shipment data for the three and six months ended June 30, 2014 and 2013.

Selected Industry Data Three Months Six Months Ended Ended June 30, June 30, (Volume in billions) 2014 2013 2014 2013Lorillard total domestic unit volume (1) (3) 9.977 10.262 18.815 19.306 Industry total domestic unit volume (1), (3) 67.542 71.474 128.556 134.209 Lorillard's premium volume as a percentage of its total volume (2) 86.3 % 85.8 % 86.3 % 85.8 % Newport's share of Lorillard's total volume (2) 85.6 % 85.0 % 85.6 % 85.0 % Newport's share of Lorillard's Cigarettes Segment net sales (2) 88.6 % 88.3 % 88.6 % 88.2 % (1) Source: Management Science Associates, Inc. ("MSAI"), an independent third-party database management organization that collects wholesale shipment data from various cigarette manufacturers. MSAI divides the cigarette market into two price segments, the premium price segment and the discount or reduced price segment. MSAI's information relating to unit sales volume and market share of certain of the smaller, primarily deep discount, cigarette manufacturers is based on estimates derived by MSAI. Management believes that volume and market share information for deep discount manufacturers may be understated.

(2) Source: Lorillard shipment reports.

(3) Domestic unit volume includes cigarette units sold as well as promotional units and excludes volumes for Puerto Rico and U.S. Possessions.

The following table presents selected Lorillard and industry retail market share data for the three and six months ended June 30, 2014 and 2013, based on Lorillard's proprietary retail shipment database administered by MSAI, which reflects shipments from wholesalers to retailers.

Selected Domestic Retail Cigarette Unit Market Share Data(1) Three Months Six Months Ended Ended June 30, June 30, 2014 2013 2014 2013 Lorillard's share of the retail market 15.0 % 14.8 % 15.1 % 14.8 % Lorillard's share of the premium market 17.5 % 17.2 % 17.6 % 17.3 % Lorillard's share of the menthol market (2) 40.3 % 40.0 % 40.5 % 40.3 % Newport's share of the retail market 12.8 % 12.5 % 12.9 % 12.6 % Newport's share of the premium market 17.3 % 17.0 % 17.5 % 17.1 % Newport's share of the menthol market (2) 37.1 % 36.9 % 37.3 % 37.2 % Total menthol segment market share for the industry (2) 31.6 % 31.4 % 31.7 % 31.3 % Total discount segment market share for the industry 26.0 % 26.4 % 26.1 % 26.5 % (1) Source: Lorillard's proprietary retail shipment database administered by MSAI, which reflect shipments from wholesalers to retailers.

(2) Lorillard has made certain adjustments to its proprietary retail shipment data to reflect management's judgment as to which brands are included in the menthol segment.

-52- -------------------------------------------------------------------------------- Table of Contents The market for electronic cigarettes is evolving at a very fast pace and is very fragmented, with many companies competing with similar product offerings. In the competition for retail presence, blu eCigs has begun the process of differentiating itself from the competition with unique technology, impactful displays and point of sale materials. Lorillard will be reporting Nielsen dollar share results for blu and the e-cigarette category going forward. According to Nielsen, blu's domestic all-outlet dollar market share of electronic cigarettes decreased 1.1 share points to 40.9% for the 13 weeks ending July 5, 2014 versus the year ago 13 week period. The method of distribution for many competing companies is predominately over the internet, with only a small number of competitors currently having a significant presence at retail.

blu Domestic Retail Electronic Cigarette Dollar Market Share Data (3)13 Week Reporting Periods Ended: March 23, 2013 35.3 % June 22, 2013 42.0 % September 21, 2013 45.3 % December 21, 2013 45.8 % March 15, 2014 45.0 % July 5, 2014 40.9 % (3) Based on Nielsen, ScanTrack Database - All Outlets Combined.

Results of Operations Three and Six Months Ended June 30, 2014 Compared to the Three and Six Months Ended June 30, 2013 Lorillard Consolidated Results Three Months Six Months Ended Ended June 30, June 30, 2014 2013 2014 2013 (in millions) (in millions) Net sales (including excise taxes of $502, $516, $947 and $971) $ 1,799 $ 1,804 $ 3,391 $ 3,381 Cost of sales (including excise taxes of $502, $516, $947 and $971) 1,116 1,126 2,090 1,990 Gross profit 683 678 1,301 1,391 Selling, general and administrative 151 138 297 290 Operating income 532 540 1,004 1,101 Investment income (loss) (2 ) - 6 1 Interest expense (45 ) (41 ) (90 ) (82 ) Income before income taxes 485 499 920 1,020 Income taxes 185 186 349 380 Net income $ 300 $ 313 $ 571 $ 640 -53- -------------------------------------------------------------------------------- Table of Contents Cigarettes Segment Results Three Months Six Months Ended Ended June 30, June 30, 2014 2013 2014 2013 (in millions) (in millions) Net sales (including excise taxes of $502, $516, $947 and $971) $ 1,762 $ 1,747 $ 3,303 $ 3,267 Cost of sales (including excise taxes of $502, $516, $947 and $971) 1,088 1,087 2,026 1,914 Gross profit 674 660 1,277 1,353 Selling, general and administrative 119 122 239 261 Operating income $ 555 $ 538 $ 1,038 $ 1,092 Three Months Ended June 30, 2014 Compared to the Three Months Ended June 30, 2013 Net sales. Cigarette net sales increased by $15 million, or 0.9%, from $1.747 billion for the three months ended June 30, 2013 to $1.762 billion for the three months ended June 30, 2014. Cigarette net sales increased due to higher average net selling prices of $74 million which reflect price increases in June and November 2013 and May 2014, partially offset by lower cigarette unit sales volume ($59 million, including $14 million of federal excise tax).

Total Lorillard wholesale cigarette unit volume, which includes Puerto Rico and U.S. Possessions, decreased 3.4% for the second quarter of 2014 compared to the corresponding period of 2013. Puerto Rico and U.S. Possessions declined 38.6% compared to a year ago period in which inventories were built by wholesale in advance of a July 2013 $1.00 per pack excise tax increase in Puerto Rico.

Domestic wholesale cigarette unit volume, which excludes Puerto Rico and U.S.

Possessions, decreased 2.8% for the second quarter of 2014 compared to the corresponding period of 2013. The Company estimates total cigarette industry domestic wholesale shipments decreased 5.5% for the second quarter of 2014 compared to the second quarter of 2013. Adjusting for the impact of changes in wholesale inventory patterns, Lorillard domestic wholesale shipments decreased an estimated 2.1% in the second quarter of 2014 versus year ago, significantly outperforming adjusted total cigarette industry domestic wholesale shipments which decreased an estimated 4.3% during the quarter compared to second quarter of 2013.

Total wholesale unit volume, including Puerto Rico, for Newport, the Company's flagship brand, decreased 2.7% for the second quarter of 2014 compared to the corresponding period of 2013. Domestic wholesale cigarette unit volume for Newport, which excludes Puerto Rico and U.S. Possessions, decreased 1.9% for the quarter versus year ago. Adjusting for inventory fluctuations, Newport domestic volume decreased an estimated 1.2% versus year ago. Domestic wholesale shipments for Maverick, the Company's leading discount brand, decreased 6.6% for the second quarter of 2014 compared to the second quarter of 2013.

Based on Lorillard's proprietary retail shipment database administered by Management Science Associates, Inc., which measures shipments from wholesale to retail and is unaffected by wholesale inventory changes, Lorillard's second quarter 2014 domestic retail market share increased 0.2 share points versus year ago to 15.0%, its second consecutive full quarter over 15%. Newport's domestic retail market share was 12.8%, an increase of 0.3 share points compared to the second quarter of 2013. Lorillard's domestic retail share of the menthol market increased 0.3 share points to 40.3% for the second quarter of 2014 compared to the corresponding period of 2013. Gains in Newport's domestic retail market share were primarily attributable to the continued strengthening of Newport Menthol in its core geographies, continued success in expansion markets and the volume impact from the growth of Newport Non-Menthol.

Cost of sales. Cost of sales increased by $1 million, or 0.1%, from $1.087 billion for the three months ended June 30, 2013 to $1.088 billion for the three months ended June 30, 2014. Cost of sales reflects higher expenses related to the State Settlement Agreements ($15 million), higher cigarette raw material input costs (primarily tobacco and other direct costs) ($3 million) and higher Food and Drug Administration fees ($2 million), partially offset by lower unit sales volume ($19 million, including $14 million of Federal Excise Tax). We recorded pre-tax charges for our obligations under the State Settlement Agreements of $358 million and $343 million for the three months ended June 30, 2014 and 2013, respectively, an increase of $15 million. The $15 million increase is primarily due to the impact of the inflation adjustment ($9 million), $4 million unfavorable impact of the reversal of a portion of the 2003 non-participating manufacturer award related to a Missouri court order, the absence of the $12 million favorable impact on Lorillard's tobacco settlement expense of the settlement to resolve certain MSA payment adjustment disputes approved by the arbitration panel in March 2013 and other adjustments ($4 million), partially offset by the favorable impact of $14 million on Lorillard's tobacco settlement expense of the settlement to resolve certain MSA payment adjustment disputes with two additional states in the second quarter of 2014.

-54- -------------------------------------------------------------------------------- Table of Contents Selling, general and administrative. Selling, general and administrative costs decreased $3 million to $119 million in the three months ended June 30, 2014 compared to the three months ended June 30, 2013, primarily due to lower legal defense costs related to Engle Progeny litigation and lower promotional expenses related to Newport Menthol, partially offset by $4 million in costs related to the agreement to merge with RAI.

Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013 Net sales. Cigarette net sales increased by $36 million, or 1.1%, from $3.267 billion for the six months ended June 30, 2013 to $3.303 billion for the six months ended June 30, 2014. Cigarette net sales increased due to higher average net selling prices of $137 million which reflect price increases in June and November 2013 and May 2014, partially offset by lower cigarette unit sales volume ($101 million, including $24 million of federal excise tax).

Total Lorillard wholesale cigarette unit volume, which includes Puerto Rico and U.S. Possessions, decreased 3.2% for the first half of 2014 compared to the corresponding period of 2013. Puerto Rico and U.S. Possessions declined 36.3% compared to a year ago period in which inventories were built by wholesale in advance of a July 2013 $1.00 per pack excise tax increase in Puerto Rico.

Domestic wholesale cigarette unit volume, which excludes Puerto Rico and U.S.

Possessions, decreased 2.5% for the first half of 2014 compared to the corresponding period of 2013. The Company estimates total cigarette industry domestic wholesale shipments decreased 4.2% for the first half of 2014 compared to the first half of 2013. Adjusting for the impact of changes in wholesale inventory patterns, Lorillard domestic wholesale shipments decreased an estimated 1.9% in the first half of 2014 versus year ago, significantly outperforming adjusted total cigarette industry domestic wholesale shipments which decreased an estimated 4.2% during the first half of 2014 compared to the first half of 2013.

Total wholesale unit volume for Newport, including Puerto Rico and U.S.

Possessions, the Company's flagship brand, decreased 2.5% for the first half of 2014 compared to the corresponding period of 2013. Domestic wholesale cigarette unit volume for Newport, which excludes Puerto Rico and U.S. Possessions, decreased 1.7% for the first half of 2014 versus year ago. Adjusting for inventory fluctuations, Newport domestic volume decreased an estimated 1.0% versus year ago, significantly outperforming the 4.2% estimated adjusted industry decline. Domestic wholesale shipments for Maverick, the Company's leading discount brand, decreased 6.3% for the first half of 2014 compared to the first half of 2013.

Based on Lorillard's proprietary retail shipment database administered by Management Science Associates, Inc., which measures shipments from wholesale to retail and is unaffected by wholesale inventory changes, Lorillard's first half 2014 domestic retail market share increased 0.3 share points versus year ago to 15.1%. Newport's domestic retail market share reached 12.9%, an increase of 0.3 share points compared to the first half of 2013. Lorillard's domestic retail share of the menthol market increased 0.2 share points to 40.5% for the first half of 2014. Gains in Newport's domestic retail market share were primarily attributable to the continued strengthening of Newport Menthol in its core geographies, continued success in expansion markets and volume growth from Newport Non-Menthol.

Cost of sales. Cost of sales increased by $112 million, or 5.9%, from $1.914 billion for the six months ended June 30, 2013 to $2.026 billion for the six months ended June 30, 2014. Cost of sales reflects higher expenses related to the State Settlement Agreements ($125 million), higher cigarette raw material input costs (primarily tobacco and other direct costs) ($13 million), higher Food and Drug Administration fees ($4 million) and an increase in the Federal Assessment for Tobacco Growers ($2 million), partially offset by lower unit sales volume ($32 million, including $24 million of Federal Excise Tax). We recorded pre-tax charges for our obligations under the State Settlement Agreements of $644 million and $519 million for the six months ended June 30, 2014 and 2013, respectively, an increase of $125 million. The $125 million increase is primarily due to the absence of the $154 million favorable impact on Lorillard's tobacco settlement expense of the settlement to resolve certain MSA payment adjustment disputes approved by the arbitration panel in March 2013, the inflation adjustment of $18 million and $4 million unfavorable impact of the reversal of a portion of the 2003 non-participating manufacturer award related to a Missouri court order, partially offset by the favorable impact of $27 million on Lorillard's tobacco settlement expense in 2014 related to the 2003 non-participating manufacturer arbitration award as a result of the September 2013 arbitration panel determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers, the $14 million favorable impact of the reduction in Lorillard's MSA payments as a result of the settlement with two more states in June 2014 and other adjustments ($6 million).

Selling, general and administrative. Selling, general and administrative costs decreased $22 million to $239 million in the six months ended June 30, 2014 compared to the six months ended June 30, 2013, primarily due to the absence of the $20 million in estimated costs to comply with or otherwise resolve the U.S.

Government Case judgment incurred in the first quarter of 2013, lower legal defense costs related to Engle Progeny litigation and lower promotional expenses related to Newport Menthol, partially offset by $4 million in costs related to the agreement to merge with RAI.

-55--------------------------------------------------------------------------------- Table of Contents Electronic Cigarettes Segment Results* Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 (in millions) (in millions) Net sales $ 37 $ 57 $ 88 $ 114 Cost of sales 28 39 64 76 Gross profit 9 18 24 38 Selling, general and administrative 32 16 58 29 Operating income (loss) $ (23 ) $ 2 $ (34 ) $ 9 * Results for the three and six months ended June 30, 2013 provided above are not comparable to the results for the three and six months ended June 30, 2014 as Lorillard purchased the assets and operations of SKYCIG on October 1, 2013.

Three Months Ended June 30, 2014 Compared to the Three Months Ended June 30, 2013 Net sales. Net sales for the Electronic Cigarettes segment were $37 million for the three months ended June 30, 2014, compared to $57 million for the three months ended June 30, 2013. The decline in sales of blu eCigs in the U.S. versus year ago reflects a decrease in unit volume as well as the estimated $4 million mix impact of a lower price on rechargeable kits that were introduced in the third quarter of 2013. The decrease in unit volume is attributed to an unfavorable comparison to the year ago period that included significant pipeline inventory as the brand was in its initial phase of national expansion and was also negatively impacted by new national competitors' launches during this year's second quarter.

blu (U.K.), formerly known as SKYCIG, was acquired on October 1, 2013 and generated $4 million in net sales during the second quarter of 2014. The product offering in the U.K. was re-branded as "blu" and launched at retail and online during the second quarter of 2014. The launch and retail rollout has been accompanied by introductory levels of advertising and promotional spending.

Retail placement and exposure is expected to increase significantly during the second half of 2014, which, along with continued marketing of blu, is expected to drive an increase in net sales.

Based on the Nielsen ScanTrack Database, blu's all-outlet dollar market share of electronic cigarettes decreased 1.1% share points to 40.9% for the 13 weeks ending July 5, 2014 versus the year ago 13 week period, tracing to the list price reduction on rechargeable packs and increased competitive activity during this year's second quarter.

Cost of sales. Cost of sales for the Electronic Cigarettes segment was $28 million for the three months ended June 30, 2014, compared to $39 million for the three months ended June 30, 2013.

Gross profit. Gross profit was $9 million, or 24.3% of net sales, for the three months ended June 30, 2014, compared to $18 million, or 31.6% of net sales, for the three months ended June 30, 2013. Gross profit and gross profit margin for the second quarter ended June 30, 2014 were negatively impacted by the mix impact of the new, lower priced rechargeable kits as well as higher retail distribution costs. This negative drag on gross margin should be minimal going forward as the Company has fully lapped the conversion to the lower priced rechargeable kits.

Selling, general and administrative. Selling, general and administrative costs were $32 million for the three months ended June 30, 2014, compared to $16 million for the three months ended June 30, 2013. Selling, general and administrative costs include increased costs to launch the blu brand in the U.K.

Selling, general and administrative costs for the three months ended June 30, 2014 also include $6 million of amortization related to the SKYCIG brand. The fair value ascribed to the SKYCIG brand in connection with the acquisition of £20 million (approximately $35 million at June 30, 2014 exchange rates) is being amortized over an estimated life of 18 months beginning October 1, 2013 after which amortization charges related to the brand will cease.

Operating income (loss). The Electronic Cigarettes segment had an operating loss of $23 million for the three months ended June 30, 2014, compared to operating income of $2 million for the three months ended June 30, 2013. blu (U.K.)'s operating loss was $15 million for the three months ended June 30, 2014.

-56--------------------------------------------------------------------------------- Table of Contents Six Months Ended June 30, 2014 Compared to the Six Months Ended June 30, 2013 Net sales. Net sales for the Electronic Cigarettes segment were $88 million for the six months ended June 30, 2014, compared to $114 million for the six months ended June 30, 2013. The decline in sales of blu eCigs in the U.S. versus year ago reflects a decrease in unit volume as well as the estimated $11 million mix impact of a lower price on rechargeable kits that were introduced in the third quarter of 2013. The year ago quarter was also favorably impacted by significant pipeline inventory as the brand was in its initial phase of national expansion.

blu (U.K.) was acquired on October 1, 2013 and generated $7 million in net sales during the first half of 2014.

Based on the Nielsen ScanTrack Database, blu's domestic all-outlet dollar market share of electronic cigarettes increased 3.3 share points to 42.8% for the 26 weeks ending July 5, 2014 versus the year ago 26 week period. blu's robust share growth at retail is attributed to strong consumer pull through from brand equity building activities and increased distribution.

Cost of sales. Cost of sales for the Electronic Cigarettes segment was $64 million for the six months ended June 30, 2014, compared to $76 million for the six months ended June 30, 2013.

Gross profit. Gross profit was $24 million, or 27.3% of net sales, for the six months ended June 30, 2014, compared to $38 million, or 33.3% of net sales, for the six months ended June 30, 2013. Gross profit and gross profit margin for the first half of 2014 were negatively impacted by the mix impact of the new, lower priced rechargeable kits as well as higher retail distribution costs.

Selling, general and administrative. Selling, general and administrative costs were $58 million for the six months ended June 30, 2014, compared to $29 million for the six months ended June 30, 2013. 2014 selling, general and administrative costs include increased advertising and marketing costs associated with brand-building activities in the U.S. and costs to launch the blu brand in the U.K. Selling, general and administrative costs for the six months ended June 30, 2014 also include $11 million of amortization related to the SKYCIG brand. The fair value ascribed to the SKYCIG brand in connection with the acquisition of £20 million (approximately $35 million at June 30, 2014 exchange rates) is being amortized over an estimated life of 18 months beginning October 1, 2013 after which amortization charges related to the brand will cease.

Operating income (loss). The Electronic Cigarettes segment had an operating loss of $34 million for the six months ended June 30, 2014, compared to operating income $9 million for the six months ended June 30, 2013. blu (U.K.)'s operating loss was $23 million for the six months ended June 30, 2014.

Lorillard Consolidated Results Investment income (loss). Investment income decreased $2 million for the three months ended June 30, 2014 compared to the three months ended June 30, 2013 primarily due to the unfavorable impact of the Missouri court ruling reversing a portion of the 2003 non-participating manufacturer award in the second quarter of 2014.

Investment income increased $5 million for the six months ended June 30, 2014 compared to the six months ended June 30, 2013, and reflects $7 million of interest income related to the 2003 non-participating manufacturer arbitration award in the first quarter of 2014, partially offset by the unfavorable impact of the Missouri court ruling in the second quarter of 2014.

Interest expense. Interest expense increased $4 million and $8 million for the three and six months ended June 30, 2014, respectively, compared to the three and six months ended June 30, 2013, and reflects interest on the Senior Notes issued in the second quarter of 2013.

Income taxes. Income taxes decreased $1 million, or 0.5%, from $186 million for the three months ended June 30, 2013 to $185 million for the three months ended June 30, 2014. The change reflects a decrease in income before income taxes of $14 million, or 2.8%, partially offset by an increase in the effective tax rate from 37.3% to 38.1% for the three months ended June 30, 2013 and 2014, respectively. The rate increase is mainly due to an increase in state taxes and United Kingdom foreign tax rate differences that negatively impacted the tax rate, partially offset by an increase in the manufacturers' deduction.

Income taxes decreased $31 million, or 8.2%, from $380 million for the six months ended June 30, 2013 to $349 million for the six months ended June 30, 2014. The change reflects a decrease in income before income taxes of $100 million, or 9.8%, partially offset by an increase in the effective tax rate from 37.2% to 37.9% for the six months ended June 30, 2013 and 2014, respectively.

The rate increase is mainly due to an increase in state taxes and United Kingdom foreign tax rate differences that negatively impacted the tax rate, partially offset by an increase in the manufacturers' deduction.

-57--------------------------------------------------------------------------------- Table of Contents Liquidity and Capital Resources Our cash and cash equivalents of $709 million at June 30, 2014 were invested in prime money market funds.

Our short-term and long-term investments totaled $172 million and $126 million as of June 30, 2014, respectively. Short-term and long-term investments consist of investment grade debt securities, all of which are classified as available for sale.

Cash Flows Cash flow from operating activities. The principal source of liquidity for our business and operating needs is internally generated funds from our operations.

We generated net cash flow from operations of $75 million for the six months ended June 30, 2014 compared to $182 million for the six months ended June 30, 2013. The decreased cash flow in 2014 primarily reflects lower net income, a higher decrease in accrued settlement costs and a higher decrease in income taxes payable, partially offset by lower inventory purchases.

Cash flow from investing activities. Our cash flows from investing activities used cash of $70 million for the six months ended June 30, 2014 compared to $34 million for the six months ended June 30, 2013. The increase in cash used by investing activities is due primarily to the purchase of investments totaling $337 million, partially offset by cash provided by sales of investments of $289 million.

Cash flow from financing activities. Our cash flow from operations has exceeded our working capital and capital expenditure requirements during the six months ended June 30, 2014. We paid cash dividends to our shareholders of $224 million on March 10, 2014, $222 million on June 10, 2014, $209 million on March 11, 2013 and $208 million on June 10, 2013. During the six months ended June 30, 2014 and 2013, we repurchased shares totaling $314 million and $318 million, respectively.

In August 2012, Lorillard Tobacco issued $500 million aggregate principal amount of 2.300% unsecured senior notes due August 21, 2017 (the "2017 Notes") pursuant to the Indenture and the Fourth Supplemental Indenture, dated August 21, 2012.

The net proceeds from the issuance were used for the repurchase of our common stock.

In May 2013, Lorillard Tobacco issued $500 million aggregate principal amount of 3.750% unsecured senior notes due May 20, 2023 (the "2023 Notes") pursuant to the Indenture and the Fifth Supplemental Indenture, dated May 20, 2013. The net proceeds from the issuance will be used for general corporate purposes, which may include, among other things, the repurchase, redemption or retirement of securities including the Company's common stock, acquisitions, additions to working capital and capital expenditures.

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

The interest rate payable on the 2019 Notes is subject to incremental increases from 0.25% to 2.00% in the event either Moody's Investors Services, Inc.

("Moody's"), Standard & Poor's Ratings Services ("S&P") or both Moody's and S&P downgrade the 2019 Notes below investment grade (Baa3 and BBB- for Moody's and S&P, respectively). As of June 30, 2014, our debt ratings were Baa2 and BBB- with Moody's and S&P, respectively, both of which are investment grade.

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

-58- -------------------------------------------------------------------------------- Table of Contents As of June 4, 2014, the Company completed its $1 billion repurchase program announced in March 2013 and amended in May 2013 by repurchasing 2.7 million shares at a cost of $156 million during the second quarter of 2014.

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

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

Both the aggregate payment obligations of the Original Participating Manufacturers, and our payment obligations, individually, under the State Settlement Agreements are subject to adjustment for several factors which include: • inflation; • aggregate volume of Original Participating Manufacturers cigarette shipments; • other Original Participating Manufacturers and our market share; and • aggregate Original Participating Manufacturers operating income, allocated to such manufacturers that have operating income increases.

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

During April 2014, we paid $1.1 billion under the State Settlement Agreements, primarily based on 2013 volume. Included in the above number was $93 million we deposited in an interest-bearing escrow account ("Disputed Payments Account") in accordance with procedures established in the MSA pending resolution of a claim by us and the other Original Participating Manufacturers that they are entitled to reduce their MSA payments based on a loss of market share to non-participating manufacturers. Most of the states that are parties to the MSA are disputing the availability of the reduction and we believe that this dispute will ultimately be resolved by judicial and arbitration proceedings. Our $93 million deposit in escrow is based upon the Original Participating Manufacturers collective loss of market share in 2011 that resulted in a reduction of $88 million and for adjustments related to escrow -59--------------------------------------------------------------------------------- Table of Contents payments for other years. In April of 2013, 2012, 2011, 2010, 2009, 2008, 2007 and 2006, we had previously deposited $119 million, $106 million, $104 million, $83 million, $73 million, $72 million, $111 million and $109 million, respectively, in the Disputed Payments Account discussed above, which were based on losses of market share in 2010, 2009, 2008, 2007, 2006, 2005, 2004 and 2003 to non-participating manufacturers. In February 2009, we directed the release of $72 million from the Disputed Payments Account to the MSA states. This amount related to the loss of market share in 2005 and this release was pursuant to an Agreement Regarding Arbitration that we and the other Participating Manufacturers entered into with certain MSA states. In April 2013, October 2013, April 2014 and June 2014, we directed the release of $298 million, $22 million, $40 million and $12 million, respectively, from the Disputed Payments Account to the signatory states to the settlement that resolved the disputes involving MSA payment adjustments relating to non-participating manufacturers, as further discussed below. In addition, in April 2014, we directed the release of $62 million from the Disputed Payments Account to Lorillard Tobacco associated with the 2003 arbitration award, as further discussed below. We and the other Original Participating Manufacturers have the right to claim additional reductions of MSA payments in subsequent years under provisions of the MSA.

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

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

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

Lorillard Tobacco will continue to pursue these claims against those states that have not settled. Fourteen states that have not joined the settlement have taken action in state court to prevent the settlement from proceeding or to seek other relief related to the settlement. As of July 25, 2014, claims in eleven states remain pending as one state withdrew its opposition and, as noted above, two additional states joined the settlement. Two of the states also unsuccessfully sought to preliminarily enjoin the implementation of the settlement. There is no assurance that such attempts will be resolved favorably to the Company.

On September 11, 2013, the arbitration panel responsible for adjudicating the 2003 NPM adjustment dispute issued a determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers. The six non-diligent states included Indiana, Kentucky, Missouri, New Mexico, Maryland, and Pennsylvania. Nine other states that did not participate in the settlement were considered by the arbitration panel because the OPMs contested their diligence as well. The arbitration panel found those nine states diligent. As a result of the panel's ruling, the OPMs are entitled to receive $458 million, plus interest and earnings, with Lorillard -60--------------------------------------------------------------------------------- Table of Contents Tobacco's share of the principal amount totaling $47 million. The six non-diligent states filed motions in their state courts to vacate the arbitration panel's non-diligence findings. On March 31, 2014 the MSA Independent Auditor issued final calculations for the April 2014 MSA payments that implement the 2003 NPM Adjustment in that fashion.

On April 10, 2014, the MSA court in Pennsylvania issued its rulings on that state's motion to vacate the arbitration panel's rulings with respect to that state. The court upheld the arbitration panel's non-diligence finding for that state. However, the court also ruled that the states that signed the settlement and had been contested in the 2003 NPM Adjustment arbitration would be deemed non-diligent for purposes of calculating that state's share of the 2003 NPM Adjustment. The OPM's appealed this ruling. The MSA Independent Auditor on April 14, 2014 issued revised final calculations for the April 2014 MSA payments that implement the Pennsylvania court's ruling. The ruling was reflected as an increase of $12 million in Lorillard Tobacco's April 15, 2014 MSA payment. On May 2, 2014, the MSA court in Missouri issued a ruling similar to Pennsylvania, which the OPMs appealed. On June 23, 2014, the MSA Independent Auditor issued revised final calculations for the April 2014 MSA payments that implement the Missouri ruling. The ruling was reflected as an increase in Lorillard Tobacco's State Settlements liability and expense of $4 million during the second quarter of 2014.

Based on the terms of the award, during the first quarter of 2014 Lorillard Tobacco recorded a reduction in its State Settlements liability and expense of $37 million and recorded $7 million as an increase to investment income related to interest earned on the proceeds from the 2003 NPM Adjustment award, including funds paid into and released from the Disputed Payments Account. The reduction was partially offset by an increase of $6 million in the State Settlements liability and expense related to the industry Volume Adjustment Offset associated with the increase in the industry aggregate operating income under the agreements with the previously settled states.

In addition, in connection with the MSA, the Original Participating Manufacturers entered into an agreement to establish a $5.2 billion trust fund payable between 1999 and 2010 to compensate the tobacco growing communities in 14 states (the "Trust"). Payments to the Trust ended in 2005 as a result of an assessment imposed under a federal law, enacted in 2004, repealing the federal supply management program for tobacco growers. Under the law, tobacco quota holders and growers will be compensated over 10 years with payments totaling $10.1 billion, funded by an assessment on tobacco manufacturers and importers.

Payments under the law to qualifying tobacco quota holders and growers commenced in 2005 and will be completed in 2014. Lorillard recorded pretax charges for its obligations under the law of $36 million and $64 million for the three and six months ended June 30, 2014 and $36 million and $62 million for the three and six months ended June 30, 2013, respectively. We estimate our remaining cash payments in 2014 under the law will be between $64 million and $65 million.

Contractual Cash Payment Obligations The following chart presents our contractual cash payment obligations of Lorillard as of June 30, 2014: Less More than 1-3 3-5 than Total 1 year years years 5 years (In millions) Senior notes $ 3,500 $ - $ 500 $ 2,000 $ 1,000 Interest payments related to notes 1,839 198 549 267 825 Leaf Purchase obligations 117 117 - - - Contractual purchase obligations 60 60 - - - Operating lease obligations 6 3 2 1 - Total $ 5,522 $ 378 $ 1,051 $ 2,268 $ 1,825 As of June 30, 2014, we do not believe that we will make any payments in the next twelve months related to gross unrecognized tax benefits. We cannot make a reasonably reliable estimate of the amount of liabilities for unrecognized tax benefits that may result in cash settlements for periods beyond twelve months.

As previously discussed, we have entered into the State Settlement Agreements which impose a stream of future payment obligations on us and the other major U.S. cigarette manufacturers. Our portion of ongoing adjusted settlement payments, including fees to settling plaintiffs' attorneys, are based on a number of factors which are described -61--------------------------------------------------------------------------------- Table of Contents above. Our cash payment under the State Settlement Agreements in 2013 amounted to $1.200 billion, net of the NPM settlement credit of $177 million, and we estimate our cash payments in 2014 under the State Settlement Agreements will be between $1.369 billion and $1.419 billion, primarily based on 2013 estimated industry volume. Payment obligations are not incurred until the related sales occur and therefore are not reflected in the above table. The 2014 estimated cash payments include the favorable impact of the release from the DPA on April 15, 2014 of $47 million as a result of the September 2013 arbitration panel determination that six states failed to diligently enforce escrow provisions applicable to non-participating manufacturers.

Off-Balance Sheet Arrangements None.

[ Back To TMCnet.com's Homepage ]