FORM 10-K

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Commission File Number 0-17506

UST Inc.

(Exact name of registrant as specified in its charter)

(203) 817-3000

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

(Title of Class)

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  o

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of June 30, 2007, the aggregate market value of Registrant’s Common Stock, $.50 par value, held by non-affiliates of Registrant (which for this purpose does not include directors or officers) was $8,479,337,561.

 

As of February 13, 2008, there were 149,471,457 shares of Registrant’s Common Stock, $.50 par value, outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

Certain pages of the Registrant’s 2008 Notice of Annual Meeting and Proxy Statement       Part III

 

FORM 10-K

 

TABLE OF CONTENTS

 

 

 

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General

 

UST Inc. was formed on December 23, 1986 as a Delaware corporation to serve as a publicly-held holding company for United States Tobacco Company (“USTC”), which was formed in 1911. Pursuant to a reorganization approved by stockholders at the 1987 Annual Meeting, USTC became a wholly-owned subsidiary of UST Inc. on May 5, 1987, and UST Inc. continued in existence as a holding company. Effective January 1, 2001, USTC changed its name to U.S. Smokeless Tobacco Company (“USSTC”). UST Inc., through its direct and indirect subsidiaries (collectively “Registrant” or the “Company” unless the context otherwise requires), is engaged in the manufacturing and marketing of consumer products in the following business segments:

 

Smokeless Tobacco Products:  The Company’s primary activities are the manufacturing and marketing of smokeless tobacco products.

 

Wine:  The Company produces and markets premium varietal and blended wines, and imports and distributes wines from Italy.

 

All Other Operations:  The Company’s international operations, which market moist smokeless tobacco products, are included in all other operations.

 

Available Information

 

The Company’s website address is www.ustinc.com. The Company makes available free of charge through its website its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material is electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). A free copy of these materials can also be requested via correspondence addressed to the Secretary at UST Inc., 6 High Ridge Park, Building A, Stamford, Connecticut 06905. The public may read and copy any materials the Company has filed with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may also obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements, and other information regarding issuers, including the Company, that file electronically with the SEC.

 

Operating Segment Data

 

The Company hereby incorporates by reference the Segment Information pertaining to the years 2005 through 2007 set forth herein in Part II, Item 8, “Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 16, Segment Information.”

 

SMOKELESS TOBACCO PRODUCTS

 

Principal Products

 

The Company’s principal smokeless tobacco products and brand names are as follows:

 

Moist:  Copenhagen, Skoal, Red Seal, Husky

 

Dry:    Bruton, CC, Red Seal

 

 

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Overview

 

Through its USSTC subsidiary, the Company is the leading producer and marketer of moist smokeless tobacco products, including its iconic premium brands, Copenhagen and Skoal, and its value brands, Red Seal and Husky. The Company’s share of the total moist smokeless tobacco category is approximately 60 percent on a volume basis, and 73 percent on a revenue basis, according to data from the Company’s Retail Account Data Share & Volume Tracking System (“RAD-SVT”) for the 52-week period ended December 29, 2007. The moist smokeless tobacco category continues to be one of the fastest growing established consumer packaged goods categories at retail, according to ACNielsen. This trend is further supported by RAD-SVT information, which indicates that moist smokeless tobacco category growth for 2007 was approximately 7 percent. See Part II, Item 7 “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Smokeless Tobacco Segment,” for additional background information regarding RAD-SVT data.

 

The vision for the Company’s smokeless tobacco business is that its smoke-free products will be recognized by adults as the preferred way to experience tobacco satisfaction. The Company’s primary objective in connection with this vision is to continue to grow the moist smokeless tobacco category by building awareness and social acceptability of smokeless tobacco products among adults, primarily smokers, with a secondary objective of competing effectively in every segment of the moist smokeless tobacco category.

 

While category growth remains the Company’s top priority, the Company is committed to competing effectively in every segment of the moist smokeless tobacco category and accelerating profitable volume growth, with the goal of growing as fast as the category. The Company is making progress towards this goal through increased brand building, its premium brand loyalty initiative and increased retail promotional efforts related to price-value products.

 

The following provides a brief summary of each of the Company’s principal moist smokeless tobacco brands and products:

 

Copenhagen

 

Introduced in 1822, Copenhagen was among the first brands of moist smokeless tobacco available, and today remains the most authentic and best-selling product in the moist smokeless tobacco category, with annual sales at retail exceeding $1 billion. Copenhagen is a natural flavor product that features a traditional metal lid and a fiberboard can that carries a made date. Copenhagen is available in original fine cut and long cut, as well as Copenhagen Pouches. Copenhagen is recognized as the brand of choice for adult consumers who identify with its rugged, individual and uncompromising image. In addition, during 2007, the Company launched Cope, an all-new line of premium moist smokeless tobacco products that was developed to broaden the appeal of the Company’s Copenhagen brand. The Cope products are available in three varieties, Smooth Hickory, Straight and Whiskey Blend Flavor.

 

Skoal

 

Skoal, introduced in 1934, is the leading flavored moist smokeless tobacco brand on the market, with current annual retail sales in excess of $1 billion. The brand’s broad range of product flavor blends, cuts and formats reflects the Company’s continued focus on innovation. Skoal is available in fine cut, long cut and two pouch formats – Skoal Pouches and Skoal Bandits.

 

Red Seal

 

A mid-priced brand that offers adult consumers 25 percent more American-grown tobacco per can, Red Seal is available in long cut and fine cut varieties.

 

 

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Husky

 

The Husky brand offers deep discount products for value-conscious adult consumers. Husky products are available in long cut and fine cut varieties.

 

Smokeless Tobacco Products and Health

 

Reports with respect to the health risks of tobacco products have been publicized for many years, and the sale, promotion and use of tobacco continue to be subject to increasing governmental regulation. In 1986, a Surgeon General’s Report reached the judgment that smokeless tobacco use “can cause cancer” and “can lead to nicotine dependence or addiction.” Also in 1986, Congress passed the Comprehensive Smokeless Tobacco Health Education Act of 1986, which requires the following warnings on smokeless tobacco packages and advertising: “WARNING: THIS PRODUCT MAY CAUSE MOUTH CANCER,” “WARNING: THIS PRODUCT MAY CAUSE GUM DISEASE AND TOOTH LOSS,” “WARNING: THIS PRODUCT IS NOT A SAFE ALTERNATIVE TO CIGARETTES.” In light of the scientific research taken as a whole, while the Company does not believe that smokeless tobacco has been shown to be a cause of any human disease, the Company does not take the position that smokeless tobacco is safe.

 

Over the last several years, smokeless tobacco has been the subject of discussion in the scientific and public health community in connection with the issue of tobacco harm reduction. Tobacco harm reduction is generally described as a public health strategy aimed at reducing the health risks to cigarette smokers who have not quit and is frequently discussed in the context of proposals for an overall tobacco regulatory regime. It is reported that approximately 45 million adult Americans continue to smoke, and many have made repeated attempts to quit, including with the use of medicinal nicotine products. There has been an ongoing debate in the scientific and public health community as to what to do for these smokers. One idea that has been debated is to suggest that they switch completely to smokeless tobacco. Many believe that certain smokeless tobacco products pose significantly less risk than cigarettes and therefore could be a potential reduced risk alternative to cigarette smoking. There are others, however, who believe that there is insufficient scientific basis to encourage switching to smokeless tobacco and that such a strategy may result in unintended public health consequences.

 

From a consumer perspective, data from some surveys indicate that at least 80 percent of smokers believe smokeless tobacco is as dangerous as cigarette smoking. The Company believes that adult cigarette smokers should be provided accurate and relevant information on these issues so that they may make informed decisions about tobacco products. This is especially so in light of data from some surveys that indicate that at least half of the approximately 45 million adult smokers are looking for an alternative. The Company believes that there is an opportunity for smokeless tobacco products to have a significant role in a tobacco harm reduction strategy and, therefore, encourages the debate of this topic.

 

Legislation and Regulation

 

As indicated above, in 1986, federal legislation was enacted regulating smokeless tobacco products by, among other things, requiring health warning notices on smokeless tobacco packages and advertising and by prohibiting the advertising of smokeless tobacco products on any medium of electronic communications subject to the jurisdiction of the Federal Communications Commission. A federal excise tax was imposed in 1986, which was increased in 1991, 1993, 1997, 2000 and 2002. Also, in recent years, proposals have been made at the federal level for additional regulation of tobacco products including, among other things, the requirement of additional warning notices, the disallowance of advertising and promotion expenses as deductions under federal tax law, a ban or further restriction of all advertising and promotion, regulation of environmental tobacco smoke and increased regulation of the manufacturing and marketing of tobacco products by new or existing federal agencies. Similar proposals will likely be considered in the future.

 

On August 28, 1996, the U.S. Food and Drug Administration (the “FDA”) published regulations asserting unprecedented jurisdiction over nicotine in tobacco as a “drug” and purporting to regulate smokeless

 

 

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tobacco products as a “medical device.” The Company and other smokeless tobacco manufacturers filed suit against the FDA seeking a judicial declaration that the FDA has no authority to regulate smokeless tobacco products. On March 21, 2000, the United States Supreme Court ruled that the FDA lacks jurisdiction to regulate tobacco products. Following this ruling, proposals for federal legislation for comprehensive regulation of tobacco products continue to be considered. Over the years, various state and local governments have continued to regulate tobacco products, including, among other things, the imposition of significantly higher taxes, increases in the minimum age to purchase tobacco products, adult sampling and advertising bans or restrictions, ingredient and constituent disclosure requirements, regulation of environmental tobacco smoke and significant tobacco control media campaigns. Additional state and local legislative and regulatory actions will likely be considered in the future, including, among other things, restrictions on the use of flavorings. The Company is unable to assess the future effects these various actions may have on its smokeless tobacco business. The Company believes that any proposals for additional regulation at the federal, state or local level should recognize the distinct differences between smokeless tobacco products and cigarettes.

 

In addition to increased regulatory restrictions, the Company is subject to various marketing and advertising restrictions under the Smokeless Tobacco Master Settlement Agreement (the “STMSA”), which the Company entered into in 1998 with the attorneys general of various states and U.S. territories to resolve the remaining health care cost reimbursement cases initiated by various attorneys general. The Company is the only smokeless tobacco manufacturer to sign the STMSA.

 

Raw Materials

 

Except as noted below, raw materials essential to the Company’s smokeless tobacco business are generally purchased in domestic markets under competitive conditions.

 

The Company purchased all of its leaf tobacco from domestic suppliers in 2007, as it has for the last several years. Various factors, including the level of domestic tobacco production, can affect the amount of tobacco purchased by the Company from domestic sources. Tobaccos used in the manufacture of smokeless tobacco products are processed and typically aged by the Company for a period of approximately three years prior to their use.

 

At the present time, the Company believes there is a sufficient supply of leaf tobacco available in the market to satisfy its current and expected production requirements. With the enactment of the Fair and Equitable Tobacco Reform Act of 2004 (the “Tobacco Reform Act”) and its repeal of federal tobacco price support and quota programs, tobacco can be grown anywhere in the United States with no volume limitations or price protection or guarantees. As a result, the Tobacco Reform Act has favorably impacted the Company’s cost of leaf tobacco purchases since its enactment. However, the continuing availability and the cost of tobacco is dependent upon a variety of factors which cannot be predicted, including, but not limited to, weather, growing conditions, local planting decisions, overall market demands and other factors.

 

The Company or its suppliers purchase certain flavoring components from foreign sources, which are used in the manufacturing of the Company’s smokeless tobacco products. The Company believes there is a sufficient supply of such flavoring components available in the market to satisfy its current and expected production requirements.

 

Working Capital

 

The principal portion of the Company’s operating cash requirements for this segment relates to its need to maintain significant inventories of leaf tobacco, primarily for the manufacturing of moist smokeless tobacco products, to ensure an aging process of approximately three years prior to manufacture and sale.

 

 

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Customers

 

The Company markets its moist smokeless tobacco products throughout the United States principally to wholesalers and retail chain stores. Approximately 35 percent of the Company’s gross sales of tobacco products are made to four wholesale customers, one of which, McLane Co. Inc., a national wholesale distributor, accounts for approximately 17 percent of the Company’s consolidated revenue. The Company has maintained satisfactory relationships with its customers over the years and expects that such relationships will continue.

 

Competitive Conditions

 

The tobacco manufacturing industry in the United States is composed of several domestic companies larger than the Company and many smaller ones. The larger companies primarily concentrate on the manufacturing and marketing of cigarettes; however, in 2006, a major cigarette company entered the smokeless tobacco category through its acquisition of one of the Company’s competitors. In addition, certain cigarette companies have begun test marketing smokeless tobacco products and have indicated the intent to continue to expand this activity. The Company is a well established and major factor in the smokeless tobacco sector of the overall tobacco market. Consequently, the Company competes actively with both larger and smaller companies in the marketing of its smokeless tobacco products. Competition also includes both domestic and international companies marketing and selling price-value and deep-discount smokeless tobacco products. The Company’s principal methods of competition in the marketing of its smokeless tobacco products include quality, advertising, promotion, sampling, price, product recognition, product innovation and distribution.

 

WINE

 

Principal Products

 

The Company’s principal wine brand names are as follows:

 

 

 

 

Overview

 

The Company, through its Ste. Michelle Wine Estates subsidiary, is an established producer of premium varietal and blended table wines, with a vision for Ste. Michelle Wine Estates to be recognized as the premier fine wine company in the world. According to ACNielsen, Ste. Michelle Wine Estates was the fastest growing of the ten largest wineries in the United States during 2007, with the Company’s wines comprising 6.8 percent of total domestic 750ml units over that period, as compared to 6.2 percent in the prior year.

 

The Company produces Chateau Ste. Michelle, Columbia Crest and other varietal table wines and Domaine Ste. Michelle sparkling wine in the State of Washington, all of which are marketed and distributed throughout the United States. Washington state wines continue to gain prominence in the market as evidenced by the fact that volume growth for such wines, where the Company maintains its strong leadership position, outpaced most other major regions during 2007 with a growth rate of 18.9 percent, as reported by ACNielsen. The Company produces and markets California premium wines under the Villa Mt. Eden and Conn Creek labels. In addition, through the 2007 acquisition of Stag’s Leap Wine Cellars, in which the Company holds an 85 percent ownership interest, the Company added the following labels: Cask 23, Fay,

 

 

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S.L.V., Arcadia, Artemis, Karia and Hawk Crest. The Company is also a leading producer of Oregon pinot noir premium wines marketed under the Erath label. The Company is also the exclusive United States importer and distributor of the portfolio of wines produced by the Italian winemaker Marchesi Antinori, Srl, which includes such labels as Tignanello, Solaia, Tormaresca, Villa Antinori and Peppoli.

 

Working Capital

 

The principal portion of the Company’s operating cash requirements for this segment relates to its need to maintain significant inventories in connection with the aging process inherent in the production of wine.

 

Customers

 

Approximately 47 percent of the Company’s Wine segment gross sales are made to two distributors, with one of these distributors accounting for approximately 32 percent of total wine segment gross sales. Substantially all wines are sold through state-licensed distributors with whom the Company maintains satisfactory relationships.

 

Legislation and Regulation

 

It has been claimed that the use of alcohol beverages may be harmful to health. In 1988, federal legislation was enacted regulating alcohol beverages by requiring health warning notices on such beverages. Still wines containing not more than 14 percent alcohol by volume, such as the majority of the Company’s wines, are subject to a federal excise tax of $1.07 per gallon for manufacturers, such as the Company, that produce more than 250,000 gallons a year. In recent years, proposals have been made at the federal level for additional regulation of alcohol beverages, including, but not limited to, increases in excise tax rates, modification of the required health warning notices and further regulation of advertising, labeling and packaging. Substantially similar proposals will likely be considered in 2008. Also in recent years, increased regulation of alcohol beverages by various states included, but was not limited to, the imposition of higher excise taxes and advertising restrictions. Additional state and local legislative and regulatory actions affecting the marketing of alcohol beverages will likely be considered during 2008. The Company is unable to assess the future effects these regulatory and other actions may have on the sale of its wines.

 

Raw Materials

 

In the production of wine, the Company uses grapes harvested from its own vineyards or purchased from independent growers located in Washington, California and Oregon, as well as bulk wine purchased from other sources. Grapes, whether grown and harvested or purchased under contracts with independent growers are, from time to time, adversely affected by weather and other forces that may limit production. At the present time, the Company believes there is a sufficient supply of grapes and bulk wine available in the market to satisfy its current and expected production requirements.

 

Competitive Conditions

 

The Company’s principal competition comes from many larger, well-established national and international companies, as well as many smaller wine producers. The Company’s principal methods of competition include quality, price, consumer and trade wine tastings, competitive wine judging and advertising.

 

ALL OTHER OPERATIONS

 

All Other Operations consists of the Company’s international operations, which market moist smokeless tobacco products in select markets. Such operations did not constitute a material portion of the Company’s operations in any of the years presented.

 

 

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ADDITIONAL BUSINESS INFORMATION

 

Environmental Regulations

 

Compliance with federal, state and local provisions regulating the discharge of materials into the environment or otherwise relating to the protection of the environment has not had a material effect upon the capital expenditures, earnings or competitive position of the Company.

 

Number of Employees

 

The Company’s average number of employees during 2007 was 4,610.

 

Trademarks and Patents

 

The Company markets its consumer products under a number of trademarks and patents. All of the Company’s trademarks and patents either have been registered or applications therefore are pending with the United States Patent and Trademark Office.

 

Seasonal Business

 

No material portion of the business of any operating segment of the Company is seasonal.

 

Backlog of Orders

 

Backlog of orders is not a material factor in any operating segment of the Company.

 

Set forth below is a description of certain risk factors which the Company believes may be relevant to an understanding of the Company and its businesses. Stockholders are cautioned that these and other factors may affect future performance and cause actual results to differ from those which may, from time to time, be anticipated. See “Cautionary Statement Regarding Forward-Looking Information” included in Part II, Item 7 of this Form 10-K.

 

 

The Company’s future results will be affected by the growth in the smokeless tobacco and wine marketplaces and the demand for the Company’s smokeless tobacco and wine products. Factors affecting demand for the Company’s products include, among other things, general economic conditions and actions by competitors, as well as the cost of the products to consumers which, in turn, is affected, in part, by the Company’s costs in manufacturing such products and the excise taxes payable. Sales volumes of the Company’s smokeless tobacco products, particularly premium products, may be impacted by fluctuations in gasoline prices, which have a direct impact on adult consumer disposable income. The impact of fluctuations in gasoline prices on smokeless tobacco product sales volume is relevant due to the fact that a significant amount of the Company’s products are sold at locations which also sell gasoline. The Company’s quarterly results may also be affected by wholesaler order patterns. Many of these factors are beyond the control of the Company which makes results of operations difficult to predict.

 

 

The Company’s ability to achieve its results of operations target is tied in part to successful implementation of its cost reduction initiative, called Project Momentum, which is designed to create additional resources for growth via operational, productivity and efficiency enhancements. Project Momentum, which commenced during the third quarter of 2006, is expected to ultimately result in targeted annual cost savings of at least

 

 

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$150 million within its first three years. While the Company believes these cost reductions will be achieved, the Company cannot guarantee the success of the initiative. If Project Momentum is not successful, the Company’s results of operations could be adversely affected.

 

 

A major fire, violent weather conditions or other disasters that affect the Company’s manufacturing facilities, or its suppliers or vendors, could have a material adverse effect on the Company’s operations. Although the Company believes it has adequate amounts of available insurance coverage and sound contingency plans for these events, a prolonged interruption in the Company’s manufacturing operations could have a material adverse effect on its ability to effectively operate its business.

 

 

Over the past three years, sales to one wholesale customer in the Smokeless Tobacco segment have averaged approximately 17 percent of annual Smokeless Tobacco segment sales, while sales to two distributors in the Wine segment have averaged 48 percent of annual Wine segment sales. No other customer accounted for 10 percent or more of Smokeless Tobacco segment or Wine segment sales over the three-year period. The loss of any of these customers, or a significant decline in sales orders from any of these customers, could have an adverse affect on the Company’s results of operations or financial condition.

 

 

The success of the Company’s brands is dependent upon the quality of those brands and the positive perception that consumers have of such brands. Adulteration, whether arising accidentally or through deliberate third-party action, could harm the quality of the Company’s products and may result in reduced sales of the affected products, or have an adverse ancillary effect on the Company’s other products, which could have an adverse affect on the Company’s results of operations or financial condition.

 

 

From time to time, the Company may make acquisitions of other entities. Depending on the nature of the acquired business, integration of such entities into existing operations may present difficulties. As a result, it is possible that the Company may not realize any or all of the expected benefits from acquisitions, such as anticipated synergies, cost savings or increases in net earnings, in a timely manner. In addition, the Company may incur significant costs and management’s time and attention may be diverted from existing businesses in connection with the integration of acquired entities. Failure to effectively integrate future acquisitions could have an adverse effect on the Company’s results of operations.

 

 

The Company faces significant competition in the smokeless tobacco category, both from existing category competitors and new entrants, which may negatively impact premium can volume trends and put pressure on its gross margins. The Company’s premium can volume trends have improved, with a shift from declining premium net can volume to growth; however, down-trading to price-value products still exists. The Company recognizes the need for continued premium net can volume growth and is therefore focused on strengthening brand loyalty, developing innovative products and expanding the overall smokeless tobacco category to ensure continued growth in its results of operations.

 

 

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The Company has been implementing plans which focus on the growth of the smokeless tobacco category by building awareness and social acceptability of smokeless tobacco products among adults and by promoting the convenience of smokeless tobacco relative to cigarettes to attract new adult consumers to the category.

 

In light of the growth of price-value products, the Company continues to execute plans to increase sales of its premium brands by building and strengthening premium brand loyalty through various promotional programs. These include the introductions of new, differentiated premium products, as well as price-focused initiatives to provide improved value in price sensitive areas of the United States. However, while the Company believes that it is pursuing the right course of action, the Company cannot guarantee the success of these action plans. If the Company’s strategy is not successful, total premium can volume may decline and results of operations could be adversely affected.

 

In 2006, a major cigarette company entered the smokeless tobacco category through its acquisition of one of the Company’s competitors. In addition, certain cigarette companies have begun test marketing smokeless tobacco products and have indicated the intent to continue to expand this activity. While there is the possibility that such actions may have the effect of expanding the smokeless tobacco category, which could be beneficial to the Company, it is also possible that such actions could be detrimental since it may require the Company to expend significant resources to maintain its premium can volume performance. The Company cannot, at this time, predict with any certainty what effect, if any, such actions may have on the Company and its results of operations.

 

 

Tobacco is the most important raw material in the manufacture of the Company’s smokeless tobacco products. The Company is not directly involved in the cultivation of tobacco leaf and is dependent on third parties to produce tobacco and other raw materials that it requires to manufacture its smokeless tobacco products. As with other agricultural commodities, the price of tobacco leaf tends to depend upon variations in weather conditions, growing conditions, local planting decisions, overall market demands or other factors. The Company’s inability to purchase tobacco leaf of the desired quality from United States suppliers on commercially reasonable terms, or an interruption in the supply of these materials, in the absence of readily available alternative sources, could have a negative impact on the Company’s business and its results of operations.

 

 

The environment in which the Company operates, as a smokeless tobacco company, presents challenges not faced by many other consumer products companies. Accordingly, the continuing ability to hire and retain qualified employees who are capable of working in this challenging environment is critical to the Company’s success.

 

 

Advertising, promotion and brand building continue to play a key role in the Company’s business, with significant expenditure on programs to support key brands and to develop new products. As described above, in 1986, federal legislation was enacted regulating smokeless tobacco products by, among other things, requiring health warning notices on smokeless tobacco packages and advertising and prohibiting the advertising of smokeless tobacco products on any medium of electronic communications subject to the jurisdiction of the Federal Communications Commission. Since 1986, other proposals have been made at both the federal and state level for additional regulation of smokeless tobacco products. These proposals have included, among other things, increased regulation of the manufacturing and marketing of tobacco products by federal and state agencies (including, without limitation, the FDA), the requirement of additional

 

 

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warning notices, a ban or further restriction on advertising and promotion, ingredients and constituent disclosure requirements, restrictions on the use of flavorings, adult sampling bans or restrictions, tax stamping, increasing the minimum purchase age and the disallowance of advertising and promotion expenses as deductions under federal tax law. The regulatory environment in which the Company operates can also be affected by general social and political factors.

 

Proposals for comprehensive federal regulation of tobacco products will continue to be considered. The Company will support federal regulation that takes into account the distinct differences between smokeless tobacco and cigarettes; allows companies to responsibly manufacture, market and sell high-quality, American-made smokeless tobacco products to tobacco-interested adults and does not stifle competition; and allows tobacco-interested adults to obtain accurate and relevant information regarding all tobacco products.

 

In addition to increased regulatory restrictions, the Company is subject to various marketing and advertising restrictions under the STMSA, which the Company entered into in 1998 with the attorneys general of various states and U.S. territories to resolve the remaining health care cost reimbursement cases initiated by various attorneys general. The Company is the only smokeless tobacco manufacturer to sign the STMSA. The Company also receives from time to time inquiries from various attorneys general relating to the STMSA and other state regulations in connection with various aspects of the Company’s business.

 

Present regulations and any further regulations, depending on the nature of the regulations and their applicability to the Company and its future plans, could have an adverse effect on the Company’s ability to advertise, promote and build its brands and/or to promote and introduce new brands and products and, as such, could have an adverse effect on its results of operations.

 

 

Smokeless tobacco products are subject to significant federal and state excise taxes, which may continue to increase over time. Any increase in the level of federal excise taxes or the enactment of new or increased state or local excise taxes would have the effect of increasing the cost of smokeless tobacco products to consumers and, as such, could affect the demand for, and consumption levels of, smokeless tobacco products in general and premium brands in particular. Furthermore, the current ad valorem method of taxation, which is utilized by most states, bases the amount of taxes payable on a fixed percentage of the wholesale price, as opposed to the method used in some other states which tax both premium and price-value brands based on weight. Therefore, the ad valorem method of taxation has the inequitable effect of increasing the taxes payable on premium brands to a greater degree than those payable on price-value brands, which further exacerbates the price gap between premium and price-value brands. To the extent that any such actions adversely affect the sale of the Company’s products, such actions could have an adverse effect on the Company’s results of operations and cash flows.

 

 

In 2007, the Company incurred expenses of approximately $3.6 million, $18.4 million and $4.7 million under the Tobacco Reform Act, the STMSA and other state settlement agreements, respectively. The Company presently expects to continue to incur expenses under the Tobacco Reform Act and other state settlement agreements. Based on information presently available to the Company, the Company does not anticipate that any increases in such expenses to be incurred in the future will have a material adverse effect on the Company. However, the amounts payable in the future cannot be predicted with certainty and may increase based upon, among other things, the relative share of the overall tobacco market held by smokeless tobacco and the Company’s share of the moist smokeless tobacco marketplace. It is also possible that the amounts payable under the Tobacco Reform Act will be offset, in part, through reductions in the cost of tobacco, which result from the competitive setting of prices expected to occur as a result of the Tobacco Reform Act.

 

 

 12

 

•  The Company is subject, from time to time, to smokeless tobacco and health litigation, which, if adversely determined, could subject the Company to substantial charges and liabilities.

 

The Company is currently subject to various legal actions, proceedings and claims arising out of the sale, use, distribution, manufacture, development, advertising, marketing and claimed health effects of its smokeless tobacco products. See “Item 3 – Legal Proceedings.” The Company believes, and has been so advised by counsel handling the respective cases, that it has a number of meritorious defenses to all such pending litigation. Except as to the Company’s willingness to consider alternative solutions for resolving certain litigation issues, all such cases are, and will continue to be, vigorously defended. The Company believes that the ultimate outcome of such pending litigation will not have a material adverse effect on its consolidated financial results or its consolidated financial position. However, if plaintiffs in these actions were to prevail, the effect of any judgment or settlement could have a material adverse impact on the Company’s consolidated financial results in the particular reporting period in which any such litigation is resolved and, depending on the size of any such judgment or settlement, a material adverse effect on the Company’s consolidated financial position. In addition, similar litigation and claims relating to the Company’s smokeless tobacco products may continue to be filed against the Company in the future. An increase in the number of pending claims, in addition to the risks posed as to outcome, could increase the Company’s costs of litigating and administering product liability claims.

 

•  The Company could be subject to additional charges and liabilities as it seeks to resolve the remaining antitrust related lawsuits.

 

In March 2000, in an action brought by one of the Company’s competitors, Conwood Company L.P. (“Conwood Litigation”), alleging violations of the antitrust laws, a significant verdict was rendered against the Company. Following the commencement of this lawsuit, actions were also brought on behalf of direct and indirect purchasers of the Company’s products. The Company has paid the verdict and settled the actions brought on behalf of direct purchasers and almost all of the actions brought on behalf of indirect purchasers, with the exception of a purported class action in the State of Pennsylvania, for which the Company believes there is insufficient basis for such a claim. See “Item 3 – Legal Proceedings.” Further, the Company has been served in a purported class action attempting to challenge certain aspects of a settlement agreement reached with indirect purchasers in multiple states and seeking additional amounts purportedly consistent with subsequent settlements of similar actions, estimated by plaintiffs to be between $8.9 million and $214.2 million, as well as punitive damages and attorneys’ fees. The Company believes that the ultimate outcome of these actions will not have a material adverse effect on its consolidated financial results or its consolidated financial position. However, if plaintiffs were to prevail, beyond the amounts previously accrued, the effect of any judgment or settlement could have a material adverse impact on the Company’s consolidated financial results in the particular reporting period in which such action is resolved and, depending on the size of any such judgment or settlement, a material adverse effect on the Company’s consolidated financial position.

 

 

While the Company believes that it is well positioned to compete based on the quality of its wines and the dedication of its workforce, its overall success may be subject to the actions of competitors in the wine category. Many of these competitors are large, well-established national and international companies with significant resources to support distribution and retail sales. In addition, sales of the Company’s wines can be affected by the quality and quantity of imports.

 

 

 

13 

 

The adequacy of the Company’s grape supply is influenced by consumer demand for wine in relation to industry-wide production levels. While the Company believes that it can grow and/or otherwise secure, through contracts with independent growers, sufficient regular supplies of high quality grapes, it cannot be certain that grape supply shortages will not occur. As grapes grown in the State of Washington account for approximately 92 percent of the Company’s harvested and contracted grapes, if eastern Washington state experiences adverse weather conditions, widespread vine disease or other crop damage, fruit availability may be compromised, quality may be negatively impacted and production costs may increase. An increase in production cost could lead to an increase in the Company’s wine prices, which may ultimately have a negative impact on its sales.

 

In cases of significant grape and bulk wine oversupply in the marketplace, the Company’s ability to increase or even sustain existing sales prices may be limited.

 

 

Significant increases in excise or other taxes on alcohol beverages could adversely affect sales of the Company’s wine products. Federal, state and local governmental agencies regulate the alcohol beverage industry through various means, including licensing requirements, pricing, labeling and advertising restrictions, and distribution and production policies. New regulations, or revisions to existing regulations, resulting in further restrictions or taxes on the manufacture and sale of alcohol beverages may have an adverse affect on the Company’s wine business.

 

Not applicable.

 

All of the principal properties in the Company’s operations were utilized only in connection with the Company’s business operations. The Company believes that the properties described below at December 31, 2007 were suitable and adequate for the purposes for which they were used, and were operated at satisfactory levels of capacity. All principal properties are owned by the Company, with the exception of certain winery properties, as noted below.

 

Smokeless Tobacco Products

 

The Company owns and operates three principal smokeless tobacco manufacturing and processing facilities located in Franklin Park, Illinois; Hopkinsville, Kentucky; and Nashville, Tennessee.

 

Wine

 

The Company operates 11 wine-making facilities – seven in Washington state, three in California and one in Oregon. All of these facilities are owned, with the exception of one facility in Washington state that is leased. In addition, in order to support the production of its wines, the Company owns or leases vineyards in Washington state, California and Oregon.

 

The Company has been named in certain health care cost reimbursement/third-party recoupment/class action litigation against the major domestic cigarette companies and others seeking damages and other relief. The complaints in these cases on their face predominantly relate to the usage of cigarettes; within that context, certain complaints contain a few allegations relating specifically to smokeless tobacco products. These actions are in varying stages of pretrial activities.

 

 

 14

 

The Company believes that these pending litigation matters will not result in any material liability for a number of reasons, including the fact that the Company has had only limited involvement with cigarettes and the Company’s current percentage of total tobacco industry sales is relatively small. Prior to 1986, the Company manufactured some cigarette products which had a de minimis market share. From May 1, 1982 to August 1, 1994, the Company distributed a small volume of imported cigarettes and is indemnified against claims relating to those products.

 

Smokeless Tobacco Litigation

 

The Company is named in certain actions in West Virginia brought on behalf of individual plaintiffs against cigarette manufacturers, smokeless tobacco manufacturers, and other organizations seeking damages and other relief in connection with injuries allegedly sustained as a result of tobacco usage, including smokeless tobacco products. Included among the plaintiffs are three individuals alleging use of the Company’s smokeless tobacco products and alleging the types of injuries claimed to be associated with the use of smokeless tobacco products. These individuals also allege the use of other tobacco products.

 

In Matthew Vassallo v. United States Tobacco Company, et al., Circuit Court of the 11th Judicial District, Miami-Dade County, Florida (Case No.: 02-28397 CA-20), this action by an individual plaintiff against various smokeless tobacco manufacturers including the Company alleges personal injuries, including cancer, oral lesions, leukoplakia, gum loss and other injuries allegedly resulting from the use of defendants’ smokeless tobacco products. Plaintiff also claims nicotine “addiction” and seeks unspecified compensatory damages and certain equitable and other relief, including, but not limited to, medical monitoring.

 

In Kelly June Hill, Executrix and Fiduciary of the Estate of Bobby Dean Hill, et al. v. U.S. Smokeless Tobacco Company, Connecticut Superior Court, Judicial District of Stamford (Docket No. FST-X05-CV-05-4003788-S) this action was brought by a plaintiff individually, as Executrix and Fiduciary of the Estate of Bobby Dean Hill, and on behalf of their minor children for injuries, including “squamous cell carcinoma of the tongue”, allegedly sustained by decedent as a result of his use of the Company’s smokeless tobacco products. The Complaint also alleges “addiction” to smokeless tobacco. The Complaint seeks compensatory and punitive damages in excess of $15,000 and other relief.

 

The Company believes, and has been so advised by counsel handling the foregoing cases, that it has a number of meritorious defenses to all such pending litigation. Except as to the Company’s willingness to consider alternative solutions for resolving certain litigation issues, all such cases are, and will continue to be, vigorously defended.

 

Antitrust Litigation

 

Following a previous antitrust action brought against the Company by a competitor, Conwood Company L.P, the Company was named as a defendant in certain actions brought by indirect purchasers (consumers and retailers) in a number of jurisdictions. As indirect purchasers of the Company’s smokeless tobacco products during various periods of time ranging from January 1990 to the date of certification or potential certification of the proposed class, plaintiffs in those actions allege, individually and on behalf of putative class members in a particular state or individually and on behalf of class members in the applicable states, that the Company has violated the antitrust laws, unfair and deceptive trade practices statutes and/or common law of those states. In connection with these actions, plaintiffs sought to recover compensatory and statutory damages in an amount not to exceed $75 thousand per purported class member or per class member, and certain other relief. The indirect purchaser actions, as filed, were similar in all material respects.

 

To date, indirect purchaser actions in almost all of the jurisdictions have been resolved, including those subject to court approval. The Company is named as a defendant in purported class actions in the states of New Hampshire and Pennsylvania, as well as class actions in the states of California and Massachusetts. In September 2007, the Company entered into a Settlement Agreement to resolve the California class action which has been preliminarily approved by the court (See the Company’s Quarterly Report on Form 10-Q for

 

 

15 

the period ended September 30, 2007 for additional information). In January 2008, the Company entered into Settlement Agreements to resolve the New Hampshire action and Massachusetts class action, as discussed further below.

 

In James Joseph LaChance, et al. v. United States Tobacco Company, et al., Superior Court of New Hampshire, Strafford County (No. 03-C-279), on January 31, 2008, the Company entered into a Settlement Agreement, which is subject to court approval, whereby adult consumers in New Hampshire will be eligible to register for the settlement. Also on January 31, 2008, in In re Massachusetts Smokeless Tobacco Litigation, Superior Court of Massachusetts, Suffolk County (No. 03-5038 BLS), the Company entered into a Settlement Agreement, which is subject to court approval, whereby adult consumers in Massachusetts will be eligible to register for the settlement. Pursuant to the settlement agreements, the Company will provide each adult consumer in New Hampshire and Massachusetts who registers with coupons redeemable on future purchases of the Company’s moist smokeless tobacco products in exchange for a dismissal of the action and a general release. The Company has also agreed to pay all administrative costs of the settlement, attorneys’ fees and costs.

 

Notwithstanding the fact that the Company has chosen to resolve various indirect purchaser actions via settlements, the Company believes, and has been so advised by counsel handling these cases, that it has meritorious defenses, and, in the event that any such settlements do not receive final court approval, these actions will continue to be vigorously defended.

 

In the Pennsylvania action, which is before a federal court in Pennsylvania, the Third Circuit Court of Appeals has accepted the Company’s appeal of the trial court’s denial of the Company’s motion to dismiss the complaint. The Company continues to believe there is insufficient basis for plaintiffs’ complaint. For the plaintiffs in the foregoing action to prevail, they will have to obtain class certification. The plaintiffs in the above action also will have to obtain favorable determinations on issues relating to liability, causation and damages. The Company believes, and has been so advised by counsel handling this case, that it has meritorious defenses in this regard, and it is, and will continue to be, vigorously defended.

 

In Jason Feuerabend, et al. v. United States Tobacco Company, et al., Circuit Court of Wisconsin, Milwaukee County (No. 02-CV-007124), on December 18, 2007, the court entered a final judgment granting final approval of the settlement, including attorneys’ fees and costs, and dismissing the action.

 

In Marvin D. Chance, Jr. and Thomas K. Osborn, on behalf of themselves and all others similarly situated v. United States Tobacco Company, et al., District Court of Seward County, Kansas (Case No. 02-C-12), counsel for plaintiffs in the settlement of the Kansas class action and New York action filed a motion for an additional amount of approximately $8.5 million in attorneys’ fees, expenses and costs, plus interest, beyond the previously agreed-upon amounts already paid by the Company. On August 17, 2007, the court granted plaintiffs’ motion and entered judgment against the Company in the amount of approximately $3 million in additional attorneys’ fees and expenses, along with prejudgment interest on a portion of the award. On November 19, 2007, the Company filed a Notice of Appeal of the judgment. On November 21, 2007, the Company entered into a Settlement Agreement relating to this additional award whereby the Company agreed to pay $2.8 million and dismiss its appeal in exchange for a satisfaction of judgment. On December 21, 2007, plaintiffs provided a satisfaction of judgment and the court entered an order dismissing the Company’s appeal.

 

In Robert A. Martin, et al. v. Gordon Ball, et al., United States District Court for the Northern District of West Virginia (No. 5:06-CV-85), the Company deemed service of the complaint to have been effective as of July 17, 2006 and filed an Answer. This action was brought by fifteen individual plaintiffs on behalf of themselves and a purported class of persons who filed claims for coupons as part of the Company’s settlement of the action entitled Philip Edward Davis, et al. v. United States Tobacco Company, et al., Circuit Court of Jefferson County, Tennessee. The Martin plaintiffs allege that the Company breached the Settlement Agreement in the Davis action, and has been unjustly enriched, because it failed to distribute to each of the purported class members a denomination of coupons with an aggregate value equal to the aggregate value of the coupons

 

 

 16

distributed as part of the settlement in another indirect purchaser action. Plaintiffs also allege claims for breach of fiduciary duty, unjust enrichment, and conversion against the counsel who represented the class members in the Davis action. Plaintiffs seek additional amounts purportedly consistent with subsequent settlements of similar actions, estimated by plaintiffs to be between $8.9 million and $214.2 million, as well as punitive damages and attorneys’ fees.

 

For the plaintiffs in the foregoing action to prevail, they will have to obtain class certification. The plaintiffs in the above action also will have to obtain favorable determinations on issues relating to liability, causation and damages. The Company believes, and has been so advised by counsel handling this case, that it has meritorious defenses in this regard, and it is, and will continue to be, vigorously defended.

 

Not applicable.

 

 

17 

 

Market for Registrant’s Common Equity

 

The Company’s common stock is listed on the New York Stock Exchange (“NYSE”) under the symbol UST. As of January 31, 2008, there were approximately 6,633 stockholders of record of the Company’s common stock. The table below sets forth the high and low sales prices per share of the Company’s common stock, as reported by the NYSE Composite Tape, and the cash dividends per share declared and paid in each quarter during fiscal years 2007 and 2006. The Company has paid cash dividends without interruption since 1912. While the Company expects to continue its policy of paying cash dividends in the future, such policy is subject to annual review and approval by the Company’s Board of Directors. Factors that are taken into consideration with regard to the level of dividend payments include the Company’s net earnings, capital requirements and financial condition.

 

		2007												2006
		High				Low				Dividends				High				Low				Dividends
First Quarter		$	61.17			$	54.55			$	0.60			$	43.14			$	37.96			$	0.57
Second Quarter			60.58				51.25				0.60				45.78				41.10				0.57
Third Quarter			55.86				47.40				0.60				55.06				44.61				0.57
Fourth Quarter			59.95				48.34				0.60				59.49				52.34				0.57
Year		$	61.17			$	47.40			$	2.40			$	59.49			$	37.96			$	2.28

 

 

 18

 

Performance Graph

 

The following graph compares the total returns for an investment in the Company’s common stock over the last five years to the Standard and Poor’s (“S&P”) 500 Stock Index and the S&P Tobacco Index assuming a $100 investment made on December 31, 2002. Each of the three measures of cumulative total return assumes reinvestment of dividends. The stock performance shown on the graph below is not necessarily indicative of future price performance.

 

COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN
Amoung UST Inc., The S&P 500 Index
And The S&P Tobacco Index

 

 

 

 

19 

Issuer Purchases of Equity Securities

 

The following table presents the monthly share repurchases by the Company during the fourth quarter of the fiscal year ended December 31, 2007:

 

										Total Number of				Maximum Number of
										Shares Purchased				Shares that May Yet
		Total Number				Average Price				as Part of the				Be Purchased Under
		of Shares				Paid Per				Repurchase				the Repurchase
		Purchased(1)				Share(2)				Programs(3)				Programs(3)
October 1 – 31, 2007			386,628			$	50.94				351,900				7,873,060
November 1 – 30, 2007			2,683,127			$	53.91				2,683,127				5,189,933
December 1 – 31, 2007			3,260,174			$	56.79				3,260,174				21,929,759
Total			6,329,929			$	55.24				6,295,201

 

⁽¹⁾ Amounts reported in this column include shares of restricted stock withheld upon vesting to satisfy tax withholding obligations.

 

⁽²⁾ The reported average price paid per share relates only to shares purchased as part of the repurchase programs.

 

⁽³⁾ In December 2004, the Company’s Board of Directors authorized a program to repurchase up to 20 million shares of its outstanding common stock. Share repurchases under this program commenced in June 2005. In December 2007, the Company’s Board of Directors authorized a new program to repurchase up to 20 million additional shares of the Company’s outstanding common stock. Repurchases under this new program will commence when repurchases under the existing program have been completed, which is expected to be during the first quarter of 2008.

 

 

 20

 

CONSOLIDATED SELECTED FINANCIAL DATA – FIVE YEARS
(Dollars in thousands, except per share amounts)

 

		2007				2006				2005				2004				2003
Summary of Operations For the Year Ended December 31
Net Sales		$	1,950,779			$	1,850,911			$	1,851,885			$	1,838,238			$	1,731,862
Cost of products sold (includes excise taxes)			524,575				466,088				443,131				412,641				384,487
Selling, advertising and administrative expenses			529,795				525,990				518,797				513,570				470,740
Restructuring charges			10,804				21,997				-				-				-
Antitrust litigation			137,111				2,025				11,762				(582	)			280,000
Total costs and expenses			1,202,285				1,016,100				973,690				925,629				1,135,227
Gain on sale of corporate headquarters			105,143				-				-				-				-
Operating income			853,637				834,811				878,195				912,609				596,635
Interest, net			40,600				41,785				50,578				75,019				76,905
Earnings from continuing operations before income taxes			813,037				793,026				827,617				837,590				519,730
Income tax expense			292,764				291,060				293,349				299,538				197,681
Earnings from continuing operations			520,273				501,966				534,268				538,052				322,049
Income (loss) from discontinued operations (including income tax effect)			-				3,890				-				(7,215	)			(3,260	)
Net earnings		$	520,273			$	505,856			$	534,268			$	530,837			$	318,789
Per Share Data
Net earnings per basic share:
Earnings from continuing operations		$	3.30			$	3.13			$	3.26			$	3.26			$	1.93
Income (loss) from discontinued operations			-				0.02				-				(0.05	)			(0.02	)
Net earnings per basic share			3.30				3.15				3.26				3.21				1.91
Net earnings per diluted share:
Earnings from continuing operations			3.27				3.10				3.23				3.23				1.92
Income (loss) from discontinued operations			-				0.02				-				(0.04	)			(0.02	)
Net earnings per diluted share		$	3.27			$	3.12			$	3.23			$	3.19			$	1.90
Dividends per share		$	2.40			$	2.28			$	2.20			$	2.08			$	2.00
Market price per share:
High			61.17				59.49				56.90				48.97				37.79
Low		$	47.40			$	37.96			$	37.59			$	34.00			$	26.73
Financial Condition at December 31
Cash and cash equivalents		$	73,697			$	254,393			$	202,025			$	450,202			$	433,040
Current assets			846,274				998,110				889,554				1,173,133				1,247,966
Current liabilities			400,174				300,077				258,778				618,873				521,093
Working capital		$	446,100			$	698,033			$	630,776			$	554,260			$	726,873
Ratio of current assets to current liabilities			2.1:1				3.3:1				3.4:1				1.9:1				2.4:1
Total assets		$	1,487,078			$	1,440,348			$	1,366,983			$	1,659,483			$	1,726,494
Long-term debt(1)			1,090,000				840,000				840,000				840,000				1,140,000
Total debt			1,090,000				840,000				840,000				1,140,000				1,140,000
Stockholders’ (deficit) equity		$	(320,202	)		$	65,826			$	75,098			$	9,565			$	(115,187	)
Other Data
Stock repurchased		$	597,738			$	200,003			$	200,038			$	200,031			$	150,095
Dividends paid		$	378,325			$	367,499			$	361,208			$	344,128			$	332,986
Dividends paid as a percentage of net earnings			72.7%				72.6%				67.6%				64.8%				104.5%
Return on net sales			26.7%				27.3%				28.8%				28.9%				18.4%
Return on average assets			35.5%				36.0%				35.3%				31.4%				14.2%
Average number of shares (in thousands) – basic			157,854				160,772				163,949				165,164				166,572
Average number of shares (in thousands) – diluted			159,295				162,280				165,497				166,622				167,376

 

⁽¹⁾ The amount reported for 2007 includes $250 million of short-term borrowings which have been classified as long-term, as the Company has both the intent and the ability to refinance such borrowings on a long-term basis.

 

See Management’s Discussion and Analysis and Notes to Consolidated Financial Statements.

 

 

21 

 

UST INC.

 

MANAGEMENT’S DISCUSSION AND ANALYSIS (“MD&A”)

 

The following discussion and analysis of the Company’s consolidated results of operations and financial condition should be read in conjunction with the consolidated financial statements and notes thereto, included in Part II, Item 8 of this Form 10-K. Herein, the Company makes forward-looking statements that involve risks, uncertainties, and assumptions. Actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including, but not limited to, those presented under the “Cautionary Statement Regarding Forward-Looking Information” section presented at the end of MD&A. In addition, the Company has presented certain risk factors relevant to the Company’s business in Item 1A in Part I of this Form 10-K.

 

INTRODUCTION

 

MD&A is provided as a supplement to the accompanying consolidated financial statements and notes thereto, to assist individuals in their review of such statements. MD&A has been organized as follows:

 

•   OVERVIEW – This section provides context for the remainder of MD&A, including a general description of the Company’s overall business, its business segments and a high-level summary of the Company-specific and industry-wide factors impacting its operations.

 

•   RESULTS OF OPERATIONS – This section provides an analysis of the Company’s results of operations for the three years ended December 31, 2007. This section is organized using a layered approach, beginning with a discussion of consolidated results at a summary level, followed by more detailed discussions of business segment results and unallocated corporate items, including interest and income taxes.

 

•   OUTLOOK – This section provides information regarding the Company’s current expectations, mainly with regard to the next fiscal year, and is organized to provide information by business segment and on a consolidated basis.

 

•   LIQUIDITY AND CAPITAL RESOURCES – This section provides an analysis of the Company’s financial condition, including cash flows for the three years ended December 31, 2007, the Company’s sources of liquidity, capital expenditures, debt outstanding, share repurchase programs, dividends paid on the Company’s common stock and the Company’s aggregate contractual obligations as of December 31, 2007.

 

•   OFF-BALANCE SHEET ARRANGEMENTS – This section provides information regarding any off-balance sheet arrangements that are, or could be, material to the Company’s results of operations or financial condition.

 

•   CRITICAL ACCOUNTING POLICIES AND ESTIMATES – This section discusses accounting policies that the Company considers to be significant to its financial condition and results of operations, requiring significant judgment and the use of estimates on the part of management in their application.

 

•   NEW ACCOUNTING STANDARDS – This section provides information regarding any newly issued accounting standards which have not yet been adopted by the Company.

 

 

 22

 

OVERVIEW

 

BUSINESS

 

UST Inc. is a holding company for its wholly-owned subsidiaries: U.S. Smokeless Tobacco Company and International Wine & Spirits Ltd. Through its largest subsidiary, U.S. Smokeless Tobacco Company, the Company is the leading manufacturer and marketer of moist smokeless tobacco products, including iconic premium brands such as Copenhagen and Skoal, and value brands Red Seal and Husky. The Company competes with larger and smaller domestic and international companies in the marketing of its moist smokeless tobacco products, including those that market and sell price-value or deep-discount smokeless tobacco products. Competition in the marketing and sales of moist smokeless tobacco products is primarily based upon quality, price, advertising, promotion, sampling, brand recognition and loyalty, packaging, product innovation and distribution.

 

Through International Wine & Spirits Ltd., the Company produces and markets premium wines sold nationally, via its Ste. Michelle Wine Estates subsidiary, under labels such as Chateau Ste. Michelle, Columbia Crest, Conn Creek, Villa Mt. Eden, Red Diamond, Distant Bay, 14 Hands, Snoqualmie and Erath. In the third quarter of 2007, through the acquisition of Stag’s Leap Wine Cellars, the Company added the following labels: Cask 23, Fay, S.L.V., Arcadia, Artemis, Karia and Hawk Crest. The Company also produces and markets sparkling wine under the Domaine Ste. Michelle label. In addition, the Company is the exclusive United States importer and distributor of the portfolio of wines produced by the Italian winemaker Marchesi Antinori, Srl (“Antinori”), which includes such labels as Tignanello, Solaia, Tormaresca, Villa Antinori and Peppoli. The Company competes with many larger, well established domestic and international companies in the production, marketing and sales of its wine products, as well as many smaller wine producers. Competition in the marketing and sales of wine is primarily based on quality, price, consumer and trade wine tastings, competitive wine judging, third-party acclaim and advertising.

 

The Company conducts its business principally in the United States, and its operations are divided primarily into two reportable segments: Smokeless Tobacco and Wine. The Company’s international smokeless tobacco operations, which are less significant, are reported as All Other Operations.

 

In 2006, the Company commenced implementation of a cost-reduction initiative called “Project Momentum,” with targeted savings of at least $100 million annually within its first three years. During 2007, the Company finalized plans on various other initiatives under Project Momentum, including, but not limited to, manufacturing operations and the procurement function, which are expected to generate at least $50 million in additional annual savings beyond the original target, resulting in a new savings target of at least $150 million annually, within the original three-year period. The Company believes that Project Momentum is an appropriate initiative from a long-term growth perspective, as it is designed to provide additional financial flexibility, which can be used to address competitive challenges in the smokeless tobacco category, make further investments behind its brands or to increase net earnings. Operating income results in 2007 include the positive contribution realized from this initiative, with certain savings realized earlier than originally planned. Given this progress to date, the Company is confident that it is on track to realize Project Momentum’s overall targeted savings within the aforementioned three-year timeframe. See Consolidated Results - Restructuring Charges within the Results of Operations section below for further information.

 

The Company’s results for 2007 reflected the continued positive impact of its strategic initiatives to accelerate profitable volume growth in both the Smokeless Tobacco and Wine segments. Consolidated net sales of $1.95 billion and diluted earnings per share of $3.27 were both record highs for the Company, representing increases of 5.4 percent and 4.8 percent, respectively, from the corresponding 2006 measures. In 2007, results for the Smokeless Tobacco segment continued to benefit from the Company’s category growth efforts aimed at converting adult smokers to moist smokeless tobacco products, along with the impact of its premium brand loyalty initiative and efforts related to price-value brands. These efforts combined to deliver record net can volume in 2007. Results for 2007 were also favorably impacted by the strong performance of the Wine segment, which once again had record case volume, net sales and operating

 

 

23 

profit. The results for 2007 also reflected increased net sales and operating profit from All Other Operations and cost savings realized in connection with Project Momentum.

 

SMOKELESS TOBACCO SEGMENT

 

The Company’s vision in the Smokeless Tobacco segment is for its smoke-free products to be recognized by adults as the preferred way to experience tobacco satisfaction. The Company’s primary objective in the Smokeless Tobacco segment is to continue to grow the moist smokeless tobacco category by building awareness and social acceptability of smokeless tobacco products among adults, primarily smokers, with a secondary objective of competing effectively in every segment of the moist smokeless tobacco category.

 

Category Growth

 

Category growth is the Company’s top focus, as moist smokeless tobacco is a low incidence category and offers a viable option to adult smokers who are increasingly facing restrictions and are seeking a discreet and convenient alternative. For perspective, the number of adults that smoke is significantly larger than the number of adults that use smokeless tobacco products. As a result, every one percent of adult smokers who converts to moist smokeless tobacco products represents a 7 percent to 8 percent increase in the moist smokeless tobacco category’s adult consumer base. The Company views this as essential because consumer research indicates that the majority of new adult consumers who enter the category do so in the premium segment, of which the Company has approximately a 90 percent share.

 

In addition to advertising initiatives focused on category growth, the Company has utilized its direct mail and one-on-one marketing programs to promote the discreetness and convenience of smokeless tobacco relative to cigarettes to over 4.5 million adult smokers. These programs, which the Company believes have been successful over the past several years, continued during 2007 and the Company intends to continue them in 2008. The success of the category growth initiatives is also impacted by product innovation, as evidenced by the contribution that new products have made to the Smokeless Tobacco segment’s results over the past several years. The success of the category growth initiative is further evidenced by the fact that over the past several years, a majority of the new adult consumers that have recently entered the moist smokeless tobacco category first smoked cigarettes and that category growth has accelerated since the inception of the program in 2004. Based on these results, the Company intends to continue its category growth initiatives and is expecting category growth of 5 to 6 percent in 2008.

 

Competing Effectively

 

The Company is committed to competing effectively in every segment of the moist smokeless tobacco category by accelerating profitable volume growth, with the goal of growing as fast as the category. The Company is making progress towards this goal through its premium brand loyalty and brand-building initiatives, and also through price-focused efforts related to price-value products. During 2007, net can volume for the Company’s moist smokeless tobacco products grew by 4.2 percent, or 3.1 percent on an underlying basis (see Smokeless Tobacco Segment – Net Sales within the Results of Operations section below for further discussion on underlying volume), in a category that grew 7.1 percent. For perspective, this is an improved performance relative to the category as compared to 2006 when the Company’s net can volume for moist smokeless tobacco products increased 1.2 percent compared to overall category growth of 6.3 percent.

 

Premium Brand Loyalty – While category growth remains the Company’s top priority, it has also significantly enhanced its efforts on adult consumer loyalty for its premium moist smokeless tobacco products. The premium brand loyalty plan is designed to minimize migration from premium to price-value products by delivering value to adult consumers through product quality and brand-building efforts, along with promotional spending and other initiatives. As a result of this effort, premium volume has grown on a year-over-year basis for six consecutive quarters, with full-year underlying premium net can volume growing 1.8 percent while market share declines moderated in

 

 

 24

 

2007. See Smokeless Tobacco Segment – Net Sales within the Results of Operations section below for further discussion on underlying volume. To build upon this success in 2008, the Company plans to further increase its brand-building efforts and will continue to selectively increase spending behind price-based loyalty initiatives. The Company expects that the anticipated 5 to 6 percent category growth in 2008, coupled with continued moderating share declines, will result in underlying premium net can volume growth of approximately 2 percent for the year.

 

Price-Value Initiatives – The Company’s commitment to accelerate profitable volume growth reflects a balanced portfolio approach, which also includes a full complement of marketing support for its price-value products. For example, the Company has implemented plans to expand the distribution and enhance the presence of its Husky brand at retail, and to be competitively priced with other deep discount brands. Likewise, additional promotional support was provided on its mid-priced Red Seal brand. During 2007, the Company’s successful execution of a balanced portfolio approach was clearly evidenced as approximately 12 percent growth in price-value net can volume occurred at the same time as approximately 3 percent growth in premium net can volume.

 

WINE SEGMENT

 

The Company’s vision in the Wine segment is for Ste. Michelle Wine Estates to be recognized as the premier fine wine company in the world. This is a vision based on continuous improvement in quality and greater recognition through third-party acclaim and superior products. In connection with that vision, the Company aims to elevate awareness of the quality of Washington state wines and increase its prestige to that of the top regions of the world through superior products, innovation and customer focus. In order to achieve these goals, attention is directed towards traditional style wines in the super premium to luxury-priced categories. The Company has made progress towards its vision, as demonstrated by its recent accomplishments. According to ACNielsen, Ste. Michelle Wine Estates was the fastest growing of the ten largest wineries in the United States during 2007. The Company continued to be the category leader for Riesling, based on ACNielsen data, with approximately 33 percent of the domestic Riesling market in 2007, reflecting a 2.6 percentage point increase over the Company’s reported 2006 share. In addition, as reported by ACNielsen, volume growth for Washington state wines, where the Company maintained its strong leadership position, outpaced most other major regions during 2007 with a growth rate of approximately 19 percent.

 

Strategic alliances and acquisitions in the Wine segment outside of Washington state have also been important in enabling the Company to achieve its long-term vision. The alliance with Antinori, to become its exclusive United States importer and distributor, and the purchase of the Erath label and winery, both of which occurred in 2006, have broadened the Company’s position with respect to the two key wine regions, Tuscany and Oregon. The addition of Antinori wines positions the Company as a leader in United States distribution of Tuscan wines, while the addition of Erath establishes the Company as one of the largest producers of Oregon Pinot Noir. The Company also completed the acquisition of Stag’s Leap Wine Cellars and its signature Napa Valley, CA vineyards for approximately $185 million, with a 15 percent minority interest held by Antinori California. This acquisition provides additional prestige to the Wine segment’s acclaimed portfolio, further strengthens the Company’s relationship with Antinori, and is expected to contribute favorably to the segment’s continued operating profit growth.

 

Another key element of the Wine segment’s strategy is expanded domestic distribution of its wines, especially in certain account categories such as restaurants, wholesale clubs and mass merchandisers. To that end, the Company remains focused on the continued expansion of its sales force and category management staff.

 

Discussion of the Company’s plans and initiatives in the Smokeless Tobacco and Wine segments is included in the Outlook section of MD&A.

 

 

25 

RESULTS OF OPERATIONS
(In thousands, except per share amounts or where otherwise noted)

 

CONSOLIDATED RESULTS

 

2007 compared with 2006

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Net sales		$	1,950,779			$	1,850,911			$	99,868				5.4
Net earnings			520,273				505,856				14,417				2.9
Basic earnings per share			3.30				3.15				0.15				4.8
Diluted earnings per share			3.27				3.12				0.15				4.8
Gain on sale of corporate headquarters			105,143				-				105,143				-
Antitrust litigation charges			137,111				2,025				135,086				-
Restructuring charges			10,804				21,997				(11,193	)			(50.9	)

 

Net Earnings

 

Consolidated net earnings increased in 2007, as compared to 2006, as a result of increased operating income, the impact of a lower effective tax rate on earnings from continuing operations and lower net interest expense. The Company reported operating income of $853.6 million for 2007, representing 43.8 percent of consolidated net sales, compared to operating income of $834.8 million, or 45.1 percent of consolidated net sales, in 2006. The increase in operating income was favorably impacted by the following:

 

•   A $105 million pre-tax gain recognized in connection with the sale of the Company’s corporate headquarters building, which favorably impacted the operating margin percentage by 5.4 percentage points;

•   Increased net sales and gross margin in all segments;

•   Lower restructuring charges incurred in connection with the Project Momentum initiative, which commenced in the third quarter of 2006 (see Restructuring Charges section below). The impact of restructuring charges adversely impacted the operating margin percentage by 0.5 percentage points and 1.2 percentage points in 2007 and 2006, respectively;

•   Lower selling, advertising and administrative (“SA&A”) expenses in the Smokeless Tobacco segment, which can be traced to the ongoing impact of savings realized under Project Momentum, as well as the resulting overall focus on cost containment; and

•   The presence of an extra billing day as compared to 2006, which is described in more detail within the Smokeless Tobacco Segment – 2007 compared with 2006 section below.

 

These factors were partially offset by:

 

•   Antitrust litigation charges of $137.1 million in 2007, primarily representing the estimated costs associated with the resolution of indirect purchaser antitrust class actions in the States of Wisconsin, California and Massachusetts, as well as the action in New Hampshire, which adversely impacted the operating margin percentage by 7 percentage points. This compares to a $2 million charge recognized in 2006, which adversely impacted operating margin percentage by 0.1 percentage points; and

 

 

 26

 

•   Increased unallocated corporate expenses, primarily due to amortization charges for the below-market short-term lease on its former corporate headquarters building and costs associated with a change in executive management, the aggregate amount of which adversely impacted the operating margin percentage by 0.6 percentage points.

 

Net earnings for 2006 included after-tax income of $3.9 million from discontinued operations, which resulted from the reversal of an accrual for an income tax-related contingency from the Company’s former cigar operations.

 

Basic and diluted earnings per share for 2007 were $3.30 and $3.27, respectively, an increase of 4.8 percent for each measure as compared to the corresponding comparative measures in 2006. Average basic shares outstanding were lower in 2007 than in 2006 primarily as a result of share repurchases, partially offset by exercises of stock options. Average diluted shares outstanding in 2007 were lower than those in 2006 due to the impact of share repurchases and a lower level of dilutive outstanding options, partially offset by the impact of a comparatively higher average stock price in 2007, as compared to 2006, which effectively increases diluted shares outstanding.

 

With regard to share repurchases, during 2007, the Company repurchased approximately 11 million shares, or 6.9 percent of its beginning outstanding common shares, for $597.7 million, of which approximately 6.3 million shares were repurchased during the fourth quarter. This repurchase activity was consistent with the Company’s announced plans to spend an incremental $300 million on share repurchases, above the previous guidance, during the fourth quarter.

 

Net Sales

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Net Sales by Segment:
Smokeless Tobacco			$1,546,638				$1,522,686				$23,952				1.6
Wine			354,001				282,403				71,598				25.4
All Other Operations			50,140				45,822				4,318				9.4
Consolidated Net Sales			$1,950,779				$1,850,911				$99,868				5.4

 

The Company reported record consolidated net sales in 2007, with the increase from 2006 attributable to the following:

 

•   Increased case volume for premium wine;

•   Net can volume growth for moist smokeless tobacco products, with increases for both premium and price-value products; and

•   Improved international results.

 

Segment Net Sales as a Percentage of Consolidated Net Sales

 

 

*Smokeless Tobacco

 

 

27 

Gross Margin

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Gross Margin by Segment:
Smokeless Tobacco		$	1,269,174			$	1,256,156			$	13,018				1.0
Wine			125,202				99,418				25,784				25.9
All Other Operations			31,828				29,249				2,579				8.8
Consolidated Gross Margin		$	1,426,204			$	1,384,823			$	41,381				3.0

 

The consolidated gross margin increase in 2007, as compared to the prior year, was primarily due to higher net sales, partially offset by higher costs of products sold, in all segments.

 

		Year Ended December 31,								Increase/
		2007				2006				(Decrease)
Gross Margin as a % of Net Sales by Segment:
Smokeless Tobacco			82.1	%			82.5	%			(0.4	)
Wine			35.4	%			35.2	%			0.2
All Other Operations			63.5	%			63.8	%			(0.3	)
Consolidated			73.1	%			74.8	%			(1.7	)

 

The decline in the consolidated gross margin, as a percentage of net sales, was mainly due to a change in segment mix, as case volume for wine, which sells at comparatively lower margins, grew faster than the net can volume for moist smokeless tobacco products. Gross margin percentages within each segment, which are discussed further below, were relatively stable.

 

Restructuring Charges

 

The Company recognized $10.8 million in restructuring charges in 2007 related to actions undertaken in connection with Project Momentum. Under this initiative, the Company has now targeted at least $150 million in annual savings to be realized within the three years following its implementation. The following table provides a summary of restructuring charges incurred during 2007, the cumulative charges incurred to date and the total amount of charges expected to be incurred in connection with this initiative for each major cost, by category:

 

		Restructuring
		Charges Incurred				Cumulative Charges				Total Charges
		for The Year Ended				Incurred as of				Expected to
		December 31, 2007				December 31, 2007				be Incurred (1)
One-time termination benefits		$	3,184			$	18,809			$	19,700 - $21,200
Contract termination costs			102				492				400 - 500
Other restructuring costs			7,518				13,500				13,400 - 13,800
Total		$	10,804			$	32,801			$	33,500 - $35,500

 

⁽¹⁾ The total cost of one-time termination benefits expected to be incurred under Project Momentum reflects the initiative’s overall anticipated elimination of approximately 10 percent of the Company’s salaried, full-time positions across various functions and operations, primarily at the Company’s corporate headquarters, as well as a reduction in the number of hourly positions within the manufacturing operations. The majority of the total one-time termination benefit costs expected to be incurred in connection with the first $100 million in targeted annual savings were recognized in 2006, with the remainder recognized in 2007, while the charges to be recognized in connection with the additional $50 million in targeted annual savings are expected to be recognized through 2008, with the majority recognized in 2007. The majority of total contract termination costs expected to be incurred were recognized in 2006, with the remainder recognized in 2007. Substantially all of the total other restructuring charges currently expected to be incurred were recognized through the end of 2007, with approximately half of such amounts recognized in each of 2006 and 2007. The remainder of the total other restructuring charges to be incurred are expected to be recognized in 2008. While the Company believes that its estimates of total restructuring charges

 

 

 28

expected to be incurred related to the aforementioned $150 million in savings are appropriate and reasonable based upon the information available, actual results could differ from such estimates. Total restructuring charges expected to be incurred currently represent the Company’s best estimates of the ranges of such charges; although there may be additional charges recognized as additional actions are identified and finalized. As any additional actions are approved and finalized and costs or charges are determined, the Company will file a Current Report on Form 8-K under Item 2.05 or report such costs or charges in its periodic reports, as appropriate.

 

One-time termination benefits relate to severance-related costs and outplacement services for employees terminated in connection with Project Momentum, as well as enhanced retirement benefits for qualified individuals. Contract termination costs primarily relate to charges for the termination of operating leases incurred in conjunction with the consolidation and relocation of facilities. Other restructuring costs are mainly comprised of other costs directly related to the implementation of Project Momentum, primarily professional fees, as well as asset impairment charges and applicable costs incurred in connection with the relocation of the Company’s headquarters. Primarily all of the restructuring charges expected to be incurred will result in cash expenditures, although approximately $4 million of such charges relate to pension enhancements offered to applicable employees, all of which will be paid directly from the respective pension plan’s assets. As of December 31, 2007, the liability balance associated with restructuring charges amounted to $1.7 million. Refer to Part II, Item 8, “Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 20, Restructuring,” for further information regarding accrued restructuring charges.

 

2006 compared with 2005

 

		Year Ended December 31,								Increase/(Decrease)
		2006				2005				Amount				%
Net sales		$	1,850,911			$	1,851,885			$	(974	)			(0.1	)
Net earnings			505,856				534,268				(28,412	)			(5.3	)
Basic earnings per share			3.15				3.26				(0.11	)			(3.4	)
Diluted earnings per share			3.12				3.23				(0.11	)			(3.4	)

 

Net Earnings

 

Consolidated net earnings decreased in 2006, as compared to 2005, as a result of lower operating income, partially offset by lower net interest and income tax expenses, as well as income from discontinued operations. The Company reported operating income of $834.8 million for 2006, representing 45.1 percent of consolidated net sales, compared to operating income of $878.2 million, or 47.4 percent of consolidated net sales, in 2005. The decrease in operating income was primarily due to the following:

 

 

These factors were partially offset by:

 

 

Net earnings for 2006 included after-tax income of $3.9 million from discontinued operations, which resulted from the reversal of an accrual for an income tax-related contingency related to the Company’s former cigar

 

 

29 

operations. The reversal was due to a change in facts and circumstances in connection with the then anticipated sale of the Company’s corporate headquarters.

 

Basic and diluted earnings per share for 2006 were $3.15 and $3.12, respectively, a decrease of 3.4 percent for each measure as compared to the corresponding comparative measures in 2005. Average basic shares outstanding were lower in 2006 than in 2005 primarily as a result of share repurchases, partially offset by the exercise of stock options. Average diluted shares outstanding in 2006 were lower than those in 2005 due to the impact of share repurchases and a lower level of dilutive outstanding options, partially offset by the impact of a higher average stock price in 2006, as compared to 2005, which has the effect of increasing diluted shares outstanding.

 

Net Sales

 

		Year Ended December 31,								Increase/(Decrease)
		2006				2005				$				%
Net Sales by Segment:
Smokeless Tobacco		$	1,522,686			$	1,561,667			$	(38,981	)			(2.5	)
Wine			282,403				248,342				34,061				13.7
All Other Operations			45,822				41,876				3,946				9.4
Consolidated Net Sales		$	1,850,911			$	1,851,885			$	(974	)			(0.1	)

 

For the year ended December 31, 2006, consolidated net sales of $1.851 billion were effectively level with those in 2005 reflecting the following:

 

 

Segment Net Sales as a Percentage of Consolidated Net Sales

 

 

*Smokeless Tobacco

 

Gross Margin

 

		Year Ended December 31,								Increase/(Decrease)
		2006				2005				Amount				%
Gross Margin by Segment:
Smokeless Tobacco		$	1,256,156			$	1,289,212			$	(33,056	)			(2.6	)
Wine			99,418				92,618				6,800				7.3
All Other Operations			29,249				26,924				2,325				8.6
Consolidated Gross Margin		$	1,384,823			$	1,408,754			$	(23,931	)			(1.7	)

 

 

 30

 

The consolidated gross margin decline, as compared to the prior year, was primarily due to lower net sales in the Smokeless Tobacco segment and higher cost of products sold for the Wine segment and All Other Operations, partially offset by higher Wine segment and All Other Operations net sales.

 

		Year Ended December 31,								Increase/
		2006				2005				(Decrease)
Gross Margin as a % of Net Sales by Segment:
Smokeless Tobacco			82.5	%			82.6	%			(0.1	)
Wine			35.2	%			37.3	%			(2.1	)
All Other Operations			63.8	%			64.3	%			(0.5	)
Consolidated			74.8	%			76.1	%			(1.3	)

 

The decline in the consolidated gross margin, as a percentage of net sales, was mainly due to the following:

 

•   Higher case volume for wine, which sells at lower margins than moist smokeless tobacco products; and

•   Lower net revenue realization per premium can in the Smokeless Tobacco segment.

 

Partially offset by:

 

•   Lower costs per can in the Smokeless Tobacco segment.

 

Restructuring Charges

 

The Company recognized $22 million in restructuring charges during 2006 in connection with the implementation of Project Momentum. For additional information regarding Project Momentum, refer to the Restructuring Charges within the 2007 compared with 2006 section above.

 

SMOKELESS TOBACCO SEGMENT

 

2007 compared with 2006

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Net sales			$1,546,638			$	1,522,686			$	23,952				1.6
Restructuring charges			8,230				19,542				(11,312	)			(57.9	)
Antitrust litigation			137,111				2,025				135,086				-
Operating profit			715,699				805,130				(89,431	)			(11.1	)

 

Net Sales

 

The increase in Smokeless Tobacco segment net sales in 2007, as compared to 2006, is due to an increase in both premium and price-value net can volume for moist smokeless tobacco products, driven by the following:

 

 

The impact of increased volume was partially offset by lower net revenue realized per can, which was attributable to:

 

 

 

31 

 

The net sales results for 2007 benefited from the presence of an extra billing day in the fourth quarter, as compared to the prior year, since December 31, 2007, the last day of the Company’s fiscal year, fell on a Monday. Since the Company’s moist smokeless tobacco products are dated for freshness, shipments of the Company’s products are scheduled so that they arrive at customer locations on Mondays, which is the point when title passes to the customer and revenue is recognized. While an extra billing day could normally be expected to represent a full extra week of moist smokeless tobacco product shipments, the shipments for the last week of 2007 were below those of a typical week since ordering patterns were adversely impacted by the holidays and there were few sales promotions during this period. Partially offsetting the benefit of the 2007 extra billing day was lower shipments to the military channel due to a supply chain disruption that affected shipments during the fourth quarter of 2007. The source of the disruption was one-time in nature and is not expected to impact volume trends going forward.

 

Percentage of Smokeless Tobacco Segment Net Sales by Product Category

 

 

* Moist smokeless tobacco products

 

** Includes dry snuff and tobacco seeds

 

Net sales results for both premium and price-value products include net can sales for standard products, which consist of straight stock and value pack products, as well as pre-pack promotional products. Prior to 2007, only premium standard products included value packs. Straight stock refers to single cans sold at wholesale list prices. Value packs, which were introduced to more effectively compete for and retain value-conscious adult consumers, are two-can packages sold year-round reflecting lower per-can wholesale list prices than wholesale list prices for straight stock single-can products. Pre-pack promotions refer to those products that are bundled and packaged in connection with a specific promotional pricing initiative for a limited period of time.

 

MSTP Net Can Volume

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Net Can Volume (in thousands):
Premium			556,909				541,387				15,522				2.9
Price-Value			102,124				91,298				10,826				11.9
Total			659,033				632,685				26,348				4.2

 

 

 32

 

Percentage of Total Moist Smokeless Tobacco Products Net Can Volume by
Category Segment

 

 

Overall net can volume for moist smokeless tobacco products increased 4.2 percent in 2007, as compared to 2006, with premium products, primarily Copenhagen and Skoal products, accounting for approximately 60 percent of the overall volume increase, on an absolute can basis. During the fourth quarter of 2007, overall and premium net can volume for moist smokeless tobacco products increased 7.3 percent and 5.9 percent, respectively. As previously discussed, fourth quarter and full-year results for 2007 benefited from the presence of an extra billing day, partially offset by lower shipments in the military channel as a result of a one-time supply chain disruption. Excluding the impact of these two items, underlying overall net can volume for moist smokeless tobacco products for the fourth quarter and full year of 2007 increased 2.7 percent and 3.1 percent, respectively, as compared to the corresponding prior year periods. This marked the eighth consecutive quarter of overall year-over-year net can volume growth – the fifth consecutive quarter in excess of 2 percent. Underlying premium net can volume increased 1.3 percent in the fourth quarter and 1.8 percent for the full year in 2007, as compared to the same prior year periods. This represented the sixth consecutive quarter of year-over-year premium net can volume growth and reflects the effects of:

 

 

Net can volume for price-value products includes the Red Seal and Husky brands. Both full year and fourth quarter 2007 net can volume for the Company’s mid-priced Red Seal brand reflected mid-single digit growth, as compared to the corresponding 2006 periods. These results reflect the benefit of focused promotional spending for Red Seal, with the increase in fourth quarter 2007 net can volume representing the fourth consecutive quarter of low-to-mid single digit growth. Net can volume for the Company’s deep discount Husky brand increased significantly for both the full year and fourth quarter of 2007, as compared to the same periods for 2006. The strong double-digit net can volume growth sustained by Husky throughout 2007 was mainly as a result of the Company’s efforts to expand distribution and strengthen Husky’s retail presence. Both Red Seal and Husky benefited from the 2007 introduction of value packs. It is important to note that the price-value volume growth of approximately 12 percent experienced in 2007 occurred at the same time as the approximately 3 percent growth in premium volume, reflecting the Company’s ability to compete effectively within every segment of the moist smokeless tobacco category.

 

The Company remains committed to the development of new products and packaging that cover both core product launches and other possible innovations. During the first quarter of 2007, the Company launched Skoal Citrus Blend in two forms, Long Cut and Pouches. In addition, during September 2007, the Company launched Cope, an all-new line of premium moist smokeless tobacco products that is designed to make the Company’s core brand, Copenhagen, more approachable for adult smokers. Net can sales for 2007 included approximately 90.1 million cans of new products that were launched nationally within the last three years,

 

 

33 

representing 13.7 percent of the Company’s total moist smokeless tobacco net can volume in 2007. These new products included:

 

 

* Includes Citrus Blend variety, which was introduced during 2007.

 

** Product introduced during 2006; Copenhagen Long Cut Straight was re-branded as Cope Straight in 2007.

 

*** Cope was introduced in September 2007 and is available in Straight, Smooth Hickory and Whiskey Blend.

 

In connection with the Company’s objective to grow the moist smokeless tobacco category by building awareness and improving the social acceptability of smokeless tobacco products among adult consumers, primarily smokers, the Company’s premium portion pack products have demonstrated continued growth. Such products are designed to differentiate the Company’s premium brands from competitive products, and to provide more approachable forms and flavors for adult smokers that continue to switch to smokeless tobacco products. Net can volume for these portion pack products, which include Copenhagen Pouches and Skoal Pouches, as well as new and improved Skoal Bandits, posted double digit growth in 2007 for both the fourth quarter and full year, as compared to the corresponding prior year periods, and represented approximately 8 percent of the Company’s premium net can volume for the year.

 

The Company continues its limited marketing of a new product, Skoal Dry, in two lead markets, and continues to evaluate the results of this initiative. In keeping with the objective to improve smokeless tobacco’s social acceptability, this product, also aimed at converting adult smokers, is designed to be spit-free. Over the course of the past 18 months, several similar competitive, spit-free products, referred to as “snus,” have also been introduced in select domestic markets. As all of these dry, spit-free products have substantially different attributes than traditional moist smokeless tobacco products, the volume associated with these launches has been largely incremental to the category and has had no measurable impact on the Company’s existing products within these markets.

 

The following provides information from the Company’s Retail Account Data Share & Volume Tracking System (“RAD-SVT”) for the 52-week period ended December 29, 2007, as provided by Management Science Associates, Inc., which measures shipments from wholesale to retail.

 

		Can-Volume %								Percentage Point
		Change from Prior								Increase/(Decrease)
		Year Period				%				from Prior Year
						Share				Period
Total Category Data:
Total Moist Smokeless Category			7.1	%			N/A				N/A
Total Premium Segment			1.5	%			55.5	%*			(3.1	)
Total Value Segments			15.2	%			44.3	%*			3.1
Company Data:
Total Moist Smokeless Category			3.3	%			60.4	%			(2.3	)
Total Premium Segment			2.1	%			90.9	%			0.5
Total Value Segments			10.0	%			22.2	%			(1.0	)

 

* Amounts reported do not add to 100 percent, as this table does not reflect the herbal segment of the total moist smokeless category.

 

When applying retail pricing data from ACNielsen to the 52-week period’s RAD-SVT shipment data, moist smokeless tobacco category revenues grew 5.5 percent in 2007 over the comparable 2006 period. The Company’s revenue share over that same period was 72.6 percent, down 1.8 percentage points from the corresponding 2006 period. Moist smokeless tobacco category revenue growth was below can volume

 

 

 34

growth primarily due to the comparatively faster growth of the price-value segment and the Company’s implementation of price-focused initiatives under its premium brand loyalty plan.

 

As reflected in such data, for the 52 weeks ended December 29, 2007, the total moist smokeless tobacco category grew 7.1 percent, which was consistent with trends seen in recent quarters and in line with the Company’s previously reported estimate of category growth of at least 6 percent for 2007. Volume for the Company’s moist smokeless tobacco products increased 3.3 percent and its share of the total category was 60.4 percent during the period. While this share reflects a decline of 2.3 percentage points from the prior year period, the rate of year-over-year share decline has improved significantly, as compared to the share loss of approximately 3.2 percentage points reported for the 52 weeks ended December 30, 2006. Volume for the Company’s premium brands grew 2.1 percent, outpacing the overall premium segment growth of 1.5 percent from the prior year period, and the Company’s 90.9 percent share of the overall premium segment increased 0.5 percentage points from the prior year period. Net can volume for the Company’s premium products increased in 36 states, representing approximately 70.3 percent of its premium net can volume, indicating the broad scale success of the Company’s premium brand loyalty plan in 2007. The Company’s value products experienced volume growth of 10 percent, which was below the overall value segment’s growth of 15.2 percent during the period, but accelerated as the year progressed in response to the Company’s price-value initiatives.

 

RAD-SVT information is provided as an indication of current domestic moist smokeless tobacco trends from wholesale to retail and is not intended as a basis for measuring the Company’s financial performance. This information can vary significantly from the Company’s actual results due to the fact that the Company reports net shipments to wholesale, while RAD-SVT measures shipments from wholesale to retail. In addition, differences in the time periods measured, as well as differences as a result of new product introductions and promotions, affect comparisons of the Company’s actual results to those from RAD-SVT. The Company believes the difference in trend between RAD-SVT and its own net shipments is due to such factors. Furthermore, Management Science Associates, Inc. periodically reviews and adjusts RAD-SVT information, in order to improve the overall accuracy of the information for comparative and analytical purposes, by incorporating refinements to the extrapolation methodology used to project data from a statistically representative sample. Adjustments are typically made for static store counts and new reporting customers.

 

Cost of Products Sold

 

Costs of products sold in 2007 increased as compared to 2006, primarily as a result of the impact of increased net can volume for moist smokeless tobacco products.

 

Gross Margin

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Gross Margin		$	1,269,174			$	1,256,156			$	13,018				1.0
Gross Margin as % of Net Sales			82.1	%			82.5	%

 

Gross margin increased in 2007, as compared to 2006, primarily as a result of the increase in net sales, partially offset by the aforementioned cost of products sold variance. The gross margin, as a percentage of net sales, declined by 0.4 percentage points in 2007, as compared to 2006, as a result of these factors and a shift in product mix, which included a higher percentage of price-value, value pack and promotional products.

 

 

35 

SA&A Expenses

 

SA&A expenses decreased 5 percent in 2007 to $408.1 million, compared to $429.5 million in 2006, reflecting overall improvements in cost management as a result of Project Momentum and other favorable spending, specifically:

 

•   Lower salaries and related costs, primarily associated with certain positions eliminated in the restructuring;

•   Lower consulting fees;

•   Lower costs associated with retail shelving systems used to promote the moist smokeless tobacco category’s products;

•   The absence of costs incurred in 2006 in connection with efforts to defeat a ballot initiative in California;

•   Decreased print advertising costs, primarily related to Skoal, as 2006 included increased advertising for the launch of new and improved Skoal Bandits;

•   Lower spending related to market research studies; and

•   A decrease in other administrative expenses.

 

These decreases were partially offset by:

 

•   Increased direct marketing expenses, one-on-one marketing costs and point-of-sale advertising expenses, the majority of which related to the Company’s category growth and premium brand-building initiatives;

•   The absence of funds received in 2006 with respect to litigation relating to the proper “other tobacco products” excise tax base;

•   Higher legal-related costs; and

•   Rent expense incurred in 2007 in connection with the Company’s new headquarters lease.

 

The Company’s SA&A expenses include legal expenses, which incorporate, among other things, costs of administering and litigating product liability claims. For the years ended December 31, 2007 and 2006, outside legal fees and other internal and external costs incurred in connection with administering and litigating product liability claims were $14.7 million and $14.3 million, respectively. These costs reflect a number of factors, including the number of claims, and the legal and regulatory environments affecting the Company’s products. The Company expects these factors to be the primary influence on its future costs of administering and litigating product liability claims. The Company does not expect these costs to increase significantly in the future; however, it is possible that adverse changes in the aforementioned factors could have a material adverse effect on such costs, as well as on results of operations and cash flows in the periods such costs are incurred.

 

Antitrust Litigation

 

Results for the Smokeless Tobacco segment in 2007 reflect the impact of $137.1 million in antitrust litigation charges, comprised of the following:

 

•   A $122.1 million charge recognized in the first quarter, representing the estimated costs to be incurred in connection with the resolution of the Company’s two most significant remaining indirect purchaser class actions. The Company believes the settlement of these actions was prudent, as it removed a major distraction from the organization and reduced uncertainties regarding legal actions. The following provides the portion of the total charge related to each action:

•   A $93.6 million pre-tax charge related to a May 2007 settlement, subject to court approval, reached in the State of California action as a result of court-ordered mediation. This charge brought the total recognized liability for the California action to $96 million, and reflects the cost of cash payments to be made to the benefit of class members, as well as plaintiffs’ attorneys’ fees and other administrative costs of the settlement. The terms of the California settlement have subsequently been preliminarily approved by the court.

•   A $28.5 million charge related to a settlement, subject to court approval, reached in the State of Wisconsin action during a court-ordered mediation session that was held in April 2007. This

 

 

 36

charge reflects costs attributable to coupons, which will be distributed to consumers, and will be redeemable, over the next several years, on future purchases of the Company’s moist smokeless tobacco products. Also reflected in this charge are plaintiffs’ attorneys’ fees and other administrative costs of the settlement. The terms of the Wisconsin settlement were approved by the court in December 2007.

 

•   A $9 million charge recognized in the fourth quarter, representing the estimated costs to be incurred in connection with the resolution of the Massachusetts and New Hampshire indirect purchaser actions, which are two of the last remaining Conwood derivative antitrust litigation cases. This charge reflects costs attributable to coupons, which will be distributed to consumers, and will be redeemable, over the next several years, on future purchases of the Company’s moist smokeless tobacco products. Also reflected in this charge are plaintiffs’ attorneys’ fees and other administrative costs of the settlement; and

•   A charge of $2.8 million related to a ruling on a motion filed with respect to the settlement of the Kansas and New York actions seeking additional plaintiffs’ attorneys’ fees and expenses, plus interest.

 

In addition, the Company recorded charges of $3.2 million and $2 million in 2007 and 2006, respectively, reflecting a change in the estimated redemption rate for coupons issued in conjunction with the resolution of certain states’ indirect purchaser antitrust actions (see Part II, Item 8, “Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 21, Contingencies,” for additional details regarding the Company’s antitrust litigation).

 

Restructuring Charges

 

Smokeless Tobacco segment results for 2007 and 2006 reflect $8.2 million and $19.5 million of the restructuring charges discussed in the Consolidated Results section above.

 

2006 compared with 2005

 

		Year Ended December 31,								Increase/(Decrease)
		2006				2005				Amount				%
Net sales		$	1,522,686			$	1,561,667			$	(38,981	)			(2.5	)
Restructuring charges			19,542				-				19,542				-
Antitrust litigation			2,025				11,762				(9,737	)			(82.8	)
Operating profit			805,130				852,478				(47,348	)			(5.6	)

 

Net Sales

 

Net sales for the Smokeless Tobacco segment decreased in 2006, as compared to 2005, primarily due to the effects of the Company’s premium brand loyalty initiative, which began in the first quarter of 2006. The Company believes that costs incurred in connection with this initiative, inclusive of adjustments from its originally announced spending under the initiative, were effectively utilized to increase the focus in states that were experiencing premium volume deterioration at, and subsequent to, the plan’s inception. Overall, the costs incurred under this initiative produced the desired effect of stabilizing premium net can volume, which increased slightly by 0.1 percent in 2006, as compared to the prior year. The segment’s net sales declined despite an increase in premium, as well as overall, net can volume for moist smokeless tobacco products, as a result of lower net revenue realization per premium can, reflecting the aforementioned impact of the premium brand loyalty initiative, due to the following:

 

 

•   An unfavorable shift in product mix, with lower net can volume for straight stock premium products more than offset by an increase in net can volume for value pack premium products; and

•   Increased sales incentive costs, primarily retail buydowns.

 

 

37 

 

Partially offset by:

 

•   Higher wholesale list selling prices.

 

Also contributing to the decline in net sales, despite higher overall net can volume for moist smokeless tobacco products, was a shift in product mix from premium to price-value products. This shift reflected an increase in net sales of price-value products, which accounted for 8.1 percent of total Smokeless Tobacco segment net sales in 2006, as compared to 7.4 percent in 2005.

 

Percentage of Smokeless Tobacco Segment Net Sales by Product Category

 

 

 

 

MSTP Net Can Volume

 

		Year Ended December 31,								Increase/(Decrease)
		2006				2005				Amount				%
Net Can Volume (in thousands):
Premium			541,387				540,968				419				0.1
Price-Value			91,298				84,384				6,914				8.2
Total			632,685				625,352				7,333				1.2

 

Percentage of Total Moist Smokeless Tobacco Products Net Can Volume by
Category Segment

 

2006		2005

 

Overall net can volume for moist smokeless tobacco products increased 1.2 percent in 2006, as compared to prior year net can volume, driven mainly by price-value products. Net can volume for premium products increased by 0.1 percent in 2006, which was slightly ahead of the Company’s stated goal of being stable as compared to corresponding 2005 levels by the second half of 2006. During the fourth quarter of 2006, net can volume for premium products and price-value products increased 1.7 percent to 134 million cans and 7.8 percent to 23.4 million cans, respectively, as compared to the corresponding 2005 period, with an increase in overall net can volume for moist smokeless tobacco products of 2.5 percent to 157.4 million cans. The premium net can volume growth of 1.7 percent in the fourth quarter of 2006 continued to reflect a

 

 

 38

sequential improvement in premium net can volume trends, indicative of the Company’s increased focus on category growth and premium brand loyalty throughout 2006.

 

As previously reported, the Company estimates that approximately 3.7 million premium cans were shifted from the first quarter of 2005 to the fourth quarter of 2004 as some wholesale and retail customers increased inventories in advance of the January 1, 2005 price increase for premium products. Adjusting for this shift, premium net can volume showed sequential improvement for the four quarters following the fourth quarter of 2005, which was the quarter immediately prior to the implementation of the Company’s premium brand loyalty initiative.

 

Full year 2006 net can volume for Red Seal decreased slightly, as compared to the prior year, although fourth quarter 2006 net can volume stabilized as compared to the prior year, reflecting the impact of increased sales incentives. Net can volume for Husky increased for both the full year and fourth quarter of 2006, as compared to the corresponding prior year periods.

 

The combined portion pack business, which includes Copenhagen Pouches and Skoal Pouches, as well as Skoal Bandits, increased 20.6 percent and 20.7 percent for the full year and the fourth quarter of 2006, respectively, as compared to the corresponding prior year periods. In 2006, portion packs represented 8.5 percent of the Company’s premium net can volume.

 

The following provides information from RAD-SVT, as provided by Management Science Associates, Inc., for the 52-week period ending December 30, 2006. As previously indicated, Management Science Associates, Inc. periodically reviews and adjusts RAD-SVT information, in order to improve the overall accuracy of the information for comparative and analytical purposes. The information below reflects such adjustments:

 

										Percentage Point
		Can-Volume %								Increase/(Decrease)
		Change from Prior				%				from Prior Year
		Year Period				Share				Period
Total Category Data:
Total Moist Smokeless Category			6.3	%			N/A				N/A
Total Premium Segment			(0.7	)%			58.6	%*			(4.1	)
Total Value Segments			18.2	%			41.2	%*			4.1
Company Data:
Total Moist Smokeless Category			1.2	%			62.6	%			(3.2	)
Total Premium Segment			(0.1	)%			90.4	%			0.5
Total Value Segments			8.9	%			23.2	%			(2.0	)

 

*Amounts reported do not add to 100 percent, as this table does not reflect the herbal segment of the total moist smokeless category.

 

When applying retail pricing data from ACNielsen to the 52-week period’s RAD-SVT shipment data, moist smokeless tobacco category revenues grew 3.7 percent in 2006 over the comparable 2005 period. The Company’s revenue share over that same period was 74.4 percent, down 1.9 percentage points from the corresponding 2005 period. Moist smokeless tobacco category revenue growth was below can volume growth primarily due to the Company’s implementation of price-focused initiatives under its premium brand loyalty plan and the faster growth of the price-value segment.

 

During the 52-week period ended December 30, 2006, premium net can volume was growing in 28 states, representing 54.6 percent of the Company’s overall premium net can volume.

 

Cost of Products Sold

 

Cost of products sold decreased 2.2 percent in 2006, compared to 2005, as the impact of lower can costs was partially offset by overall increased net can volume for moist smokeless tobacco products. In addition, the cost of products sold comparison was favorably impacted by impairment charges, recorded in 2005, related

 

 

39 

to certain manufacturing equipment, lower charges recorded in connection with the tobacco quota buyout legislation, and lower charges for inventory obsolescence. The decreased moist smokeless tobacco can costs were primarily due to lower leaf tobacco and other costs, partially offset by higher labor and overhead.

 

Gross Margin

 

		Year Ended December 31,								Increase/(Decrease)
		2006				2005				Amount				%
Gross Margin		$	1,256,156			$	1,289,212			$	(33,056	)			(2.6	)
Gross Margin as % of Net Sales			82.5%				82.6%

 

Gross margin decreased 2.6 percent in 2006 compared to 2005, primarily as a result of the aforementioned decrease in net sales, partially offset by lower costs of products sold. The gross margin, as a percentage of net sales, was relatively flat year-over-year, as the aforementioned decrease in net sales was largely offset by the positive impact of the lower costs of products sold.

 

SA&A Expenses

 

SA&A expenses increased 1.1 percent in 2006 to $429.5 million, compared to $425 million in 2005, reflecting the following:

 

•   Higher expenses related to direct marketing, print advertising and one-on-one marketing efforts, the majority of which related to the Company’s category growth and premium brand loyalty initiatives;

•   Increased spending on market research to support premium brand loyalty initiatives and product innovation;

•   Higher legal and government relations expenses, as well as increased other professional fees;

•   Higher share-based compensation expense;

•   Costs incurred in connection with efforts to defeat ballot initiatives, primarily a November 2006 ballot initiative in California;

•   Absence of the recovery of amounts due in connection with a bankrupt smokeless tobacco customer, which had a favorable impact in 2005; and

•   Absence of the gain recognized in 2005 from the sale of the Company’s corporate aircraft.

 

These increases were significantly offset by:

 

•   Lower salaries and related costs associated with certain positions eliminated in the restructuring under Project Momentum;

•   Lower costs associated with retail shelving systems used to promote the moist smokeless tobacco category’s products, as the prior year included charges related to a physical inventory of previously installed units;

•   Funds received with respect to litigation relating to the proper “other tobacco products” excise tax base;

•   Lower costs related to trade promotional materials and point-of-sale advertising;

•   The absence of $3.3 million in impairment charges recorded in 2005 for goodwill and intangible assets at F.W. Rickard Seeds, Inc.; and

•   The absence of certain tobacco settlement-related charges recognized in 2005.

 

For the years ended December 31, 2006 and 2005, outside legal fees and other internal and external costs incurred in connection with administering and litigating product liability claims were $14.3 million and $13.9 million, respectively. These costs reflect a number of factors, including the number of claims, and the legal and regulatory environments affecting the Company’s products.

 

 

 40

 

Antitrust Litigation

 

Results for the Smokeless Tobacco Segment in 2006 were favorably impacted by the absence of $11.8 million in charges related to the 2005 resolution of certain states’ indirect purchaser antitrust actions that were for amounts in excess of those previously recorded. This favorable variance was partially offset by a $2 million pre-tax charge recognized in 2006, reflecting a change in the estimated redemption rate and an administrative fee adjustment for coupons issued in connection with the resolution of certain states’ indirect purchaser antitrust actions (see Part II, Item 8, “Financial Statements and Supplementary Data – Notes to Consolidated Financial Statements – Note 21, Contingencies,” for additional details).

 

Restructuring Charges

 

Smokeless Tobacco segment results for 2006 reflect $19.5 million of the restructuring charges discussed in the Consolidated Results section above.

 

WINE SEGMENT

 

2007 compared with 2006

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Net sales		$	354,001			$	282,403			$	71,598				25.4
Restructuring charges			-				322				(322	)			-
Operating profit			59,883				44,080				15,803				35.9

 

Net Sales

 

The Wine segment reported record net sales for 2007, driven by a 17 percent increase in premium case volume, as compared to 2006. These favorable net sales results reflect the following factors:

 

•   Strong performance by core brands, primarily Chateau Ste. Michelle;

•   The incremental impact of the Antinori and Erath labels, which were added to the Company’s portfolio in the second half of 2006, as well as the Stag’s Leap Wine Cellars labels, which were added in September 2007;

•   Expanded distribution of the Company’s wines; and

•   Favorable third-party acclaim and product ratings in 2007, as the Company has received a total of 86 ratings of 90 and higher from various national wine publications. Three products sold by the Company, Columbia Crest Grand Estates Merlot, Antinori’s Tignanello, and Erath Estate Selection Dundee Hills Pinot Noir, were listed on Wine Spectator’s Top 100 Wines of the Year in 2007.

 

Case Volume

 

Percentage of Total Case Volume by Brand

 

 

*Includes Stag’s Leap Wine Cellars, which was acquired in September 2007.

 

 

41 

Chateau Ste. Michelle and Columbia Crest, the Company’s two leading brands, accounted for 68.8 percent of the Company’s total premium case volume in 2007, as compared to 72.5 percent in 2006.

 

Case volume for 2007 reflected the following:

 

•   Double digit increases in case volume for Chateau Ste. Michelle primarily due to higher case volume for white varietals, particularly Riesling and Chardonnay, and to a lesser extent certain red varietals;

•   Mid-single digit increases in Columbia Crest case volume primarily due to higher case volume for Grand Estates red varietals. In addition, for the full year of 2007, all varietals of the Two Vines products had higher case volume, as compared to 2006, with the exception of Two Vines Chardonnay, which was lower. These increases were also partially offset by lower case volume for Grand Estates Chardonnay for both the fourth quarter and full year 2007 periods;

•   Increased case volume for the Antinori and Erath brands, which the Company added to its portfolio in the second half of 2006. Case volume for these brands accounted for 26 percent (or 4.4 percentage points) of the overall 17 percent case volume increase;

•   Increased case volume for Red Diamond and 14 Hands, two of the Company’s newer labels;

•   Case volume related to the Stag’s Leap Wine Cellars labels, which accounted for 6.7 percent (or 1.1 percentage points) of the overall 17 percent case volume increase. The Stag’s Leap Wine Cellars labels were added to the Company’s portfolio in September 2007; and

•   Lower case volume for Domaine Ste. Michelle.

 

Cost of Products Sold

 

Segment cost of products sold in 2007 increased 25 percent from 2006, which was primarily attributable to the increased case volume and the impact of higher costs per case, partially offset by lower costs associated with Antinori products.

 

Gross Margin

 

		Year Ended December 31,								Increase/(Decrease)
		2007				2006				Amount				%
Gross Margin		$	125,202			$	99,418			$	25,784				25.9
Gross Margin as % of Net Sales			35.4%				35.2%