• its efforts to broaden its business with new types of tobacco products;

• its focus on continuous productivity improvement and complexity reduction; and

• its commitment to keep its cost structure in line with the company's performance.

RJR Tobacco is committed to building and maintaining a portfolio of profitable brands. RJR Tobacco's marketing programs are designed to strengthen brand image, build brand awareness and loyalty, and switch adult smokers of competing brands to RJR Tobacco brands. In addition to building strong brand equity, RJR Tobacco's marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend certain brands' shares of market against competitive pricing pressure. RJR Tobacco's competitive pricing methods include list price changes, discounting programs, such as retail buydowns, free product promotions and consumer coupons. Retail buydowns refer to payments made to the retailer to reduce the price that consumers pay at retail. Consumer coupons are distributed by a variety of methods, including in, or on, the cigarette pack and by direct mail. Free product promotions include offers such as "Buy 2 packs, Get 1 pack free." The need for competitive pricing has increased significantly over time as a result of, among other things, higher state excise taxes and the strength of deep-discount brands. Deep-discount brands are brands marketed by manufacturers that are not original participants in the MSA, and accordingly, do not have cost structures burdened with MSA payments to the same extent as the original participating manufacturers.
Competition is based primarily on brand positioning, including price, product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other incentives to maintain or improve market position or to introduce a new brand style. RJR Tobacco, other cigarette manufacturers and smokeless tobacco manufacturers also are introducing products in a new smokeless, spitless category, known as snus. CAMEL Snus is pasteurized tobacco that is currently sold in a small pouch that provides discreet and convenient tobacco consumption. RJR Tobacco expanded the sale of CAMEL Snus into a total of 17 markets in the first half of 2008 and is planning to expand nationally in 2009.
In September 2008, RJR Tobacco completed a comprehensive business analysis to evaluate the best way to continue to improve performance, efficiency and competitive position. As a result, RJR Tobacco announced changes to its organizational structure to streamline non-core business processes and programs in order to allocate additional resources to strategic growth initiatives. RJR Tobacco has determined to evolve its operations to a total tobacco business model that includes both cigarettes and innovative smokeless tobacco products. In October 2008, RJR Tobacco announced its intent to introduce a new line of modern, smoke-free tobacco products called CAMEL Dissolvables that include CAMEL Orbs, Sticks and Strips. CAMEL Dissolvables are made of finely milled tobacco, and dissolve completely in the mouth. They are designed to provide current adult smokers and smokeless tobacco users with additional, convenient alternative ways to enjoy tobacco products. CAMEL Dissolvables will be launched in lead markets in the first half of 2009.
Conwood
RAI's other reportable segment, Conwood, is the second largest smokeless tobacco products manufacturer in the United States. Conwood's primary brands include its largest selling moist snuff brands, GRIZZLY and KODIAK, two of the seven best-selling brands of moist snuff in the United States, and LEVI GARRETT, a loose leaf brand. Conwood's other products include dry snuff, plug and twist tobacco products. Conwood also distributes a variety of other tobacco products including WINCHESTER and CAPTAIN BLACK little cigars, and BUGLER roll-your-own tobacco.
The moist snuff category is divided into premium and price-value brands. The moist snuff category has developed many of the characteristics of the larger cigarette market, including pricing tiers with intense competition, focused marketing programs and significant product innovation. GRIZZLY, the nation's largest price-value brand, has led to Conwood's increased share of the smokeless market. KODIAK is Conwood's leading premium brand.
In contrast to the declining U.S. cigarette market, U.S. moist snuff volumes grew at over 7% for the first nine months of 2008 compared with the first nine months of 2007, driven by the accelerated growth of price-value brands. Profit margins on moist snuff products are generally higher than on cigarette products. Moist snuff's growth is partially

attributable to cigarette smokers switching from cigarettes to smokeless tobacco products or using both. Within the moist snuff category, premium brands have lost market share to price-value brands, led by GRIZZLY, in recent years.
Conwood faces significant competition in the smokeless tobacco categories. Similar to the cigarette market, competition is based primarily on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Recently, Altria Group Inc., parent company of Philip Morris USA Inc., announced it expected to complete its acquisition of UST Inc., the largest smokeless tobacco products manufacturer in the United States, in January 2009. RAI believes the acquisition of UST by Altria could have a negative impact on the businesses of Conwood and RJR Tobacco.
Critical Accounting Policies
GAAP requires estimates and assumptions to be made that affect the reported amounts in RAI's condensed consolidated financial statements (unaudited) and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain, and as a result, actual results could differ from those estimates. Due to the estimation processes involved, the following summarized accounting policies and their application are considered to be critical to understanding the business operations, financial condition and results of operations of RAI and its subsidiaries.
Litigation
RAI discloses information concerning litigation for which an unfavorable outcome is more than remote. RAI and its subsidiaries record their legal expenses and other litigation costs and related administrative costs as selling, general and administrative expenses as those costs are incurred. RAI and its subsidiaries will record any loss related to litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. When the reasonable estimate is a range, the recorded loss will be the best estimate within the range. If no amount in the range is a better estimate than any other amount, the minimum amount of the range will be recorded.
As discussed in note 12 to condensed consolidated financial statements (unaudited), RJR Tobacco, the Conwood companies and their affiliates, including RAI, and indemnitees, have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments have been returned in a number of tobacco-related cases and state enforcement actions. As of October 10, 2008, RJR Tobacco had paid approximately $12 million since January 1, 2006, related to such unfavorable judgments.
RAI and its subsidiaries believe that they have valid bases for appeal of adverse verdicts against them and have valid defenses to all actions, and they intend to defend all actions vigorously. RAI's management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, including B&W, or the loss of any particular claim concerning the use of smokeless tobacco against the Conwood companies, when viewed on an individual basis, is not probable or estimable. RJR has liabilities totaling $94 million that were recorded in 1999 in connection with certain indemnification claims, unrelated to smoking and health. These claims were asserted by JTI against RJR and RJR Tobacco, concerning the activities of Northern Brands and related litigation.
Litigation is subject to many uncertainties, and it is possible that some of the tobacco-related legal actions, proceedings or claims could ultimately be decided against RJR Tobacco, the Conwood companies or their affiliates, including RAI, and indemnitees. Any unfavorable outcome of such actions could have a material adverse effect on the consolidated results of operations, financial position or cash flows of RAI or its subsidiaries. Settlement Agreements
RJR Tobacco, Santa Fe and Lane are participants in the Master Settlement Agreement, and RJR Tobacco is a participant in other state settlement agreements related to governmental health-care cost recovery actions. Their obligations and the related expense charges under the MSA are subject to adjustments based upon, among other things, the volume of cigarettes sold by the operating subsidiaries, their relative market share and inflation. Since relative market share is based on cigarette shipments, the best estimate of the allocation of charges to RJR Tobacco under these agreements is recorded in cost of products sold as the products are shipped. Adjustments to these estimates are recorded in the period that the change becomes probable and the amount can be reasonably estimated. The Conwood companies are not

participants in the MSA. For more information related to historical and expected settlement expenses and payments under the MSA, see "-Litigation Affecting the Cigarette Industry-Health-Care Cost Recovery Cases-MSA" and "-MSA-Enforcement and Validity" in note 12 to condensed consolidated financial statements (unaudited).
Income Taxes
Tax law requires certain items to be included in taxable income at different times than is required for book reporting purposes under SFAS No. 109, "Accounting for Income Taxes." These differences may be permanent or temporary in nature. FIN No. 48, "Accounting for Uncertainty in Income Taxes," clarifies SFAS No. 109 by providing guidance for consistent reporting of uncertain income tax positions recognized in a company's financial statements.
RAI determines its annual effective income tax rate based on forecasted pre-tax book income and forecasted permanent book and tax differences. The rate is established at the beginning of the year and is evaluated on a quarterly basis. Any changes to the forecasted information may cause the effective rate to be adjusted. Additional tax, interest, and penalties associated with uncertain tax positions are recognized in tax expense on a quarterly basis.
To the extent that any book and tax differences are temporary in nature, that is, the book realization will occur in a different period than the tax realization, a deferred tax asset or liability is established as required under SFAS No. 109. To the extent that a deferred tax asset is created, management evaluates RAI's ability to realize this asset. Management currently believes it is more likely than not that the deferred tax assets recorded in RAI's condensed consolidated balance sheet (unaudited) will be realized. To the extent a deferred tax liability is established under SFAS No. 109, it is recorded, tracked and, once it becomes currently due and payable, paid to the taxing authorities.
The condensed consolidated financial statements (unaudited) reflect management's best estimate of RAI's current and deferred tax liabilities and assets. Future events, including but not limited to, additional resolutions with taxing authorities could have an impact on RAI's current estimate of tax liabilities, realization of tax assets and upon RAI's effective income tax rate. Restructuring Charge
During the third quarter of 2008, RAI and certain of its operating subsidiaries recorded charges related to workforce reductions in accordance with the provisions of SFAS No. 112, "Employers' Accounting for Postemployment Benefits," and SFAS No. 88, "Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits." The calculation of severance pay requires management to estimate the population of employees to be terminated and the timing of their severance from employment. The calculation of benefits charges requires actuarial assumptions including determination of discount rates. These restructuring charges were based on management's best estimate at the time of the restructuring. The status of the restructuring activities is reviewed on a quarterly basis and any adjustments to the reserve, which could differ from previous estimates, would be recorded as an adjustment to operating income. See note 3 to condensed consolidated financial statements (unaudited) for more information related to restructuring charges. Trademark Impairment
During the third quarter of 2008, RJR Tobacco recorded a trademark impairment charge related to its KOOL brand in accordance with the provisions of SFAS No. 142, "Goodwill and Other Intangible Assets." RAI generally engages an independent appraisal firm to assist it in determining the fair value of its reporting units' trademarks with indefinite lives annually in the fourth quarter or more frequently if events indicate that the asset might be impaired. The determination of fair value involves considerable estimates and judgment, including, among other things, developing forecasts of future cash flows and determining an appropriate discount rate. Although RAI believes it has based its impairment testing and impairment charges on reasonable estimates and assumptions, the use of different estimates and assumptions could result in materially different results. Generally, if the current competitive environment worsens or RAI's operating companies' strategic initiatives adversely affect their financial performance, the fair value of goodwill, trademarks and other intangibles could be impaired in future periods. See note 2 to condensed consolidated financial statements (unaudited) for more information related to RJR Tobacco's trademark impairment.

Recently Adopted Accounting Pronouncements Effective January 1, 2008, RAI adopted SFAS No. 157, "Fair Value Measurements," for financial assets and financial liabilities. SFAS No. 157 does not require any new fair value measurements but provides a definition of fair value, establishes a framework for measuring fair value and expands disclosure about fair value measurements. RAI will adopt SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on January 1, 2009. The adoption of SFAS No. 157 on financial assets and financial liabilities did not have a material impact on RAI's consolidated results of operations, financial position or cash flows. RAI is currently assessing the impact of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities on its consolidated results of operations, financial position and cash flows.
On October 10, 2008, the FASB issued FSP No. FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active." FSP FAS 157-3 clarifies the application of SFAS No. 157, "Fair Value Measurements," in a market that is not active and provides an example to illustrate key considerations in determining the fair value of a financial asset when the market for that financial asset is not active. FSP FAS 157-3 is effective immediately, including prior periods for which financial statements have not been issued. RAI has adopted FSP FAS 157-3 effective with the financial statements ended September 30, 2008. The adoption of FSP FAS 157-3 had no impact on RAI's consolidated results of operations, financial position or cash flows. Recently Issued Accounting Pronouncements In March 2008, the FASB issued SFAS No. 161, "Disclosures about Derivative Instruments and Hedging Activities-an amendment of FASB Statement No. 133." SFAS No. 161 seeks qualitative disclosures about the objectives and strategies for using derivatives, quantitative data about the fair value of and gains and losses on derivative contracts, and details of credit-risk-related contingent features in hedged positions. SFAS No. 161 also seeks enhanced disclosure around derivative instruments in financial statements, accounting under SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities," and how hedges affect an entity's financial position, financial performance and cash flows. SFAS No. 161 is effective for RAI as of January 1, 2009. RAI does not expect the adoption of SFAS No. 161 to have a material impact on its consolidated results of operations, financial position or cash flows.
In April 2008, the FASB issued FSP No. FAS 142-3, "Determination of the Useful Life of Intangible Assets." FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under SFAS No. 142, "Goodwill and Other Intangible Assets." The objective of FSP FAS 142-3 is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under SFAS No. 141(R) and GAAP. FSP FAS 142-3 is effective for financial statements issued for years beginning after December 15, 2008, and interim periods within those years and is applied prospectively to intangible assets acquired after the effective date. RAI does not expect the adoption of FSP FAS 142-3 to have a material impact on its financial position, results of operations or cash flows.

Results of Operations

                                    Three Months Ended                             Nine Months Ended
                                       September 30,                                 September 30,
                                                            %                                             %
                            2008           2007          Change           2008           2007          Change
Net sales:1
RJR Tobacco                $ 1,977        $ 2,019           (2.1 )%      $ 5,798        $ 5,995           (3.3 )%
Conwood                        181            166            9.0 %           536            495            8.3 %
All Other                      114            112            1.8 %           334            303           10.2 %

Net sales                    2,272          2,297           (1.1 )%        6,668          6,793           (1.8 )%
Cost of products
sold1, 2                     1,229          1,250           (1.7 )%        3,698          3,768           (1.9 )%
Selling, general and
administrative
expenses                       375            440          (14.8 )%        1,148          1,237           (7.2 )%
Amortization expense             5              5              -              16             17           (5.9 )%
Restructuring charge            91              -           NM3               91              -           NM3
Trademark impairment
charge                         173              -           NM3              173              -           NM3
Operating income:
RJR Tobacco                    293            499          (41.3 )%        1,231          1,483          (17.0 )%
Conwood                         98             90           10.2 %           275            260            6.0 %
All Other                       35             37           (5.4 )%          112            107            4.7 %
Corporate expense              (27 )          (24 )         12.5 %           (76 )          (79 )         (3.8 )%

Operating income           $   399        $   602          (33.7 )%      $ 1,542        $ 1,771          (12.9 )%

1 Excludes excise taxes of:

RJR Tobacco                $   438        $   474                        $ 1,276        $ 1,413
Conwood                          5              5                             15             14
All Other                       49             42                            138            117

                           $   492        $   521                        $ 1,429        $ 1,544

2 See below for further information related to MSA settlement and federal tobacco buyout expense included in cost of products sold.

3 Percentage change not meaningful.

In the third quarter of 2008, RAI and RJR Tobacco announced changes in their organizational structures to streamline non-core business processes and programs in order to allocate additional resources to strategic growth initiatives. The reorganizations will result in the elimination of approximately 600 full-time jobs, expected to be substantially completed by December 31, 2009.
Under existing benefit plans, $84 million of severance-related cash benefits and $7 million of non-cash pension-related benefits comprised a restructuring charge of $91 million. Of this charge, $81 million was recorded in the RJR Tobacco segment. None of the cash portion of the charge was paid as of September 30, 2008. The cash benefits are expected to be substantially paid by December 31, 2010. Cost savings related to the restructuring are expected to be $42 million in 2009, $53 million in 2010 and $55 million on an annualized basis thereafter.
RJR Tobacco
Net Sales
Domestic cigarette shipment volume, in billions of units for RJR Tobacco and the industry, was as follows1:

                                       Three Months Ended                 Nine Months Ended
                                          September 30,                     September 30,
                                  2008      2007      % Change       2008       2007      % Change
    Growth brands:
    CAMEL excluding non-filter     6.3       6.2           0.6 %     17.7       18.5        (4.3 )%
    PALL MALL                      2.4       1.8          33.9 %      6.2        5.3        17.6 %

                                   Three Months Ended                  Nine Months Ended
                                     September 30,                       September 30,
                              2008       2007      % Change      2008        2007       % Change
      Total growth brands      8.7        8.1         8.1 %       23.9        23.8         0.6 %

      Support brands2         11.6       13.3       (12.7 )%      35.5        39.7       (10.5 )%
      Non-support brands       2.8        3.6       (23.2 )%       8.4        11.1       (24.2 )%
. . .