RJR Tobacco
RJR Tobacco primarily conducts business in the highly competitive U.S. cigarette market, which has a few large manufacturers and many smaller participants. The U.S. cigarette market is a mature market in which overall consumer demand has declined since 1981 and is expected to continue to decline. Trade inventory adjustments may result in short-term changes in demand for RJR Tobacco's products when wholesale and retail tobacco distributors adjust the timing of their purchases of product to manage their inventory levels. RJR Tobacco believes it is not appropriate for it to speculate on other external factors that may impact the purchasing decisions of the wholesale and retail tobacco distributors.
RJR Tobacco's brand portfolio strategy is based upon three brand categories:
growth, support and non-support. The growth brands consist of a premium brand, CAMEL, and a value brand, PALL MALL. Although both of these brands are managed for long-term market share and profit growth, CAMEL will continue to receive the most significant investment support. The support brands include four premium brands, WINSTON, KOOL, SALEM and CAPRI, and two value brands, DORAL and MISTY, all of which receive limited marketing support. The non-support brands, consisting of all other brands, are managed to maximize near-term profitability. The key objectives of the portfolio strategy are to ensure the long-term market share growth of the growth brands while managing the support brands for long-term sustainability and profitability.
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. Having expanded beyond the cigarette market as an innovative tobacco company, RJR Tobacco offers a smokeless, spitless tobacco, known as snus, and new smoke-free tobacco products called CAMEL Dissolvables. CAMEL Snus, launched nationally in 2009, is pasteurized tobacco in a small pouch that provides convenient tobacco consumption. CAMEL Dissolvables include CAMEL Orbs, Sticks and Strips, all of which are made of finely milled tobacco and dissolve completely in the mouth. CAMEL Orbs were launched in three lead markets during the first quarter of 2009, and CAMEL Sticks and Strips were launched in those lead markets at the beginning of the third quarter of 2009.
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 may include list price changes, discounting programs, such as retail buydowns, periodic price reductions, dollar-off promotions, 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 generally 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, Get 1 free." The cost of free product promotions, including federal excise tax, is recorded in cost of goods sold.
Conwood
Conwood offers a range of differentiated smokeless and other tobacco products to adult consumers. 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 multiple pricing tiers with intense competition, focused marketing programs and significant product innovation.
In contrast to the declining U.S. cigarette market, U.S. moist snuff volumes grew over 3% in the first half of 2009 and have grown at an average rate of approximately 6% per year over the last four years, driven by the accelerated growth of price-value brands. The growth in the moist snuff volumes is lower in 2009 than prior years due to adjustments in trade inventories following the federal excise tax increase and changes in competitive promotional strategies. 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 the

growth of GRIZZLY, in recent years. Leveraging RAI's total tobacco business model, Conwood launched CAMEL Dip, a premium moist snuff, in lead markets during the second quarter of 2009.
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. The parent company of RJR Tobacco's largest competitor in the cigarette market, Philip Morris USA, Inc., completed its acquisition of Conwood's largest competitor, UST, in January 2009. Critical Accounting Policies and Estimates 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 position 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 10 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 July 10, 2009, RJR Tobacco had paid approximately $7 million since January 1, 2007, related to 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. As of June 30, 2009, RJR Tobacco had $2 million accrued for non-smoking and health litigation, and RJR, including its subsidiary RJR Tobacco, had liabilities totaling $94 million that were recorded in 1999 in connection with certain non-smoking indemnification claims asserted by JTI relating to certain 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, cash flows or financial position of RAI or its subsidiaries. For further discussion of the litigation and legal proceedings pending against RAI or its affiliates or indemnitees, see note 10 to condensed consolidated financial statements (unaudited).
Settlement Agreements
RJR Tobacco, Santa Fe and Lane are participants in the MSA and RJR Tobacco is a participant in the other State Settlement Agreements related to governmental health-care cost recovery actions. Their obligations and the related expense charges under the State Settlement Agreements 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 State Settlement Agreements. For more information related to historical and expected settlement expenses and payments under the State Settlement Agreements, see "- Litigation Affecting the Cigarette Industry- Health-Care Cost Recovery Cases - State Settlement Agreements" and "- State Settlement Agreements - Enforcement and Validity" in note 10 to condensed consolidated financial statements (unaudited). Intangible Assets
Intangible assets include goodwill, trademarks and other intangible assets and are accounted for under SFAS No. 142, "Goodwill and Other Intangible Assets." The determination of fair value involves considerable estimates and judgment. In particular, the fair value of a reporting unit involves, among other things, developing forecasts of future cash flows, determining an appropriate discount rate, and when goodwill impairment is implied, determining the fair value of individual assets and liabilities, including unrecorded intangibles. 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 or regulatory environment worsens or RAI's operating companies' strategic initiatives adversely affect their financial performance, the fair value of goodwill, trademarks and other intangible assets could be impaired in future periods. See note 3 to condensed consolidated financial statements (unaudited) for a discussion of the impairment charge in connection with RAI's ongoing application of SFAS No. 142. Fair Value Measurement
RAI determines fair value of assets and liabilities under SFAS No. 157, which provides a definition of fair value, establishes a fair value hierarchy that distinguishes between market participant assumptions developed based on market data obtained from sources independent of the reporting entity, and the reporting entity's own assumptions about market participant assumptions developed based on the best information available in the circumstances and expands disclosure about fair value measurements.
FSP No. FAS 157-3, "Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active," clarifies the application of SFAS No. 157 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.
SFAS No. 157 defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, essentially an exit price.
The levels of the fair value hierarchy established by SFAS No. 157 are:
Level 1: inputs are quoted prices, unadjusted, in active markets for identical assets or liabilities that the reporting entity has the ability to access at the measurement date.
Level 2: inputs are other than quoted prices included within Level 1 that are observable for the asset or liability, either directly or indirectly. A Level 2 input must be observable for substantially the full term of the asset or liability.
Level 3: inputs are unobservable and reflect the reporting entity's own assumptions about the assumptions that market participants would use in pricing the asset or liability.
Investments
As of June 30, 2009, RAI held investments primarily in money market funds, auction rate securities and a mortgage-backed security. Certain money market funds are classified as short-term investments due to the liquidity restrictions by the fund managers preventing immediate withdrawal. Adverse changes in financial markets caused certain auction rate securities and the mortgage-backed security to revalue lower than carrying value and become

less liquid. Auction rate securities and the mortgage-backed security will not become liquid until a successful auction occurs or a buyer is found. These investments will be evaluated on a quarterly basis to determine if it is probable that RAI will realize some portion of the unrealized loss.
RAI reviews impairments associated with the above in accordance with SFAS No. 115, FSP No. FAS 115-1 and FAS 124-1, FSP No. EITF 99-20-1 and FSP No. 115-2 and FAS 124-2 to determine the classification of the impairment as temporary or other-than-temporary. For additional information relating to these investments, see note 6 to condensed consolidated financial statements (unaudited). Income Taxes
Tax law requires certain items to be excluded or 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. FASB Interpretation 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 consolidated balance sheets 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 financial statements 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.
Recently Adopted Accounting Pronouncements and Recently Issued Accounting Pronouncements
For additional information relating to recently adopted accounting pronouncements and recently issued accounting pronouncements, see note 1 to condensed consolidated financial statements (unaudited).

Results of Operations

                                                     For the Three Months Ended                  For the Six Months Ended
                                                              June 30,                                   June 30,
                                                 2009           2008        % Change         2009         2008        % Change
Net sales:(1)
RJR Tobacco                                    $   1,975       $ 2,057           (4.0 )%   $   3,646     $ 3,864           (5.6 )%
Conwood                                              169           188          (10.1 )%         335         355           (5.6 )%
All other                                            106            94           12.8 %          190         177            7.3 %

Net sales                                          2,250         2,339           (3.8 )%       4,171       4,396           (5.1 )%
Cost of products sold(1)(2)                        1,201         1,305           (8.0 )%       2,199       2,469          (10.9 )%
Selling, general and administrative expenses         393           391            0.5 %          758         773           (1.9 )%
Amortization expense                                   7             6           16.7 %           15          11           36.4 %

                                    For the Three Months Ended                           For the Six Months Ended
                                             June 30,                                            June 30,
                             2009             2008            % Change            2009            2008           % Change
Trademark impairment
charges                    $      -         $      -                 NM (3)      $   453         $     -                NM (3)
Operating income:
RJR Tobacco                     556              538                3.3 %            638             964             (33.8 )%
Conwood                          92               96               (4.2 )%           100             177             (43.5 )%
All other                        25               26               (3.8 )%            49              51              (3.9 )%
Corporate expense               (24 )            (23 )              4.3 %            (41 )           (49 )           (16.3 )%

Operating income           $    649         $    637                1.9 %        $   746         $ 1,143             (34.7 )%

(1) Excludes excise taxes of:

                                   2009       2008       2009       2008
                    RJR Tobacco   $ 1,131     $ 447     $ 1,493     $ 838
                    Conwood            45         5          50        10
                    All other          71        48         114        89

                                  $ 1,247     $ 500     $ 1,657     $ 937

(2) See below for further information related to the State Settlement Agreements and federal tobacco buyout expense included in cost of products sold.

(3) Percentage change not meaningful.

RJR Tobacco
Net Sales
   Domestic shipment volume, in billions of units for RJR Tobacco and the
industry, were as follows(1):

                                   For the Three Months Ended             For the Six Months Ended
                                            June 30,                              June 30,
                                 2009          2008      % Change      2009        2008       % Change
 Growth brands:
 CAMEL excluding non-filter        5.7          6.1        (7.8 )%      10.7        11.4        (6.5 )%
 PALL MALL                         4.5          2.2       105.0 %        6.4         3.8        68.5 %

                                  10.2          8.4        22.1 %       17.1        15.2        12.3 %
 Support brands                   10.1         12.6       (19.5 )%      19.8        23.9       (16.9 )%
 Non-support brands                2.1          2.9       (28.5 )%       4.2         5.6       (25.9 )%

 Total domestic                   22.4         23.9        (6.0 )%      41.1        44.7        (8.1 )%

 Total premium                    12.9         15.0       (13.6 )%      24.6        28.1       (12.5 )%
 Total value                       9.5          8.9         6.7 %       16.5        16.6        (0.6 )%
 Premium/total mix                57.6 %       62.6 %                   59.9 %      62.9 %
 Industry(2):
 Premium                          60.6         65.3        (7.1 )%     112.1       124.0        (9.6 )%
 Value                            25.3         24.4         3.7 %       45.9        46.0        (0.3 )%

 Total domestic                   86.0         89.7        (4.1 )%     157.9       170.1        (7.1 )%

 Premium/total mix                70.5 %       72.8 %                   71.0 %      72.9 %

(1) Amounts presented in this table are rounded on an individual basis and, accordingly, may not sum on an aggregate basis. Percentages are calculated on unrounded numbers.

(2) Based on information from Management Science Associates, Inc., referred to as MSAi.

RJR Tobacco's net sales are dependent upon its cigarette shipment volume in a declining market, premium versus value-brand mix and list pricing, offset by promotional spending, trade incentives and federal excise taxes. RJR Tobacco believes the federal excise tax increase, effective April 1, 2009, has had, and will continue to have, a significant and adverse impact on cigarette sales volume. RJR Tobacco also believes its consumers are more price-sensitive than consumers of competing brands and, therefore, are more negatively affected by an increase in the federal excise tax and by the current adverse economic environment.
RJR Tobacco's net sales for the quarter ended June 30, 2009, decreased $82 million, or 4.0%, from the prior-year quarter, driven by $106 million attributable to lower cigarette volume. Net sales for the six months ended June 30, 2009, decreased $218 million, or 5.6%, from the prior-year quarter, . . .