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E-Cigarettes, Vapor & E-Cigars EPPS

Vapor, Smoke and Mirrors Key Trends Facing the Industry

February 11, 2015 12:20 – 1:00 PM Bonnie Herzog, Senior Analyst Managing Director Tobacco, Beverage & Convenience Store Research Wells Fargo Securities, LLC 212-214-5051 [email protected]

All estimates/forecasts are as of 2/6/15 unless otherwise stated.

Please see page 39 for rating definitions, important disclosures and required analyst

certifications and to view price charts.

Wells Fargo Securities, LLC does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of the report and investors should consider this report as only a single factor in making their investment decision.

Wells Fargo Securities, LLC 2

Discussion Topics

Total Tobacco Industry Consumption and Distribution Trends

Reynolds’ Acquisition of Lorillard – Value Creating Transaction

Should Be a Favorable Cig Pricing Environment in 2015

Vapor Consumption Could Surpass Combustible Cigs in 10 Years…

…But Near Term, Vapor & E-Cig Growth is Decelerating

Vapors/Tanks/Mods – Key Trend to Watch in Our View

Vape Shops Popping Up All Over

Retailers Divided on Best Way to Merchandise Vapor Category – “Tobacco Talk” Survey Takeaways

Who Will Win the Vapor War?

FDA Regulation Continues to be a Hot Topic

What Is On The Top of Retailers’ Minds?

Wells Fargo Securities, LLC

Tobacco Industry Volume Outlook

Total cigarette volume declining around 3-4% per year – but still

$80 billion in U.S. retail sales.

Premium Brands’ share is declining – now ~70% of total industry volume, down from 91% in 1984.

“Other” tobacco product (OTP) category and e-cigs – provide growth opportunity in our view, though smokeless tobacco growth is slowing.

3

600

700

800

900

1,000

1,100

1,200

1,300

1,400

1,500

1,600

1,700

1,800

1,900

2,000

'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14E

Mil

lio

ns

of

ca

ns

Total Smokeless Volume

CAGR '96-'14E = 4.4%CAGR '08-'14E = 5.5%

-

50

100

150

200

250

300

350

400

450

500

'95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06 '07 '08 '09 '10 '11 '12 '13 '14E

Bill

ions o

f S

ticks

Total Tobacco Volume: Premium and Discount

Premium Discount

CAGR '96-'14E = -4.1%CAGR '08-'14E = -5.9%

Source for both graphs: Company data and Wells Fargo Securities, LLC estimates


Source for graphs: Company data and Wells Fargo Securities, LLC estimates

Vapor Revolutionizing Tobacco Industry

4

Vapor Consumption (e-cigs and vapors/tanks/mods or VTMs) could surpass combustible cigs in 10 years

The combined profit pool could grow at a CAGR of 6.6% over the next decade

0.0

2.0

4.0

6.0

8.0

10.0

12.0

14.0

16.0

2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E

Eq

uiv

ale

nt

Pa

ck V

olu

me

(in

bil

lio

ns)

E-Cigarettes (in equivalent packs) Combustible Cigarettes (in packs)

2011 2012 2013 2014E 2015E 2016E 2017E 2018E 2019E 2020E 2021E 2022E 2023E0.0

2.0

4.0

6.0

8.0

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14.0

16.0

18.0

Op

era

tin

g P

rofi

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oo

l (i

n $

bil

lio

ns)

E-Cigarettes Combustible Cigarettes


Convenience, 65%

Tobacco Shops, 15%

Grocery, 10%

Drug Stores, 5%

Mass & Other, 5%

5

Distribution Channels – Convenience Still Winning

Convenience continues to take tobacco share from other channels

Dollar stores have entered category (Family Dollar and Dollar General)

Leading drug store CVS has stopped selling tobacco products – c-stores

experiencing halo effect on tobacco sales

Vape Shops – a trend to monitor

Retailer Comment – “Dollar Stores will

show continued growth and will be stealing share from

entrenched retailers.” Retailer Comment – “Some pressure from Vape shops

on our e-cig business. However, helping to grow

the product and awareness.”

Source for data and charts: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys


RAI/LO Combination: Value Creating Transaction for LT Shareholders

Reynolds is divesting its Kool, Winston, and Salem brands to Imperial – as well as the blu

e-cig brand - Marty Orlowsky (former Lorillard CEO) is to oversee Imperial’s U.S.

Operations.

Reynolds formalized its strategic partnership with BAT

Probability of BAT acquiring Reynolds now higher in our view (Reynolds has not weighed

in on this)

Vast majority (98%) of retailers believe deal will get approved, albeit with additional

brand divestitures, though market is pricing in only ~65% probability as shown below:

RAI-LO transaction may spark further industry consolidation with

e-cigs/vapor as the catalyst

6

Source: Wells Fargo Securities, LLC estimates

45%52%

58% 58%50% 49%

42% 38% 39% 38% 41% 41% 41% 41% 40% 40% 37% 37%42%

52%47%

53% 50%55% 57% 57% 61% 62% 62% 65%

0%10%20%30%40%50%60%70%

Market Implied Probability of RAI-LO Deal Being Approved

Bonnie Herzog - Wells Fargo Securities, LLC | Beverage & Tobacco Sectors

RAI/LO Combination: What Does It Mean for Retailers?

Retailers see both pros & cons to RAI-LO combination

Stronger competitor to Altria welcomed

Lower cig margins remain a concern

Vapor expected to flourish - Lower vapor margins from Big 3 remain a concern

Majority of retailers believe no impact to pricing

Impact on retailer gross margin – majority believe retailer gross margins on cigarettes would go down

Retailers generally positive on RAI-LO Combination’s impact on overall vapor category - Many believe this would create higher barriers to entry for smaller brands

BOTTOM LINE:

RAI-LO combination both positive & negative in our opinion – competition should be lower, but Altria could be better kept “in check” and retailers would have one less rep and complexity to deal with

7


Expect Robust Cigarette Net Price Realization in 2015

Large stockpiles of cash getting larger

Pricing not as critical to drive top line

Manufacturers Realize 2.5x More Earnings Leverage on a Point of Pricing vs. a Point of Volume

Source for graphs: Company data and Wells Fargo Securities, LLC estimates

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

60%

Cigarette Net Price Realization 1997-2015E

Altria Group Reynolds American Lorillard Average

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

2009 2010 2011 2012 2013 2014E 2015E

Cigarette Net Price Realization 2009-2015E

Altria Group Reynolds American Lorillard Long-Term Average

We expect strong cigarette net pricing over the next few years – close to the long-term average of ~6%.

8


Price Increases Helping Manufacturers More Than Retailers

“Tobacco Talk” survey respondents said price increases do not have much of a positive impact on retailer gross profit margins

Cigarette gross profit margins continue to decline for retailers

Environment expected to remain challenging

Retailer Comment –

“Slight increase for the

retailer but most of the

money is going to the

manufacturer.” Retailer Comment – “Given

small increase, volume

shouldn’t suffer so better

profit potential for

manufacturers.”


9

Retailer Penny Profit per pack on Combustible Cigs

$0.72

$0.52

$0.77

$0.68

$0.78 $0.73

$0.54

$0.78

$0.71

$0.76

$0.70

$0.54

$0.77

$0.61

$0.76

$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

Current Quarter Year-Ago Quarter Next Quarter


C-Store Vapor Growth Remains Robust (>20%) But Slightly Moderating

Vapor taking total tobacco share, currently ~4%,

Total e-cig/vapor retail size likely around $3.5b by end of 2015

Vapor is to tobacco what energy drinks are to beverages –

Profitable and quickly growing in volume and shelf space at retail

Increasingly gaining consumer acceptance


10

Overall Growth Trend of the Vapor Category

83.3%

7.1%9.5%

60.6%

15.2%

24.2%

58.1%

22.6%19.4%

65.4%

30.8%

3.8%

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

Accelerated Stayed the Same Decelerated

Q1 2014 Q2 2014 Q3 2014 Q4 2014

Overall Growth of the Vapor Category

23.1%

20.8%

17.4%

0%

5%

10%

15%

20%

25%

Q2 2014 Q3 2014 Q4 2014


2015 Vapor Market Size – $3.5B in the U.S.

Vapor consumption could surpass combustible cigs in 10 years

Source: Nielsen C-Store Database, Wells Fargo Securities, LLC estimates *Other Non-Tracked channels include tobacco-only outlets and other e-cig retail locations.

11

Expected 2015 Vapor Market Size – $3.5B

E-Cigarettes $1.5B

C-Store, Food, Drug and Mass Retail Channels

$700M

Online and Other Retail

Channels

$800M

Online $400M

Other $400M*

Vapors/Tanks/Mods & Personal Vaporizers

$2.0B

Online and Other

Retail

Channels

$400M

Vape Shops $1,200M

C-Store, Food, Drug and Mass

Retail Channels $400M


2015 Global Vapor Market Size – Exceeds $7B

Source: Wells Fargo Securities, LLC estimates and Tobacco Talk Surveys

12

According to our Independent Vapor Manufacturer Survey, the global market for vapor products expected by the end of 2015 is ~$7.3B

There are more than 19,000 vape shops globally – about half of which are in the U.S.

Va p e sho p s in the U.S. a nd Glo b a lly

8,459

19,409

0

5,000

10,000

15,000

20,000

25,000

Number of Vape Shops in the U.S. Number of Vape Shops Globally


Vape Shops Impacting E-Cig Sales: Increasing Awareness and

Consumer Education

Vape shops opening up around the country

62% of retailers say they are impacting e-cig sales

15% expect a negative impact in the future.

Source for data and chart: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys

13

Are "Vape Shops" Impacting E-cig Sales?

47.2%

33.3%

19.4%

41.9%34.9%

23.3%

45.5%

33.3%

21.2%

45.2%

38.7%

16.1%

61.5%

23.1%

15.4%

0%

10%

20%

30%

40%

50%

60%

70%

Yes - Negative Impact No impact No Impact Currently - ButExpect Negative Impact in

Future

Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014


Public Perception of the Vapor Category is Deteriorating

The % of people who believe vapor/e-cigs are just as harmful as combustible cigs doubled in 2014 vs. 2013 to 15%

However, category momentum continues and we expect ~40% growth in 2015

14

Source: Action on Smoking and Health, Wells Fargo Securities, LLC

7%

53%

39%

15%

54%

30%

0%

10%

20%

30%

40%

50%

60%

More/Just As Harmful AsCigarettes

Not Harmful or Less HarmfulThan Cigarettes

Don't Know

% o

f R

esp

on

den

ts

Public Perception of Safety of Vapor/E-Cigs Relative to Combustible Cigs

2013 2014


Wake Up Call! Action Needed to Keep Vapor Momentum Alive

We’re Increasingly Concerned That Action is Needed For Vapor Momentum to Continue

“Tobacco Talk” Survey –Highlights Key Issues:

1) FDA must take leadership and act soon to improve consumers’ increasingly negative perception of the relative risks of vapor and uncertainty surrounding the category;

2) The industry must align, particularly to push for modified risk claims so that public perception doesn’t deteriorate further; and

3) Vape shops need to be regulated more closely as they are “playing by their own set of rules” potentially harming the industry’s reputation.

We Remain Bullish Long-Term

We still believe consumption of vapor and other non-combustibles (such as heat-not-burn) could surpass consumption of combustible cigs in the next decade (by 2023).

Technological innovation is crucial

Big Tobacco will be pivotal in shaping the non-combustible nicotine industry

15


Vapors/Tanks/Mods (VTM): Not Your Father’s E-Cig Typical VTM user - former smoker, tried e-cigs, but quickly moved to

tank-style systems and eventually mods

Vaping substantially more affordable than combustible cigs and rechargeable e-cigs

“Open system” VTMs not emulating the razor/blade model since any juice can be used with any VTM –

LOGIC Pro and blu+ are “closed” system – hitting shelves over next few months

VTMs could be a threat OR potential opportunity for Big Tobacco

Source: Wells Fargo Securities, LLC estimates; pictures from Henleycigs.com.

16


VTMs Taking E-Cig Share - Growing 3x Faster Than Vapor Category

VTMs overwhelmingly taking e-cig share according to our “Tobacco Talk” surveys

VTM growth expected to continue in 2015

Average VTM consumer's weekly spend about 30% less than e-cig consumer’s weekly spend

VTMs provide: (1) greater consumer satisfaction; (2) an attractive “vaping lifestyle” factor; and (3) better affordability

Source for data and charts: Wells Fargo Securities, LLC estimates and Tobacco Talk Retailer Surveys

17

% growth in U.S. retail sales of the total e-vapor category

150.1%

187.1%

147.1%

57.3% 55.8%

0%

20%

40%

60%

80%

100%

120%

140%

160%

180%

200%

2012 2013 2014E 2015E

1Q14 1Q15

% growth in U.S. retail sales of JUST the vapors/tanks category

195.1%

282.7%298.4%

128.1%

161.2%

0%

50%

100%

150%

200%

250%

300%

350%

2012 2013 2014 2015E

1Q14 1Q15


Mix Shift to VTMs Taking Place in the U.S. and Globally

Mix shift of E-Cigs to VTMs Is 45%/55% Currently in the U.S. – From 65%/35% A Year Ago

Global Mix of E-Cigs to VTMs is 50%/50%

Source for data and charts: Wells Fargo Securities, LLC estimates and Tobacco Talk Retailer Surveys

18

% mix o f to ta l U .S. re ta il sa le s - E-c ig s vs . VT Ms

65.0%

35.0%

45.0%

55.0%

0%

10%

20%

30%

40%

50%

60%

70%

E-Cigs and Accessories Vaporizers and Accessories

1Q14 1Q15

% mix o f to ta l Glo b a l re ta il sa le s - E-c ig s vs . VT Ms

49.6%

50.4%

40%

45%

50%

E-Cigs and E-Cig Accessories Vaporizers and VaporizerAccessories


Do you currently carry E-Cig and/or Vapor-Tank-Mod (VTM) products?

100.0%

85.3%

100.0%

85.2%

100.0%96.3%

14.7% 11.1%

3.7%3.7%

0%

20%

40%

60%

80%

100%

120%

E-Cigs VTMs E-Cigs VTMs E-Cigs VTMs

Q2 2014 Q3 2014 Q4 2014

Yes - Currently Carry No - But Plan to Carry in Next 6 Months No - No Plans to Carry

VTM Traction at Retail Continues

Vast majority of retailers carry or plan to carry E-cigs & VTMs

Increasing prevalence of VTMs could be somewhat marginalizing the “cig-alike” e-cigs but, incrementally growing the overall “Vapor” category


Interestingly, nearly

everyone now plans to carry E-Cigs

& VTMs.

19


% Vapor Sales - Repeat Sales vs. Trial

40.5%

45.8%

56.8%

41.3%

59.2%

39.9%

0%

10%

20%

30%

40%

50%

60%

70%

Repeat Purchases Trial Purchases

Q2 2014 Q3 2014 Q4 2014

Vapor Repeat Purchases Surpass Trial Purchases

Nearly 60% of total vapor sales are repeat purchases

Significant dual use of cigs and e-cigs

Source: Wells Fargo Securities, LLC Tobacco Talk Surveys

Vapor Repeat Purchases Have Surpassed Trial Purchases

20


Vapor Displacing >4% of Combustible Cig Volume

Dual Use (~19% of Vapor Consumers) Is More Prevalent Than Full Conversion (~8% of Vapor Consumers)

Conversion is HIGHER for VTM Consumers (8% vs. 7.4% for E-Cig Consumers) – Bodes well for Better Performing Products

Retailers Believe 4.3% of Combustible Cigarette Volume is Being Displaced by the Vapor Category – Speaks to Vapor’s Potential – Still Early Innings

Source for both charts: Wells Fargo Securities, LLC estimates Tobacco Talk Surveys

21

Combustible Cigarette Volume Displaced Into the Vapor Category

3.4%

3.8%

4.2% 4.3%

0.0%

0.5%

1.0%

1.5%

2.0%

2.5%

3.0%

3.5%

4.0%

4.5%

5.0%

Q1 2014 Q2 2014 Q3 2014 Q4 2014

% of Consumers Dual Using and Fully Converting to Vapor Products

14.3%

19.0%

26.9%

22.7%

7.4% 7.9%

18.7% 18.9%

0%

5%

10%

15%

20%

25%

30%

Full Conversion to E-Cigs?

Full Conversion toVTMs?

Dual Usage WithCombustible Cigs?

Dual Usage WithCombustible VTMs?

Q3 2014 Q4 2014


0

10

20

30

40

50

60

70

80

1Q12 2Q12 3Q12 4Q12 1Q13 2Q13 3Q13 4Q13 1Q14 2Q14 3Q14 4Q14E

Billio

ns

of

Cig

are

tte

s

Total Industry Cigarette Volume - Decline Rate ~-3.7%

Combustible Cig Volumes Not Declining As Much As Expected

One key reason is dual use remains high

According to Lorillard, 47% of adult smokers have tried e-cigs with 24% having used in the past 3 months and 15% in past 7 days

Source: Wells Fargo Securities, LLC estimates, company reports

22


Revenue Mix of E-cigs vs. VTMs in 6 Months Revenue Mix of E-cigs vs. VTMs TODAY?

51.1%

48.9%

53.2%

46.8%

54.4%

45.6%

40%

42%

44%

46%

48%

50%

52%

54%

56%


Q2 2014 Q3 2014 Q4 2014

69.4%

30.6%

67.0%

33.0%

65.0%

35.0%

0%

10%

20%

30%

40%

50%

60%

70%

80%


Q2 2014 Q3 2014 Q4 2014

Vapors/Tanks Expected to Further Penetrate C-Stores in Next 6 Months

Revenue mix of E-cigs to VTM expected to be ~55/45% in 6 months

compared to ~65/35% today


VTM Mix Expected to be ~45% in

6 months

VTM Mix is 35% Today

23


Change in Shelf Space Allocation Y/Y

0.7%

-1.1% -2.3%-5.4% -4.8%

3.1% 4.8%1.9% 2.9% 3.4%

-4.7%-2.5% -1.7% -1.3%

-1.4%-1.1%

-1.9%

-0.7% 2.0%

1.7%

31%

18%18%

32%

2%0.0%

30.3%

20.6%

31.9%

12.0%

34.3%

12.4%

-25%

0%

25%

50%

Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

Cigarettes Smokeless Snus Cigars E-Cigs VTMs (hardware only) E-liquids

Vapor Gaining Share and Shelf Space From Combustible Cigarettes

E-cigs and VTMs continue to take shelf space

E-cig growth driven by

Increased advertising spend

Greater visibility at retail

Do you believe e-cigarettes are taking share from traditional cigarettes?

67.6%

32.4%

82.0%

18.0%

74%

26%

92%

8%

0%

20%

40%

60%

80%

100%

Yes No

Q1 2013 Q2 2013 Q3 2013 Q4 2013

E-cigs increasingly

thought to be taking

combustible cig share.


Vapors Products Incl. E-Liquids Got +1.7-12.4%

More Shelf Space in 4Q14

24


Vapor Trends at Retail Shifting to VTM from E-Cigs

Mixed feedback on VTM introductions from NJOY and FIN

However if retailers can look beyond the companies' recent e-cig trends,

their new VTM offerings show promise

Source for chart: Wells Fargo Securities, LLC Tobacco Talk Retailer Surveys

25

Sequential Sales Growth of Key C-Store Vapor Brands

1.5%

6.3%

-7.2%

0.2%3.1%

-13.0%

8.6%

-0.9% -2.5%

-24.4%

-10.4%

41.2%

12.2%10.1%

6.4%4.2%

-13.6%

-25.1%-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

Vuse LOGIC Mistic blu MarkTen NJOY FIN

Q1 2014 Q2 2014 Q3 2014 Q4 2014


E-Cigs 3x More Profitable to Retailers Than Combustible Cigs

E-cig margin trends vs. Combustible cigs improving for retailers

We expect retailers to continue to embrace vapor – cigarette gross

profit margins for retailers remain on downward trend

Independents offer higher margins than Big Tobacco


26

Retailer Penny Profit per pack on Combustible Cigs

$0.72

$0.52

$0.77

$0.68

$0.78 $0.73

$0.54

$0.78

$0.71

$0.76

$0.70

$0.54

$0.77

$0.61

$0.76

$0.00

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

$0.70

$0.80

$0.90

Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

Current Quarter Year-Ago Quarter Next Quarter

Actual or expected margins (in %) on the following brands

35.4%35.0%

28.0% 26.4%24.7% 25.9%

35.0%31.8% 32.2%

27.8% 28.1%26.3%

25.9%

37.1%

36.0%34.0% 34.0%

30.9%28.7%

26.2%

0%

5%

10%

15%

20%

25%

30%

35%

40%

Haus(Mistic)

Logic FIN NJOY blu(Lorillard)

MarkTen(Altria)

Vuse(Reynolds)

Q2 2014 Q3 2014 Q4 2014


E-Cigarette Growth [Q/Q]

54.1%

27.0%

18.9%

50.0%

26.1%23.9%

48.0%

27.0%28.0%

41.9%

25.8%

32.3%

44.4%

18.5%

37.0%

0%

10%

20%

30%

40%

50%

60%

Accelerated Stayed the Same Decelerated

Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014

E-Cig Growth Continues to Decelerate

C-stores Reign Supreme in E-Cig Distribution – Retailers Drawn to E-Cigs for Fat Margins and "Low Maintenance" Selling (No Controlling Contracts)

Technology Must Improve for E-Cigarette Growth to Re-Accelerate In Our View

E-Cig Volume Increasing Driven by Vuse and MarkTen - But $ Sales Not Growing as Fast Given Heavy Discounting


E-Cig growth is decelerating

27

Annual Growth of E-Cigarettes

19.2%

15.3%

12.0%

6.6%

4.8%

0%

5%

10%

15%

20%

25%

Q4 2013 Q1 2014 Q2 2014 Q3 2014 Q4 2014


Annual Growth Estimated To Be ~10%

Category Growth in Measured Channels Decelerating

However, Category Growth Improved with National Rollouts from Reynolds & Philip Morris USA

Why?

1. The Need for the Next Step Function in Innovation

2. Emerging Vapors/Tanks/Mods Vapor Products Could be Marginalizing the “Cig-alike” E-Cigs but Incrementally Growing the Overall Vapor Category

Source: The Nielsen Company and Wells Fargo Securities, LLC.

28

-25%

-20%

-15%

-10%

-5%

0%

-10%

0%

10%

20%

30%

40%

50%

60%

70%

80%

01/18/14 02/15/14 03/15/14 04/12/14 05/10/14 06/07/14 07/05/14 08/02/14 08/30/14 09/27/14 10/25/14 11/22/14 12/20/14 01/17/15

Pri

cin

g

Vo

lum

e

e-Cigarette Category Volume Vs Pricing Growth

Volume Growth Pricing Growth

E-Cig Growth Continues to Decelerate Per Nielsen Data


0%

10%

20%

30%

40%

50%

60%

70%

Jul-12 Sep-12 Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13 Jan-14 Mar-14 May-14 Jul-14 Sep-14 Nov-14 Jan-15

Dolla

r S

ha

re

e-Cigs Category - C-Store and XAOC Combined, Dollar Share By Company

Lorillard Fin Branding Ballantyne DNA Green Smart Living

Njoy CB Distributors Vapor Corp Nicotek Logic

Reynolds American Altria VMR Products All Other

E-Cigarette Category - Dollar Share By Company

Source: The Nielsen Company and Wells Fargo Securities, LLC, last 12 months retail value tracked by Nielsen $551M

“Nationwide” e-cig launches by Altria and Reynolds have taken share from Lorillard

In the recent Nielsen period, Reynolds and Altria took 35% and 5% $ share in c-stores, respectively.

RAI gaining momentum

29


Revenue Mix ($ Share) of Vapor Products (E-Cigs and VTM) IN 6 MONTHS

37.8%

10.0%6.0% 8.5%

3.8% 3.1%0.8%

3.7%

26.3%

23.0%

20.0%

5.9%

15.6%

1.4% 1.5% 1.1%2.6%

30.3%

22.1%24.8%

15.9%14.5%

12.3%

8.9% 8.0%

35.6%

0%

10%

20%

30%

40%

50%

blu Vuse Logic MarkTen NJOY Mistic/Haus FIN GS Vapors Others

Q2 2014 Q3 2014 Q4 2014

Revenue Mix ($ Share) of Vapor Products (E-Cigs and VTM) TODAY

48.6%

3.0%

8.1%

3.6% 1.7%

6.4%

1.0% 0.9%

26.7%

31.6%

16.8%

7.4%

11.5%

1.3%

4.7%1.3% 2.4%

23.3%27.7%

24.1%

15.6%

11.1%7.6% 6.0%

4.5%

36.1%

0%

10%

20%

30%

40%

50%

blu Vuse Logic MarkTenMistic/Haus NJOY FIN GS Vapors Others

Q2 2014 Q3 2014 Q4 2014

Lorillard’s blu Ceding Share as Vuse and MarkTen Go Nationwide

Lorillard’s blu has lost share – and expected to fall further as Vuse and

MarkTen expand nationwide

Reynolds and Altria are heavily utilizing coupons, other promos &

consumer engagement strategies to drive trial and awareness of Vuse

and MarkTen

Excited about VTMs blu+ and LOGIC Pro, coming out in next few months


Vuse and MarkTen expected to take 25% and 15% $ share in 6 months

Vuse and MarkTen currently have 24% and 11% $ share

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Quotes on VTMs From our Recent “Tobacco Talk” Surveys

“Tanks are growing faster than all other categories.”

“Looks like a growth segment we can't ignore.”

“Outpacing all traditional E-Cigs in sales....Higher margins and consumer satisfaction is amazing.”

“Be careful here!! These are likely ‘target one’ of regulation.”

“Looking forward to getting Vaporizers and e-liquids rolled out in test sites to see how they perform.”

“E-Cigs are slowing dramatically now that vapors have hit the streets.”

“As the consumer became more aware of the Vapor devices we are seeing sales move from E-Cigs to the Vapor side.”

“Vapor is what help us to accelerate sales.”

“The liquid vapors are coming on strong.”

Source : Wells Fargo Securities, LLC Tobacco Talk Surveys

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Retailers Divided on Best Way to Merchandise E-cigs

Retailers want a separate E-Cig section to merchandise effectively,

preferably near conventional cigarettes

Lack of counter space remains a challenge

Source : Wells Fargo Securities, LLC Tobacco Talk Surveys

Best Way to Merchandise E-cigarettes

Separate Category, 50%

With Cigarettes,

30%

On the Front Counter, 20%

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Who Will Win The Vapor War?

“Big Tobacco” presents a triple threat in our view – plentiful cash, strong distribution power, superior brand building capabilities

Plenty of room for several other players including: Logic, NJOY, Mistic, Fin, 21st Century and Krave

We expect growth of the combined profit pool for e-cigs & combustible cigs will increase 6.6% in the next decade in our view (above the 4-5% historical growth for cigs)

Big Tobacco incentivized to switch consumers to e-cigs given MSA payments tied only to combustible cigs

Big Tobacco may have no choice but to enter the vapor/tank category either organically or via acquisition. However, we see a few challenges:

1)distribution of vapors/tanks is primarily online and in vape shops, channels over which big tobacco has limited control (this would also be a challenge for c-store retailers)

2)limited branding and commoditization of vapors/tanks

3)potential compression of revenue pool given lower spend per consumer on vapors/tanks

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FDA Deeming E-Cigs Regulation

Highlights Include:

Companies can keep existing products on the market and can bring

new products to market – this is key in our view since continued

innovation is critical to future growth;

No free samples;

No sale to anyone under age 18;

No health claims in advertising;

Must register ingredients with the FDA; and

Must have a warning label stating nicotine is addictive but this isn’t

required until 2 years after rule is finalized

Proposal Did NOT Include:

Restrictions of flavors (although this could be re-evaluated later);

A ban on internet sales to adults; and

A ban on t.v. advertising

Bottom line, e-cig/vapor regulations should ultimately increase the

barriers to entry. For now, regs don’t seem onerous for retailers which is

positive in our view.

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E-Cigarette/Vapor Taxation: States Have Started to Pursue

Source for table: Wells Fargo Securities, LLC, National Association of Tobacco Outlets (NATO)

State Rate Status

North Carolina $0.05 per mL of nicotine liquid Passed

Minnesota 95% OTP Passed

Hawaii Actual wholesale cost Failed

Indiana 24% OTP Failed

Kentucky 15% and 20% OTP Failed

New Jersey 75% Sales Tax/$2.70 Failed

Oregon 81.25% OTP Failed

Rhode Island 80% OTP Failed

Vermont 92% OTP Failed

Washington 95% OTP Failed

Michigan $0.15 per 1.5 mL of nicotine liquid Pending

New York 75% OTP Pending

Ohio $1.85 Cigarette Tax Pending

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What is on the Top of Retailers’ Minds?

Most Excited About:

Growth of vapor/tanks/mods

Altria and Reynolds’ national launches of MarkTen and Vuse

Moist tobacco rebounding

Increasing innovation across the board

Most Concerned About:

Taxes on the category

Profit erosion for retailers

Continued consumption decline for the tobacco category and how the c-store channel should think about merchandising

Manufacturers’ low commodity-style price points for e-cigs

FDA regulations that could ultimately stifle innovation once finalized

36


In Conclusion…

So we wonder:

Is this the beginning of the end of

combustible cigarettes?

37


Disclosures LO Basis and Risks: Our valuation range of $69-71 implies a forward EV/EBITDA multiple of 10.4x and a forward P/E multiple of 16.4x, above historical averages, but in-line with RAI's acq. terms. Risks include unfavorable regulation and increased competition in cigarettes. RAI Basis and Risks: Our valuation range of $79-81 assumes an 11.8x forward EV/EBITDA multiple and an 18.4x forward P/E multiple, both above RAI's historical averages. Risks to our valuation include increased competitive pressure within the category and a pullback in consumer spending. MO Basis and Risks: Our valuation range of $59-61 is based on a 12.5x forward EV/EBITDA multiple and a 19.4x forward P/E multiple--both premiums to historical averages, which we believe are justified given MO's total tobacco strategy. Risks include increased price competition and increased downtrading by consumers.

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Disclosures Additional Information Available Upon Request I certify that: 1) All views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers discussed; and 2) No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by me in this research report. Wells Fargo Securities, LLC maintains a market in the common stock of Altria Group, Inc., Reynolds American Inc. Wells Fargo Securities, LLC or its affiliates managed or comanaged a public offering of securities for Altria Group, Inc. within the past 12 months. Wells Fargo Securities, LLC or its affiliates intends to seek or expects to receive compensation for investment banking services in the next three months from Altria Group, Inc., Reynolds American Inc. Wells Fargo Securities, LLC or its affiliates received compensation for investment banking services from Altria Group, Inc. in the past 12 months. Altria Group, Inc. currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided investment banking services to Altria Group, Inc. Altria Group, Inc., Reynolds American Inc. currently is, or during the 12-month period preceding the date of distribution of the research report was, a client of Wells Fargo Securities, LLC. Wells Fargo Securities, LLC provided noninvestment banking securities-related services to Altria Group, Inc., Reynolds American Inc. Wells Fargo Securities, LLC received compensation for products or services other than investment banking services from Reynolds American Inc., Altria Group, Inc. in the past 12 months. Wells Fargo Securities, LLC or its affiliates has a significant financial interest in Altria Group, Inc., Lorillard, Inc., Reynolds American Inc. LO: Risks include unfavorable regulation and increased competition in cigarettes. MO: Risks include increased price competition and increased downtrading by consumers. RAI: Risks to our valuation include increased competitive pressure within the category and a pullback in consumer spending. Wells Fargo Securities, LLC does not compensate its research analysts based on specific investment banking transactions. Wells Fargo Securities, LLC’s research analysts receive compensation that is based upon and impacted by the overall profitability and revenue of the firm, which includes, but is not limited to investment banking revenue. STOCK RATING 1=Outperform: The stock appears attractively valued, and we believe the stock's total return will exceed that of the market over the next 12 months. BUY 2=Market Perform: The stock appears appropriately valued, and we believe the stock's total return will be in line with the market over the next 12 months. HOLD 3=Underperform: The stock appears overvalued, and we believe the stock's total return will be below the market over the next 12 months. SELL SECTOR RATING O=Overweight: Industry expected to outperform the relevant broad market benchmark over the next 12 months. M=Market Weight: Industry expected to perform in-line with the relevant broad market benchmark over the next 12 months. U=Underweight: Industry expected to underperform the relevant broad market benchmark over the next 12 months. VOLATILITY RATING V = A stock is defined as volatile if the stock price has fluctuated by +/-20% or greater in at least 8 of the past 24 months or if the analyst expects significant volatility. All IPO stocks are automatically rated volatile within the first 24 months of trading. As of: 2/6/2015 44% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Outperform. Wells Fargo Securities, LLC has provided investment banking services for 43% of its Equity Research Outperform-rated companies. 54% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Market Perform. Wells Fargo Securities, LLC has provided investment banking services for 29% of its Equity Research Market Perform-rated companies. 2% of companies covered by Wells Fargo Securities, LLC Equity Research are rated Underperform. Wells Fargo Securities, LLC has provided investment banking services for 37% of its Equity Research Underperform-rated companies. Important Disclosure for International Clients

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Disclosures

EEA – The securities and related financial instruments described herein may not be eligible for sale in all jurisdictions or to certain categories of investors. For recipients in the EEA, this report is distributed by Wells Fargo Securities International Limited (“WFSIL”). WFSIL is a U.K. incorporated investment firm authorized and regulated by the Financial Conduct Authority. For the purposes of Section 21 of the UK Financial Services and Markets Act 2000 (“the Act”), the content of this report has been approved by WFSIL a regulated person under the Act. WFSIL does not deal with retail clients as defined in the Markets in Financial Instruments Directive 2007. The FCA rules made under the Financial Services and Markets Act 2000 for the protection of retail clients will therefore not apply, nor will the Financial Services Compensation Scheme be available. This report is not intended for, and should not be relied upon by, retail clients. Australia – Wells Fargo Securities, LLC is exempt from the requirements to hold an Australian financial services license in respect of the financial services it provides to wholesale clients in Australia. Wells Fargo Securities, LLC is regulated under U.S. laws which differ from Australian laws. Any offer or documentation provided to Australian recipients by Wells Fargo Securities, LLC in the course of providing the financial services will be prepared in accordance with the laws of the United States and not Australian laws. Canada – This report is distributed in Canada by Wells Fargo Securities Canada, Ltd., a registered investment dealer in Canada and member of the Investment Industry Regulatory Organization of Canada (IIROC) and Canadian Investor Protection Fund (CIPF). This report has not been prepared subject to Canadian disclosure requirements. Hong Kong – This report is issued and distributed in Hong Kong by Wells Fargo Securities Asia Limited (“WFSAL”), a Hong Kong incorporated investment firm licensed and regulated by the Securities and Futures Commission of Hong Kong (“the SFC”) to carry on types 1, 4, 6 and 9 regulated activities (as defined in the Securities and Futures Ordinance (Cap. 571 of The Laws of Hong Kong), “the SFO”). This report is not intended for, and should not be relied on by, any person other than professional investors (as defined in the SFO). Any securities and related financial instruments described herein are not intended for sale, nor will be sold, to any person other than professional investors (as defined in the SFO). The author or authors of this report is or are not licensed by the SFC. Professional investors who receive this report should direct any queries regarding its contents to Mark Jones at WFSAL (email: [email protected] ). 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Any decisions to invest in securities or transactions should be made after reviewing policies and methodologies used for assigning credit ratings and assumptions, significance and limitations of the credit ratings stated on the respective rating agencies’ websites. About Wells Fargo Securities Wells Fargo Securities is the trade name for the capital markets and investment banking services of Wells Fargo & Company and its subsidiaries, including but not limited to Wells Fargo Securities, LLC, a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and a member of NYSE, FINRA, NFA and SIPC, Wells Fargo Institutional Securities, LLC, a member of FINRA and SIPC, Wells Fargo Prime Services, LLC, a member of FINRA, NFA and SIPC, Wells Fargo Securities Canada, Ltd., a member of IIROC and CIPF, Wells Fargo Bank, N.A. and Wells Fargo Securities International Limited, authorized and regulated by the Financial Conduct Authority. This report is for your information only and is not an offer to sell, or a solicitation of an offer to buy, the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal, or the entity that provided this report to them, if they desire further information. The information in this report has been obtained or derived from sources believed by Wells Fargo Securities, LLC, to be reliable, but Wells Fargo Securities, LLC does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Wells Fargo Securities, LLC, at this time, and are subject to change without notice. For the purposes of the U.K. Financial Conduct Authority's rules, this report constitutes impartial investment research. Each of Wells Fargo Securities, LLC and Wells Fargo Securities International Limited is a separate legal entity and distinct from affiliated banks. 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