SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 1997
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-8940
Philip Morris Companies Inc.
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(Exact name of registrant as specified in its charter)
Virginia 13-3260245
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
120 Park Avenue, New York, New York 10017
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (212) 880-5000
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Former name, former address and former fiscal year, if changed since last report
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, and (2) has been subject to such filing
requirements for the past 90 days. Yes X No ______
At October 31, 1997, there were 2,424,393,006 shares outstanding of the
registrant's common stock, par value $0.33 1/3 per share.
PHILIP MORRIS COMPANIES INC.
TABLE OF CONTENTS
Page No.
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited).
Condensed Consolidated Balance Sheets at
September 30, 1997 and December 31, 1996 3 - 4
Condensed Consolidated Statements of Earnings
For the Nine Months Ended September 30, 1997 and 1996 5
For the Three Months Ended September 30, 1997 and 1996 6
Condensed Consolidated Statements of Stockholders'
Equity for the Year Ended December 31, 1996
and the Nine Months Ended September 30, 1997 7
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 1997 and 1996 8 - 9
Notes to Condensed Consolidated Financial Statements 10 - 27
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations. 28 - 52
PART II - OTHER INFORMATION
Item 1. Legal Proceedings. 53
Item 6. Exhibits and Reports on Form 8-K. 53
Signature 54
-2-
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(in millions of dollars)
(Unaudited)
September 30, December 31,
1997 1996
------------- ------------
ASSETS
Consumer products
Cash and cash equivalents $ 779 $ 240
Receivables, net 5,050 4,466
Inventories:
Leaf tobacco 3,903 4,143
Other raw materials 1,993 1,854
Finished product 3,029 3,005
------- -------
8,925 9,002
Other current assets 1,397 1,482
------- -------
Total current assets 16,151 15,190
Property, plant and equipment, at cost 19,999 19,972
Less accumulated depreciation 8,390 8,221
------- -------
11,609 11,751
Goodwill and other intangible assets
(less accumulated amortization of
$4,670 and $4,391) 17,823 18,998
Other assets 3,688 3,015
------- -------
Total consumer products assets 49,271 48,954
Financial services and real estate
Finance assets, net 5,593 5,345
Real estate held for development and sale 314
Other assets 179 258
------- -------
Total financial services and
real estate assets 5,772 5,917
------- -------
TOTAL ASSETS $55,043 $54,871
======= =======
See notes to condensed consolidated financial statements.
Continued
-3-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Continued)
(in millions of dollars)
(Unaudited)
September 30, December 31,
1997 1996
------------- ------------
LIABILITIES
Consumer products
Short-term borrowings $ 189 $ 260
Current portion of long-term debt 1,687 1,846
Accounts payable 2,305 3,409
Accrued marketing 2,170 2,106
Accrued taxes, except income taxes 1,467 1,331
Other accrued liabilities 3,896 3,668
Income taxes 1,342 1,269
Dividends payable 972 978
-------- -------
Total current liabilities 14,028 14,867
Long-term debt 12,440 11,827
Deferred income taxes 832 731
Accrued postretirement health care costs 2,438 2,372
Other liabilities 5,515 5,773
-------- -------
Total consumer products liabilities 35,253 35,570
Financial services and real estate
Short-term borrowings 319 173
Long-term debt 843 1,134
Deferred income taxes 3,723 3,636
Other liabilities 264 140
-------- -------
Total financial services and
real estate liabilities 5,149 5,083
-------- -------
Total liabilities 40,402 40,653
Contingencies (Note 3)
STOCKHOLDERS' EQUITY
Common stock, par value $0.33 1/3 per share
(2,805,961,317 shares issued) 935 935
Earnings reinvested in the business 24,519 22,478
Currency translation adjustments (947) 192
-------- -------
24,507 23,605
Less cost of repurchased stock
(381,968,524 and 374,615,043 shares) 9,866 9,387
-------- -------
Total stockholders' equity 14,641 14,218
-------- -------
TOTAL LIABILITIES AND
STOCKHOLDERS' EQUITY $ 55,043 $54,871
======== =======
See notes to condensed consolidated financial statements.
-4-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions, except per share data)
(Unaudited)
For the Nine Months Ended
September 30,
-------------------------
1997 1996
-------- --------
Operating revenues $54,722 $52,414
Cost of sales 19,978 20,001
Excise taxes on products 12,348 11,232
------- -------
Gross profit 22,396 21,181
Marketing, administration and research costs 11,904 11,724
Settlement charges (Note 3) 812
Amortization of goodwill 438 443
------- -------
Operating income 9,242 9,014
Interest and other debt expense, net 815 824
------- -------
Earnings before income taxes 8,427 8,190
Provision for income taxes 3,412 3,358
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Net earnings $ 5,015 $ 4,832
======= =======
Weighted average number of shares 2,425 2,471
======= =======
Per share data:
Net earnings $ 2.07 $ 1.96
======= =======
Dividends declared $ 1.20 $ 1.07
======= =======
See notes to condensed consolidated financial statements.
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Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions, except per share data)
(Unaudited)
For the Three Months Ended
September 30,
--------------------------
1997 1996
-------- --------
Operating revenues $18,092 $17,414
Cost of sales 6,571 6,596
Excise taxes on products 4,101 3,726
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Gross profit 7,420 7,092
Marketing, administration and research costs 3,854 3,871
Settlement charges (Note 3) 812
Amortization of goodwill 142 150
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Operating income 2,612 3,071
Interest and other debt expense, net 249 281
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Earnings before income taxes 2,363 2,790
Provision for income taxes 957 1,144
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Net earnings $ 1,406 $ 1,646
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Weighted average number of shares 2,423 2,454
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Per share data:
Net earnings $ 0.58 $ 0.67
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Dividends declared $ 0.40 $ 0.40
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See notes to condensed consolidated financial statements.
-6-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders' Equity
for the Year Ended December 31, 1996 and
the Nine Months Ended September 30, 1997
(in millions of dollars, except per share data)
(Unaudited)
Earnings Total
Reinvested Currency Cost of Stock-
Common in the Translation Repurchased holders'
Stock Business Adjustments Stock Equity
------ ---------- ----------- ----------- --------
Balances, January 1, 1996 $ 935 $19,779 $ 467 $(7,196) $13,985
Net earnings 6,303 6,303
Exercise of stock options
and issuance of other stock
awards (28) 609 581
Cash dividends declared
($1.47 per share) (3,606) (3,606)
Currency translation adjustments (275) (275)
Stock repurchased (2,800) (2,800)
Net unrealized appreciation
on securities 30 30
------ ------- ------ ------- -------
Balances, December 31, 1996 935 22,478 192 (9,387) 14,218
Net earnings 5,015 5,015
Exercise of stock options
and issuance of other stock
awards (66) 264 198
Cash dividends declared
($1.20 per share) (2,910) (2,910)
Currency translation adjustments (1,139) (1,139)
Stock repurchased (743) (743)
Net unrealized appreciation
on securities 2 2
------ ------- ------ ------- -------
Balances, September 30, 1997 $ 935 $24,519 $ (947) $(9,866) $14,641
====== ======= ====== ======= =======
See notes to condensed consolidated financial statements.
-7-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(in millions of dollars)
(Unaudited)
For the Nine Months Ended
September 30,
-------------------------
1997 1996
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CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
Net earnings - Consumer products $ 4,881 $ 4,744
- Financial services and real estate 134 88
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Net earnings 5,015 4,832
Adjustments to reconcile net earnings to
operating cash flows:
Consumer products
Depreciation and amortization 1,246 1,259
Deferred income tax provision 130 220
Gains on sales of businesses (182) (68)
Cash effects of changes, net of the effects
from acquired and divested companies:
Receivables, net (942) (630)
Inventories (331) (617)
Accounts payable (972) (915)
Income taxes (40) 260
Other working capital items 663 (240)
Other 335 207
Financial services and real estate
Deferred income tax provision 113 110
Gain on sale of business (103)
Other 156 104
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Net cash provided by operating activities 5,088 4,522
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CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
Consumer products
Capital expenditures (1,176) (1,108)
Purchases of businesses, net of acquired cash (628) (515)
Proceeds from sales of businesses 402 154
Other 12
Financial services and real estate
Investments in finance assets (501) (306)
Proceeds from finance assets 256 154
Proceeds from sale of business 427
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Net cash used in investing activities (1,220) (1,609)
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See notes to condensed consolidated financial statements.
Continued
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Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Continued)
(in millions of dollars)
(Unaudited)
For the Nine Months Ended
September 30,
-------------------------
1997 1996
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CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
Consumer products
Net (repayment) issuance of short-term borrowings $(1,006) $ 329
Long-term debt proceeds 2,852 1,966
Long-term debt repaid (1,330) (1,487)
Financial services and real estate
Net issuance (repayment) of short-term borrowings 146 (450)
Long-term debt proceeds 175 363
Long-term debt repaid (387)
Repurchase of outstanding stock (805) (2,097)
Dividends paid (2,916) (2,483)
Issuance of shares 97 341
Other (72) (31)
------- -------
Net cash used in financing activities (3,246) (3,549)
Effect of exchange rate changes on cash and
cash equivalents (83) (43)
------- -------
Cash and cash equivalents:
Increase (decrease) 539 (679)
Balance at beginning of period 240 1,138
------- -------
Balance at end of period $ 779 $ 459
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See notes to condensed consolidated financial statements.
-9-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1. Accounting Policies:
The interim condensed consolidated financial statements of Philip Morris
Companies Inc. (the "Company") are unaudited. It is the opinion of the Company's
management that all adjustments necessary for a fair statement of the interim
results presented have been reflected therein. All such adjustments were of a
normal recurring nature. Operating revenues and net earnings for any interim
period are not necessarily indicative of results that may be expected for the
entire year.
These statements should be read in conjunction with the consolidated financial
statements and related notes which appear in the Company's annual report to
stockholders and which are incorporated by reference into the Company's Annual
Report on Form 10-K for the year ended December 31, 1996.
Balance sheet accounts are segregated by two broad types of business. Consumer
products assets and liabilities are classified as either current or non-current,
whereas financial services and real estate assets and liabilities are
unclassified, in accordance with respective industry practices.
Note 2. Capital Stock:
On February 26, 1997, the Company's Board of Directors declared a three-for-one
split of the Company's common stock, effected by a distribution on April 10,
1997, of two shares for each share held of record at the close of business on
March 17, 1997. In addition, the par value of the Company's common stock was
changed from $1.00 to $0.33 1/3 per share and authorized shares of common stock
were increased from 4 billion to 12 billion shares. All share and per share data
have been restated to reflect this stock split for all periods presented.
Note 3. Contingencies:
Legal proceedings covering a wide range of matters are pending in various U.S.
and foreign jurisdictions against the Company, its subsidiaries, including
Philip Morris Incorporated ("PM Inc."), the Company's domestic tobacco
subsidiary, and indemnitees. Various types of claims are raised in these
proceedings, including products liability, consumer protection, antitrust,
securities law, tax, patent infringement, employment matters and claims for
contribution.
OVERVIEW OF TOBACCO-RELATED LITIGATION
Types and Number of Cases
Pending claims related to tobacco products generally fall within three
categories: (i) smoking and health cases alleging personal injury brought on
behalf of individual plaintiffs, (ii) smoking and health cases alleging personal
injury and purporting to be brought on behalf of a class of individual
plaintiffs, and (iii) health care cost recovery actions, including class
actions, brought by state and local governments, unions and others seeking
reimbursement for Medicaid and/or other health care expenditures allegedly
caused by cigarette smoking. The theories of recovery asserted and defenses
raised in these cases are described below under "Smoking and Health Litigation"
and "Health Care Cost Recovery Litigation." Damages claimed in some of the
smoking and health class actions and health care cost recovery cases range into
the billions of dollars.
There continues to be a substantial increase in the number of tobacco-related
cases pending in the United States, with many of the new cases having been filed
in Florida and New York on behalf of individual plaintiffs. As of November 1,
1997, there were approximately 365 smoking and health cases filed and served on
behalf of individual plaintiffs in the United States against PM Inc. and, in
some cases,
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
the Company (excluding approximately 50 cases in Texas that were voluntarily
dismissed but which may be refiled under certain conditions), compared to
approximately 300 such cases as of June 30, 1997, and approximately 200 such
cases as of September 30, 1996. Seventeen of the individual cases involve
allegations of various personal injuries allegedly related to exposure to
environmental tobacco smoke ("ETS").
In addition, as of November 1, 1997, there were approximately 45 purported
smoking and health class actions pending in the United States against PM Inc.
and, in some cases, the Company (including four that involve allegations of
various personal injuries related to exposure to ETS) compared to approximately
40 such cases on June 30, 1997, and 20 such cases on September 30, 1996.
Most of these actions purport to constitute statewide class actions and were
filed after the Fifth Circuit Court of Appeals, in the Castano case, reversed a
federal district court's certification of a purported nationwide class action on
behalf of persons who were allegedly "addicted" to tobacco products. One
purported smoking and health class action is pending in Canada (against an
entity in which the Company, through subsidiaries, owns a 40% interest) and
another in Brazil against affiliates of the Company. Recently, a purported
smoking and health class action was filed in Nigeria against a subsidiary of
Philip Morris International Inc., the Company's international tobacco
subsidiary.
As of November 1, 1997, approximately 95 health care cost recovery actions were
pending, compared to approximately 70 on June 30, 1997, and 20 on September
30, 1996. In California, individuals and local governments and other
organizations purportedly acting as "private attorneys general" have filed suits
seeking, among other things, injunctive relief, restitution and disgorgement of
profits for alleged violations of California's consumer protection statutes
(Ellis, et al. v. R.J. Reynolds Tobacco Company, et al.; Cordova, et al. v.
Liggett Group, Inc., et al.).
Verdicts in Recent Cases
In August 1996, a Florida jury awarded a former smoker and his spouse $750,000
in a smoking and health case against another United States cigarette
manufacturer (Carter v. American Tobacco Co., et al.), and that manufacturer was
subsequently ordered to pay approximately $1.8 million in attorneys fees and
costs. Neither PM Inc. nor the Company was a party to that litigation. The
defendant in that action has appealed the verdict. Later that month, a jury
returned a verdict for defendants in a smoking and health case in Indiana
against United States cigarette manufacturers, including PM Inc. (Rogers v. R.J.
Reynolds Tobacco Company, et al.). Plaintiff has filed a motion seeking a new
trial based on the alleged discovery of new evidence. In May and October 1997,
Florida juries also returned verdicts for defendants in smoking and health cases
involving another United States cigarette manufacturer (Connor v. R.J. Reynolds
Tobacco Company; Karbiwnyk v. R.J. Reynolds Tobacco Company). In September 1997,
a court in Brazil awarded plaintiffs in a smoking and health case the Brazilian
real equivalent of $81,000, attorneys' fees (in an amount to be determined by
the court) and a monthly annuity for 35 years equal to two-thirds of the
deceased smoker's last monthly salary (Alves v. Souza Cruz). Defendant is
appealing the judgment. Neither the Company nor its affiliates were parties to
that action.
Settlements
In recent months, PM Inc. and other companies in the domestic tobacco industry
agreed to settle a smoking and health class action brought on behalf of flight
attendants alleging injury caused by exposure to ETS aboard aircraft and two
health care cost recovery actions brought by the states of Florida and
Mississippi. These settlements are discussed below under the headings "Smoking
and Health
-11-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Litigation -- Broin," "Health Care Cost Recovery Litigation -- Florida" and
"Health Care Cost Recovery Litigation -- Mississippi."
Trial Dates
A number of smoking and health cases and health care cost recovery actions
pending against PM Inc. and, in some cases, the Company, are scheduled for trial
through the end of 1998, although trial dates are subject to change. A Florida
class action is set for trial in February 1998 (Engle, et al. v. R.J. Reynolds
Tobacco Company, et al.). A New York class action may commence during the first
quarter of 1998, although a firm trial date has not yet been set (Frosina, et
al. v. Philip Morris, Inc., et al.). A Maryland class action is scheduled to go
to trial in September 1998 (Richardson, et al. v. Philip Morris Incorporated, et
al.). The Texas health care cost recovery trial, previously scheduled to begin
in September, has been delayed and no new trial date has been set at this time.
The Minnesota health care cost recovery action is scheduled for trial in January
1998. Several other health care cost recovery actions are scheduled for trial
later in 1998: Washington (September), Arizona (October) and Oklahoma
(November). Approximately 30 other individual cases are currently scheduled for
trial in 1998 against PM Inc. and, in some cases, the Company, of which
approximately 20 are set for trial in Florida commencing in June 1998.
A description of certain recent developments in smoking and health class
actions, health care cost recovery litigation and certain other actions pending
against the Company and/or its subsidiaries and affiliates follows.
SMOKING AND HEALTH LITIGATION
Plaintiffs' allegations of liability in smoking and health cases are based on
various theories of recovery, including negligence, gross negligence, strict
liability, fraud, misrepresentation, design defect, failure to warn, breach of
express and implied warranties, conspiracy, concert of action, violations of
deceptive trade practice laws and consumer protection statutes, and claims under
the federal Racketeer Influenced and Corrupt Organization Act ("RICO") and state
RICO statutes. Plaintiffs in these actions seek various forms of relief,
including compensatory and punitive damages, creation of a medical monitoring
fund, disgorgement of profits, various injunctive and equitable relief. Defenses
raised by defendants in these cases include lack of proximate cause, assumption
of the risk, comparative fault and/or contributory negligence, statutes of
limitations or repose, and preemption by the Federal Cigarette Labeling and
Advertising Act, as amended (the "Labeling Act"). In June 1992, the United
States Supreme Court held that the Labeling Act, as enacted in 1965, does not
preempt common law damage claims but that the Labeling Act, as amended in 1969,
preempts claims arising after July 1969 against cigarette manufacturers "based
on failure to warn and the neutralization of federally mandated warnings to the
extent that those claims rely on omissions or inclusions in advertising or
promotions." The Court also held that the 1969 Labeling Act does not preempt
claims based on express warranty, fraudulent misrepresentation or conspiracy.
The Court also held that claims for fraudulent concealment were preempted except
"insofar as those claims relied on a duty to disclose...facts through channels
of communication other than advertising or promotion." (The Court did not
consider whether such common law damage claims were valid under state law.) The
Court's decision was announced by a plurality opinion. The effect of the
decision on pending and future cases will be the subject of further proceedings
in the lower federal and state courts. Additional similar litigation could be
encouraged if legislation to eliminate the federal preemption defense, proposed
in Congress in recent years, were enacted. It is not possible to predict whether
any such legislation will be enacted.
-12-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Recently Filed Smoking and Health Class Actions
Since July 1, 1997 through November 1, 1997, the following smoking and health
class actions have been filed against PM Inc. and, in some cases, the Company
and/or its other subsidiaries:
Daley, et al. v. American Brands, Inc., et al., Circuit Court, Cook County,
Illinois, filed July 7, 1997.
Piscitello, et al. v. Philip Morris, Incorporated, Superior Court, Middlesex
County, New Jersey, filed July 28, 1997.
Azorsky, et al. v. R.J. Reynolds Tobacco Company, et al., United States
District Court, Western District, Pennsylvania, filed August 15, 1997.
McCauley, et al. v. Brown & Williamson Tobacco Corporation, et al., United
States District Court, Northern District, Georgia, filed August 20, 1997.
DaSilva, et al. v. Nigerian Tobacco Company, et al., High Court of Lagos State,
Nigeria, filed September 8, 1997.
Bush, et al. v. Philip Morris Incorporated, et al., United States District
Court, Eastern District, Texas, filed September 10, 1997.
Nwanze, et al. v. Philip Morris Companies, Inc., et al., United States District
Court, Southern District, New York, filed September 29, 1997.
Badillo, et al. v. The American Tobacco Company, Inc., et al., United States
District Court, Nevada, filed October 8, 1997.
Newborn, et al. v. Brown & Williamson Tobacco Corporation, et al., United States
District Court, Western District, Tennessee, filed October 9, 1997.
Certain Developments in Smoking and Health Class Actions
In addition to the recently filed smoking and health class actions listed above,
since July 1, 1997, there have been certain developments in the smoking and
health class actions.
Broin -- This class action was settled in October 1997 by PM Inc. and other
companies in the domestic tobacco industry, subject to final approval by the
court. The class, as certified by the court, consisted of "all non-smoking
flight attendants who are or have been employed by airlines based in the United
States and are suffering from various diseases and disorders caused by their
exposure to second-hand smoke in airline cabins." The defendants expressly did
not admit liability for injury of any member of the settlement class or that ETS
can cause any disease. Under the settlement, the settling defendants will pay
$300 million to establish a foundation to sponsor scientific research with
respect to diseases associated with cigarette smoking. These funds will be paid
in three equal annual installments, with interest, commencing in April 1998.
Settling defendants also agreed to pay attorneys' fees of up to $46 million and
costs of $3 million, subject to court approval. PM Inc.'s share of all the
foregoing payments (exclusive of interest) is approximately $175 million and was
charged to expense in the third quarter of 1997. The settling defendants also
agreed to support the enactment of federal legislation prohibiting smoking on
segments of international flights originating or terminating in the United
States. Under the settlement, all defendants (and certain other entities and
persons) are released from liability for the claims asserted in the present
action. Each individual member of the class, however, may later bring an
individual action for diseases and conditions existing on or before January 15,
1997 ("retained claims") based upon certain legal theories against the settling
defendants with the following limitations:
1. The individual claims can only seek compensatory damages; they may not
seek punitive damages;
2. The defendants retain all defenses against the individual claims,
except as noted below.
In any individual lawsuits brought by members of the settlement class for
retained claims seeking damages on account of specified diseases the settling
-13-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
defendants have assumed the burden of proof as to whether ETS can cause certain
conditions, but the plaintiff retains the burden of proving that his or her
condition was caused by exposure to ETS. Such individual lawsuits may be brought
in Dade County, Florida, or wherever the venue is proper. The settling
defendants have also agreed not to raise a statute of limitations defense with
respect to any retained claims brought by a member of the settlement class
within one year after final court approval of the settlement. The settlement
does not apply to, nor does it have any effect on, "future" claims brought by
members of the settlement class for any new and unrelated diseases or conditions
that arose or might arise after January 15, 1997. Broin, et al. v. Philip Morris
Incorporated, et al., Circuit Court, Dade County, Florida, filed October 31,
1991.
Engle -- The trial of this class action is scheduled to begin in February 1998.
Recently, the court reversed an earlier order that had granted defendants
partial summary judgment on the grounds that plaintiffs' claims were preempted
by the Labeling Act. Engle, et al. v. R.J. Reynolds Tobacco Company, et al.,
Circuit Court, Dade County, Florida, filed May 5, 1994.
Barnes (formerly Arch) -- In October 1997, the court decertified the class and
granted defendants' motions for summary judgment against the individual named
plaintiffs. Barnes, et al. v. The American Tobacco Company Inc., et al., United
States District Court, Eastern District, Pennsylvania, filed August 8, 1996.
Frosina -- In October 1997, the court certified the class. Defendants are
appealing the class certification. The trial of this case, originally scheduled
to begin in November 1997, may commence during the first quarter of 1998.
Frosina, et al. v. Philip Morris, Inc., et al., Supreme Court of the State of
New York, County of New York, filed June 19, 1996.
Reed -- In August 1997, the court denied plaintiffs' motion for class
certification and denied a motion by five individuals to intervene as class
representatives. Reed, et al. v. Philip Morris Incorporated, et al., Superior
Court of the District of Columbia, filed June 21, 1996.
Langdeau -- In October 1997, this case was dismissed without prejudice by the
Tribal Court on the grounds that plaintiffs failed to effect proper service of
process and otherwise failed to follow Tribal Court rules. Langdeau, et al. v.
The American Tobacco Company, et al., Tribal Court, Lower Brule Sioux Tribe,
Lower Brule, South Dakota, filed June 4, 1997.
Thomas -- In October 1997, plaintiffs voluntarily dismissed this purported class
action without prejudice. Thomas, et al. v. American Tobacco Company, Inc., et
al., Circuit Court for the County of Wayne, State of Michigan, filed June 6,
1997.
HEALTH CARE COST RECOVERY LITIGATION
In certain of the pending proceedings, foreign, state and local government
entities, unions, federal and state taxpayers, Native American tribes and others
seek reimbursement for Medicaid and/or other health care expenditures allegedly
caused by tobacco products and, in some cases, for future expenditures and
damages as well. In one of these cases private citizens seek recovery of alleged
tobacco-related health care expenditures by the federal Medicaid and Medicare
programs and, in another case, seek recovery of such expenditures by the
Department of Defense and the Department of Veterans Administration. In one
purported class action, Blue Cross/Blue Shield subscribers in the United States
are seeking reimbursement of allegedly increased medical insurance premiums
caused by tobacco products. In the Native American cases, claims are also
asserted for alleged lost productivity of tribal government employees. Other
relief sought by some but not all plaintiffs includes punitive damages, treble
damages for alleged antitrust
-14-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
law violations, injunctions prohibiting alleged marketing and sales to minors,
disclosure of research, disgorgement of profits, funding of anti-smoking
programs, disclosure of nicotine yields and payment of attorney and expert
witness fees.
The claims asserted in these health care cost recovery actions vary. In most of
these cases plaintiffs assert the equitable claim that the tobacco industry was
"unjustly enriched" by plaintiffs' payment of health care costs allegedly
attributable to smoking and seek reimbursement of those costs. Other claims made
by some but not all plaintiffs include the equitable claim of indemnity, common
law claims of negligence, strict liability, breach of express and implied
warranty, violation of a voluntary undertaking or special duty, fraud, negligent
misrepresentation, conspiracy, public nuisance, claims under federal and state
statutes governing consumer fraud, antitrust, deceptive trade practices and
false advertising, and claims under federal and state RICO statutes.
Defenses raised by defendants include failure to state a valid claim, lack of
benefit, adequate remedy at law, "unclean hands" (namely, that plaintiffs cannot
recover because they participated in, and benefited from, the sale of
cigarettes), lack of antitrust injury, federal preemption, lack of proximate
cause and statute of limitations. In addition, defendants argue that they should
be entitled to "set-off" any alleged damages to the extent the plaintiff
benefits economically from the sale of cigarettes through the receipt of excise
taxes or otherwise. Defendants also argue that these cases are improper because
plaintiffs must proceed under principles of subrogation and assignment. Under
traditional theories of recovery, a payor of medical costs (such as an insurer
or a state) can seek recovery of health care costs from a third party solely by
"standing in the shoes" of the injured party. Defendants argue that plaintiffs
should be required to bring an action on behalf of each individual health care
recipient and should be subject to all defenses available against the injured
party. In certain of these cases, defendants have also challenged the ability of
the plaintiffs to use contingency fee counsel to prosecute these actions.
Further, certain cigarette companies, including PM Inc., have filed declaratory
judgment actions in Massachusetts, Texas, Maryland, Connecticut, Utah, New
Jersey, Alaska and Hawaii seeking to block the health care cost recovery actions
in those states and/or to prevent the state from hiring contingency fee counsel.
The Maryland and New Jersey actions have been dismissed. The plaintiff tobacco
companies have sought appeals to overturn these dismissals. The New Jersey
appellate court has refused to hear the appeal.
Recently Filed Health Care Cost Recovery Actions
Since July 1, 1997 through November 1, 1997, the following health care cost
recovery actions have been filed against PM Inc. and, in some cases, the Company
and/or its other subsidiaries.
Connecticut Pipe Trades Health Fund, et al. v. Philip Morris, Inc., et al.,
United States District Court, Connecticut, filed July 1, 1997.
Seafarers Welfare Plan and United Industrial Workers Welfare Plan v. Philip
Morris, Inc., et al., United States District Court, Maryland, Southern
Division, filed July 2, 1997.
Laborers and Operating Engineers Utility Agreement Health and Welfare Trust Fund
for Arizona v. Philip Morris Incorporated, et al., United States District
Court, Arizona, filed July 7, 1997.
Woods v. The American Tobacco Company, et al., Superior Court, Wake County,
North Carolina, filed July 10, 1997.
West Virginia Laborers Pension Fund v. Philip Morris, Inc., et al., United
States District Court, Southern District, West Virginia, Huntington
Division, filed July 11, 1997.
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Philip Morris Companies Inc. and Subsidiaries
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Rhode Island Laborers Health and Welfare Fund, et al. v. Philip Morris
Incorporated, et al., United States District Court, Providence, Rhode
Island, filed on or about July 20, 1997.
Eastern States Health and Welfare Fund, et al. v. Philip Morris, Inc., et al.,
United States District Court, Southern District, New York, filed July 28,
1997.
Asbestos Workers Local 53 Health and Welfare Fund, et al. v. Philip Morris,
Inc., et al., United States District Court, Eastern District, Louisiana,
filed August 15, 1997.
Steamfitters Local Union No. 420 Welfare Fund, et al. v. Philip Morris, Inc., et
al., United States District Court, Eastern District, Pennsylvania, filed
August 20, 1997.
State of Georgia v. Philip Morris, Inc., et al., Superior Court, Fulton County,
Georgia, filed August 29, 1997.
Construction Laborers of Greater St. Louis Welfare Fund, et al. v. Philip
Morris, Inc., et al., United States District Court, Eastern District,
Missouri, filed September 2, 1997.
Southeast Florida Laborers District Council Health and Welfare Trust Fund, et
al. v. Philip Morris, Inc., et al., United States District Court, Southern
District, Florida, filed September 11, 1997.
West Virginia--Ohio Valley Area International Brotherhood of Electrical Workers
Welfare Fund v. The American Tobacco Company, et al., United States
District Court, West Virginia, filed September 11, 1997.
The Crow Creek Sioux Tribe v. The American Tobacco Company, et al., Tribal
Court, Crow Creek Sioux Tribe, filed September 14, 1997.
Teamsters Union No. 142, Health and Welfare Trust Fund, et al. v. Philip Morris
Incorporated, et al., United States District Court, Northern District,
Indiana, filed September 15, 1997.
Operating Engineers Local 12 Health and Welfare Trust, et al. v. American
Tobacco Co., Inc., et al., United States District Court, Central District,
California, filed September 16, 1997.
Puerto Rican ILGWU Health & Welfare Fund, et al. v. Philip Morris Inc., et al.,
Supreme Court, New York County, New York, filed September 17, 1997.
New Jersey Carpenters Health Fund, et al. v. Philip Morris, Inc., et al.,
United States District Court, New Jersey, filed September 25, 1997.
New Mexico and West Texas Multi-Craft Health and Welfare Trust Fund, et al. v.
Philip Morris, Inc., et al., Second Judicial District Court, Bernalillo
County, New Mexico, filed October 10, 1997.
Goodpasture v. American Tobacco Company, Inc., et al., United States District
Court, Kansas, filed October 15, 1997.
Moore v. American Tobacco Company, et al., United States District Court, Kansas,
filed October 15, 1997.
The Republic of the Marshall Islands v. The American Tobacco Company, et al.,
High Court, Republic of the Marshall Islands, filed October 20, 1997.
Central States Joint Board Health & Welfare Trust Fund v. Philip Morris, Inc.,
et al., Circuit Court, Cook County, Illinois, filed October 20, 1997.
International Brotherhood of Teamsters, Local 734 Health & Welfare Trust Fund v.
Philip Morris, Inc., et al., Circuit Court, Cook County, Illinois, filed
October 20, 1997.
Texas Carpenters Health Benefit Fund, et al. v. Philip Morris, Inc., et al.,
United States District Court, Eastern District, Texas, Beaumont Division,
filed October 31, 1997.
In addition to these actions, other foreign, state and local government entities
and others, including unions, have announced that they are considering filing
health care cost recovery actions.
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Notes to Condensed Consolidated Financial Statements
(Unaudited)
Certain Developments in Health Care Cost Recovery Actions
In addition to the recently filed health care cost recovery actions listed
above, since July 1, 1997, there have been certain developments in the health
care cost recovery actions.
Florida -- In August 1997, PM Inc. and other companies in the domestic tobacco
industry entered into a settlement agreement with the State of Florida to settle
all present and future economic claims relating to the subject matter of
Florida's health care cost recovery action. The State of Florida, et al. v. The
American Tobacco Company, et al., Circuit Court of the Fifteenth Judicial
Circuit in and for Palm Beach County, Florida, filed February 21, 1996.
Under the settlement agreement, the settling defendants have deposited into an
escrow account $550 million, representing the State's estimate of its share of
the $10 billion initial payment under the proposed Resolution discussed below
under the caption "Proposed Resolution of Certain Regulatory and Litigation
Issues." This amount was allocated among the settling defendants in accordance
with their relative market capitalization, resulting in a charge to expense by
PM Inc. of $374 million in the third quarter of 1997.
On September 15, 1998 and annually thereafter on December 31, the settling
defendants will make ongoing payments into a special account for the benefit of
the State in the following amounts: 1998: $220 million; 1999: $247.5 million;
2000: $275 million; 2001: $357.5 million; 2002: $357.5 million; and each year
thereafter: $440 million. These amounts equal that portion of the annual
industry payments under the proposed Resolution which is contemplated to be paid
to Florida. These payments would be adjusted for inflation and changes in volume
as provided in the proposed Resolution. The settling defendants have reimbursed
Florida's expenses and those of its attorneys. PM Inc.'s share of this payment
resulted in a charge to expense in the third quarter of 1997 of approximately
$11 million. The settling defendants have also agreed to pay reasonable
attorneys' fees of Florida's private contingency fee counsel. The amount of such
fees will be set by a panel of independent arbitrators. Each of these payments
would be allocated among the settling defendants in accordance with their
relative unit volume of domestic tobacco product sales.
Certain of Florida's private contingency fee counsel filed charging liens
against the funds paid by defendants into the Florida escrow account. In filing
the charging liens, contingency counsel argued that the settlement agreement had
no effect on their rights under their contingency fee agreement with Florida. On
November 12, 1997, the court ordered all parties to comply with the provisions
for obtaining attorneys' fees, as set forth in the settlement agreement, and
quashed the charging liens. Contingency fee counsel are appealing this ruling.
Under the settlement agreement, the settling defendants will also support a
two-year pilot program by Florida aimed at reducing the use of tobacco products
by persons under the age of eighteen, and have paid into escrow $200 million for
the pilot program. PM Inc.'s share of this payment resulted in a charge to
expense in the third quarter of 1997 of approximately $99 million.
The settling defendants also agreed to discontinue all tobacco product
billboards, signs in arenas and stadia and transit advertisements in Florida
within several months and to support new legislative and administrative
initiatives to prohibit the sale of cigarettes in vending machines, except in
adult-only facilities, and to strengthen civil penalties for sales of tobacco
products to minors and for possession of tobacco products by minors.
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Philip Morris Companies Inc. and Subsidiaries
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If legislation implementing the proposed Resolution or its substantial
equivalent is enacted, the settlement will remain in place, but the terms of the
federal legislation will supersede the settlement agreement (except for the
terms of the pilot program and payments thereunder) and the ongoing payments
described above will be adjusted so that Florida would receive the same payments
as it would receive under the proposed Resolution, provided that in all events
Florida will be entitled to the amount of the initial payment described above
without any adjustment.
The agreement also provides that if federal legislation implementing the
proposed Resolution or its substantial equivalent is enacted, the parties
contemplate that Florida and any other similar state which has made an
exceptional contribution to secure resolution of these matters may apply to a
panel of independent arbitrators for reasonable compensation for its efforts in
securing the proposed Resolution. The settling defendants have agreed not to
oppose an application of $250 million by Florida, payable over five years. The
parties have agreed to a nationwide annual cap for all such payments of $100
million.
The agreement also provides that if the settling defendants enter into any
future pre-verdict settlement agreement with a non-federal governmental
plaintiff on more favorable terms (after due consideration of relevant
differences in population or other appropriate factors), Florida will obtain
treatment at least as relatively favorable as such governmental plaintiff.
The agreement provides that it is not an admission or concession or evidence of
any liability or wrongdoing on the part of any party, and is entered into by the
settling defendants solely to avoid the further expense, inconvenience, burden
and uncertainty of litigation.
Finally, the agreement provides that the court retains jurisdiction over
plaintiffs' claim for non-economic injunctive relief. The court has scheduled a
trial date for September 8, 1998 on this claim in the event that the proposed
Resolution, or its substantial equivalent, is not enacted.
Mississippi -- In July 1997, PM Inc. and other companies in the United States
tobacco industry entered into a Memorandum of Understanding (the "MOU") with the
State of Mississippi setting forth the principal terms and conditions of an
agreement in principle to settle all present and future claims relating to the
subject matter of Mississippi's health care cost recovery action. Moore v. The
American Tobacco Company, et al., Chancery Court of Jackson County, Mississippi,
filed May 23, 1994. A final settlement agreement, based on the MOU, was signed
on October 17, 1997.
Under the settlement agreement, the settling defendants have deposited into an
escrow account $170 million, representing Mississippi's estimate of its share of
the $10 billion initial payment under the proposed Resolution and have paid an
additional $15 million (subject to later adjustment) to reimburse Mississippi
and its attorneys for legal expenses. The settling defendants have also
deposited into an escrow account approximately $62 million to support a pilot
program aimed at reducing the use of tobacco products by persons under the age
of eighteen. PM Inc.'s share of all of the foregoing payments was approximately
$153 million. This amount was charged to expense in the third quarter of 1997.
The settlement also provides that beginning December 31, 1998, the settling
defendants will pay into escrow 1.7% of that portion of the annual industry
payments under the proposed Resolution which is contemplated to be paid to the
states. These payments, which are not offset by potential credits for civil tort
liability and which would be adjusted as provided in the proposed Resolution,
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
could result in payments to the State of Mississippi of $68 million with respect
to 1998 and $76.5 million with respect to 1999. These amounts would increase
annually to $136 million with respect to 2003 and would continue at that level
thereafter. The settling defendants will also be responsible for the attorneys'
fees of counsel for Mississippi (which will be set by a panel of arbitrators).
Each of these payments would be allocated among the settling defendants in
accordance with their relative volume of domestic cigarette sales.
If legislation implementing the proposed Resolution or its substantial
equivalent is enacted, the settlement will remain in place, but the terms of the
federal legislation will supersede the settlement agreement (except for the
terms of the pilot program and payments thereunder) and the foregoing payment
amounts will be adjusted so that Mississippi would receive the same payment as
it would receive under the proposed Resolution, provided that in all events
Mississippi will be entitled to the $170 million initial payment described above
without any adjustment.
The settlement agreement also provides that if the settling defendants enter
into any future pre-verdict settlement agreement with a non-federal governmental
plaintiff on more favorable terms (after due consideration of relevant
differences in population or other appropriate factors), Mississippi will obtain
treatment at least as relatively favorable as such governmental plaintiff. In
addition, in the event of any future settlement or final judgment with respect
to the claims for non-economic injunctive relief pending in Florida's health
care cost recovery action, the terms of the Mississippi settlement agreement
will be revised so that Mississippi will receive comparable benefits (after due
consideration of relevant differences in population or other appropriate
factors).
The settlement agreement also provides that if federal legislation implementing
the proposed Resolution or its substantial equivalent is enacted, the parties
contemplate that Mississippi and any other similar state which has made an
exceptional contribution to secure resolution of these matters may apply to a
panel of independent arbitrators for reasonable compensation for its efforts in
securing the proposed Resolution. The settling defendants have agreed not to
oppose an application of $75 million by Mississippi, payable over five years.
The parties have agreed to a nationwide annual cap for all such payments of $100
million.
The settlement agreement also provides that the settling defendants will
discontinue all tobacco billboards, signs in arenas and stadia, and transit
advertisements in Mississippi within several months and will support legislative
and administrative initiatives to prohibit the sale of cigarettes in vending
machines, except in adult-only facilities, and to strengthen civil penalties for
sales of tobacco products to minors and for possession of tobacco products by
minors.
Finally, the settlement agreement provides that it is not an admission or
concession or evidence of any liability or wrongdoing on the part of any party,
and is entered into by the settling defendants solely to avoid the further
expense, inconvenience, burden and uncertainty of litigation.
Texas -- In September 1997, the court denied defendants' motions for summary
judgment and denied defendants' motions to dismiss as to the RICO, simple and
gross negligence, strict liability, breach of express and implied warranties,
common law fraud (actual and constructive), simple and gross negligent
misrepresentation, conspiracy and concert of action, aiding and abetting and
vicarious responsibility/respondeat superior causes of action. The court granted
defendants' motions to dismiss as to the antitrust, restitution/unjust
enrichment, common law public nuisance, negligent performance of a voluntary
undertaking, and Texas Deceptive Trade Practices and Consumer Protection Act
claims. The court also entered an order dividing the trial into three separate
phases. The court directed that Phase I of the trial will consider whether
defendants have engaged in conduct prohibited by the RICO statute and any
defenses that may be applicable to the initial liability phase of civil RICO.
Phase II of the trial will consider issues that relate to any duties imposed
upon the parties, any breach of those duties, whether any misrepresentations
have been made, whether elements of conspiracy have been satisfied and any
defenses that may be applicable to the initial liability elements of these
various claims. Phase III, which will occur only if plaintiff prevails in Phase
I or Phase II, will consider issues that relate to causation, the materiality of
misrepresentations, reliance and the amount of damages. In October 1997, the
United States Court of
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Appeals for the Fifth Circuit denied defendants' petition for review of various
of the trial court's rulings, including the decision to permit the State to
establish causation through the use of statistical proof without making a
showing of individual injury and the decision to trifurcate the trial. Trial in
this matter, originally scheduled to begin in September of this year, has been
delayed. No new trial date has been set. The State of Texas v. The American
Tobacco Company, et al., United States District Court, Eastern District of
Texas, filed March 28, 1996.
Massachusetts -- In October 1997, the court denied in part defendants' motions
to dismiss the complaint, but reserved ruling on plaintiff's claims of
special duty and a portion of plaintiff's deceptive trade practices claim.
Commonwealth of Massachusetts v. Philip Morris Inc., et al., Superior Court,
Middlesex County, filed December 19, 1995.
Washington -- In August 1997, the court reinstated plaintiff's previously
dismissed consumer protection statute claims for damages solely to the extent
such claims are confined to relief sought for individual consumers, but not for
the State itself. Trial of this case is scheduled for September 1998. State of
Washington v. American Tobacco Co., Inc., et al., Superior Court of Washington,
King County, filed June 5, 1996.
Alabama -- This health care cost recovery action was brought as a purported
class action on behalf of Alabama taxpayers. In September 1997, the court
dismissed plaintiffs' claims that were asserted on behalf of the State of
Alabama, but denied defense motions to dismiss claims insofar as they related to
plaintiffs' individual claims or those asserted on behalf of children. Crozier,
et al. v. The American Tobacco Company, et al., Circuit Court, Montgomery
County, Alabama, filed August 18, 1996.
Los Angeles County -- The court consolidated for trial the claims under
California's consumer protection statutes with similar claims in the Ellis and
Cordova cases referenced above under the heading "Overview of Tobacco-Related
Litigation--Types and Number of Cases." Trial is scheduled to begin in February
1999. County of Los Angeles v. R.J. Reynolds Tobacco Company, et al., Superior
Court of California, San Diego, filed August 5, 1996.
Arizona -- After having been instructed by the former governor of Arizona to
dismiss the case, the attorney general had filed an amended complaint that
abandoned claims for Medicaid payments, but sought recovery of other health care
costs as well as other damages and forms of relief. In October 1997, the new
governor authorized the attorney general to amend the complaint to include a
claim for Medicaid reimbursement. State of Arizona, et al. v. American Tobacco
Co., Inc., et al., Superior Court, Maricopa County, Arizona, filed August 20,
1996.
Illinois -- In November, 1997, the court denied defendants' motions to dismiss
the antitrust, negligence and conspiracy claims and granted defendants' motions
to dismiss the special duty, restitution, nuisance and unjust enrichment claims.
People of the State of Illinois v. Philip Morris, Inc., et al., Circuit Court of
Cook County, Illinois, filed November 12, 1996.
Iowa -- In August 1997, the court dismissed plaintiff's claims for deception,
breach of assumed duty, disgorgement of profits, and indemnity. The court also
denied defendants' motion to dismiss plaintiff's claims for violation of the
Iowa Consumer Fraud Act, civil conspiracy, aiding and abetting, nuisance, and
injunctive relief. State of Iowa v. R.J. Reynolds Tobacco Co., et al., District
Court for Polk County, Iowa, filed November 26, 1996.
California -- In October 1997, the court struck several of defendants'
affirmative defenses including comparative fault, assumption of risk, failure to
mitigate, improper class action, federal preemption (in part), lack of standing,
separation of powers doctrine, lack of authority to retain contingency counsel,
improper accumulation of actions and "antitrust-related defenses." People of the
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
State of California, et al. v. Philip Morris, Inc., et al., San Francisco
Superior Court, County of San Francisco, filed September 5, 1996.
University of South Alabama -- In August 1997, the court granted the attorney
general's motion to dismiss the action on the ground that the university, as an
instrumentality of the State, did not have authority to bring this action on its
own behalf. University of South Alabama v. The American Tobacco Company, et al.,
United States District Court, Southern District of Alabama, filed May 19, 1997.
The Lower Brule Sioux Tribe -- In October 1997, this case was dismissed without
prejudice by the Tribal Court on the grounds that plaintiffs failed to effect
proper service of process and otherwise failed to follow Tribal Court rules. The
Lower Brule Sioux Tribe, et al. v. The American Tobacco Company, et al., Tribal
Court, Lower Brule Sioux Tribe, Lower Brule, South Dakota, filed May 28, 1997.
Iowa Laborers District Council Health and Welfare Fund -- This case was
voluntarily dismissed without prejudice by plaintiffs in September 1997. The
Iowa Laborers District Council Health and Welfare Fund, et al. v. Philip Morris,
Inc., et al., United States District Court, Southern District of Iowa, filed
June 20, 1997.
The Chehalis Tribe -- In October 1997, plaintiffs voluntarily dismissed this
case without prejudice. The Chehalis Tribe, et al. v. The American Tobacco
Company, et al., Chehalis Tribal Court, Oakville, Washington, filed June 23,
1997.
Marshall Islands -- This case, originally filed in June 1997, was voluntarily
dismissed by plaintiffs without prejudice in July 1997. The Citizens of the
Republic of the Marshall Islands v. The American Tobacco Company, et al., United
States District Court, Hawaii, filed June 18, 1997. A new health care cost
recovery action was recently filed by the Republic of the Marshall Islands. The
Republic of the Marshall Islands v. The American Tobacco Company, et al., High
Court, Republic of the Marshall Islands, filed October 20, 1997.
CERTAIN OTHER TOBACCO-RELATED LITIGATION
In September 1997, Raymark Industries, Inc., an asbestos company, filed suits in
Georgia and Florida against domestic tobacco manufacturers, including PM Inc.
and others, for contribution for damages Raymark incurred in asbestos
litigation. Raymark Industries, Inc. v. Brown & Williamson Tobacco Corporation,
et al., United States District Court, Northern District, Georgia, filed
September 15, 1997; Raymark Industries, Inc. v. R.J. Reynolds Tobacco Company,
et al., United States District Court, Northern District, Florida, filed
September 15, 1997. Causes of action alleged in the complaint include
negligence, strict liability, fraud and misrepresentation, and conspiracy.
Plaintiff seeks contribution and/or indemnity for the defense and payment of
asbestos claims in an amount specified to be in excess of $400 million.
In November 1997, Fibreboard Corporation and Owens Corning, former asbestos
manufacturers, filed suit against domestic tobacco manufacturers, including PM
Inc., and others, to recover, among other things, past sums paid by these
companies to individuals with smoking-related diseases. Fibreboard Corporation
and Owens Corning v. The American Tobacco Company, et al., Superior Court,
Alameda County, California, filed November 6, 1997. Plaintiffs also seek
punitive damages. Causes of action alleged in the complaint include unfair
competition, unjust enrichment and restitution, indemnity, spoliation (i.e.,
alleged concealment of evidence) and declaratory relief.
CERTAIN OTHER ACTIONS
In April 1994, the Company, PM Inc. and certain officers and directors were
named as defendants in several purported class actions that were consolidated in
the United States District Court in the Southern District of New York. Kurzweil,
et al. v. Philip Morris Companies Inc., et al., United States District Court for
the Southern District of New York, filed April 4, 1994 and State Board of
Administration of Florida, et al. v. Philip Morris Companies Inc., et al.,
United
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
States District Court for the Southern District of New York, filed September 7,
1994. In those cases, plaintiffs asserted that defendants violated federal
securities laws by, among other things, making allegedly false and misleading
statements regarding the allegedly "addictive" qualities of cigarettes. In each
case, plaintiffs claimed to have been misled by defendants' knowing and
intentional failure to disclose material information. In September 1995, the
court granted defendants' motion to dismiss the two complaints in their
entirety. The court granted plaintiff in the State Board action leave to replead
one of its claims. In April 1996, the court entered an order stipulating the
dismissal of the State Board claims. In August 1996, the court entered judgment
dismissing the claims in Kurzweil. In April 1997, the district court granted a
motion filed by the Kurzweil plaintiffs to vacate the judgment and for leave to
amend their complaint. Defendants' appeal of this ruling was dismissed by the
Court of Appeals on August 5, 1997, for lack of appellate jurisdiction.
Since April 1996, five purported class action suits have been filed in Wisconsin
alleging that Kraft Foods, Inc. ("Kraft") and others engaged in a conspiracy to
fix and depress the prices of bulk cheese and milk through their trading
activity on the National Cheese Exchange. Plaintiffs seek injunctive and
equitable relief and treble damages. Stuart, et al. v. Kraft Foods, Inc., et
al., United States District Court, Eastern District of Wisconsin, filed April 4,
1996; Sheeks, et al. v. Kraft Foods, Inc., et al., United States District Court,
Eastern District of Wisconsin, filed September 24, 1996; Servais, et al. v.
Kraft Foods, Inc. and the National Cheese Exchange, Inc., Circuit Court of Dane
County, Wisconsin, filed May 5, 1997; Dodson, et al. v. Kraft Foods, Inc., et
al., United States District Court, Western District of Wisconsin, filed July 1,
1997; Noll, et al. v. Kraft Foods, Inc., et al., United States District Court,
Western District of Wisconsin, filed July 11, 1997. The court has granted the
Sheeks and Stuart plaintiffs' respective motions for voluntary dismissal without
prejudice. Plaintiffs in the three remaining cases have filed a single
consolidated class action complaint in Wisconsin seeking certification of a
class consisting of all milk producers in the U.S. In October 1997, a purported
class action suit was filed against Kraft only. Vincent, et al. v. Kraft Foods,
Inc., Circuit Court of Cook County, Illinois, filed October 27, 1997. This suit
contains allegations similar to those in the consolidated Wisconsin class action
discussed above, but only seeks a class comprised of Kraft's milk suppliers.
In September 1997, a purported class action was commenced by private plaintiffs
in Alabama state court alleging that the U.S. tobacco companies and others
conspired to fix cigarette prices in Alabama, that agreements leading to the
price increases were reached during the negotiations leading to the proposed
Resolution discussed below, and that prices were increased pursuant to the
alleged conspiracy in 1997. The purported class consists of Alabama residents
who purchased cigarettes in 1997. Plaintiffs seek actual damages of no more than
$500 per class member and statutory damages of $500 for each instance of injury
or damages, and costs and interest. In September 1997, the state court
conditionally certified the class. Defendants subsequently removed the case to
federal court, and the federal court then vacated the state court's conditional
class certification. Mosley, et al. v. Philip Morris Companies Inc., et al.,
United States District Court, Southern District of Alabama, filed September 24,
1997.
Tax assessments alleging the nonpayment of taxes in Italy (value added taxes for
the years 1988 to 1995 and income taxes for the years 1987 to 1995) have been
served upon certain affiliates of the Company. The aggregate amount of unpaid
taxes assessed to date is alleged to be the Italian lire equivalent of $2.7
billion. In addition, the Italian lire equivalent of $6.3 billion in interest
and penalties have been assessed. The Company anticipates that value added and
income tax assessments may also be received in respect of 1996. In September
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
1997, in the first of several appeals filed by an affiliate of the Company, the
Italian administrative tax court in Milan overturned one of the assessments for
value added taxes. A hearing on a second appeal was held in October 1997, and
hearings on additional appeals are currently scheduled for December 1997 and
January 1998. In a separate proceeding in Naples, a court has dismissed charges
of criminal association against certain present and former officers and
directors of affiliates of the Company, but permitted charges of tax evasion to
proceed to trial. The Company, its affiliates and the officers and directors who
are subject to the proceedings believe they have complied with applicable
Italian tax laws and are vigorously contesting the pending tax assessments and
the pending proceedings in Naples.
It is not possible to predict the outcome of the litigation pending against the
Company and its subsidiaries. Litigation is subject to many uncertainties, and
it is possible that some of these actions could be decided unfavorably. An
unfavorable outcome of a pending smoking and health case could encourage the
commencement of additional similar litigation. There have also been a number of
adverse legislative, regulatory, political and other developments concerning
cigarette smoking and the tobacco industry that have received widespread media
attention, including the announcement in March 1997 that another cigarette
manufacturer had settled certain health care cost recovery actions and a
purported nationwide smoking and health class action, and a decision by a
federal district court on a motion for summary judgment not to preclude the
United States Food and Drug Administration (the "FDA") from asserting
jurisdiction over cigarettes as "drugs" or "medical devices," which decision is
now under appeal. These developments, as well as the widespread media attention
given to the proposed Resolution discussed below and the settlements of the
Florida and Mississippi health care cost recovery actions and the Broin class
action, may negatively affect the perception of potential triers of fact with
respect to the tobacco industry, possibly to the detriment of certain pending
litigation, and may prompt the commencement of additional similar litigation.
Management is unable to make a meaningful estimate of the amount or range of
loss that could result from an unfavorable outcome of pending litigation. It is
possible that the Company's results of operations or cash flows in a particular
quarterly or annual period or its financial position could be materially
affected by an unfavorable outcome of certain pending litigation or by the
proposed Resolution discussed below or by settlement, if any, of certain pending
cases. However, implementation of the proposed Resolution would resolve the most
significant tobacco litigation against the Company and its subsidiaries.
Furthermore, the Company and each of its subsidiaries named as a defendant
believe, and each has been so advised by counsel handling the respective cases,
that it has a number of valid defenses to all litigation pending against it.
Except as described below under the heading "Proposed Resolution of Certain
Regulatory and Litigation Issues--Effects on Litigation," all such cases are,
and will continue to be, vigorously defended.
PROPOSED RESOLUTION OF CERTAIN REGULATORY AND LITIGATION ISSUES
On June 20, 1997, PM Inc. and other companies in the United States tobacco
industry entered into a Memorandum of Understanding to support the adoption of
federal legislation and any necessary ancillary undertakings, incorporating the
features described in the proposed Resolution attached to the Memorandum of
Understanding (together, the "Resolution"). The proposed Resolution, which is
subject to approval of the boards of directors of the participating companies,
can be implemented only by federal legislation. The Company's Board of Directors
approved the proposed Resolution in June 1997. If enacted into law, the
legislation would resolve many of the regulatory and litigation issues affecting
the United States tobacco industry and, thereby, reduce uncertainties facing the
industry and increase stability in business and capital markets.
-23-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
There can be no assurance that federal legislation in the form of the proposed
Resolution will be enacted or that it will be enacted without modification that
is materially adverse to the Company or that any modification would be
acceptable to the Company or that, if enacted, the legislation would not face
legal challenges. Moreover, the negotiation and signing of the proposed
Resolution could affect other federal, state and local regulation of the United
States tobacco industry and regulation of the international tobacco industry.
The proposed Resolution includes provisions relating to advertising and
marketing restrictions, product warnings and labeling, access restrictions,
licensing of tobacco retailers, the adoption and enforcement of "no sales to
minors" laws by states, surcharges against the industry for failure to achieve
underage smoking reduction goals (discussed below), regulation of tobacco
products by the FDA, public disclosure of industry documents and research,
smoking cessation programs, compliance programs by the industry, public smoking
and smoking in the workplace, enforcement of the proposed Resolution, industry
payments (discussed below) and litigation (discussed below).
Surcharge for Failure to Achieve Underage Smoking Reduction Goals
The proposed Resolution would impose surcharges on the industry if required
reductions in underage smoking are not achieved. A "look back" provision would
require the following reductions in the incidence of underage smoking from
estimated levels over the past decade: 30% in the fifth and sixth years after
enactment of implementing federal legislation, 50% in the seventh, eighth and
ninth years, and 60% in the tenth year, with incidence remaining at such reduced
levels thereafter.
For any year in which these required reductions are not met, the FDA must impose
a mandatory surcharge on the participating members of the cigarette industry
based upon an approximation of the present value of the profit the companies
would earn over the lives of the number of underage consumers in excess of the
required reduction. The annual surcharge would be $80 million (as adjusted for
changes in population and cigarette profitability) for each percentage point by
which the reduction in underage smoking falls short of the required reductions
(as adjusted to prevent double counting of persons whose smoking has already
resulted in the imposition of a surcharge in previous years). The annual
surcharge would be subject to a $2 billion annual cap (as adjusted for
inflation). The surcharge would be the joint and several obligation of
participating manufacturers allocated among participating manufacturers based on
their market share of the United States cigarette industry and would be payable
on or before July 1 of the year in which it is assessed. Manufacturers could
receive a partial refund of this surcharge (up to 75%) only after paying the
assessed amount and only if they could thereafter prove to the FDA that they had
fully complied with the proposed Resolution, had taken all reasonably available
measures to reduce youth tobacco usage and had not acted to undermine the
achievement of the reduction goals.
Industry Payments
The proposed Resolution would require participating manufacturers to make
substantial payments in the year of implementation and thereafter ("Industry
Payments"). Participating manufacturers would be required to make an aggregate
$10 billion initial Industry Payment on the date federal legislation
implementing the terms of the proposed Resolution is signed. This Industry
Payment would be based on relative market capitalizations and the Company
currently estimates that its share of the initial Industry Payment would be
approximately $6.6 billion (to be adjusted downward for initial payments made to
Mississippi and Florida pursuant to settlements of health care cost recovery
actions). Thereafter, the companies would be required to make specified annual
Industry Payments determined and allocated among the companies based on volume
of domestic
-24-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
sales as long as the companies continue to sell tobacco products in the United
States. These Industry Payments, which would begin on December 31 of the first
full year after implementing federal legislation is signed, would be in the
following amounts (at 1996 volume levels): year 1: $8.5 billion; year 2: $9.5
billion; year 3: $11.5 billion; year 4: $14 billion; and each year thereafter:
$15 billion. These Industry Payments would be increased by the greater of 3% or
the previous year's inflation rate determined with reference to the Consumer
Price Index. The Industry Payments would increase or decrease in proportion to
changes from 1996 domestic sales volume levels. Volume declines would be
measured based on adult sales volume figures; volume increases would be measured
by total sales volume. If sales volume declines but the industry's domestic net
operating profit exceeds base year inflation-adjusted levels, the reduction in
the annual Industry Payment due to volume decline, if any, would be offset to
the extent of 25% of the increased profit. At current levels of sales and prior
to any adjustment for inflation, the proposed Resolution would require total
Industry Payments of $368.5 billion over the first 25 years (subject to credits
described below in connection with potential civil tort liability).
The Industry Payments would be separate from any surcharges required under the
"look back" provision discussed above under the heading "Surcharge for Failure
to Achieve Underage Smoking Reduction Goals." The Industry Payments would
receive priority and would not be dischargeable in any bankruptcy or
reorganization proceeding and would be the obligation only of entities selling
tobacco products in the United States (and not their affiliated companies). The
proposed Resolution provides that all payments by the industry would be ordinary
and necessary business expenses in the year of payment, and no part thereof
would be either in settlement of an actual or potential liability for a fine or
penalty (civil or criminal) or the cost of a tangible or intangible asset. The
proposed Resolution would provide for the pass-through to consumers of the
annual Industry Payments in order to promote the maximum reduction in underage
use.
Effects on Litigation
If enacted, the federal legislation provided for in the proposed Resolution
would settle present attorney general health care cost recovery actions (or
similar actions brought by or on behalf of any governmental entity other than
the federal government), parens patriae and smoking and health class actions and
all "addiction"/dependence claims and would bar similar actions from being
maintained in the future. However, the proposed Resolution provides that no stay
applications will be made in pending governmental actions without the mutual
consent of the parties. In recent months PM Inc. and other companies in the
domestic tobacco industry agreed to settle two health care cost recovery actions
in Mississippi and Florida and a smoking and health class action brought on
behalf of flight attendants alleging injury caused by exposure to ETS aboard
aircraft. The Company may enter into discussions to postpone or settle other
actions pending the enactment of the legislation contemplated by the proposed
Resolution. No assurance can be given whether a postponement or settlement will
be achieved, or, if achieved, as to the terms thereof. The proposed Resolution
would not affect any smoking and health class action or any health care cost
recovery action that is reduced to final judgment before implementing federal
legislation is effective.
Under the proposed Resolution, the rights of individuals to sue the tobacco
industry would be preserved, as would existing legal doctrine regarding the
types of tort claims that can be brought under applicable statutory and case law
except as expressly changed by implementing federal legislation. Claims,
however, could not be maintained on a class or other aggregated basis and could
be maintained only against tobacco manufacturing companies (and not their
retailers,
-25-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
distributors or affiliated companies). In addition, all punitive damage claims
based on past conduct would be resolved as part of the proposed Resolution and
future claimants could seek punitive damages only with respect to claims
predicated upon conduct taking place after the effective date of implementing
federal legislation. Finally, except with respect to actions pending as of June
9, 1997, third-party payor (and similar) claims could be maintained only based
on subrogation of individual claims. Under subrogation principles, a payor of
medical costs can seek recovery from a third party only by "standing in the
shoes" of the injured party and being subject to all defenses available against
the injured party.
The proposed Resolution contemplates that participating tobacco manufacturers
would enter into a joint sharing agreement for civil liabilities relating to
past conduct. Judgments and settlements arising from tort actions would be paid
as follows. The proposed Resolution would set an annual aggregate cap of up to
33% of the annual base Industry Payment (including any reductions for volume
declines). Any judgments or settlements exceeding the cap in a year would roll
over into the next year. While judgments and settlements would run against the
defendant, they would give rise to an 80-cents-on-the-dollar credit against the
annual Industry Payment. Finally, any individual judgments in excess of $1
million would be paid at the rate of $1 million per year unless every other
judgment and settlement could first be satisfied within the annual aggregate
cap. In all circumstances, however, the companies would remain fully responsible
for costs of defense and certain costs associated with the fees of attorneys
representing certain plaintiffs in the litigation that would be settled by the
proposed Resolution.
Financial Effects
The Company anticipates that its share of the industry's $10 billion initial
payment, which it currently estimates would be approximately $6.6 billion
(adjusted downward for initial payments made to Mississippi and Florida pursuant
to settlements of health care cost recovery actions) would be charged to expense
in the period in which federal legislation implementing the terms of the
proposed Resolution is enacted. In addition, the Company currently anticipates
that implementation of the proposed Resolution would require a significant
charge to expense in the period of enactment to comply with the proposed
Resolution's regulations on advertising, marketing and production. The initial
payment would be funded from a combination of available cash, commercial paper
issuances, bank borrowings and long-term debt issuances in global markets. The
initial payment would have a material adverse effect on the Company's operating
income and cash flows in the quarter and year in which the proposed Resolution
is enacted and on its financial position. The initial payment would result in
higher debt and higher interest expense, the amounts of which would depend upon
the final form of the proposed Resolution, borrowing requirements and interest
rates.
The Company anticipates that PM Inc.'s share of future annual Industry Payments
related to cigarette sales would be charged to expense as the related sales
occur and would be funded through price increases. The Company anticipates that
annual surcharges, if any, imposed by the FDA for failure to meet required
reduction levels in underage smoking beginning in the fifth year after the
proposed Resolution is implemented would be charged to expense in the year of
assessment or in the year prior thereto if it is then probable that such
assessment will be made.
The Company believes that implementation of the proposed Resolution would
materially adversely affect the volume, operating revenues, cash flows and/or
operating income of the Company in future years. The degree of the adverse
impact would depend, among other things, on the rates of decline in United
States
-26-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
cigarette sales in the premium and discount segments, PM Inc.'s share of the
domestic premium and discount cigarette segments, interest rates and the timing
of principal payments on debt incurred to finance the initial payment due under
the proposed Resolution, and the effect of the proposed Resolution on cigarette
consumption and the regulatory and litigation environment outside the United
States.
Note 4. New Accounting Standards:
In 1996, the American Institute of Certified Public Accountants' Accounting
Standards Executive Committee issued Statement of Position ("SOP") No. 96-1,
"Environmental Remediation Liabilities," which, as required, was adopted by the
Company as of January 1, 1997. The adoption and application of SOP No. 96-1 had
no material effect on the Company's 1997 results of operations or financial
position for the three or nine month periods ended September 30, 1997.
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share," which is
effective for the year ending December 31, 1997. SFAS No. 128 establishes
standards for computing and presenting earnings per share ("EPS") and requires
the presentation of both basic and diluted EPS. Based upon the Company's current
capitalization structure, the basic and diluted EPS amounts calculated in
accordance with SFAS No. 128 are expected to approximate the Company's EPS
amounts computed in accordance with Accounting Principles Board Opinion No. 15,
"Earnings Per Share."
-27-
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
- ------------------------------------------------------------------------
Consolidated Operating Results
For the Nine Months Ended September 30,
Operating Revenues
---------------------------------------
(in millions)
1997 1996
---- ----
Tobacco $ 30,506 $ 27,837
Food 20,619 20,888
Beer 3,318 3,418
Financial services and real estate 279 271
-------- --------
Operating revenues $ 54,722 $ 52,414
======== ========
Operating Income
---------------------------------------
(in millions)
1997 1996
---- ----
Tobacco $ 6,339 $ 6,356
Food 3,065 2,909
Beer 410 392
Financial services and real estate 256 139
-------- --------
Operating companies income 10,070 9,796
Amortization of goodwill (438) (443)
General corporate expenses (334) (313)
Minority interest in earnings of
consolidated subsidiaries (56) (26)
-------- --------
Operating income $ 9,242 $ 9,014
======== ========
For the Three Months Ended September 30,
Operating Revenues
---------------------------------------
(in millions)
1997 1996
---- ----
Tobacco $ 10,433 $ 9,497
Food 6,455 6,710
Beer 1,125 1,118
Financial services and real estate 79 89
-------- --------
Operating revenues $ 18,092 $ 17,414
======== ========
Operating Income
---------------------------------------
(in millions)
1997 1996
---- ----
Tobacco $ 1,667 $ 2,226
Food 947 941
Beer 125 117
Financial services and real estate 150 49
-------- --------
Operating companies income 2,889 3,333
Amortization of goodwill (142) (150)
General corporate expenses (112) (103)
Minority interest in earnings of
consolidated subsidiaries (23) (9)
-------- --------
Operating income $ 2,612 $ 3,071
======== ========
-28-
Operating revenues and operating income for the first nine months of 1997
increased $2.3 billion (4.4%) and $228 million (2.5%), respectively, over the
comparable 1996 period. Operating revenues were higher due primarily to
increases in domestic and international tobacco and North American food
operations. Operating income was reduced as a result of pretax charges of $812
million taken by PM Inc., the Company's domestic tobacco subsidiary, for
up-front payments related to settling health care cost recovery litigation in
Mississippi and Florida and a one-time charge for settling the Broin case, a
Florida class action brought on behalf of non-smoking flight attendants.
Excluding the settlement charges, operating income increased 11.5%, reflecting
favorable results of operations in domestic tobacco, international tobacco,
North American food, beer and financial services operations.
Operating revenues for the third quarter of 1997 increased $678 million (3.9%)
over the comparable 1996 period, while operating income for the third quarter of
1997 decreased $459 million (14.9%) from the third quarter of 1996, reflecting
settlement charges of $812 million discussed previously. Operating revenues were
higher due primarily to increases in domestic and international tobacco.
Excluding the settlement charges, operating income increased 11.5%, reflecting
favorable results of operations in domestic tobacco, international tobacco,
North American food, beer and financial services operations.
Currency movements, primarily the strengthening of the U.S. dollar versus key
European and Asian currencies, decreased operating income by $334 million and
$154 million in the first nine months and third quarter of 1997, respectively,
versus the comparable 1996 periods. Although the Company cannot predict future
movements in currency rates, it anticipates that the strength of the U.S. dollar
will continue to have an unfavorable impact on operating income for the
remainder of 1997 and will negatively impact 1998 at current exchange rates.
Net earnings per share of $2.07 in the first nine months of 1997 increased by
5.6% over the comparable 1996 period, due to higher net earnings and fewer
shares outstanding. Net earnings per share of $0.58 in the third quarter of 1997
decreased 13.4% from the comparable 1996 period due to lower net earnings,
partially offset by fewer shares outstanding. Net earnings in both periods in
1997 were lowered by the after-tax effect of PM Inc.'s settlement charges ($496
million). Excluding the impact of these charges, net earnings and earnings per
share increased over the comparable 1996 period by 14.1% and 15.8%,
respectively, for the first nine months and 15.6% and 16.4%, respectively, for
the third quarter. As a result of share repurchases, the weighted average number
of shares outstanding decreased 1.9% to 2,425 million shares in the first nine
months of 1997 and decreased 1.3% to 2,423 million shares in the third quarter
of 1997 from the comparable 1996 periods.
The Company does not believe that the anticipated costs of Year 2000 systems
conversions will have a material impact on the Company's future consolidated
results of operations. However, in any given reporting period, such costs may be
a factor in describing changes in operating income for the Company's business
segments.
Operating Results by Business Segment
Tobacco
Business Environment
As discussed below, the tobacco industry, including PM Inc., the Company's
domestic tobacco subsidiary, and Philip Morris International Inc. ("PMI"), the
Company's international tobacco subsidiary, have faced, and continue to face, a
number of issues which may adversely affect volume, operating revenues, cash
flows, operating income and financial position.
-29-
In the United States, these issues include proposed federal regulatory controls
(including, as discussed below, the issuance of final regulations by the United
States Food and Drug Administration (the "FDA") which regulate cigarettes as
"drugs" or "medical devices"); actual and proposed excise tax increases; new and
proposed federal, state and local governmental and private restrictions on
smoking (including proposals to ban or restrict smoking in workplaces and in
buildings permitting public access); new and proposed restrictions on tobacco
manufacturing, marketing, advertising (including decisions by certain companies
to limit or not accept tobacco advertising) and sales; new and proposed
legislation and regulations to require substantial additional health warnings on
cigarette packages and in advertising, and to eliminate the tax deductibility of
tobacco advertising and promotional costs; actual and proposed requirements
regarding disclosure of cigarette ingredients and other proprietary information;
increased assertions of adverse health effects associated with both smoking and
exposure to environmental tobacco smoke ("ETS"); legislation or other
governmental action seeking to ascribe to the industry responsibility and
liability for the purported adverse health effects associated with both smoking
and exposure to ETS; the diminishing social acceptance of smoking; increased
pressure from anti-smoking groups; unfavorable press reports; governmental and
grand jury investigations; increased smoking and health litigation, including
private plaintiff class action litigation and health care cost recovery actions
brought by state and local governments, unions and others seeking reimbursement
for Medicaid and/or other health care expenditures allegedly caused by cigarette
smoking; and the proposed legislative resolution of certain regulatory and
litigation issues affecting the United States tobacco industry discussed below.
Cigarettes are subject to substantial excise taxes in the United States and to
similar taxes in most foreign markets. The United States federal excise tax on
cigarettes is currently $12 per 1,000 cigarettes ($0.24 per pack of 20
cigarettes). In August 1997, legislation was enacted that will raise the federal
excise tax to $17 per 1,000 cigarettes ($0.34 per pack of 20 cigarettes)
starting in the year 2000 and then to $19.50 per 1,000 cigarettes ($0.39 per
pack of 20 cigarettes) in 2002. In general, excise taxes, sales taxes and other
cigarette-related taxes levied by various states, counties and municipalities
have been increasing, and additional increases have been proposed in a number of
states. These taxes vary considerably and, when combined with the current
federal excise tax, may be as high as $1.50 per pack.
In the opinion of PM Inc. and PMI, past increases in excise and similar taxes
have had an adverse impact on sales of cigarettes. Any future increases, the
extent of which cannot be predicted, could result in volume declines for the
cigarette industry, including PM Inc. and PMI, and might cause sales to shift
from the premium segment to the discount segment.
In August 1996, the FDA issued final regulations pursuant to which it asserts
jurisdiction over cigarettes as "drugs" or "medical devices" under the
provisions of the Food, Drug and Cosmetic Act. The final regulations include
severe restrictions on the distribution, marketing and advertising of
cigarettes, and would require the industry to comply with a wide range of
labeling, reporting, recordkeeping, manufacturing, and other requirements
applicable to medical devices and their manufacturers. For the most part, the
regulations were scheduled to become effective on August 28, 1997. The FDA's
exercise of jurisdiction, if not reversed by judicial or legislative action,
could lead to more expansive FDA-imposed restrictions on cigarette operations
than those set forth in the final regulations, and could materially adversely
affect the volume, operating revenues and operating income of PM Inc. PM Inc.
and other domestic cigarette manufacturers and an advertising firm sued the FDA,
seeking a judicial declaration that the FDA has no authority to regulate
cigarettes and asking the court to permanently enjoin the FDA from enforcing its
regulations. Similar suits have been filed against the FDA by manufacturers of
smokeless tobacco products, by a trade association of cigarette retailers and by
advertising agency associations. In April 1997, a U.S. district court ruled that
Congress has not precluded the FDA from regulating cigarettes as "drugs" or
"medical devices" and that the FDA may so regulate cigarettes if the facts
asserted in support of the
-30-
FDA's assertion of jurisdiction are proven to be correct. The court also ruled,
however, that the section of the Food, Drug and Cosmetic Act relied upon by the
agency does not give the FDA authority to implement its regulations restricting
cigarette advertising and promotions. The court stayed implementation of the
FDA's regulations scheduled for August 28, 1997. The court left in effect the
specific regulations that took effect in February 1997 establishing a federal
minimum age of 18 for the sale of tobacco products and requiring proof of age
for anyone under age 27. The tobacco company plaintiffs, including PM Inc., are
appealing that portion of the district court's order relating to the FDA's
assertion of jurisdiction. The FDA is appealing that portion of the order
enjoining the advertising and promotion restrictions. The respective appeals
were heard by the U.S. Court of Appeals for the Fourth Circuit in August 1997.
The outcome of the litigation challenging the FDA regulations cannot be
predicted.
In August 1996, the Commonwealth of Massachusetts enacted legislation that would
require cigarette manufacturers to disclose to the Massachusetts Department of
Public Health ("DPH") the flavorings and other ingredients used in each brand of
cigarettes sold in the Commonwealth, and to provide "nicotine-yield ratings" for
their products based on standards to be established by the DPH. PM Inc. believes
that enforcement of the statute, which is scheduled to take effect on December
15, 1997, could permit the disclosure by DPH to the public of valuable
proprietary information concerning its brands. PM Inc. and three other domestic
cigarette manufacturers have filed suit in federal district court in Boston
challenging the legislation as being preempted by the Federal Cigarette Labeling
and Advertising Act, as amended (the "Labeling Act") and as violating the
commerce, full faith and credit, due process and takings clauses of the U.S.
Constitution. In February 1997, the court ruled on summary judgment motions that
the Labeling Act does not preempt the requirement that ingredient information be
provided to the Commonwealth and that decision was subsequently affirmed by the
First Circuit Court of Appeals. The plaintiffs will continue to assert their
other constitutional claims. The ultimate outcome of this lawsuit cannot be
predicted. The enactment of this legislation has encouraged efforts to enact,
and the enactment of, ingredients disclosure legislation in other states, such
as Texas and Minnesota.
In June 1995, PM Inc. announced that it had voluntarily undertaken a program to
limit minors' access to cigarettes. Elements of the program include
discontinuing free cigarette sampling to consumers in the United States,
discontinuing the distribution of cigarettes by mail to consumers in the United
States, placing a notice on cigarette cartons and packs for sale in the United
States stating "Underage Sale Prohibited," working with others in support of
state legislation to prevent youth access to tobacco products, taking measures
to encourage retailer compliance with minimum-age laws, and independent auditing
of the program.
Some foreign countries have also taken steps to restrict or prohibit cigarette
advertising and promotion, to require ingredient disclosure (such as Thailand),
to impose maximum constituent levels, to increase taxes on cigarettes, to
control prices, to restrict imports, to ban or severely restrict smoking in
workplaces and public places, and otherwise to discourage cigarette smoking. It
is not possible to predict what, if any, other foreign governmental legislation
or regulations will be adopted relating to the manufacturing, advertising, sale
or use of cigarettes or to the tobacco industry generally.
PM Inc. has received requests for information (including grand jury subpoenas)
in connection with governmental investigations of the tobacco industry, and is
cooperating with respect to such requests. Certain present and former employees
of PM Inc. have testified or have been asked to testify in connection with
certain of these matters. The investigations are as follows:
PM Inc. has been informed that an investigation by the United States Attorney
for the Southern District of New York, which had been initiated following the
publication of an article in The New York Times that made allegations about PM
Inc. documents and supposedly secret research relating to nicotine, has been
-31-
consolidated with the United States Department of Justice investigation
discussed immediately below.
PM Inc. has been informed of an investigation by the United States Attorney for
the Eastern District of New York relating to The Council for Tobacco
Research-U.S.A., Inc., a research organization of which PM Inc. is a sponsor;
and an investigation by the United States Department of Justice relating to
issues raised in testimony provided by tobacco industry executives before
Congress and other related matters.
PM Inc. has been advised that the Federal Trade Commission has commenced an
investigation to determine whether PM Inc. unfairly restricts the distribution
of competing manufacturers' cigarette brands through its merchandising practices
at the wholesale and retail levels.
While the outcomes of these investigations cannot be predicted, PM Inc. believes
it has acted lawfully.
In March 1997, Liggett Group Inc. ("Liggett"), a United States cigarette
manufacturer with approximately 2% of the domestic cigarette market, announced
agreements with the attorneys general of twenty-two states to settle the health
care cost recovery actions pending against Liggett in those states. Liggett also
entered into an agreement to settle a purported nationwide class action suit
which, subject to court approval, provides, during its 25-year term, for (i) the
mandatory settlement of all present and future claims by Liggett smokers and
their estates and families, as well as claims by individuals who allege injury
from exposure to ETS, and (ii) the settlement of all present and future claims
against Liggett by individuals or entities alleging economic loss as a result of
payments for the treatment of diseases or medical conditions allegedly caused by
cigarette smoking or exposure to ETS. As a part of the settlements, Liggett
agreed, among other things, (i) to pay 25% of its "Pre-tax Income," if any, for
the next 25 years into a settlement fund, subject to certain conditions and
offsets, (ii) to comply with certain aspects of the FDA regulations discussed
above, (iii) to acknowledge that cigarettes cause health problems and that
nicotine is "addictive," (iv) to add a warning to each package of its cigarettes
and its advertising stating that "Smoking is Addictive," (v) to acknowledge that
cigarette companies have targeted marketing programs toward minors, and (vi) to
cooperate with otherwise adverse parties in certain investigations and lawsuits
and, in furtherance thereof, to waive the attorney-client privilege and other
protections with respect to certain of its documents and information and to
assist in obtaining court adjudication with respect to documents ("protected
documents") in its possession that are subject to joint defense or other
privileges and protections held by other members of the tobacco industry. The
issue of Liggett's proposed disclosure of these protected documents is being
litigated in state courts. In Florida's health care cost recovery action certain
-32-
of these protected documents were publicly disclosed pursuant to court order.
The settlement agreements contain certain provisions that would apply to any
other member of the tobacco industry having a share of the domestic cigarette
market of less than 30% that acquires, or is acquired by, Liggett. Each
settlement can be terminated by Liggett upon the occurrence of specified events.
Liggett has sought to have the purported nationwide class action certified, and
the related settlement agreement approved, in actions brought in Alabama state
court and in federal court in West Virginia. In March 1997, the Alabama state
court conditionally certified the nationwide class and preliminarily approved
the related settlement agreement, subject to final approval after a fairness
hearing. In August 1997, the federal court in the West Virginia case withdrew
its earlier preliminary approval of the settlement and the settlement class and
denied plaintiffs' motion to certify the class.
As further discussed in Note 3 to the Condensed Consolidated Financial
Statements ("Note 3"), there is litigation pending in various jurisdictions
related to tobacco products. These cases generally fall within three categories:
(i) smoking and health cases alleging personal injury brought on behalf of
individual plaintiffs, (ii) smoking and health cases alleging personal injury
and purporting to be brought on behalf of a class of individual plaintiffs, and
(iii) health care cost recovery actions. Damages claimed in some of the smoking
and health class actions and health care cost recovery cases range into the
billions of dollars.
There continues to be a substantial increase in the number of tobacco-related
cases pending in the United States, with many of the new cases having been filed
in Florida and New York on behalf of individual plaintiffs. As of November 1,
1997, there were approximately 365 smoking and health cases filed and served on
behalf of individual plaintiffs in the United States against PM Inc. and, in
some cases, the Company (excluding approximately 50 cases in Texas that were
voluntarily dismissed but which may be refiled under certain conditions),
compared to approximately 300 such cases as of June 30, 1997, and approximately
200 such cases as of September 30, 1996. Seventeen of the individual cases
involve allegations of various personal injuries allegedly related to exposure
to ETS.
In addition, as of November 1, 1997, there were approximately 45 purported
smoking and health class actions pending in the United States against PM Inc.
and, in some cases, the Company (including four that involve allegations of
various personal injuries related to exposure to ETS) compared to approximately
40 such cases on June 30, 1997, and 20 such cases on September 30, 1996. Most of
these actions purport to constitute statewide class actions and were filed after
the Fifth Circuit Court of Appeals, in the Castano case, reversed a federal
district court's certification of a purported nationwide class action on behalf
of persons who were allegedly "addicted" to tobacco products. One purported
smoking and health class action is pending in Canada and another in Brazil
against affiliates of the Company. Recently, a purported smoking and health
class action was filed in Nigeria against a subsidiary of PMI.
As of November 1, 1997, approximately 95 health care cost recovery actions were
pending compared to approximately 70 on June 30, 1997, and 20 on September
30, 1996. In California, individuals and local governments and other
organizations purportedly acting as "private attorneys general" have filed suits
seeking, among other things, injunctive relief, restitution and disgorgement of
profits for alleged violations of California's consumer protection statutes.
Legislation has recently been enacted in California removing a statutory bar to
the filing of smoking and health cases by private plaintiffs and health care
cost recovery actions by public entities under California law. As a result,
additional smoking and health cases similar to those now pending in other states
may be filed in California, and existing health care cost recovery actions in
California may be expanded to claim the benefit of the amended statute.
-33-
Other foreign, state, and local government entities and others, including
unions, have announced that they are considering filing health care cost
recovery actions.
It is not possible to predict the outcome of the litigation pending against the
Company and its subsidiaries. Litigation is subject to many uncertainties, and
it is possible that some of these actions could be decided unfavorably. An
unfavorable outcome of a pending smoking and health case could encourage the
commencement of additional similar litigation. There have also been a number of
adverse legislative, regulatory, political and other developments concerning
cigarette smoking and the tobacco industry that have received widespread media
attention, including the announcement in March 1997 that another cigarette
manufacturer had settled certain health care cost recovery actions and a
purported nationwide smoking and health class action, and a decision by a
federal district court on a motion for summary judgment not to preclude the FDA
from asserting jurisdiction over cigarettes as "drugs" or "medical devices"
which decision is now under appeal. These developments, as well as the
widespread media attention given to the proposed Resolution, discussed below
under the heading "Proposed Resolution of Certain Regulatory and Litigation
Issues," and the settlements of the Florida and Mississippi health care cost
recovery actions and the Broin class action discussed in Note 3, may negatively
affect the perception of potential triers of fact with respect to the tobacco
industry, possibly to the detriment of certain pending litigation, and may
prompt the commencement of additional similar litigation.
Management is unable to make a meaningful estimate of the amount or range of
loss that could result from an unfavorable outcome of pending litigation. It is
possible that the Company's results of operations or cash flows in a particular
quarterly or annual period or its financial position could be materially
affected by an unfavorable outcome of certain pending litigation or by the
proposed Resolution discussed below or by settlement, if any, of certain pending
cases. However, implementation of the proposed Resolution would resolve the most
significant tobacco litigation against the Company and its subsidiaries.
Furthermore, the Company and each of its subsidiaries named as a defendant
believe, and each has been so advised by counsel handling the respective cases,
that it has a number of valid defenses to all litigation pending against it.
Except as described below under the heading "Proposed Resolution of Certain
Regulatory and Litigation Issues -- Effects on Litigation," all such cases are,
and will continue to be, vigorously defended.
PROPOSED RESOLUTION OF CERTAIN REGULATORY AND LITIGATION ISSUES
On June 20, 1997, PM Inc. and other companies in the United States tobacco
industry entered into a Memorandum of Understanding to support the adoption of
federal legislation and any necessary ancillary undertakings, incorporating the
features described in the proposed Resolution attached to the Memorandum of
Understanding.
The Memorandum of Understanding and the proposed Resolution (together, the
"Resolution") resulted from negotiations with state attorneys general,
representatives of the public health community and attorneys representing
plaintiffs in certain smoking and health litigation. The proposed Resolution
contains certain regulatory and legislative provisions with which the industry
does not necessarily agree, but which the industry has agreed to accept in the
interest of achieving the proposed Resolution. The proposed Resolution, which is
subject to approval of the boards of directors of the participating companies,
can be implemented only by federal legislation. The Company's Board of Directors
approved the proposed Resolution in June 1997. If enacted into law, the
legislation would resolve many of the regulatory and litigation issues affecting
the United States tobacco industry and, thereby, reduce uncertainties facing the
industry and increase stability in business and capital markets.
Certain members of the public health community have expressed concern with
certain aspects of the proposed Resolution, the White House has announced policy
guidelines supporting modifications to the proposed Resolution and various
-34-
members of Congress have introduced or indicated that they may introduce
alternative legislation. Accordingly, there can be no assurance that federal
legislation in the form of the proposed Resolution will be enacted or that it
will be enacted without modification that is materially adverse to the Company
or that any modification would be acceptable to the Company or that, if enacted,
the legislation would not face legal challenges. In any event, implementation of
the proposed Resolution would materially adversely affect the financial position
of the Company in the year of implementation and would materially adversely
affect the volume, operating revenues, cash flows and/or operating income of the
Company in future years. Moreover, the negotiation and signing of the proposed
Resolution could affect other federal, state and local regulation of the United
States tobacco industry and regulation of the international tobacco industry.
The following summary of the proposed Resolution is qualified by reference to
the complete text, which has been filed with the Securities and Exchange
Commission as Exhibit 10 to the Company's Current Report on Form 8-K dated June
20, 1997, and which is incorporated herein by reference. Certain terms of the
proposed Resolution would apply to all tobacco products sold in the United
States; certain terms would apply only to tobacco manufacturers that consent to
participate in the proposed Resolution; other terms would apply only to
non-consenting manufacturers.
Advertising and Marketing Restrictions
The proposed Resolution would incorporate certain restrictions previously
promulgated by the FDA and add additional restrictions to curtail tobacco
product advertising and marketing. Among other things, it would:
Prohibit the use of human images and cartoon characters, such as Joe Camel
and the Marlboro man, in all tobacco-product advertising.
Ban all outdoor tobacco-product advertising, including advertising in
enclosed stadia and advertising inside a retail establishment that is
directed outside.
Except for advertising in adult-only facilities or adult publications,
limit tobacco-product advertising to black text on a white background.
Ban sponsorships (including concerts and sporting events) in the name, logo
or selling message of a tobacco brand.
Ban all non-tobacco merchandise (such as caps, jackets and bags) bearing
the name, logo or selling message of a tobacco brand.
Ban offers of non-tobacco items or gifts based on proof of purchase of
tobacco products.
Ban direct or indirect payments for tobacco product placement in movies,
television programs and video games.
Prohibit direct and indirect payments to "glamorize" tobacco use in media
appealing to minors, including live and recorded music performances.
Prohibit tobacco-product advertising on the Internet unless designed to be
inaccessible in or from the United States.
In addition, the proposed Resolution would require that use of currently
employed product descriptors such as "low tar" and "light" be accompanied by a
mandatory health disclaimer in advertisements, and would prohibit the use of any
new descriptors embodying express or implied health claims unless approved by
the FDA. The FDA would also have the corresponding power, but not the
obligation, to modify advertising restrictions with respect to tobacco products
that it concludes present sufficiently reduced health risks. Exemplars of all
new
-35-
advertising and tobacco product labeling would be submitted to the FDA for its
ongoing review.
Warnings and Labeling
The proposed Resolution would mandate a new set of rotating warnings to be
placed on packages of tobacco products with greater prominence than previous
warnings (25% of the front of cigarette packs at the top of the pack). The new
rotating warnings would also appear in all advertisements in an area that would
occupy 20% of press advertisements. Cigarette packs and advertisements would
also carry the FDA mandated statement of intended use ("Nicotine Delivery
Device"), and the FDA would be authorized to require that they also carry
disclaimers about "tar and nicotine yields."
Access Restrictions
The proposed Resolution would restrict access to tobacco products by minors.
Without preventing state and local governments from imposing stricter measures,
the proposed Resolution would incorporate regulations previously promulgated by
the FDA that restrict access to tobacco products and would also add additional
restrictions. Taken together, these access restrictions would include the
following:
Setting a minimum age of 18 to purchase tobacco products.
Requiring retailers to check photo identification of anyone under 27 years
of age.
Establishing a requirement of face-to-face transactions for all sales of
tobacco products.
Banning the sale of tobacco products from opened packages, requiring a
minimum package size of 20 cigarettes, and banning the sampling of tobacco
products.
Banning the distribution of tobacco products through the mail except for
sales subject to proof of age (with subsequent FDA review to determine if
minors are obtaining tobacco products through the mail).
Imposing retailer compliance obligations to ensure that all displays,
advertising, labeling, and other items conform with all applicable
requirements.
Banning all sales of tobacco products through vending machines.
Banning self-service displays of tobacco products except in adult-only
facilities.
Licensing of Tobacco Retailers
The proposed Resolution would require that any entity that sells tobacco
products directly to consumers obtain a license. Sellers would be subject to
monetary penalties and suspension or loss of their licenses if they do not
comply with the access restrictions. The federal government and state and local
authorities would enforce these access and licensing provisions through funding
provided by Industry Payments, as defined below under the heading "Industry
Payments."
State Enforcement
The proposed Resolution would require states to adopt "no sales to minors" laws
and would contain economic incentives for the states to enforce such laws. If a
state does not meet "no sales to minors" performance targets, the FDA may refuse
to pay that state certain funds otherwise payable under the proposed Resolution.
To comply with the "no sales to minors" law, the state must achieve compliance
-36-
rate results of 75% by the fifth year after enactment of federal legislation,
85% by the seventh year and 90% by the tenth year and each year thereafter.
Compliance would be measured as a percentage of random, unannounced compliance
checks in which the retailer refused to sell tobacco products to minors. Funds
withheld from states for failure to achieve the performance targets would, in
turn, be reallocated to those states that demonstrated superior "no sales to
minors" enforcement records.
Surcharge for Failure to Achieve Underage Smoking Reduction Goals
The proposed Resolution would impose surcharges on the industry if required
reductions in underage smoking are not achieved. A "look back" provision would
require the following reductions in the incidence of underage smoking from
estimated levels over the past decade: 30% in the fifth and sixth years after
enactment of implementing federal legislation, 50% in the seventh, eighth and
ninth years, and 60% in the tenth year, with incidence remaining at such reduced
levels thereafter.
For any year in which these required reductions are not met, the FDA must impose
a mandatory surcharge on the participating members of the cigarette industry
based upon an approximation of the present value of the profit the companies
would earn over the lives of the number of underage consumers in excess of the
required reduction. The annual surcharge would be $80 million (as adjusted for
changes in population and cigarette profitability) for each percentage point by
which the reduction in underage smoking falls short of the required reductions
(as adjusted to prevent double counting of persons whose smoking has already
resulted in the imposition of a surcharge in previous years). The annual
surcharge would be subject to a $2 billion annual cap (as adjusted for
inflation). The surcharge would be the joint and several obligation of
participating manufacturers allocated among participating manufacturers based on
their market share of the United States cigarette industry and would be payable
on or before July 1 of the year in which it is assessed. Manufacturers could
receive a partial refund of this surcharge (up to 75%) only after paying the
assessed amount and only if they could thereafter prove to the FDA that they had
fully complied with the proposed Resolution, had taken all reasonably available
measures to reduce youth tobacco usage and had not acted to undermine the
achievement of the reduction goals. The FDA would use the surcharges to fund its
administrative costs and to fund grants to states for additional efforts to
reduce underage smoking.
Regulation
Under the proposed Resolution, the FDA would oversee the development,
manufacturing, marketing and sale of tobacco products in the United States,
including FDA oversight of ingredients and imposition of standards for reducing
or eliminating the level of certain constituents, including nicotine.
Under the proposed Resolution, tobacco would continue to be categorized as a
"drug" and a "device" under the Food, Drug and Cosmetic Act. The FDA's authority
to regulate tobacco products as "restricted medical devices" would be explicitly
recognized and tobacco products would be classified as a new subcategory of
Class II devices.
For a period of at least twelve years after implementing legislation is
effective, the FDA would be permitted, subject to certain procedures and
judicial review, to adopt performance standards that require the modification of
existing tobacco products, including the gradual reduction, but not the
elimination, of nicotine yields, and the possible elimination of other
constituents or components of the tobacco product, based upon a finding that the
modification: (i) will result in a significant reduction of the health risks
associated with such products to consumers thereof; (ii) is technologically
feasible; and (iii) will not result in the creation of a significant demand for
contraband or other tobacco products that do not meet the performance standards.
-37-
The proposed Resolution would also require, effective three years after
implementing legislation is effective, that no cigarette sold in the United
States can exceed a 12 mg. "tar" yield, using the Federal Trade Commission's
presently existing methodology to determine "tar" yields.
Beginning twelve years after implementing legislation becomes effective, the FDA
would be permitted to set performance standards that exceed those discussed
above, including the elimination of nicotine and the elimination of other
constituents or other demonstrated harmful components of tobacco products, based
upon a finding that: (i) the safety standard will result in a significant
overall reduction of the health risks to tobacco consumers as a group; (ii) the
modification is technologically feasible; and (iii) the modification will not
result in the creation of a significant demand for contraband or other tobacco
products that do not meet the performance standards. An FDA determination to
eliminate nicotine would have to be based upon a preponderance of the evidence
and be subject to judicial review and a two-year phase-in to permit
Congressional review.
The proposed Resolution would require disclosure of non-tobacco ingredients to
the FDA, require manufacturers to submit within five years a safety assessment
for non-tobacco ingredients currently used, and require manufacturers to obtain
comparable review for any new non-tobacco ingredients. The FDA would have
authority to disapprove an ingredient's safety. The proposed Resolution also
outlines legislation that would require companies to notify the FDA of
technology they develop or acquire that reduces the risk from tobacco products
and that would mandate cross-licensing of technology that the FDA determines
reduces the risk from tobacco products and that would authorize the FDA to
mandate the introduction or licensing of "less hazardous tobacco products" that
are technologically feasible.
The proposed Resolution would subject the tobacco industry to "good
manufacturing practice" standards, including requirements regarding quality
control systems, FDA inspections and record-keeping and reporting.
Public Disclosure
The proposed Resolution would require the tobacco industry to disclose to the
public previously confidential internal laboratory research as well as certain
other documents relating to smoking and health, "addiction" or nicotine
dependency, "safer or less hazardous" cigarettes and underage tobacco use and
marketing. The proposed Resolution would also require the industry to disclose
all such internal laboratory research generated in the future. The proposed
Resolution would provide protection for proprietary information and applicable
privileges, and would establish a streamlined process by which interested
persons could contest claims of privilege.
Cessation Programs
The proposed Resolution would authorize the Secretary of Health and Human
Services to accredit smoking cessation programs and techniques that the agency
determines to be potentially effective.
Compliance Programs
Participating tobacco manufacturers would be required to create, and to update
each year, plans to ensure compliance with all applicable laws and regulations,
to identify ways to reduce underage use of tobacco products, and to provide
internal incentives for reducing underage use and for developing products with
"reduced risk."
Participating manufacturers would also be required to implement compliance
programs setting compliance standards and procedures for employees and agents
that are reasonably capable of reducing violations. These programs must assign
to
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specific high-level personnel the overall responsibility for overseeing
compliance, forbid delegation of substantial discretionary authority to
individuals who have shown a propensity to disregard corporate policies,
establish training or equivalent means of educating employees and agents, and
institute appropriate disciplinary measures and steps to respond to violations
and prevent similar ones from recurring.
Participating manufacturers would be required to promulgate corporate principles
that express and explain the company's commitment to compliance, reduction of
underage tobacco use, and development of "reduced risk" tobacco products. They
would be required to work with retail organizations on compliance, including
retailer compliance checks and financial incentives for compliance, and disband
certain industry associations and only form new ones subject to regulatory
oversight.
Participating manufacturers would be subject to fines and penalties for
breaching any of these obligations. Companies would be required to direct their
employees to report known or alleged violations to the company compliance
officer, who in turn would be required to provide reports to the FDA. Finally,
companies would be prohibited from taking adverse action against
"whistleblowers" who report violations to the government.
Public Smoking
The proposed Resolution would mandate minimum federal standards governing
smoking in public facilities (with states and localities retaining power to
impose stricter requirements). These restrictions, which would be enforced by
the Occupational Safety and Health Administration, would:
Restrict indoor smoking in "public facilities" to ventilated areas with
systems that exhaust the air directly to the outside, maintain the smoking
area at "negative pressure" compared with adjoining areas and do not
recirculate the air inside the public facility.
Ensure that no employee may be required to enter a designated smoking area
while smoking is occurring.
Exempt restaurants (other than fast food restaurants) and bars, private
clubs, hotel guest rooms, casinos, bingo parlors, tobacco merchants and
prisons.
Enforcement
Violations of the proposed Resolution's terms would carry civil and criminal
penalties based upon the penalty provisions of the Food, Drug and Cosmetic Act
and, where applicable, the provisions of the United States criminal code.
Special enhanced civil penalties of up to ten times the penalties applicable to
similar violations by drug companies would attach to violations of the
obligations to disclose research about health effects of tobacco products and
information about the toxicity of non-tobacco ingredients.
Terms of the proposed Resolution would be embodied in state consent decrees,
giving the states concurrent enforcement powers. State enforcement could not
impose obligations or requirements beyond those imposed by the proposed
Resolution (except where the proposed Resolution specifically does not preempt
additional state-law obligations) and would be limited to the penalties
specified in the proposed Resolution and by prohibition of duplicative
penalties.
Industry Payments
The proposed Resolution would require participating manufacturers to make
substantial payments in the year of implementation and thereafter ("Industry
Payments"). Participating manufacturers would be required to make an aggregate
$10 billion initial Industry Payment on the date federal legislation
implementing
-39-
the terms of the proposed Resolution is signed. This Industry Payment would be
based on relative market capitalizations and the Company currently estimates
that its share of the initial Industry Payment would be approximately $6.6
billion (to be adjusted downward for initial payments made to Mississippi and
Florida pursuant to settlements of health care cost recovery actions).
Thereafter, the companies would be required to make specified annual Industry
Payments determined and allocated among the companies based on volume of
domestic sales as long as the companies continue to sell tobacco products in the
United States. These Industry Payments, which would begin on December 31 of the
first full year after implementing federal legislation is signed, would be in
the following amounts (at 1996 volume levels): year 1: $8.5 billion; year 2:
$9.5 billion; year 3: $11.5 billion; year 4: $14 billion; and each year
thereafter: $15 billion. These Industry Payments would be increased by the
greater of 3% or the previous year's inflation rate determined with reference to
the Consumer Price Index. The Industry Payments would increase or decrease in
proportion to changes from 1996 domestic sales volume levels. Volume declines
would be measured based on adult sales volume figures; volume increases would be
measured by total sales volume. If sales volume declines but the industry's
domestic net operating profit exceeds base year inflation-adjusted levels, the
reduction in the annual Industry Payment due to volume decline, if any, would be
offset to the extent of 25% of the increased profit. At current levels of sales
and prior to any adjustment for inflation, the proposed Resolution would require
total Industry Payments of $368.5 billion over the first 25 years (subject to
credits described below in connection with potential civil tort liability).
The Industry Payments would be separate from any surcharges required under the
"look back" provision discussed above under the heading "Surcharge for Failure
to Achieve Underage Smoking Reduction Goals." The Industry Payments would
receive priority and would not be dischargeable in any bankruptcy or
reorganization proceeding and would be the obligation only of entities selling
tobacco products in the United States (and not their affiliated companies). The
proposed Resolution provides that all payments by the industry would be ordinary
and necessary business expenses in the year of payment, and no part thereof
would be either in settlement of an actual or potential liability for a fine or
penalty (civil or criminal) or the cost of a tangible or intangible asset. The
proposed Resolution would provide for the pass-through to consumers of the
annual Industry Payments in order to promote the maximum reduction in underage
use.
The Industry Payments would be made to a central trust and then allocated among
various programs and entities to provide funds for federal and state enforcement
efforts; federal, state and local governments' health benefit programs; public
benefits to resolve past punitive damages claims that might be asserted in
private litigation; and the expenses related to the administration of federal
legislation enacted pursuant to the proposed Resolution. A portion of these
expenditures would be to fund a variety of public and private non-profit efforts
to discourage minors from beginning to use tobacco products and to assist
current tobacco consumers to quit. Those programs include research, public
education campaigns, individual cessation programs, and impact grants.
Effects on Litigation
If enacted, the federal legislation provided for in the proposed Resolution
would settle present attorney general health care cost recovery actions (or
similar actions brought by or on behalf of any governmental entity other than
the federal government), parens patriae and smoking and health class actions and
all "addiction"/dependence claims and would bar similar actions from being
maintained in the future. However, the proposed Resolution provides that no stay
applications will be made in pending governmental actions without the mutual
consent of the parties. In recent months PM Inc. and other companies in the
domestic tobacco industry agreed to settle two health care cost recovery actions
in Mississippi and Florida and a smoking and health class action brought on
behalf of flight attendants alleging injury caused by exposure to ETS aboard
aircraft. The Company may enter into discussions to postpone or settle other
actions pending the enactment of the legislation contemplated by the proposed
Resolution. No assurance can be given whether a postponement or settlement will
be achieved, or, if achieved, as to the terms thereof. The proposed Resolution
-40-
would not affect any smoking and health class action or any health care cost
recovery action that is reduced to final judgment before implementing federal
legislation is effective.
Under the proposed Resolution, the rights of individuals to sue the tobacco
industry would be preserved, as would existing legal doctrine regarding the
types of tort claims that can be brought under applicable statutory and case law
except as expressly changed by implementing federal legislation. Claims,
however, could not be maintained on a class or other aggregated basis and could
be maintained only against tobacco manufacturing companies (and not their
retailers, distributors or affiliated companies). In addition, all punitive
damage claims based on past conduct would be resolved as part of the proposed
Resolution and future claimants could seek punitive damages only with respect to
claims predicated upon conduct taking place after the effective date of
implementing federal legislation. Finally, except with respect to actions
pending as of June 9, 1997, third-party payor (and similar) claims could be
maintained only based on subrogation of individual claims. Under subrogation
principles, a payor of medical costs can seek recovery from a third party only
by "standing in the shoes" of the injured party and being subject to all
defenses available against the injured party.
The proposed Resolution contemplates that participating tobacco manufacturers
would enter into a joint sharing agreement for civil liabilities relating to
past conduct. Judgments and settlements arising from tort actions would be paid
as follows. The proposed Resolution would set an annual aggregate cap of up to
33% of the annual base Industry Payment (including any reductions for volume
declines). Any judgments or settlements exceeding the cap in a year would roll
over into the next year. While judgments and settlements would run against the
defendant, they would give rise to an 80-cents-on-the-dollar credit against the
annual Industry Payment. Finally, any individual judgments in excess of $1
million would be paid at the rate of $1 million per year unless every other
judgment and settlement could first be satisfied within the annual aggregate
cap. In all circumstances, however, the companies would remain fully responsible
for costs of defense and certain costs associated with the fees of attorneys
representing certain plaintiffs in the litigation that would be settled by the
proposed Resolution.
Non-participating Manufacturers
The proposed Resolution would contain certain measures to ensure that
non-participating manufacturers are not free to undercut the proposed Resolution
by selling tobacco products at lower prices because they were not making the
Industry Payments.
Financial Effects
The Company anticipates that its share of the industry's $10 billion initial
payment, which it currently estimates would be approximately $6.6 billion (to be
adjusted downward for initial payments made to Mississippi and Florida pursuant
to settlements of health care cost recovery actions) would be charged to expense
in the period in which federal legislation implementing the terms of the
proposed Resolution is enacted. In addition, the Company currently anticipates
that implementation of the proposed Resolution would require a significant
charge to expense in the period of enactment to comply with the proposed
Resolution's regulations on advertising, marketing and production. The initial
payment would be funded from a combination of available cash, commercial paper
issuances, bank borrowings and long-term debt issuances in global markets. The
initial payment would have a material adverse effect on the Company's operating
income and cash flows in the quarter and year in which the proposed Resolution
is enacted and on its financial position. The initial payment would result in
higher debt and higher interest expense, the amounts of which would depend upon
the final form of the proposed Resolution, borrowing requirements and interest
rates.
-41-
The Company anticipates that PM Inc.'s share of future annual Industry Payments
related to cigarette sales would be charged to expense as the related sales
occur and would be funded through price increases. The Company anticipates that
annual surcharges, if any, imposed by the FDA for failure to meet required
reduction levels in underage smoking beginning in the fifth year after the
proposed Resolution is implemented would be charged to expense in the year of
assessment or in the year prior thereto if it is then probable that such
assessment will be made.
The Company believes that implementation of the proposed Resolution would
materially adversely affect the volume, operating revenues, cash flows and/or
operating income of the Company in future years. The degree of the adverse
impact would depend, among other things, on the rates of decline in United
States cigarette sales in the premium and discount segments, PM Inc.'s share of
the domestic premium and discount cigarette segments, interest rates and the
timing of principal payments on debt incurred to finance the initial payment due
under the proposed Resolution, and the effect of the proposed Resolution on
cigarette consumption and the regulatory and litigation environment outside the
United States.
At the request of a United States Senate task force analyzing the financial
impact of the proposed Resolution on the tobacco industry, PM Inc., together
with other companies in the United States tobacco industry, submitted a report
to the task force. The report concludes, among other things, that (i) "[t]he
industry conservatively estimates that retail [cigarette] prices will increase
by an absolute minimum of $1.20 per pack by the fifth year and by an absolute
minimum of $1.50 per pack by the tenth year of implementation of the proposed
[R]esolution", (ii) "[c]igarette consumption would decline by up to 43% in the
next decade . . . and [the industry] believes the decline in consumption could
be greater," and (iii) "[i]ndustry pretax earnings will suffer even if unit
margins rise to offset the higher burden of unit fixed costs in the face of
declining sales volumes." The report is filed as Exhibit 99 hereto and is
incorporated herein by reference. The foregoing estimates constitute
forward-looking information and are based on assumptions with respect to
elasticity, smoking trends and retail price structure, among others, as set
forth in the report and in the preceding paragraph. Any change in the final
terms of the proposed Resolution could materially alter the conclusions
contained in the report. The Company does not undertake to update the
information contained in this paragraph in the event of such change.
In view of the foregoing, the Company may reevaluate its share repurchase and
dividend policies.
Operating Results
For the Nine Months Ended September 30,
--------------------------------------------
Operating Revenues Operating Income
-------------------- ------------------
(in millions)
1997 1996 1997 1996
---- ---- ---- ----
Domestic tobacco $ 9,959 $ 9,251 $2,685 $3,131
International tobacco 20,547 18,586 3,654 3,225
------- ------- ------ ------
Total $30,506 $27,837 $6,339 $6,356
======= ======= ====== ======
Domestic tobacco. During the first nine months of 1997, PM Inc.'s operating
revenues increased 7.7% over the comparable 1996 period, due to pricing ($408
million), higher volume ($254 million) and improved product mix ($46 million).
Operating income for the first nine months of 1997 decreased 14.2% from the
comparable 1996 period, due primarily to tobacco litigation settlement charges
($812 million) higher marketing, administration and research costs
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($209 million, primarily higher marketing expense) and higher fixed
manufacturing expense ($55 million), partially offset by pricing ($408 million),
higher volume ($162 million) and improved product mix ($43 million).
As discussed in Note 3, "Contingencies," of the Notes to the Condensed
Consolidated Financial Statements, in the third quarter of 1997, PM Inc. and
other companies in the United States tobacco industry entered into agreements to
settle health care cost recovery actions in Mississippi and Florida, and, in
October 1997, PM Inc. and other companies in the United States tobacco industry
entered into an agreement to settle a class action lawsuit in Florida. Based on
the agreements, PM Inc. recorded settlement charges of $812 million in the third
quarter of 1997. Excluding the impact of settlement charges, PM Inc.'s operating
income for the first nine months of 1997 increased 11.7% over the comparable
1996 period.
PM Inc.'s shipment volume for the first nine months of 1997 was 177.0 billion
units, an increase of 2.8% over the first nine months of 1996 on higher Marlboro
volume and wholesaler purchases, which the Company believes was in anticipation
of price increases. Marlboro shipment volume increased 7.5 billion units (6.4%)
to 123.7 billion units for a 34.3% share of the total industry, an increase of
2.2 share points over the first nine months of 1996. Domestic tobacco industry
volume declined 0.4%; however, PM Inc. estimates that, excluding the effects of
increased wholesaler buying mentioned above, the industry's volume continued to
decline in line with historical trends of 1% to 2% per annum. While PM Inc.
cannot predict future growth rates, it believes that, over the long term,
industry shipments will continue to decline in line with these historical
trends, subject to the effects, if implemented, of the proposed Resolution
discussed under "Tobacco--Business Environment" above.
PM Inc.'s shipment market share was 49.1%, an increase of 1.5 share points over
the comparable 1996 period. Based on shipments, the premium and discount
segments accounted for approximately 72.6% and 27.4%, respectively, of domestic
cigarette industry volume in the first nine months of 1997, versus approximately
71.5% and 28.5%, respectively, in the comparable 1996 period. This reflects a
continued shift to the higher-margin premium segment, which began in the second
half of 1993.
In the premium segment, PM Inc.'s volume increased 4.6%, compared with a 1.1%
increase for the industry, resulting in a premium segment share of 58.0%, an
increase of 1.9 share points over the first nine months of 1996, reflecting
higher Marlboro volume.
In the discount segment, PM Inc.'s shipments decreased 6.7%, to 25.4 billion
units in the first nine months of 1997 compared with an industry decline of
4.2%, resulting in a discount segment share of 25.7%, a decrease of 0.7 share
points from the first nine months of 1996. Basic shipment volume increased 233
million units to 17.6 billion units, for a 17.8% share of the discount segment,
an increase of 0.9 share points over the first nine months of 1996.
Retail sales data (compiled by the ACNielsen Company) indicate PM Inc. and
Marlboro market shares of 50.9% and 35.1%, respectively, during the first nine
months of 1997, compared with 49.3% and 33.2%, respectively, in the comparable
1996 period.
PM Inc. cannot predict future change or rates of change in the relative sizes of
the premium and discount segments or in PM Inc.'s shipments, shipment market
share or retail market share; however, it believes that implementation of the
proposed Resolution discussed above would materially adversely affect PM Inc.'s
shipments.
In September 1997, PM Inc. announced a price increase of $3.50 per thousand
cigarettes on its domestic premium and discount brands. PM Inc. previously
announced a price increase of $2.50 per thousand cigarettes on its domestic
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premium and discount brands in March 1997 and increased the price of its
domestic premium and discount brands by $2.00 per thousand cigarettes in the
second quarter of 1996.
In October 1997, PM Inc. announced that it would commence limited consumer
acceptability research on a new cigarette smoking system. The new smoking system
includes a cigarette specially designed to be smoked while partially inside an
electronic Puff Activated Lighter(TM) so that the cigarette burns only when
puffed. The limited consumer research is expected to take approximately 12
months to complete.
International tobacco. During the first nine months of 1997, tobacco operating
revenues of PMI increased 10.6% over the comparable 1996 period, due to higher
foreign excise taxes ($1.2 billion, principally for the consolidation of
previously unconsolidated and newly acquired subsidiaries), favorable volume/mix
($525 million), price increases ($554 million) and the consolidation of
previously unconsolidated and newly acquired subsidiaries ($431 million),
partially offset by unfavorable currency movements ($719 million). Operating
income for the first nine months of 1997 increased 13.3% over the comparable
1996 period, due to price increases, net of cost increases ($443 million),
favorable volume/mix ($330 million) and the consolidation of previously
unconsolidated and newly acquired subsidiaries ($60 million), partially offset
by unfavorable currency movements ($306 million) and higher marketing,
administration and research costs.
PMI's volume grew 40.3 billion units (7.8%) in the first nine months of 1997
over the comparable 1996 period to 558.1 billion units, including local brands
manufactured by Tabaqueira, Portugal's leading tobacco company, and ZPT-Krakow,
Poland's largest cigarette manufacturer. PMI acquired a controlling interest in
these companies during the first quarters of 1997 and 1996, respectively. Volume
advanced in most markets, including Germany, Italy, the Benelux countries,
Spain, Central and Eastern Europe, the Baltics, Turkey, the Middle East, the
Asia/Pacific region and Mexico. Volume was down in France, Japan and Australia.
However, Marlboro gained both volume and market share in France and Japan.
Volume continued to grow for PMI's portfolio of international brands, including
Marlboro, PMI's largest brand. PMI recorded market share gains in most major
markets.
For the Three Months Ended September 30,
-------------------------------------------
Operating Revenues Operating Income
------------------- ------------------
(in millions)
1997 1996 1997 1996
---- ---- ---- ----
Domestic tobacco $ 3,590 $3,284 $ 426 $1,098
International tobacco 6,843 6,213 1,241 1,128
------- ------ ------ ------
Total $10,433 $9,497 $1,667 $2,226
======= ====== ====== ======
Domestic tobacco. During the third quarter of 1997, PM Inc.'s operating revenues
increased 9.3% over the comparable 1996 period, due to pricing ($159 million),
higher volume ($128 million) and improved product mix ($19 million). Operating
income for the 1997 third quarter decreased 61.2% from the comparable 1996
period, due primarily to tobacco litigation settlement charges ($812 million),
higher marketing, administration and research costs ($111 million, primarily
higher marketing expense) and higher fixed manufacturing expense ($28 million),
partially offset by pricing ($159 million), higher volume ($82 million) and
improved product mix ($17 million). Excluding the impact of previously discussed
settlement charges, PM Inc.'s operating income increased 12.8%.
PM Inc.'s shipment volume for the third quarter of 1997 was 62.8 billion units,
an increase of 4.0% over the third quarter of 1996. The increase in PM Inc.'s
shipments was due largely to higher Marlboro volume and wholesaler purchases,
which the Company believes was in anticipation of price increases, which also
affected industry volume. For the third quarter of 1997, Marlboro shipment
volume increased 3.2 billion units (7.7%) to 44.4 billion units for a 34.7%
share of the total industry, an increase of 1.9 share points over the third
quarter of 1996. Domestic tobacco industry volume increased 1.8%, reflecting
increases in wholesaler purchases; however, PM Inc. estimates that, excluding
the effects of
-44-
increased wholesaler buying mentioned above, the industry's volume continued to
decline in line with historical trends of 1% to 2% per annum. While PM Inc.
cannot predict future growth rates, it believes that, over the long term,
industry shipments will continue to decline in line with these historical
trends, subject to the effects, if implemented, of the proposed Resolution
discussed under "Tobacco--Business Environment" above.
PM Inc.'s 1997 third quarter shipment market share was 49.2%, an increase of 1.0
share points over the comparable 1996 period. Based on shipments, the premium
and discount segments accounted for approximately 73.3% and 26.7%, respectively,
of domestic cigarette industry volume in the third quarter of 1997, versus
approximately 71.9% and 28.1%, respectively, in the comparable 1996 period. This
reflects a continued shift to the higher-margin premium segment, which began in
the second half of 1993.
In the premium segment, PM Inc.'s volume increased 6.2%, compared with a 3.8%
increase for the industry, resulting in a premium segment share of 58.0%, an
increase of 1.3 share points over the third quarter of 1996, due largely to
higher Marlboro volume.
In the discount segment, PM Inc.'s shipments decreased 8.0%, to 8.5 billion
units in the third quarter of 1997 compared with an industry decline of 3.3%,
resulting in a discount segment share of 25.0%, down 1.3 share points from the
third quarter of 1996. Basic shipment volume increased 114 million units to 6.1
billion units for a 17.9% share of the discount segment, an increase of 0.9
share points over the third quarter of 1996.
Retail sales data (compiled by the ACNielsen Company) indicate PM Inc. and
Marlboro market shares of 51.3% and 35.7%, respectively, during the third
quarter of 1997, compared with 49.7% and 33.7%, respectively, in the comparable
1996 period.
PM Inc. cannot predict future change or rates of change in the relative sizes of
the premium and discount segments or in PM Inc.'s shipments, shipment market
share or retail market share; however, it believes that implementation of the
proposed Resolution discussed above would materially adversely affect PM Inc.'s
shipments.
International tobacco. During the third quarter of 1997, tobacco operating
revenues of PMI increased 10.1% over the comparable 1996 period, due to higher
foreign excise taxes ($445 million, principally for the consolidation of
previously unconsolidated and newly acquired subsidiaries), favorable volume/mix
($183 million), price increases ($170 million) and the consolidation of
previously unconsolidated and newly acquired subsidiaries ($139 million),
partially offset by unfavorable currency movements ($307 million). Operating
income for the 1997 third quarter increased 10.0% over the comparable 1996
period, due primarily to price increases, net of cost increases ($146 million),
favorable volume/mix ($102 million), the consolidation of previously
unconsolidated and newly acquired subsidiaries ($21 million), partially offset
by higher marketing, administrative and research costs and unfavorable currency
movements ($141 million).
PMI's volume grew 12.9 billion units (7.3%) in the third quarter of 1997 over
the comparable 1996 period to 190.1 billion units, including local brands
manufactured by Tabaqueira, in which PMI acquired a controlling interest in
January 1997. Volume advanced in most markets, including Germany, Italy, the
Benelux countries, Spain, Central and Eastern Europe, the Baltics, Turkey,
Mexico and the Asia/Pacific region, where gains in most of this region's markets
were partially offset by lower volume in Japan due to the impact of the April
tax-driven retail price increase. In France, industry and PMI volume were down.
However, in Japan and France, Marlboro gained both volume and market share.
Volume continued to grow for PMI's portfolio of international brands, including
Marlboro, PMI's largest brand. PMI recorded market share gains in most major
markets.
-45-
Food
Business Environment
Kraft Foods, Inc. ("Kraft"), the largest processor and marketer of retail
packaged food in the United States, and its subsidiary Kraft Foods
International, Inc. ("KFI"), which markets coffee, confectionery and grocery
products in Europe and the Asia/Pacific region, are subject to fluctuating
commodity costs and competitive challenges in various product categories and
markets. Certain subsidiaries and affiliates of PMI that manufacture and sell
food products in Latin America are also subject to competitive challenges in
various product categories and markets. In addition, the results of KFI, as well
as PMI's food operations in Latin America, are subject to the impact of currency
fluctuations.
Steps continue to be taken to build the value of premium brands, reduce costs
and improve the Company's food business portfolio. The North American food
business has been reorganized to streamline operations and improve effectiveness
and customer response. The realignment included the creation of a unified sales
force in the United States. KFI has been realigned to capitalize on future
growth opportunities and reorganized into separate regional units.
During 1996, Kraft sold its bagel business and KFI sold its margarine businesses
in the U.K. and Italy. In the first nine months of 1997, KFI sold a Scandinavian
sugar confectionery business and Kraft sold certain of its maple-flavored syrup
businesses, including the Log Cabin and Country Kitchen brands. Kraft and KFI
have also sold several smaller non-strategic businesses in 1996 and 1997.
In October 1997, PMI sold its Brazilian ice cream business along with its share
of a Brazilian ice cream joint venture for $930 million, subject to adjustment.
The sale is expected to result in a pretax gain in excess of $700 million in
the fourth quarter of 1997.
The Company is currently evaluating cost reduction alternatives regarding its
international food operations, which may result in material charges to fourth
quarter 1997 operating income.
Kraft acquired the Taco Bell grocery business during the third quarter of 1996.
In Latin America, PMI acquired nearly all of the remaining voting shares of
Industrias de Chocolate Lacta S.A. ("Lacta"), a Brazilian chocolate
confectionery company, in the second quarter of 1996.
The North American and international food businesses are affected by fluctuating
commodity costs, particularly coffee bean prices, which can influence consumer
and trade buying patterns, affect retail price volatility and lead to price
competition in some markets. During the first quarter of 1997, coffee prices
rose dramatically due primarily to speculation concerning 1997's South American
crop and unusually low world stocks. Coffee bean prices reached a twenty-year
high in late May and led to price increases by Kraft, KFI and their competitors.
Coffee volume declined in the first nine months of 1997 from the comparable 1996
period as customers reacted to commodity-driven price increases. Kraft and KFI
estimate that coffee consumption may remain sluggish, as higher than average
coffee bean prices persist. Kraft was also affected by record high cheese
commodity costs in 1996, as well as other higher dairy commodity costs, arising
from low U.S. milk production. Cheese and dairy commodity costs moderated in the
first quarter of 1997 and have remained stable.
Kraft's cereal business continues to be affected by intense price competition,
particularly from value brands. In response, Kraft implemented a price rollback
and simplified couponing of its cereal products in the second quarter of 1996.
Several competitors followed with similar pricing strategies. The reduction of
cereal prices in 1996 lowered operating revenues and operating income in 1996
and the first quarter of 1997 in relation to prior period results.
-46-
Operating Results
For the Nine Months Ended September 30,
--------------------------------------------
Operating Revenues Operating Income
------------------- ------------------
(in millions)
1997 1996 1997 1996
---- ---- ---- ----
North American food $12,779 $12,509 $2,245 $2,062
International food 7,840 8,379 820 847
------- ------- ------ ------
Total $20,619 $20,888 $3,065 $2,909
======= ======= ====== ======
North American food. During the first nine months of 1997, operating revenues
increased 2.2% over the comparable 1996 period, due to volume increases in
ongoing operations ($382 million), pricing ($211 million) and the impact of
acquisitions ($47 million), partially offset by the impact of divestitures ($267
million), unfavorable product mix ($89 million) and unfavorable currency
movements ($14 million). Operating income for the first nine months of 1997
increased 8.9% over the comparable 1996 period, due primarily to price increases
and net cost decreases (aggregating $268 million) and volume increases in
ongoing operations ($233 million), partially offset by the impact of
divestitures ($41 million), unfavorable product mix ($21 million) and higher
marketing, administration and research costs ($256 million, due primarily to
higher marketing expense, which included additional marketing activities for
new products). Included in marketing, administration and research costs was a
gain of $159 million on the sale of certain maple-flavored syrup businesses, as
well as charges of $64 million related to the discontinuation of several small
operations, Year 2000 systems conversion costs of $38 million and the above
mentioned additional marketing expense for new product initiatives.
Excluding operating results of the divested North American food businesses
discussed above, operating revenues and operating income increased 4.4% and
11.2%, respectively, in the first nine months of 1997 over the comparable 1996
period.
Strong ongoing volume gains were achieved in frozen pizza, driven by new
products; meals, due to strength in macaroni and cheese dinners and the
acquisition and subsequent growth of Taco Bell grocery products; beverages, on
the strength of ready-to-drink products; cereals, aided by new product
introductions and the implementation of a price rollback as discussed
previously; and desserts and snacks, due to new product introductions and
strength in refrigerated ready-to-eat desserts and shelf stable puddings. Volume
gains were also realized in processed meats, driven by continued growth of lunch
combinations (including new product introductions) and growth in hot dogs and
cold cuts. Cheese volume also increased, benefiting from new products and
marketing initiatives. Coffee volume declined in the first nine months of 1997
from the comparable 1996 period as customers reacted to commodity-driven price
increases.
International food. Operating revenues for the first nine months of 1997
decreased 6.4% from the comparable 1996 period, due to unfavorable currency
movements ($609 million), lower volume/mix ($249 million) and the impact of
divestitures ($156 million), partially offset by the impact of newly acquired
and previously unconsolidated subsidiaries ($263 million) and pricing ($212
million). Operating income for the first nine months of 1997 decreased 3.2% over
the first nine months of 1996, due to lower volume ($76 million), cost
increases, net of price increases (aggregating $33 million), unfavorable
currency movements ($28 million) and the impact of divestitures ($25 million),
partially offset by the impact of newly acquired and previously unconsolidated
subsidiaries ($39 million) and lower marketing, administration and research
costs ($88 million).
-47-
Excluding operating results of the divested international food businesses
discussed above, operating revenues decreased 4.7% and operating income
decreased 0.2% in the first nine months of 1997 from the comparable 1996 period.
Lower ongoing volume for the first nine months of 1997 for KFI was due primarily
to lower coffee and confectionery volumes and to one less selling week during
the first quarter of 1997 compared to the first quarter of 1996. KFI's coffee
volume decreased during the first nine months of 1997, reflecting customers'
reactions to commodity-driven price increases. KFI's confectionery volume
declined, due primarily to an exceptionally warm summer in Scandinavia and lower
volume in Romania and Bulgaria, reflecting poor economic environments. KFI's
cheese and grocery volumes decreased due primarily to the impact of one less
selling week during the first quarter of 1997, partially offset by gains in
KFI's Asian markets. PMI's food volume in Latin America for the first nine
months of 1997 increased over the comparable 1996 period, due primarily to the
acquisition of Lacta and higher volume in beverages.
For the Three Months Ended September 30,
-----------------------------------------
Operating Revenues Operating Income
------------------ ----------------
(in millions)
1997 1996 1997 1996
---- ---- ---- ----
North American food $4,048 $4,062 $687 $642
International food 2,407 2,648 260 299
------ ------ ---- ----
Total $6,455 $6,710 $947 $941
====== ====== ==== ====
North American food. During the third quarter of 1997, operating revenues
decreased 0.3% from the comparable 1996 period, due primarily to the impact of
divestitures ($114 million), unfavorable product mix ($24 million) and
unfavorable currency movements ($9 million), partially offset by pricing ($76
million), volume increases in ongoing operations ($49 million) and the impact of
acquisitions ($8 million). Operating income for the third quarter of 1997
increased 7.0% over the comparable 1996 period, due primarily to price increases
and net cost decreases (aggregating $146 million) and volume increases in
ongoing operations ($26 million), partially offset by the impact of divestitures
($24 million), unfavorable product mix ($5 million) and higher marketing,
administration and research costs ($98 million, due primarily to higher
marketing expense which included additional marketing activities for new
products). Included in marketing, administration and research costs was a gain
of $159 million on the sale of certain maple-flavored syrup businesses, as well
as charges of $64 million related to the discontinuation of several small
operations, Year 2000 systems conversion costs of $28 million and the above
mentioned additional marketing expense for new product initiatives.
Excluding operating results of the divested North American businesses discussed
above, operating revenues and operating income increased 2.5% and 11.2%,
respectively, in the third quarter of 1997 over the comparable 1996 period.
Strong ongoing volume gains were achieved in meals, due to strength in macaroni
and cheese dinners and instant stuffing as well as the acquisition and
subsequent growth of Taco Bell grocery products; beverages, on the strength of
ready-to-drink products; cheese, benefiting from new products and marketing
initiatives as well as a favorable comparison with the third quarter of 1996,
when shipments declined following a commodity-driven price increase; and frozen
pizza, driven by new products. Volume gains were realized in processed meats,
driven by continued growth of lunch combinations (including new product
introductions) and growth in hot dogs and cold cuts; desserts and snacks, due to
new product introductions in refrigerated ready-to-eat and dry packaged
desserts; and cereals, aided by new product introductions. Volume was down in
barbecue sauce and spoonable
-48-
dressings. Coffee volume declined in the third quarter of 1997 from the
comparable 1996 period as customers reacted to commodity-driven price increases.
International food. Operating revenues for the third quarter of 1997 decreased
9.1% from the third quarter of 1996, due to unfavorable currency movements ($266
million), lower volume/mix ($124 million) and the impact of divestitures ($40
million), partially offset by pricing ($124 million) and the impact of newly
acquired and previously unconsolidated subsidiaries ($65 million). Operating
income for the third quarter of 1997 decreased 13.0% from the third quarter of
1996, due to cost increases, net of price increases ($54 million), lower volume
($20 million), unfavorable currency movements ($11 million) and the impact of
divestitures ($7 million), partially offset by the impact of newly acquired and
previously unconsolidated subsidiaries ($4 million) and lower marketing,
administration and research costs ($49 million). During the quarter, cost
increases lowered margins in key European coffee and cocoa businesses reflecting
higher U.S. dollar- and sterling-denominated coffee and cocoa costs.
Excluding operating results of the divested international food businesses
discussed above, operating revenues decreased 7.7% and operating income
decreased 11.0% in the third quarter of 1997 from the comparable 1996 period.
Lower third quarter ongoing volume for KFI primarily reflects a decline in
coffee volume during the third quarter of 1997 as a result of market contraction
as consumers respond to commodity-driven price increases. KFI's confectionery
volume declined slightly, due primarily to exceptionally warm weather in
Scandinavia and volume declines in Romania and Bulgaria, reflecting poor
economic environments. KFI's cheese and grocery volumes increased reflecting
recoveries in sliced beef volume in Italy, and peanut butter volume in
Australia, which had been adversely affected by a product recall in 1996. In
addition, cheese and grocery volume grew in KFI's Asian markets. PMI's food
volume in Latin America for the third quarter of 1997 increased over the
comparable 1996 period, due primarily to the acquisition of Lacta and higher
volume in beverages.
Beer
Nine Months ended September 30
Operating revenues of the Miller Brewing Company ("Miller") for the first nine
months of 1997 decreased $100 million (2.9%) from the comparable 1996 period,
due to unfavorable price/mix ($80 million) and lower volume ($20 million).
Operating income for the first nine months of 1997 increased $18 million (4.6%)
over the comparable 1996 period, due primarily to lower marketing,
administration and research costs ($53 million) and lower fixed manufacturing
expense ($21 million), partially offset by unfavorable price/mix ($51 million)
and lower volume ($8 million). Operating revenues, manufacturing costs and
marketing, administration and research costs were impacted by actions taken by
Miller in the fourth quarter of 1996 to restore growth, streamline its
organization and reduce costs.
Miller's 1997 shipment volume of 34.3 million barrels for the first nine months
of 1997 decreased 0.6% from the comparable 1996 period, reflecting lower
shipments of premium-priced brands. Lower shipment volume was due largely to a
decision to reduce wholesaler inventories in 1997 and an unfavorable comparison
to last year, which was favorably affected by the launch of Miller Beer.
However, wholesalers' sales to retailers in the first nine months of 1997
increased slightly from the comparable 1996 period, reflecting higher sales of
Miller Lite, as Miller's new advertising and promotional campaigns renewed focus
on core brands.
Quarter ended September 30
Operating revenues for Miller for the third quarter of 1997 increased $7 million
(0.6%) from the comparable 1996 period due to higher volume ($40 million),
partially offset by unfavorable price/mix ($33 million). Operating income for
the third quarter of 1997 increased $8 million (6.8%) over the comparable 1996
-49-
period, due primarily to higher volume ($16 million), lower fixed manufacturing
expense ($9 million) and lower marketing, administration and research costs ($4
million), partially offset by unfavorable price/mix ($21 million).
Miller's 1997 third quarter shipment volume of 11.8 million barrels increased
3.6% from the comparable 1996 period, reflecting higher shipments of
premium-priced and budget-priced brands. Shipments of Miller Lite rose, driven
by new advertising and promotional activity. Shipment volume increases were also
recorded for Miller High Life, Red Dog, Milwaukee's Best, Icehouse and Foster's.
Wholesalers' sales to retailers in the third quarter increased slightly.
Financial Services and Real Estate
During the third quarter of 1997, Philip Morris Capital Corp. ("PMCC") sold its
real estate subsidiary, Mission Viejo Company, for a pretax gain of $103
million. Operating revenues and operating income from PMCC's financial services
business increased in the first nine months and third quarter due to the
continued growth of its finance lease portfolio.
Financial Review
Net Cash Provided by Operating Activities
During the first nine months of 1997, cash provided by operating activities was
$5.1 billion, $566 million higher than in the first nine months of 1996, due
primarily to higher net earnings and lower cash requirements for working capital
items. The $5.1 billion of cash provided by operating activities during the
first nine months of 1997 is after making up-front payments of $606 million for
settling litigation.
Net Cash Used in Investing Activities
During the first nine months of 1997, cash used in investing activities was $1.2
billion, compared with $1.6 billion used during the comparable 1996 period. The
change was due primarily to higher cash provided by divestitures. During 1997,
cash provided by divestitures reflects the sale of Mission Viejo Company and
several food businesses. Cash used in acquisitions during 1997 reflects the
purchase of a tobacco operation in Portugal and an increased equity interest in
a Mexican cigarette business. In the fourth quarter of 1997, PMI sold its
Brazilian ice cream businesses for proceeds of $930 million, subject to
adjustment.
Net Cash Used in Financing Activities
During the first nine months of 1997, the Company's net cash used in financing
activities decreased to $3.2 billion, compared to $3.5 billion used in the first
nine months of 1996, due primarily to lower stock repurchases, partially offset
by higher dividends paid and lower net proceeds from the issuance of debt.
Debt
The Company's total debt and consumer products debt were $15.5 billion and $14.3
billion, respectively, at September 30, 1997, compared to $15.2 billion and
$13.9 billion, respectively, at December 31, 1996. At both September 30, 1997
and December 31, 1996, the Company's ratio of consumer products debt to total
equity was 0.98. The ratio of total debt to total equity was 1.06 and 1.07 at
September 30, 1997 and December 31, 1996, respectively.
The Company has negotiated new revolving bank credit agreements totaling $10.0
billion. These facilities are used to support the Company's commercial paper
borrowings and are available for acquisitions and other corporate purposes. An
agreement for $2.0 billion expires in October 1998. An agreement for $8.0
billion expires in 2002, enabling the Company to refinance short-term debt on a
long-term basis, based upon its intent and ability to refinance such debt. At
-50-
September 30, 1997, $0.5 billion of consumer products commercial paper was
reclassified as long-term debt. The Company expects to continue to refinance
long-term and short-term debt from time to time. The nature and amount of the
Company's long-term and short-term debt and the proportionate amount of each can
be expected to vary as a result of future business requirements, market
conditions and other factors.
As discussed above in "Tobacco--Business Environment," PM Inc. estimates that
the proposed Resolution in its current form, would result in an initial payment
by PM Inc. of approximately $6.6 billion upon enactment (to be adjusted downward
for initial payments made to Mississippi and Florida pursuant to settlements of
health care cost recovery actions). The Company anticipates that the payment
would be funded from a combination of available cash, commercial paper
issuances, bank borrowings and long-term debt issuances in global markets. The
Company further anticipates that the payment will result in significant
increases in its consumer products debt to total equity ratio, total debt to
total equity ratio and total debt outstanding.
The Company operates internationally, with manufacturing and sales facilities in
various locations around the world. The Company continually evaluates its
foreign currency net asset exposure (primarily the Swiss franc, German mark,
Netherlands guilder, Swedish krona and Canadian dollar) based on current market
conditions and business strategies, and it acts to manage such exposure, when
deemed prudent, through various hedging transactions. The Company has entered
into currency and related interest rate swap agreements to manage exposure to
currency movements. The U.S. dollar value of aggregate notional principal
amounts for these agreements outstanding was equivalent to $1.4 billion and $2.2
billion at September 30, 1997 and December 31, 1996, respectively. Of these
amounts, $726 million and $1.5 billion related to consumer products debt at
September 30, 1997 and December 31, 1996, respectively.
The Company enters into forward exchange and option contracts, for purposes
other than trading, to reduce the effects of fluctuating foreign currency on
foreign currency denominated current assets, liabilities, commitments and
short-term intercompany transactions. At September 30, 1997 and December 31,
1996, the Company had entered into contracts, with maturities of less than one
year and U.S. dollar equivalents of $3.0 billion (including $1.8 billion in
option contracts) and $1.7 billion, respectively.
Use of the above mentioned derivative financial instruments has not had a
material impact on the Company's financial position at September 30, 1997 or
results of operations for the three and nine months then ended.
The Company's credit ratings by Moody's at September 30, 1997 and December 31,
1996 were "P-1" in the commercial paper market and "A2" for long-term debt
obligations. The Company's credit ratings by Standard & Poor's ("S&P") at
September 30, 1997 and December 31, 1996 were "A-1" in the commercial paper
market and "A" for long-term debt obligations. In April 1997, S&P placed the
debt ratings of the Company on its CreditWatch list with the intent of
monitoring tobacco litigation developments.
Equity and Dividends
On February 26, 1997, the Company's Board of Directors declared a three-for-one
split of the Company's common stock, effected by a distribution on April 10,
1997, of two shares for each share held of record at the close of business on
March 17, 1997. All share and per share data have been restated to reflect this
stock split for all periods presented.
During the first nine months of 1997, the Company repurchased 18.2 million
shares of its common stock at an aggregate cost of $743 million. Of these
purchases, 16.9 million shares ($692 million) were made pursuant to the
Company's repurchase program, announced in 1994, to purchase up to $6.0 billion
of its common stock in the open market, and the remainder were made under an
$8.0 billion share repurchase program approved by the Board of Directors in the
first quarter of
-51-
1997. These 1997 repurchases, net of 10.9 million shares issued under the
Company's stock award plans during 1997, resulted in lower weighted average
shares outstanding for the first nine months and third quarter of 1997 as
compared to the first nine months and third quarter of 1996. No shares were
repurchased during the third quarter of 1997.
Dividends paid in 1997 were 17.4% higher than in 1996, reflecting a higher
dividend rate in the first half of 1997, partially offset by fewer shares
outstanding. The Board of Directors increased the Company's quarterly dividend
rate to $0.40 per share in the third quarter of 1996, resulting in an annualized
dividend rate of $1.60 per share.
As discussed above in the last paragraph of "Tobacco--Business
Environment--Proposed Resolution of Certain Regulatory and Litigation Issues,"
the Company may reevaluate its share repurchase and dividend policies.
During the first nine months of 1997, currency translation adjustments reduced
equity by $1.1 billion due to the strengthening of the U.S. dollar versus
European currencies, primarily the Swiss franc, German mark, Netherlands guilder
and Swedish krona.
New Accounting Standards
In 1996, the American Institute of Certified Public Accountants' Accounting
Standards Executive Committee issued Statement of Position ("SOP") No. 96-1,
"Environmental Remediation Liabilities," which, as required, was adopted by the
Company as of January 1, 1997. The adoption and application of SOP No. 96-1 had
no material effect on the Company's 1997 results of operations or financial
position for the three or nine month periods ended September 30, 1997.
In February 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share," which is
effective for the year ending December 31, 1997. SFAS No. 128 establishes
standards for computing and presenting earnings per share ("EPS") and requires
the presentation of both basic and diluted EPS. Based upon the Company's current
capitalization structure, the basic and diluted EPS amounts calculated in
accordance with SFAS No. 128 are expected to approximate the Company's EPS
amounts computed in accordance with Accounting Principles Board Opinion No. 15,
"Earnings Per Share."
Contingencies
See Note 3 to the Condensed Consolidated Financial Statements for a discussion
of contingencies.
Forward-Looking and Cautionary Statements
Reference is made to Item 1 (c) "Other Matters--Forward-Looking and Cautionary
Statements" in the Company's Form 10-K regarding important factors that could
cause actual results to differ materially from those contained in any
forward-looking statement made by or on behalf of the Company, including
forward-looking statements contained in this report. Reference is also made to
the section herein under the heading "Tobacco--Business Environment."
-52-
Part II - OTHER INFORMATION
Item 1. Legal Proceedings.
Reference is made to Note 3, "Contingencies," of the Notes to the
Condensed Consolidated Financial Statements included in Part I, Item 1 of this
report, and to "Tobacco--Business Environment," of the Management's Discussion
and Analysis of Financial Condition and Results of Operations included in Part
I, Item 2 of this report.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
3.2 By-Laws, as amended, of the Company.
4.3 5-Year Revolving Credit Agreement dated as of October 14,
1997, among the Company and the Initial Lenders named therein
and Citibank, N.A. and The Chase Manhattan Bank, as
Administrative Agents, and Credit Suisse First Boston, as
Syndication Agent, and Deutsche Bank AG, New York Branch, as
Documentation Agent.
12 Statement regarding computation of ratios of earnings to fixed
charges.
27 Financial Data Schedule.
99 Report to the Senate Democratic Task Force on Tobacco, Impact
of Proposed Resolution on U.S. Cigarette Industry, dated
October 8, 1997.
(b) Reports on Form 8-K. Since the beginning of the quarter for which
this report is filed, the Registrant filed a Current Report on Form
8-K, dated July 2, 1997, concerning the proposed Resolution and
other recent developments, including an agreement in principle to
settle Mississippi's health care cost recovery action, and a Current
Report on Form 8-K, dated August 25, 1997, concerning an agreement
to settle Florida's health care cost recovery action.
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Signature
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PHILIP MORRIS COMPANIES INC.
/s/ LOUIS C. CAMILLERI
Louis C. Camilleri, Senior Vice President and
Chief Financial Officer
November 13, 1997
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