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 June 30, 1999
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.
- --------------------------------------------------------------------------------
(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 (917) 663-5000
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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 July 31, 1999, there were 2,390,127,126 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
June 30, 1999 and December 31, 1998 3 - 4
Condensed Consolidated Statements of Earnings for the
Six Months Ended June 30, 1999 and 1998 5
Three Months Ended June 30, 1999 and 1998 6
Condensed Consolidated Statements of Stockholders'
Equity for the Year Ended December 31, 1998 and the
Six Months Ended June 30, 1999 7
Condensed Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 1999 and 1998 8 - 9
Notes to Condensed Consolidated Financial Statements 10 - 23
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations. 24 - 43
PART II - OTHER INFORMATION
Item 1. Legal Proceedings. 44
Item 6. Exhibits and Reports on Form 8-K. 44
Signature 45
-2-
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(in millions of dollars)
(Unaudited)
June 30, December 31,
1999 1998
-------- ------------
ASSETS
Consumer products
Cash and cash equivalents $ 4,408 $ 4,081
Receivables, net 4,865 4,691
Inventories:
Leaf tobacco 4,260 4,729
Other raw materials 1,917 1,728
Finished product 2,927 2,988
------- -------
9,104 9,445
Other current assets 2,095 2,013
------- -------
Total current assets 20,472 20,230
Property, plant and equipment, at cost 21,275 21,234
Less accumulated depreciation 9,105 8,899
------- -------
12,170 12,335
Goodwill and other intangible assets
(less accumulated amortization of
$5,605 and $5,436) 17,268 17,566
Other assets 3,492 3,309
------- -------
Total consumer products assets 53,402 53,440
Financial services
Finance assets, net 6,911 6,324
Other assets 140 156
------- -------
Total financial services assets 7,051 6,480
------- -------
TOTAL ASSETS $60,453 $59,920
======= =======
See notes to condensed consolidated financial statements.
Continued
-3-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Continued)
(in millions of dollars, except per share data)
(Unaudited)
June 30, December 31,
1999 1998
-------- ------------
LIABILITIES
Consumer products
Short-term borrowings $ 197 $ 225
Current portion of long-term debt 1,123 1,822
Accounts payable 2,630 3,359
Accrued marketing 2,617 2,637
Accrued taxes, except income taxes 1,745 1,408
Accrued settlement charges 2,732 1,135
Other accrued liabilities 3,087 3,576
Income taxes 1,356 1,144
Dividends payable 1,061 1,073
-------- --------
Total current liabilities 16,548 16,379
Long-term debt 12,386 11,906
Deferred income taxes 956 929
Accrued postretirement health care costs 2,587 2,543
Other liabilities 6,592 7,019
-------- --------
Total consumer products liabilities 39,069 38,776
Financial services
Long-term debt 666 709
Deferred income taxes 4,217 4,151
Other liabilities 560 87
-------- --------
Total financial services liabilities 5,443 4,947
-------- --------
Total liabilities 44,512 43,723
Contingencies (Note 5)
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 27,957 26,261
Accumulated other comprehensive earnings (including
currency translation of $1,684 and $1,081) (1,709) (1,106)
-------- --------
27,183 26,090
Less cost of repurchased stock
(407,880,049 and 375,426,742 shares) 11,242 9,893
-------- --------
Total stockholders' equity 15,941 16,197
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 60,453 $ 59,920
======== ========
See notes to condensed consolidated financial statements.
-4-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions of dollars, except per share data)
(Unaudited)
For the Six Months Ended
June 30,
------------------------
1999 1998
------- -------
Operating revenues $39,307 $37,361
Cost of sales 14,747 13,590
Excise taxes on products 8,606 8,419
------- -------
Gross profit 15,954 15,352
Marketing, administration and research costs 8,924 8,354
Settlement charges (Note 5) 1,005
Amortization of goodwill 292 290
------- -------
Operating income 6,738 5,703
Interest and other debt expense, net 428 482
------- -------
Earnings before income taxes 6,310 5,221
Provision for income taxes 2,493 2,103
------- -------
Net earnings $ 3,817 $ 3,118
======= =======
Per share data:
Basic earnings per share $ 1.58 $ 1.28
======= =======
Diluted earnings per share $ 1.57 $ 1.28
======= =======
Dividends declared $ 0.88 $ 0.80
======= =======
See notes to condensed consolidated financial statements.
-5-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions of dollars, except per share data)
(Unaudited)
For the Three Months Ended
June 30,
--------------------------
1999 1998
------- -------
Operating revenues $19,810 $18,978
Cost of sales 7,487 6,883
Excise taxes on products 4,243 4,192
------- -------
Gross profit 8,080 7,903
Marketing, administration and research costs 4,358 4,420
Settlement charges (Note 5) 199
Amortization of goodwill 145 144
------- -------
Operating income 3,577 3,140
Interest and other debt expense, net 222 238
------- -------
Earnings before income taxes 3,355 2,902
Provision for income taxes 1,325 1,166
------- -------
Net earnings $ 2,030 $ 1,736
======= =======
Per share data:
Basic earnings per share $ 0.84 $ 0.72
======= =======
Diluted earnings per share $ 0.84 $ 0.71
======= =======
Dividends declared $ 0.44 $ 0.40
======= =======
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, 1998 and
the Six Months Ended June 30, 1999
(in millions of dollars, except per share data)
(Unaudited)
Accumulated
Other Comprehensive Earnings
Earnings ---------------------------- Total
Reinvested Currency Cost of Stock-
Common in the Translation Repurchased holders'
Stock Business Adjustments Other Total Stock Equity
----- -------- ----------- ----- ----- ----- ------
Balances, January 1, 1998 $ 935 $ 24,924 $ (1,109) $(1,109) $ (9,830) $ 14,920
Comprehensive earnings:
Net earnings 5,372 5,372
Other comprehensive earnings,
net of income taxes:
Currency translation adjustments 28 28 28
Additional minimum pension liability $ (25) (25) (25)
-------- ------ ------- ---------
Total other comprehensive earnings 28 (25) 3 3
-------- ------ ------- ---------
Total comprehensive earnings 5,375
Exercise of stock options and
issuance of other stock awards 50 287 337
Cash dividends
declared ($1.68 per share) (4,085) (4,085)
Stock repurchased (350) (350)
--------- --------- -------- ------ ------- --------- ---------
Balances, December 31, 1998 935 26,261 (1,081) (25) (1,106) (9,893) 16,197
Comprehensive earnings:
Net earnings 3,817 3,817
Other comprehensive earnings,
net of income taxes:
Currency translation adjustments (603) (603) (603)
-------- ------- ---------
Total other comprehensive earnings (603) (603) (603)
-------- ------- ---------
Total comprehensive earnings 3,214
Exercise of stock options and
issuance of other stock awards 4 83 87
Cash dividends
declared ($0.88 per share) (2,125) (2,125)
Stock repurchased (1,432) (1,432)
--------- --------- -------- ------ ------- --------- ---------
Balances, June 30, 1999 $ 935 $ 27,957 $ (1,684) $ (25) $(1,709) $ (11,242) $ 15,941
========= ========= ======== ====== ======= ========= =========
Total comprehensive earnings, which represents net earnings partially offset by
currency translation adjustments, were $1,902 million and $1,696 million,
respectively, for the quarters ended June 30, 1999 and 1998, and $2,897 million
for the first six months of 1998.
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 Six Months Ended
June 30,
------------------------
1999 1998
------- -------
CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
Net earnings - Consumer products $ 3,749 $ 3,059
- Financial services 68 59
------- -------
Net earnings 3,817 3,118
Adjustments to reconcile net earnings to
operating cash flows:
Consumer products
Depreciation and amortization 824 828
Deferred income tax provision 27 121
Gain on sale of a business (20)
Cash effects of changes, net of the effects
from acquired and divested companies:
Receivables, net (383) (1,133)
Inventories 53 (63)
Accounts payable (638) (951)
Income taxes 235 176
Accrued liabilities and other current assets 1,566 778
Other (173) 660
Financial services
Deferred income tax provision 66 59
Other 77 66
------- -------
Net cash provided by operating activities 5,451 3,659
------- -------
CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
Consumer products
Capital expenditures (724) (806)
Purchases of businesses, net of acquired cash (385)
Proceeds from sales of businesses 29
Other (111) 22
Financial services
Investments in finance assets (196) (263)
Proceeds from finance assets 38 67
------- -------
Net cash used in investing activities (1,349) (980)
------- -------
See notes to condensed consolidated financial statements.
Continued
-8-
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Continued)
(in millions of dollars)
(Unaudited)
For the Six Months Ended
June 30,
------------------------
1999 1998
------- -------
CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
Consumer products
Net (repayment) issuance of short-term borrowings $ (9) $ 693
Long-term debt proceeds 1,275 1,985
Long-term debt repaid (1,339) (1,205)
Financial Services
Net issuance of short-term borrowings 103
Dividends paid (2,137) (1,942)
Issuance of common stock 69 98
Repurchase of common stock (1,475)
Other (54) (73)
------- -------
Net cash used in financing activities (3,670) (341)
------- -------
Effect of exchange rate changes on cash and
cash equivalents (105) (15)
------- -------
Cash and cash equivalents:
Increase 327 2,323
Balance at beginning of period 4,081 2,282
------- -------
Balance at end of period $ 4,408 $ 4,605
======= =======
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. For interim reporting purposes, certain expenses are
charged to results of operations as a percentage of sales. 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, 1998 (the "1998 Form 10-K").
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 assets and liabilities are unclassified, in
accordance with respective industry practices.
Note 2. Recently Adopted Accounting Standards:
In 1998, the American Institute of Certified Public Accountants' Accounting
Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP") No.
98-5, "Reporting on the Costs of Start-Up Activities." SOP No. 98-5 established
standards on accounting for start-up and organization costs and, in general,
requires such costs to be expensed as incurred. The Company adopted SOP No. 98-5
effective January 1, 1999. Neither the adoption of SOP 98-5 nor its application
for the six months or the quarter ended June 30, 1999 had an effect on the
Company's financial position or results of operations.
Note 3. Earnings Per Share:
Basic and diluted earnings per share ("EPS") were calculated using the
following:
For the Six Months Ended
June 30,
------------------------
1999 1998
---- ----
(in millions)
Net earnings $3,817 $3,118
====== ======
Weighted average shares for
basic EPS 2,415 2,427
Plus incremental shares from conversions:
Restricted stock and stock rights 2 1
Stock options 11 15
------ ------
Weighted average shares for
diluted EPS 2,428 2,443
====== ======
-10-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
For the Three Months Ended
June 30,
------------------------
1999 1998
---- ----
(in millions)
Net earnings $2,030 $1,736
====== ======
Weighted average shares for
basic EPS 2,406 2,428
Plus incremental shares from conversions:
Restricted stock and stock rights 2 1
Stock options 9 14
------ ------
Weighted average shares for
diluted EPS 2,417 2,443
====== ======
Options on shares of common stock were excluded from the calculation of weighted
average shares for diluted EPS because their effects were antidilutive, as
follows:
1999 1998
---- ----
(in millions)
For the three months ended June 30, 37 39
For the six months ended June 30, 15 20
Note 4. Segment Reporting:
The Company's products include cigarettes, food (consisting principally of
coffee, cheese, chocolate confections, processed meat products and various
packaged grocery products) and beer. A subsidiary of the Company, Philip Morris
Capital Corporation, invests in leveraged and direct finance leases, other
tax-oriented financing transactions and third-party financial instruments. These
products and services constitute the Company's reportable segments of domestic
tobacco, international tobacco, North American food, international food, beer
and financial services.
The Company's management reviews operating companies income to evaluate segment
performance and allocate resources. Operating companies income for the
reportable segments excludes general corporate expenses, minority interest and
amortization of goodwill. Interest and other debt expense, net (consumer
products) and provision for income taxes are centrally managed at the corporate
level and, accordingly, such items are not presented by segment since they are
excluded from the measure of segment profitability reviewed by the Company's
management. Goodwill and amortization of goodwill are principally attributable
to the North American food segment.
-11-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Reportable segment data were as follows:
For the Six Months Ended
June 30,
------------------------
1999 1998
-------- --------
(in millions)
Operating revenues:
Domestic tobacco $ 9,195 $ 7,062
International tobacco 14,266 14,274
North American food 9,022 8,905
International food 4,446 4,805
Beer 2,208 2,176
Financial services 170 139
-------- --------
Total operating revenues $ 39,307 $ 37,361
======== ========
Operating companies income:
Domestic tobacco $ 2,069 $ 1,061
International tobacco 2,683 2,670
North American food 1,631 1,686
International food 521 507
Beer 314 286
Financial services 110 93
-------- --------
Total operating companies income 7,328 6,303
Amortization of goodwill (292) (290)
General corporate expenses (235) (248)
Minority interest (63) (62)
-------- --------
Total operating income 6,738 5,703
Interest and other debt expense, net (428) (482)
-------- --------
Total earnings before income taxes $ 6,310 $ 5,221
======== ========
For the Three Months Ended
June 30,
--------------------------
1999 1998
-------- --------
Operating revenues: (in millions)
Domestic tobacco $ 4,735 $ 3,726
International tobacco 6,926 6,947
North American food 4,626 4,540
International food 2,204 2,495
Beer 1,222 1,196
Financial services 97 74
-------- --------
Total operating revenues $ 19,810 $ 18,978
======== ========
-12-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
For the Three Months Ended
June 30,
--------------------------
1999 1998
-------- --------
Operating companies income: (in millions)
Domestic tobacco $ 1,151 $ 831
International tobacco 1,252 1,252
North American food 946 884
International food 275 272
Beer 178 158
Financial services 60 51
-------- --------
Total operating companies income 3,862 3,448
Amortization of goodwill (145) (144)
General corporate expenses (111) (133)
Minority interest (29) (31)
-------- --------
Total operating income 3,577 3,140
Interest and other debt expense, net (222) (238)
-------- --------
Total earnings before income taxes $ 3,355 $ 2,902
======== ========
Operating companies income for the first six months and the second quarter of
1999 includes pre-tax charges of $175 million and $45 million, respectively, in
the domestic tobacco segment related to the cost for separation programs
covering approximately 1,400 employees at the Philip Morris Incorporated ("PM
Inc.") Louisville, Kentucky manufacturing plant. In addition, operating
companies income for the first six months of 1999 includes pre-tax charges of
$157 million related primarily to voluntary workforce reductions covering
approximately 1,100 employees in the Company's North American food segment.
During the first six months and second quarter of 1998, operating companies
income for the domestic tobacco segment included pre-tax tobacco litigation
settlement charges of $1,005 million and $199 million, respectively, related to
settling health care cost recovery litigation. In addition, 1998 operating
companies income for the domestic tobacco segment was further reduced by pre-tax
charges of $309 million and $214 million for the first six months and second
quarter of 1998, respectively, related to voluntary early retirement and
separation programs. General corporate expenses for the first six months and the
second quarter of 1998 also included a pre-tax charge of $18 million related to
voluntary early retirement and separation programs at the Company's corporate
headquarters.
Note 5. Contingencies:
Legal proceedings covering a wide range of matters are pending or threatened in
various United States and foreign jurisdictions against the Company, its
subsidiaries and affiliates, including PM Inc., the Company's domestic tobacco
subsidiary, and Philip Morris International Inc. ("PMI"), the Company's
international tobacco subsidiary, and their respective indemnitees. Various
types of claims are raised in these proceedings, including product liability,
consumer protection, antitrust, tax, patent infringement, employment matters,
claims for contribution and claims of competitors and distributors.
Overview of Tobacco-Related Litigation
Types and Number of Cases
Pending claims related to tobacco products generally fall within the following
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, (iii) health care cost recovery cases brought by governmental (both
domestic and foreign) and non-governmental plaintiffs seeking
-13-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
reimbursement for health care expenditures allegedly caused by cigarette
smoking, and (iv) other tobacco-related litigation, including suits by former
asbestos manufacturers seeking contribution or reimbursement for amounts
expended in connection with the defense and payment of asbestos claims that were
allegedly caused in whole or in part by cigarette smoking. Damages claimed in
some of the smoking and health class actions, health care cost recovery cases
and asbestos contribution cases range into the billions of dollars. Plaintiffs'
theories of recovery and the defenses raised in the smoking and health and
health care cost recovery cases are discussed below. Exhibit 99.1 hereto lists
the smoking and health class actions, health care cost recovery cases and
certain other actions pending as of August 1, 1999, and discusses certain
developments in such cases since April 1, 1999.
In recent years, there has been a substantial increase in the number of
tobacco-related cases being filed.
As of August 1, 1999, there were approximately 425 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, compared with approximately 410 such
cases on August 1, 1998, and approximately 190 such cases on August 1, 1997.
Many of these cases are pending in New York, West Virginia and Florida. Twelve
of the individual cases involve allegations of various personal injuries
allegedly related to exposure to environmental tobacco smoke ("ETS").
In addition, as of August 1, 1999, there were approximately 55 smoking and
health putative class actions pending in the United States against PM Inc. and,
in some cases, the Company (including eight that involve allegations of various
personal injuries related to exposure to ETS), compared with approximately 55
such cases on August 1, 1998, and approximately 25 such cases on August 1, 1997.
Most of these actions purport to constitute statewide class actions and were
filed after May 1996 when 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.
As of August 1, 1999, there were approximately 80 health care cost recovery
actions pending in the United States (excluding the cases covered by the 1998
Master Settlement Agreement discussed below), compared with approximately 140
health care cost recovery cases pending on August 1, 1998, and 75 cases on
August 1, 1997.
There are also a number of tobacco-related actions pending outside the United
States against PMI and its affiliates and subsidiaries, including approximately
35 smoking and health cases initiated by one or more individuals (Argentina
(25), Brazil (1), Canada (1), Ireland (1), Italy (1), Japan (1), the Philippines
(1), Scotland (1), Spain (1) and Turkey (2)), up from approximately 20 such
cases in August 1998. In addition, there are nine smoking and health putative
class actions pending outside the United States (Australia (2), Brazil (2),
Canada (3), Israel (1; not officially served) and Nigeria (1)), up from four in
August 1998. In addition, during the past two years, health care cost recovery
actions have been brought in Israel, the Marshall Islands, British Columbia,
Canada and France (by a local agency of the French social security health
insurance system) and, in the United States, by Bolivia, Guatemala, Panama,
Nicaragua, Thailand (recently voluntarily dismissed), Venezuela and the State of
Rio de Janeiro, Brazil.
Industry Trial Results
There have been several jury verdicts in tobacco-related litigation during the
past three years. On July 9, 1999, a Louisiana jury returned a verdict in favor
of defendants in an individual smoking and health case against other cigarette
manufacturers. On July 7, 1999, the jury in the Engle smoking and health class
action pending in Florida returned a verdict against PM Inc. and several other
tobacco companies in "Phase One" of the trial, which concerned certain issues
determined by the trial court to be "common" to the causes of action of the
plaintiff class. Liability and damages in relation to any individual class
member were not decided in Phase One (see "Engle Trial" below for a more
detailed discussion of the Phase One verdict and certain other developments in
this case).
-14-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
In June 1999, a Mississippi jury returned a verdict in favor of defendants,
including PM Inc., in an action brought on behalf of an individual who died
allegedly as a result of exposure to ETS. In May 1999, a Missouri jury returned
a verdict in favor of defendant in an individual smoking and health case against
another cigarette manufacturer. Also in May 1999, a Tennessee jury returned a
verdict in favor of defendants, including PM Inc., in two of three individual
smoking and health cases consolidated for trial. In the third case (not
involving PM Inc.), the jury found liability against defendants and apportioned
fault between plaintiff and defendants equally. Under Tennessee's system of
modified comparative fault, because the jury found plaintiff's fault equal to
that of the defendants, recovery was not permitted. In March 1999, an Oregon
jury awarded $800,000 in actual damages, $21,500 in medical expenses and $79.5
million in punitive damages against PM Inc. In February 1999, a California jury
awarded $1.5 million in compensatory damages and $50 million in punitive damages
against PM Inc. The punitive damage awards in the Oregon and California actions
have been reduced to $32 million and $25 million, respectively. In July 1999,
the court denied PM Inc.'s motion for a new trial and its motion for a judgment
notwithstanding the verdict in the Oregon case. PM Inc. is appealing this
decision as well as the verdicts and the damage awards in these cases. In March
1999, a jury returned a verdict in favor of defendants, including PM Inc., on
all counts in a union health care cost recovery action brought on behalf of
approximately 114 employer-employee trust funds in Ohio. Plaintiffs' motion for
a new trial has been denied and plaintiffs are appealing to the United States
Sixth Circuit Court of Appeals.
Previously, juries had returned verdicts for defendants in three individual
smoking and health cases and in one individual ETS smoking and health case. In
January 1999, a Florida court set aside a jury award totaling approximately $1
million in a smoking and health case against another United States cigarette
manufacturer and ordered a new trial in the case. In June 1998, a Florida
appeals court reversed a $750,000 jury verdict awarded in August 1996 against
another United States cigarette manufacturer and the Florida Supreme Court has
since agreed to review this ruling. In 1997, a court in Brazil awarded
plaintiffs in a smoking and health case the Brazilian currency equivalent of
$81,000, attorneys' fees and a monthly annuity for 35 years equal to two-thirds
of the deceased smoker's last monthly salary. In March 1999, an appeals court
reversed the trial court's award and dismissed the case. Neither the Company nor
its affiliates were parties to that action.
Engle Trial
Trial in this Florida smoking and health class action case began in July 1998.
The plaintiff class seeks compensatory and punitive damages, each in excess of
one hundred billion dollars, as well as attorneys' fees and court costs. The
class consists of all Florida residents and citizens, and their survivors, who
have suffered, presently suffer or have died from diseases and medical
conditions caused by their addiction to cigarettes that contain nicotine.
On July 7, 1999, the jury returned a verdict against defendants in Phase One of
the three phase trial plan. The Phase One verdict concerned certain issues
determined by the trial court to be "common" to the causes of action of the
plaintiff class. Among other things, the jury found that smoking cigarettes
causes twenty diseases or medical conditions, that cigarettes are addictive or
dependence producing, defective and unreasonably dangerous, that defendants made
materially false statements with the intention of misleading smokers, that
defendants concealed or omitted material information concerning the health
effects and/or the addictive nature of smoking cigarettes and agreed to
misrepresent and conceal the health effects and/or the addictive nature of
smoking cigarettes, and that defendants were negligent and engaged in extreme
and outrageous conduct or acted with reckless disregard with the intent to
inflict emotional distress. The jury also found that defendants' conduct "rose
to a level that would permit a potential award or entitlement to punitive
damages."
Liability and damages in relation to any individual class member were not
decided in Phase One. Phase Two of the trial plan is scheduled to commence on
September 7, when two of the named plaintiffs will have their claims adjudicated
in a consolidated trial before the same jury which returned the verdict in Phase
One. Under the trial plan, the jury in Phase Two will determine issues of
specific causation, reliance, affirmative defenses, and other
individual-specific issues related to the claims of the two named plaintiffs and
their entitlement to damages, if any.
-15-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Phase Three of the trial plan would address other class members' claims,
including issues of specific causation, reliance, affirmative defenses and other
individual-specific issues regarding entitlement to damages, in individual
trials before separate juries.
On July 29, 1999, the trial judge denied defendants' motions to set aside the
Phase One verdict, to grant a new trial and to decertify the class. By order
dated July 30, 1999 and supplemented on August 2, 1999 (together, the "order"),
the trial judge amended the trial plan in respect of the manner of determining
punitive damages, if any. The order provides that the jury in Phase Two will
determine punitive damages, if any, on a dollar amount basis for the entire
qualified class.
Defendants will seek immediate appellate relief from the order on various
grounds including that (i) the order violates the appellate court's earlier
ruling that "individual issues will have to be tried as to each class member,
principally the issue of damages", (ii) under applicable law, punitive damages
may not be awarded to any particular plaintiff before first determining that
defendants are liable to that plaintiff and the amount of actual harm caused to
that plaintiff, (iii) under the U.S. Constitution, as recently decided by the
U.S. Supreme Court, a punitive damage award must bear a reasonable relationship
to actual damages (which is an impossibility under the amended trial plan
because liability and actual damages will not be determined at the time punitive
damages, if any, are set), (iv) the order effectively and unlawfully certifies a
new class for purposes of determining punitive damages, and (v) the order is
unlawful and unconstitutional on other enumerated grounds. Although there is no
assurance that appellate review will be forthcoming at this stage of the
proceedings, PM Inc. and the Company believe that if appellate review is granted
it should be successful.
If appellate review is not forthcoming at this stage or is not successful, it is
unclear how the order would be implemented. The order provides that the punitive
damage amount, if any, should be standard as to each class member and
acknowledges that the actual size of the class will not be known until the last
case has withstood appeal, i.e., the punitive damage amount, if any, determined
for the entire qualified class, would be divided equally among those plaintiffs
who are ultimately successful. The order does not address whether defendants
would be required to pay the punitive damage award, if any, prior to a
determination of claims of all class members, a process that could take years to
conclude. PM Inc. and the Company do not believe that an adverse class-wide
punitive damage award in Phase Two would permit entry of a judgment at that time
that would require the posting of a bond to stay its execution pending appeal or
that any party would be entitled to execute on such a judgment in the absence of
a bond. However, in a worst case scenario, it is possible that a judgment for
punitive damages could be entered in an amount not capable of being bonded,
resulting in an execution of the judgment before it could be set aside on
appeal. PM Inc. and the Company believe that such a result would be
unconstitutional and would also violate Florida laws. PM Inc. and the Company
will take all appropriate steps to seek to prevent this worst case scenario from
occurring and believe these efforts should be successful.
On August 2, 1999, PM Inc. and other defendants filed a motion to disqualify the
trial judge after recently having called to their attention press reports
stating that the judge is a former smoker. The motion asserts among other things
that the trial judge was required to disqualify himself because he has a serious
medical condition of a type that the plaintiffs claim and the jury has now found
is caused by smoking, making him financially interested in the result of the
case and, under plaintiffs' theory of the case, a potential member of the
plaintiff class. On August 4, 1999, the trial judge denied the disqualification
motion; PM Inc. and the Company believe that the denial was in error and
defendants have appealed the denial.
PM Inc. and the Company remain of the view that the Engle case should not have
been certified as a class action. That certification is inconsistent with the
overwhelming majority of federal and state court decisions which have held that
mass smoking and health claims are inappropriate for class treatment. PM Inc.
intends to challenge the class certification, as well as other numerous
reversible errors that it believes occurred during the Phase One trial, at the
earliest time that an appeal of these issues is permissible under Florida law.
In any event, PM Inc. would be entitled to appeal these issues following any
judgment in favor of an individual named or absent class member plaintiff. PM
Inc. and the Company believe that such an appeal should prevail.
-16-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Upcoming Trial Dates
As set forth in Exhibit 99.3, additional cases against PM Inc. and, in some
cases, the Company as well, are scheduled for trial through the end of 2000,
including six health care cost recovery actions, two purported smoking and
health class actions, two asbestos contribution cases (discussed below), two
"Proposition 65" cases (discussed below) and approximately 16 individual smoking
and health cases. Cases against other tobacco companies are also scheduled for
trial during this period. Trial dates, however, are subject to change.
Litigation Settlements
In November 1998, PM Inc. and certain other United States tobacco product
manufacturers entered into the Master Settlement Agreement (the "MSA") with 46
states, the District of Columbia, the Commonwealth of Puerto Rico, Guam, the
United States Virgin Islands, American Samoa and the Northern Marianas to settle
asserted and unasserted health care cost recovery and other claims. PM Inc. and
certain other United States tobacco product manufacturers had previously settled
similar claims brought by Mississippi, Florida, Texas and Minnesota (together
with the MSA, the "State Settlement Agreements") and an ETS smoking and health
class action brought on behalf of airline flight attendants. The State
Settlement Agreements and certain ancillary agreements are filed as exhibits to
various of the Company's reports filed with the Securities and Exchange
Commission, and such agreements and the ETS settlement are discussed in detail
therein.
The settlement agreements require that the domestic tobacco industry make
substantial annual payments in the following amounts (excluding future annual
payments contemplated by the agreement with tobacco growers discussed below),
subject to adjustment for several factors, including inflation, market share and
industry volume: 1999, $4.2 billion (of which PM Inc. has paid a majority of its
share); 2000, $9.2 billion; 2001, $9.9 billion; 2002, $11.3 billion; 2003, $10.9
billion; 2004 through 2007, $8.4 billion; and, thereafter, $9.4 billion. In
addition, the domestic tobacco industry is required to pay settling plaintiffs'
attorneys' fees, subject to an annual cap of $500 million, as well as additional
amounts as follows: 1999, $450 million; 2000, $416 million; and 2001 through
2002, $250 million. These payment obligations are the several and not joint
obligations of each settling defendant. PM Inc.'s portion of the future adjusted
payments and legal fees, which is not currently estimable, will be based on its
share of domestic cigarette shipments in the year preceding that in which the
payment is due.
The State Settlement Agreements also include provisions, discussed below in
Management's Discussion and Analysis of Financial Condition and Results of
Operations, relating to advertising and marketing restrictions, public
disclosure of certain industry documents, limitations on challenges to certain
tobacco control and underage use laws, lobbying activities and other provisions.
As set forth in Exhibit 99.2, the MSA has been initially approved by trial
courts in all settling jurisdictions. If a jurisdiction does not obtain "final
judicial approval" (as defined in Exhibit 99.2) of the MSA by December 31, 2001,
then, unless the settling defendants and the relevant jurisdiction agree
otherwise, the agreement will be terminated with respect to such jurisdiction.
As part of the MSA, the settling defendants committed to work cooperatively with
the tobacco-growing community to address concerns about the potential adverse
economic impact of the MSA on that community. To that end, the four major
domestic tobacco product manufacturers, including PM Inc., have agreed to
participate in the establishment of a $5.15 billion trust fund to be
administered for the benefit of the tobacco-growing community. The trust will be
funded by these four manufacturers over 12 years, beginning in 1999. PM Inc. has
agreed to pay $300 million into the trust in 1999, which amount was charged
against 1998 operating companies income. Subsequent industry payments are to be
adjusted for several factors, including inflation and United States cigarette
volume, and are to be allocated based on each manufacturer's relative market
share.
-17-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
The Company believes that the State Settlement Agreements may materially
adversely affect the business, volume, results of operations, cash flows or
financial position of PM Inc. and the Company in future periods. The degree of
the adverse impact will 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, and the effect of
any resulting cost advantage of manufacturers not subject to the MSA and the
other State Settlement Agreements. As of August 1, 1999, manufacturers
representing almost all domestic shipments in 1998 had agreed to become subject
to the terms of the MSA.
Certain litigation has arisen out of the State Settlement Agreements, including
the actions described below, as well as actions in California, Colorado,
Florida, Illinois and Wisconsin in which plaintiffs are seeking a portion of the
state's settlement proceeds.
In December 1998, a putative class action was filed against PM Inc. and certain
other domestic tobacco manufacturers on behalf of a class consisting of citizens
of the United States who consume tobacco products manufactured by defendants.
One count of the complaint alleges that defendants conspired to raise the prices
of their tobacco products in order to pay the costs of the MSA in violation of
the federal antitrust laws. The other two counts allege that the actions of
defendants amount to an unconstitutional deprivation of property without due
process of law and an unlawful burdening of interstate trade. The complaint
seeks unspecified damages (to be trebled under the antitrust count), injunctive
and declaratory relief, costs and attorneys' fees. In April 1999, the court
granted defendants' motions for summary judgment and plaintiffs have appealed.
In February 1999, a putative class action was filed on behalf of tobacco
consumers in the United States against the States of California and Utah, other
public entity defendants, certain domestic tobacco manufacturers, including PM
Inc., and others, challenging the MSA. Plaintiffs are seeking, among other
things, an order (i) prohibiting the states from collecting any monies under the
MSA, (ii) restraining the domestic tobacco manufacturers from further collection
of price increases related to the MSA and compelling them to reimburse to
plaintiffs all monies paid by plaintiffs in the form of price increases related
to the MSA, and (iii) declaring the MSA "unfair, discriminatory,
unconstitutional and unenforceable."
In April 1999, a putative class action was filed on behalf of all firms who
directly buy cigarettes in the United States from defendant tobacco
manufacturers. The complaint alleges violation of antitrust law, based in part
on the MSA. Plaintiffs seek treble damages computed as three times the
difference between current prices and the price plaintiffs would have paid for
cigarettes in the absence of an alleged conspiracy to restrain and monopolize
trade in the domestic cigarette market, together with attorneys' fees.
Plaintiffs also seek injunctive relief against certain aspects of the MSA and
against PM Inc.'s acquisition of the U.S. rights to manufacture and market three
cigarette trademarks, L&M, Lark and Chesterfield.
-18-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
A description of the smoking and health litigation, health care cost recovery
litigation and certain other proceedings 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, breach of special duty, 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. In certain of these cases,
plaintiffs claim that cigarette smoking exacerbated the injuries caused by their
exposure to asbestos. Plaintiffs in the smoking and health actions seek various
forms of relief, including compensatory and punitive damages, treble/multiple
damages and other statutory damages and penalties, creation of medical
monitoring and smoking cessation funds, disgorgement of profits, and injunctive
and equitable relief. Defenses raised in these cases include lack of proximate
cause, assumption of the risk, comparative fault and/or contributory negligence,
statutes of limitations and preemption by the Federal Cigarette Labeling and
Advertising Act.
In May 1996, the Fifth Circuit Court of Appeals in the Castano case held that a
putative class consisting of all "addicted" smokers nationwide did not meet the
standards and requirements of the federal rules governing class actions. Since
this class decertification, lawyers for plaintiffs have filed numerous smoking
and health class action suits in various state and federal courts. In general,
these cases purport to be brought on behalf of residents of a particular state
or states (although a few cases purport to be nationwide in scope) and raise
"addiction" claims similar to those raised in the Castano case and, in many
cases, claims of physical injury as well. As of August 1, 1999, smoking and
health class actions were pending in Alabama, Arkansas, California, District of
Columbia, Florida, Hawaii, Illinois, Indiana, Iowa, Louisiana, Maryland,
Massachusetts, Michigan, Minnesota, Missouri, Nevada, New Jersey, New Mexico,
New York, North Carolina, Oklahoma, Pennsylvania, South Carolina, Tennessee,
Texas, Utah, Virginia and West Virginia, as well as in Australia, Brazil,
Canada, Israel and Nigeria. Class certification has been denied or reversed by
courts in 17 smoking and health class actions involving PM Inc. in Arkansas,
Louisiana, District of Columbia, Illinois, New York (2), Pennsylvania, Puerto
Rico, New Jersey (6), Ohio, Wisconsin and Kansas, while classes remain certified
in three cases in Florida, Louisiana and Maryland. A number of these class
certification decisions are on appeal. In May 1999, the United States Supreme
Court declined to review the Third Circuit Court of Appeals' decision to affirm
a lower court's decertification of a class. Class certification motions are
pending in a number of the other putative smoking and health class actions. As
mentioned above, one ETS smoking and health class action was settled in 1997.
-19-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Health Care Cost Recovery Litigation
In certain of the pending proceedings, domestic and foreign governmental
entities and non-governmental plaintiffs, including union health and welfare
funds ("unions"), native American tribes, insurers and self-insurers, taxpayers
and others are seeking reimbursement of health care cost expenditures allegedly
caused by tobacco products and, in some cases, for future expenditures and
damages as well. Certain of these cases purport to be brought on behalf of a
class of plaintiffs and, in some cases, the class has been certified by the
court. In one health care cost recovery case, private citizens seek recovery of
alleged tobacco-related health care expenditures incurred by the federal
Medicare program. In another, Blue Cross subscribers seek 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/multiple damages and other
statutory damages and penalties, 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 include the
equitable claim that the tobacco industry was "unjustly enriched" by plaintiffs'
payment of health care costs allegedly attributable to smoking, 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 include failure to state a valid claim, lack of benefit,
adequate remedy at law, "unclean hands" (namely, that plaintiffs cannot obtain
equitable relief because they participated in, and benefited from, the sale of
cigarettes), lack of antitrust injury, federal preemption, lack of proximate
cause, remoteness of injury, lack of statutory authority to bring suit 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)
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 any actions as subrogees of individual health care recipients
and should be subject to all defenses available against the injured party.
Excluding the cases covered by the MSA, as of August 1, 1999, there were
approximately 80 health care cost recovery cases pending in the United States
against PM Inc. and, in some cases, the Company, of which approximately 50 were
filed by unions. Health care cost recovery actions have also been brought in
Israel, the Marshall Islands, British Columbia, Canada and France and, in the
United States, by Bolivia, Guatemala, Panama, Nicaragua, Thailand (voluntarily
dismissed), Venezuela and the State of Rio de Janeiro, Brazil. The actions
brought by Bolivia, Guatemala, Nicaragua and Venezuela have been consolidated
for pre-trial purposes and transferred to the United States District Court for
the District of Columbia. Other foreign entities and others have stated that
they are considering filing health care cost recovery actions. In January 1999,
President Clinton announced that the United States Department of Justice is
preparing a litigation plan to take tobacco companies to court and to use
recovered funds to strengthen Medicare. Recent press reports indicate that the
Department of Justice is continuing its assessment of possible theories for
proceeding.
Recently, three federal appeals courts issued rulings in health care cost
recovery actions that were favorable to the tobacco industry. In March 1999, the
United States Third Circuit Court of Appeals affirmed the district court's final
judgment dismissing plaintiffs' complaint and ruling that "all of plaintiffs'
primary claims [were] too remote from any alleged wrongdoing of defendants, and
other claims [were] concomitantly lacking in merit" and failed on proximate
cause grounds. In April 1999, the United States Second Circuit Court of Appeals
-20-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
reversed another district court's order denying defendants' motion to dismiss on
remoteness grounds and instructed the district court to dismiss the complaint.
Similarly, in July 1999, the United States Ninth Circuit Court of Appeals
affirmed the trial court's August 3, 1998 order that granted defendants' motion
for judgment on the pleadings. In its opinion, the Ninth Circuit ruled that
plaintiffs' claims were barred by the remoteness rule, stating that it agreed
with rulings by the Third and Second Circuit Courts of Appeals that "plaintiffs'
RICO and antitrust claims are 'too remote' from defendants' alleged wrongdoing
to allow recovery." The court further held that plaintiffs' claims were
predicated upon "personal injury" and are not recoverable under the Oregon
Unfair Trade Practices Act. The court went on to hold that plaintiffs' claims
for fraud were barred under Oregon law ("...for the same reasons that proximate
cause did not exist for plaintiffs' RICO and antitrust claims, proximate cause
is lacking for their fraud claim"). In addition, the court held that plaintiffs
could not assert their claims for unjust enrichment and for civil conspiracy.
Although there have been some decisions to the contrary, to date most lower
courts that have decided motions in these cases have dismissed all or most of
the claims against the industry. In March 1999, in the only union case to go to
trial thus far, the jury returned a verdict in favor of defendants on all
counts. Plaintiffs' motion for a new trial has been denied and an appeal of that
ruling is pending.
Certain Other Tobacco-Related Litigation
Asbestos Contribution Cases: As of August 1, 1999, eleven suits had been filed
by former asbestos manufacturers, asbestos manufacturers' personal injury
settlement trusts and an insurance company against domestic tobacco
manufacturers, including PM Inc. and others. These cases seek, among other
things, contribution or reimbursement for amounts expended in connection with
the defense and payment of asbestos claims that were allegedly caused in whole
or in part by cigarette smoking. Plaintiffs in most of these cases also seek
punitive damages. The aggregate amounts claimed in these cases range into the
billions of dollars. Trials in two of these cases are scheduled to begin in
February 2000.
Marlboro Light/Ultra Light Cases: As of August 1, 1999, there were seven class
actions pending against PM Inc. and the Company, in Arizona, Florida,
Massachusetts, New Jersey, Ohio, Pennsylvania and Tennessee, on behalf of
individuals who purchased and consumed Marlboro Lights and, in one case,
Marlboro Ultra Lights, as well. These cases allege, in connection with the use
of the term "Lights" and/or "Ultra Lights," among other things, deceptive and
unfair trade practices and unjust enrichment, and seek injunctive and equitable
relief.
Retail Leaders Case: Three domestic tobacco manufacturers have filed suit
against PM Inc. seeking to enjoin the PM Inc. "Retail Leaders" program that
became available to retailers in October 1998. The complaint alleges that this
retail merchandising program is exclusionary and creates unreasonable restraint
of trade and unlawful monopolization. In addition to an injunction, plaintiffs
seek unspecified treble damages, attorneys' fees, costs and interest. In June
1999, the court issued a preliminary injunction enjoining PM Inc. from
prohibiting retail outlets that participate in the program at one of four levels
from installing competitive permanent signage in any section of the "industry
fixture" that displays or holds packages of cigarettes manufactured by a firm
other than PM Inc., requiring those outlets to allocate a percentage of
cigarette-related permanent signage to PM Inc. greater than PM Inc.'s market
share, or prohibiting retail outlets from advertising or conducting promotional
programs of cigarette manufacturers other than PM Inc. The preliminary
injunction applies only to certain accounts and does not affect any other aspect
or level of the Retail Leaders program.
Vending Machine Case: Plaintiffs, a purported nationwide class of cigarette
vending machine operators, allege that PM Inc. has violated the Robinson-Patman
Act in connection with its promotional and merchandising programs available to
retail stores and not available to cigarette vending machine operators.
Plaintiffs request
-21-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
actual damages, treble damages, injunctive relief, attorneys' fees and costs,
and other unspecified relief. In June 1999, the court denied plaintiffs' motion
for a preliminary injunction.
Proposition 65 Cases: Since July 1998, a number of suits have been filed in
California courts alleging that domestic cigarette manufacturers, including PM
Inc. and others, have violated a California statute known as "Proposition 65" by
not informing the public of the alleged risks of ETS to non-smokers. Plaintiffs
also allege violations of California's Business and Professions Code regarding
unfair and fraudulent business practices. Plaintiffs seek statutory penalties,
injunctions barring the sale of cigarettes or requiring issuance of appropriate
warnings, restitution, disgorgement of profits and other relief. The courts have
denied defendants' motions to dismiss in both of these cases. Trial in these
cases is scheduled to begin in February 2000.
Certain Other Actions
National Cheese Exchange Cases: In September 1997, a putative class action suit
consolidating several previously filed class actions was filed in Wisconsin
alleging that Kraft Foods, Inc. 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. Two other putative class actions containing allegations similar
to those in the Wisconsin class action were recently dismissed on motion by
courts in Illinois and California.
----------
One hundred eighty-eight 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 alleged unpaid taxes assessed to date is the Italian lira
equivalent of $2.5 billion. In addition, the Italian lira equivalent of $3.5
billion in interest and penalties has been assessed. The Company anticipates
that value-added and income tax assessments may also be received with respect to
subsequent years. All of the assessments are being vigorously contested. To
date, the Italian administrative tax court in Milan has overturned 127 of the
assessments. The decisions to overturn 66 assessments have been appealed by the
tax authorities. In a separate proceeding in Naples, in October 1997, a court
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 remain pending. In February 1998, the tax evasion charges were
dismissed by the criminal court in Naples following a determination that
jurisdiction was not proper, and the case file was transmitted to the public
prosecutor in Milan, who will determine whether to bring charges, in which case
a preliminary investigations judge will make a new finding as to whether there
should be a trial on these charges. 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
assessments and proceedings.
----------
It is not possible to predict the outcome of the litigation pending against the
Company and its subsidiaries. Litigation is subject to many uncertainties. Two
individual smoking and health cases in which PM Inc. is a defendant have been
decided unfavorably at the trial court level and are in the process of being
appealed, and an unfavorable verdict has been returned in the first phase of the
Engle smoking and health class action trial underway in Florida. It is possible
that additional cases could be decided unfavorably and that there could be
further adverse developments in the Engle case. An unfavorable outcome or
settlement of a pending smoking and health or health care cost recovery 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. These developments may negatively affect
the perception
-22-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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. The
present legislative and litigation environment is substantially uncertain, and
it is possible that the Company's business, volume, results of operations, cash
flows or financial position could be materially affected by an unfavorable
outcome or settlement of certain pending litigation or by the enactment of
federal or state tobacco legislation. 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. All such cases are, and will continue to be, vigorously
defended. However, the Company and its subsidiaries may enter into discussions
in an attempt to settle particular cases if they believe it is in the best
interests of the Company's stockholders to do so.
Note 6. Recently Issued Accounting Pronouncements:
During 1998, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which had an initial adoption date by the
Company of January 1, 2000. During the second quarter of 1999, the FASB
postponed the adoption date of SFAS No. 133 until January 1, 2001. SFAS No. 133
requires that all derivative financial instruments be recorded on the
consolidated balance sheets at their fair value. Changes in the fair value of
derivatives will be recorded each period in earnings or other comprehensive
earnings, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. Gains and losses on
derivative instruments reported in other comprehensive earnings will be
reclassified as earnings in the periods in which earnings are affected by the
hedged item. The Company has not yet determined the impact that adoption or
subsequent application of SFAS No. 133 will have on its financial position or
results of operations.
-23-
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Consolidated Operating Results
For the Six Months Ended June 30,
Operating Revenues
-------------------------
(in millions)
1999 1998
------- -------
Domestic tobacco $ 9,195 $ 7,062
International tobacco 14,266 14,274
North American food 9,022 8,905
International food 4,446 4,805
Beer 2,208 2,176
Financial services 170 139
------- -------
Operating revenues $39,307 $37,361
======= =======
Operating Income
-------------------------
(in millions)
1999 1998
------- -------
Domestic tobacco $ 2,069 $ 1,061
International tobacco 2,683 2,670
North American food 1,631 1,686
International food 521 507
Beer 314 286
Financial services 110 93
------- -------
Operating companies income 7,328 6,303
Amortization of goodwill (292) (290)
General corporate expenses (235) (248)
Minority interest (63) (62)
------- -------
Operating income $ 6,738 $ 5,703
======= =======
For the Three Months Ended June 30,
Operating Revenues
-------------------------
(in millions)
1999 1998
------- -------
Domestic tobacco $ 4,735 $ 3,726
International tobacco 6,926 6,947
North American food 4,626 4,540
International food 2,204 2,495
Beer 1,222 1,196
Financial services 97 74
------- -------
Operating revenues $19,810 $18,978
======= =======
-24-
For the Three Months Ended June 30, (continued)
Operating Income
-------------------------
(in millions)
1999 1998
------- -------
Domestic tobacco $ 1,151 $ 831
International tobacco 1,252 1,252
North American food 946 884
International food 275 272
Beer 178 158
Financial services 60 51
------- -------
Operating companies income 3,862 3,448
Amortization of goodwill (145) (144)
General corporate expenses (111) (133)
Minority interest (29) (31)
------- -------
Operating income $ 3,577 $ 3,140
======= =======
Amortization of goodwill is primarily attributable to the North American food
segment for all periods presented.
Results of Operations for the Six Months Ended June 30, 1999
Operating revenues for the first six months of 1999 increased $1.9 billion
(5.2%) over 1998, due primarily to an increase in revenues from domestic tobacco
operations. Excluding the revenues of several international food businesses
divested since 1998, underlying operating revenues for the first six months of
1999 increased $2.0 billion (5.3%) over the comparable 1998 period.
Operating income for the first six months of 1999 increased $1,035 million
(18.1%) over the comparable 1998 period. Operating income for the first half of
1999 includes pre-tax charges of $175 million, principally for the cost of
separation programs covering approximately 1,400 employees at the Philip Morris
Incorporated ("PM Inc.") Louisville, Kentucky manufacturing plant (the
"Louisville plant"), and $157 million related to voluntary workforce reduction
programs covering approximately 1,100 employees at the Company's North American
food segment. Operating income for the first half of 1998 includes pre-tax
charges of $1,005 million related to tobacco litigation settlements with the
states of Minnesota, Mississippi and Texas and $327 million related primarily to
domestic tobacco voluntary early retirement and separation programs. Excluding
these pre-tax charges, as well as results from operations divested since the
beginning of 1998, operating income for 1999 increased $39 million (0.6%) from
the first six months of 1998, due primarily to higher operating income from the
Company's North American food operations. On a reported basis, operating
companies income, which is defined as operating income before general corporate
expenses, minority interest and amortization of goodwill, increased $1,025
million (16.3%) from the first six months of 1998, due primarily to a lower
level of pre-tax charges, principally for tobacco litigation settlements in the
domestic tobacco segment during the first six months of 1999. Excluding the
previously mentioned pre-tax charges, as well as the results of divested
operations, operating companies income increased $47 million (0.6%) from the
first six months of 1998.
Currency movements, primarily reflecting the strength of the U.S. dollar against
Eastern European and Latin American currencies as well as the continued
weakening of the euro during the first six months of 1999, decreased operating
companies income by $26 million. Although the Company cannot predict future
movements in currency rates, the continued strength of the dollar against these
currencies, if sustained during the remainder of 1999, could have an adverse
impact on operating revenues and operating companies income comparisons with
1998. In addition, the Company's businesses in Eastern European and certain
Latin American markets have been adversely affected by economic instability in
those areas. Although the
-25-
Company cannot predict future economic developments, the Company anticipates
that economic instability may continue to adversely affect its businesses in
those markets during the remainder of 1999.
Interest and other debt expense, net, decreased $54 million (11.2%) in the first
six months of 1999 from the comparable 1998 period. This decrease was due
primarily to higher interest income, lower average debt outstanding and lower
average interest rates on the Company's consumer products debt portfolio during
the first six months of 1999.
Diluted and basic EPS, which were $1.57 and $1.58, respectively, for the first
six months of 1999, increased by 22.7% and 23.4%, respectively, over the first
six months of 1998. These results reflect the charges for the previously
discussed 1999 and 1998 separation programs and the 1998 tobacco-related
litigation settlement charges. Excluding the after-tax impact of these items,
net earnings increased 2.2% to $4.0 billion, and both diluted and basic EPS
increased 2.5% to $1.65 and $1.66, respectively, compared to the comparable 1998
figures.
Results of Operations for the Three Months Ended June 30, 1999
Operating revenues for the second quarter of 1999 increased $832 million (4.4%)
over the comparable 1998 period, due primarily to an increase in revenues from
domestic tobacco operations. Excluding the revenues of several international
food businesses divested since 1998, underlying operating revenues for the
second quarter of 1999 increased $861 million (4.5%) over the second quarter of
1998.
Operating income for the second quarter of 1999 increased $437 million (13.9%)
over the comparable 1998 period. Second quarter 1999 operating income includes
pre-tax charges of $45 million, principally for a portion of the cost of the
aforementioned PM Inc. separation programs covering certain employees of the
Louisville plant. Operating income for the second quarter of 1998 includes
pre-tax charges of $199 million related to settling tobacco litigation with the
states of Mississippi and Texas and $232 million related primarily to domestic
tobacco voluntary early retirement and separation programs. Excluding these
pre-tax charges, as well as the results from operations divested since the
beginning of 1998, operating income for 1999 increased $54 million (1.5%) from
the second quarter of 1998 due primarily to higher operating income from North
American food operations. On a reported basis, operating companies income, which
is defined as operating income before general corporate expenses, minority
interest and amortization of goodwill, increased $414 million (12.0%) from the
second quarter of 1998, due primarily to a lower level of pre-tax charges,
principally for tobacco litigation settlements and employee separation programs,
in the domestic tobacco segment during the second quarter of 1999. Excluding the
previously mentioned pre-tax charges as well as the results of divested
operations, operating companies income increased $49 million (1.3%) from the
second quarter of 1998.
During the second quarter of 1999, currency movements, primarily the continued
strength of the U.S. dollar against Eastern European and certain Latin American
currencies, as well as the continued weakening of the euro, decreased operating
revenues by $177 million and operating companies income by $60 million versus
the comparable 1998 period. Although the Company cannot predict future movements
in currency rates, the continued strength of the dollar against these
currencies, if sustained, could have an adverse impact on operating revenues and
operating companies income for the remainder of 1999.
Interest and other debt expense, net, decreased $16 million (6.7%) in the second
quarter of 1999 from the comparable 1998 period. This decrease was due primarily
to higher interest income and lower average interest rates on the Company's
consumer products debt portfolio during the second quarter of 1999.
Diluted and basic EPS, which were both $0.84 for the second quarter of 1999,
increased by 18.3% and 16.7%, respectively, over the second quarter of 1998.
These results reflect the charges for the previously discussed 1999 and 1998
separation programs and the 1998 tobacco-related litigation settlements.
Excluding the after-
-26-
tax impact of these items, net earnings increased 2.9% to $2.1 billion, and both
diluted and basic EPS increased 3.7% to $0.85.
Year 2000
As many computer systems and other equipment with embedded chips or processors
(collectively, "Business Systems") use only two digits to represent the year,
they may be unable to process accurately certain data before, during or after
the year 2000. As a result, business and governmental entities are at risk for
possible miscalculations or systems failures causing disruptions in their
business operations. This is commonly known as the Year 2000 ("Y2K") or Century
Date Change ("CDC") issue. The CDC issue can arise at any point in the Company's
supply, manufacturing, processing, distribution and financial chains.
As described below, the Company and each of its operating subsidiaries have been
implementing a CDC readiness program with the objective of having all
significant Business Systems, including those that affect facilities and
manufacturing activities, functioning properly with respect to the CDC issue
before January 1, 2000, and taking other appropriate measures to minimize
possible disruptions to their business operations due to the CDC issue.
During the first phase of the CDC readiness program, those internal Business
Systems of the Company and its operating subsidiaries that are susceptible to
system failures or processing errors as a result of the CDC issue were
identified and assessed. This effort is complete.
The second phase of the CDC readiness program involves the actual remediation
and replacement of internal Business Systems. The Company and its operating
subsidiaries are using both internal and external resources to complete this
process. As of June 30, 1999, this effort, as well as the testing and
certification of individual systems for CDC readiness, was over 95% complete;
the remaining internal Business Systems are scheduled to be fully remediated,
tested and certified by the end of September 1999. Integration testing and
certification (i.e., the testing and certification of the interfaces among
individual Business Systems previously certified as Year 2000 ready as well as
the testing and certification of certain external linkages between the Company's
systems with those of third parties) is expected to be substantially completed
by the end of September 1999. These anticipated completion dates may be extended
somewhat if the Company and its operating subsidiaries continue to receive "more
compliant" software releases for programs previously certified as Year 2000
ready by software vendors and others. The Company believes that this should not
have a material adverse effect on its overall CDC readiness program.
As part of the CDC readiness program, significant service providers, vendors,
suppliers, customers and governmental entities ("Key Business Partners") that
are believed to be critical to continuing business operations have been
identified and steps have been undertaken in an attempt to assess their stage of
CDC readiness through questionnaires, interviews, on-site visits and other
available means. This initial evaluation is complete, although the monitoring
and reassessment of certain Key Business Partners continues. With the exception
of certain utilities and governmental entities (particularly outside the United
States), the Company currently believes that the vast majority of Key Business
Partners are making acceptable progress toward Year 2000 readiness and, in
general, should be able to provide required goods and services without material
disruptions. However, as of June 30, 1999, the Company considered approximately
700 of its more than 6,000 Key Business Partners to be higher risk, or likely to
suffer some Year 2000 related failures, of which approximately 600 are located
outside the United States. As discussed below, contingency plans are being
developed that seek to address these higher risk Key Business Partners.
Because of the vast number of Business Systems used by the Company and its
operating subsidiaries, the significant number of Key Business Partners, the
extent of the Company's foreign operations, including operations within
countries that are not actively promoting remediation of the CDC issue, the
Company
-27-
presently believes that its operating subsidiaries will experience some
disruption in their businesses due to the CDC issue. Because of the
interdependent nature of Business Systems, the Company and its operating
subsidiaries could be materially adversely affected if utilities, private
businesses and governmental entities with which they do business or that provide
essential services are not CDC ready. The Company currently believes that the
greatest risks of disruption in its operating subsidiaries' businesses exist in
certain international markets and with respect to the CDC readiness of certain
Key Business Partners. Each of the Company's operating subsidiaries is
finalizing its own risk assessment of the possible impact of the CDC issue on
its business operations. The Company currently believes that the most reasonably
likely worst case scenario entails some localized CDC disruptions that may
affect individual facilities or operations for short periods of time rather than
long-term, systemic problems. The possible consequences of these disruptions
include temporary plant closings, delays in the delivery of products, delays in
the receipt of supplies, invoice and collection errors, and inventory and supply
obsolescence. Depending on the number and severity of CDC-related disruptions,
it is possible that the business and results of operations of the Company and
its operating subsidiaries could be materially adversely affected by the CDC
issue. However, the Company believes that its CDC readiness program, including
the contingency plans discussed below, should reduce the adverse effect any such
disruptions may have.
The Company and its operating subsidiaries have substantially completed the
development of contingency plans intended to mitigate the possible business
disruptions that may result from the CDC issue, but are continuing to evaluate
and modify these plans as additional information becomes available. Contingency
plans fall into two categories: "event-triggered" and "preemptive."
Event-triggered plans are those that are implemented in response to actual Year
2000 events or disruptions as they arise, whereas preemptive strategies are
those that are implemented in advance of 2000 in order to avoid or minimize the
impact of anticipated or potential Year 2000 problems. The Company's
event-triggered and preemptive contingency plans include stockpiling raw,
packaging and promotional materials; increasing finished goods inventories at
the operating company, wholesale and retail levels; adjusting the timing of
promotional programs; securing alternate sources of supply, distribution and
warehousing; adjusting facility shut-down and start-up schedules; utilizing
manual workarounds; procuring back-up power generators and heat supply for key
plants; and other appropriate measures. The Company estimates that the
anticipated increases in year-end inventories and trade receivables contemplated
by the Company's preemptive contingency plans will likely result in incremental
cash outflows during 1999 of approximately $600 million, which should be
reversed in early 2000. In addition, the incremental cost of the preemptive
measures currently planned is estimated to be $85 million. The Company cannot
reasonably estimate at this time the aggregate cost of implementing its
event-triggered contingency plans, since such costs will depend on the nature
and extent of future Year 2000 events. However, it currently does not believe
that such costs, together with its preemptive contingency costs, should have a
material adverse effect 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 companies income for the Company's business
segments and the Company's cash flows.
As an adjunct to the contingency planning process, the Company and its operating
subsidiaries are actively preparing for the transition management phase of the
CDC readiness program. Transition management refers to the process to be used to
recover from CDC-related errors and interruptions that may occur before and
after the actual transition to the Year 2000. During the transition management
phase, there will be command and control structures in place to capture, direct
and track responses to CDC-related problems through to resolution. Transition
management teams will also prepare employees for the anticipated impact of the
Year 2000 on their roles and develop communication plans for the transition
period covering both the method in which communications will be conveyed (e.g.,
radio, cell phone, fax) and the content of communications.
It is currently estimated that the aggregate cost of the Company's CDC
compliance/remediation efforts will be approximately $550 million, of which
approximately $450 million has been spent. The remaining costs relate to
remediation efforts, the final testing and certification of Business Systems and
other CDC-related efforts, including incremental costs associated with
transition management that will be incurred in the Year 2000.
-28-
Generally, the above costs are being expensed as they are incurred and are being
funded through operating cash flow. These cost estimates do not include amounts
associated with the implementation of preemptive contingency plans
(approximately $85 million as discussed above) or event-triggered contingency
plans. The costs associated with the replacement of computerized systems,
hardware or equipment (estimated to be approximately $150 million),
substantially all of which would be capitalized, are also not included in the
above estimates. Other non-Year 2000 information technology projects have not
been materially affected by the Company's Year 2000 initiatives.
The Company's CDC readiness program is an ongoing process and the risk
assessments and estimates of costs and completion dates for various components
of the CDC readiness program described above are forward looking statements and
are subject to change. Factors that may cause such changes include, among
others, the continued availability of qualified personnel and other information
technology resources; the ability to identify and remediate all date-sensitive
lines of computer code and embedded chips; the adequacy of testing protocols
employed by the Company; the performance of Business Systems certified Year 2000
compliant by manufacturers, suppliers and other third parties; the continuing
receipt of "more compliant" software releases for programs previously certified
as Year 2000 compliant by software vendors and others; the timely receipt and
installation of CDC-ready replacement systems; the actions of governmental
agencies, utilities and other third parties with respect to the Year 2000 issue;
the ability to implement contingency plans; and the occurrence of broad-based or
systemic economic failures.
Euro
On January 1, 1999, eleven of the fifteen member countries of the European Union
established fixed conversion rates between their existing currencies ("legacy
currencies") and one common currency--the euro. At that time, the euro began
trading on currency exchanges and could be used in financial transactions.
Beginning in January 2002, new euro-denominated currency (bills and coins) will
be issued, and legacy currencies will be withdrawn from circulation. The
Company's operating subsidiaries affected by the euro conversion have
established and, where required, implemented plans to address the systems and
business issues raised by the euro currency conversion. These issues include,
among others, (1) the need to adapt computer and other business systems and
equipment to accommodate euro-denominated transactions; and (2) the competitive
impact of cross-border price transparency, which may make it more difficult for
businesses to charge different prices for the same products on a
country-by-country basis, particularly once the euro currency is issued in 2002.
The euro conversion has not had, and the Company currently anticipates that it
will not have, a material adverse impact on its financial condition or results
of operations.
Operating Results by Business Segment
Tobacco
Business Environment
The tobacco industry, both in the United States and abroad, has faced, and
continues to face, a number of issues that may adversely affect the business,
volume, results of operations, cash flows and financial position of PM Inc.,
Philip Morris International Inc. ("PMI") and the Company.
These issues, some of which are more fully discussed below, include legislation
or other governmental action seeking to ascribe to the industry responsibility
and liability for the adverse health effects associated with both smoking and
exposure to environmental tobacco smoke ("ETS"); increased smoking and health
litigation and recent jury verdicts against PM Inc., including in Phase One of
the Engle class action trial discussed above in Note 5. Contingencies; price
increases in the United States related to the settlement of certain tobacco
litigation; actual and proposed excise tax increases; an increase in diversion
into the United States market of product intended for
-29-
sale outside the United States; the issuance of final regulations by the United
States Food and Drug Administration (the "FDA") that, if upheld by the courts,
would regulate cigarettes as "drugs" or "medical devices"; governmental and
grand jury investigations; actual and proposed requirements regarding disclosure
of cigarette ingredients and other proprietary information, as well as the
testing of the yields of "tar," nicotine and other constituents found in
cigarette smoke; governmental and private bans and restrictions on smoking;
actual and proposed price controls and restrictions on imports in certain
jurisdictions outside the United States; actual and proposed restrictions
affecting tobacco manufacturing, marketing, advertising and sales outside the
United States; proposed legislation to eliminate the U.S. tax deductibility of
tobacco advertising and promotional costs; proposed legislation in the United
States to require the establishment of ignition propensity performance standards
for cigarettes; the diminishing social acceptance of smoking and increased
pressure from anti-smoking groups and unfavorable press reports; and other
tobacco legislation that may be considered by the Congress, the states and other
jurisdictions inside and outside the United States.
Excise Taxes: Cigarettes are subject to substantial federal and state excise
taxes in the United States and to similar taxes in most foreign markets. The
United States federal excise tax on cigarettes is currently $0.24 per pack of 20
cigarettes and is scheduled to increase to $0.34 per pack in the year 2000 and
then to $0.39 per pack in 2002. In general, excise taxes and other taxes on
cigarettes have been increasing. These taxes vary considerably and, when
combined with sales taxes and the current federal excise tax, may be as high as
$1.50 per pack in a given locality in the United States. Congress has been
considering significant increases in the federal excise tax or other payments
from tobacco manufacturers, and the Clinton Administration's fiscal year 2000
budget proposal includes an additional increase of $0.55 per pack in the federal
excise tax. Increases in other cigarette-related taxes have been proposed at the
state and local level and in many jurisdictions outside the United States.
In the opinion of PM Inc. and PMI, 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.
Federal Trade Commission ("FTC"): In September 1997, the FTC issued a request
for public comments on its proposed revision of its "tar" and nicotine test
methodology and reporting procedures established by a 1970 voluntary agreement
among domestic cigarette manufacturers. In February 1998, PM Inc. and three
other domestic cigarette manufacturers filed comments on the proposed revisions.
In November 1998, the FTC wrote to the Department of Health and Human Services
requesting its assistance in developing specific recommendations on the future
of the FTC's program for testing the "tar," nicotine and carbon monoxide content
of cigarettes.
FDA Regulations: The FDA has promulgated regulations asserting jurisdiction over
cigarettes as "drugs" or "medical devices" under the provisions of the Food,
Drug and Cosmetic Act. These 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. 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
regulations, and could materially adversely affect the business, volume, results
of operations, cash flows and financial position of PM Inc. and the Company. In
August 1998, the Fourth Circuit Court of Appeals ruled that the FDA does not
have the authority to regulate tobacco products, and declared the FDA's
regulations invalid. In April 1999, the U.S. Supreme Court agreed to review the
Fourth Circuit's decision. The ultimate outcome of this litigation cannot be
predicted.
Ingredient Disclosure Laws: The Commonwealth of Massachusetts has enacted
legislation to require cigarette manufacturers to report yearly the flavorings
and other ingredients used in each brand style of cigarettes sold in the
Commonwealth, and on a qualified, by-brand basis to provide "nicotine-yield
ratings" for their products based on standards established by the Commonwealth.
Enforcement of the ingredient disclosure provisions of
-30-
the statute could result in the public disclosure of valuable proprietary
information. In December 1997, a federal district court in Boston granted the
tobacco company plaintiffs a preliminary injunction and enjoined the
Commonwealth from enforcing the ingredient disclosure provisions of the
legislation. In November 1998, the First Circuit Court of Appeals affirmed this
ruling. In addition, both parties' cross-motions for summary judgment are
pending before the district court. The ultimate outcome of this lawsuit cannot
be predicted. Similar legislation has been enacted or proposed in other states.
Some jurisdictions outside the United States have also enacted or proposed some
form of ingredient disclosure legislation or regulation.
Health Effects of Smoking and Exposure to ETS: Reports with respect to the
health risks of cigarette smoking have been publicized for many years, and the
sale, promotion and use of cigarettes continue to be subject to increasing
governmental regulation. Since 1964, the Surgeon General of the United States
and the Secretary of Health and Human Services have released a number of reports
linking cigarette smoking with a broad range of health hazards, including
various types of cancer, coronary heart disease and chronic lung disease, and
recommending various governmental measures to reduce the incidence of smoking.
The 1988, 1990, 1992 and 1994 reports focus upon the "addictive" nature of
cigarettes, the effects of smoking cessation, the decrease in smoking in the
United States, the economic and regulatory aspects of smoking in the Western
Hemisphere, and cigarette smoking by adolescents, particularly the "addictive"
nature of cigarette smoking in adolescence.
Studies with respect to the health risks of ETS to nonsmokers (including lung
cancer, respiratory and coronary illnesses, and other conditions) have also
received significant publicity. In 1986, the Surgeon General of the United
States and the National Academy of Sciences reported that nonsmokers were at
increased risk of lung cancer and respiratory illness due to ETS. In 1993, the
U.S. Environmental Protection Agency (the "EPA") issued a report relating to
certain health effects of ETS. The report included a risk assessment relating to
the association between ETS and lung cancer in nonsmokers, and a determination
by the EPA to classify ETS as a "Group A" carcinogen. In July 1998, a federal
district court vacated those sections of the report relating to lung cancer,
finding that the EPA may have reached different conclusions had it complied with
certain relevant statutory requirements. The federal government has appealed the
court's ruling. The ultimate outcome of this litigation cannot be predicted.
In October 1997, at the request of the United States Senate Judiciary Committee,
the Company provided the Committee with a document setting forth the Company's
position on a number of issues. On the issues of the role played by cigarette
smoking in the development of lung cancer and other diseases in smokers, and
whether nicotine, as found in cigarette smoke, is "addictive," the Company
stated that despite the differences that may exist between its views and those
of the public health community, it would, in order to ensure that there will be
a single, consistent public health message on these issues, refrain from
debating the issues other than as necessary to defend itself and its opinions in
the courts and other forums in which it is required to do so. The Company also
stated that in relation to these issues, and the health effects of exposure to
ETS, the Company is prepared to defer to the judgment of public health
authorities as to what health warning messages will best serve the public
interest.
Other Legislative Initiatives: In recent years, various members of Congress have
introduced legislation, some of which has been the subject of hearings or floor
debate, that would subject cigarettes to various regulations under the
Department of Health and Human Services or regulation under the Consumer
Products Safety Act, establish anti-smoking educational campaigns or
anti-smoking programs, or provide additional funding for governmental
anti-smoking activities, further restrict the advertising of cigarettes,
including requiring additional warnings on packages and in advertising,
eliminate or reduce the tax deductibility of tobacco advertising, provide that
the Federal Cigarette Labeling and Advertising Act and the Smoking Education Act
not be used as a defense against liability under state statutory or common law,
and allow state and local governments to restrict the sale and distribution of
cigarettes. Legislative initiatives adverse to the tobacco industry have also
been considered in a number of jurisdictions outside the United States.
-31-
It is not possible to determine the outcome of the FDA regulatory initiative or
the related litigation discussed above, or to predict what, if any, other
foreign or domestic governmental legislation or regulations will be adopted
relating to the manufacturing, advertising, sale or use of cigarettes, or to the
tobacco industry generally. However, if any or all of the foregoing were to be
implemented, the business, volume, results of operations, cash flows and
financial position of PM Inc., PMI and the Company could be materially adversely
affected.
Governmental and Grand Jury Investigations: 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. Present and former employees of PM Inc. have testified or have been
asked to testify in connection with certain of these matters. The investigations
include four grand jury investigations being conducted by: the United States
Department of Justice in Washington, D.C., relating to issues raised in
testimony provided by tobacco industry executives before Congress and other
related matters; the United States Department of Justice Antitrust Division in
the Eastern District of Pennsylvania relating to tobacco leaf purchases; the
United States Attorney for the Northern District of New York relating to alleged
contraband transactions primarily in Canadian-brand tobacco products; and the
United States Attorney for the Western District of New York apparently relating
to the sale of cigarettes by third parties upon which state taxes had allegedly
not been paid. PMI and its subsidiary, Philip Morris Duty Free Inc., have also
received subpoenas in connection with the investigation being conducted by the
United States Attorney for the Northern District of New York. While the outcomes
of these investigations cannot be predicted, PM Inc., PMI and Philip Morris Duty
Free Inc. believe they have acted lawfully.
Tobacco-Related Litigation and Threatened Federal Action: There is substantial
litigation pending related to tobacco products in the United States and certain
foreign jurisdictions. (See Note 5. Contingencies, above for a discussion of
such litigation.) In addition, in January 1999 President Clinton announced that
the United States Department of Justice is preparing a litigation plan to take
tobacco companies to court and to use the recovered funds to strengthen
Medicare. Recent press reports indicate that the Department of Justice is
continuing its assessment of possible theories for proceeding.
State Settlement Agreements: As discussed in Note 5. Contingencies, during 1997
and 1998, PM Inc. and other major domestic tobacco product manufacturers entered
into agreements with states and various U.S. jurisdictions settling asserted and
unasserted health care cost recovery and other claims. These settlements provide
for substantial annual payments. They also place numerous restrictions on the
tobacco industry's conduct of its business operations, including restrictions on
the advertising and marketing of cigarettes. Among these are restrictions or
prohibitions on the following: targeting youth; use of cartoon characters; use
of brand name sponsorships and brand name non-tobacco products; outdoor and
transit brand advertising; payments for product placement; and free sampling. In
addition, the settlement agreements require companies to affirm corporate
principles to reduce underage use of cigarettes; impose requirements regarding
lobbying activities; mandate public disclosure of certain industry documents;
limit the industry's ability to challenge certain tobacco control and underage
use laws; and provide for the dissolution of certain tobacco-related trade
associations and place restrictions on the establishment of any replacement
organizations.
-32-
Operating Results
For the Six Months Ended June 30,
-------------------------------------------
Operating
Operating Revenues Companies Income
------------------- -------------------
(in millions)
1999 1998 1999 1998
------- ------- ------- -------
Domestic tobacco $ 9,195 $ 7,062 $ 2,069 $ 1,061
International tobacco 14,266 14,274 2,683 2,670
------- ------- ------- -------
Total tobacco $23,461 $21,336 $ 4,752 $ 3,731
======= ======= ======= =======
Historical operating revenues and operating companies income for the domestic
tobacco and international tobacco operations were reclassified to reflect the
transfer of tobacco sales in certain U.S. territories from the international
tobacco business to the domestic tobacco business, consistent with the terms of
PM Inc.'s settlements of state health care cost recovery and other claims.
Domestic tobacco. During the first six months of 1999, PM Inc.'s operating
revenues increased $2.1 billion (30.2%) over the comparable 1998 period, due
primarily to pricing ($2.8 billion), partially offset by lower volume ($676
million).
During February 1999, PM Inc. announced plans to phase out cigarette production
at its Louisville plant. As a result, during the first six months of 1999, PM
Inc. recorded pre-tax charges of $175 million, principally for the cost of
separation programs covering approximately 1,400 employees. In addition, during
the first six months of 1998, PM Inc. recorded pre-tax charges of $309 million
related to separation programs and $1,005 million related to tobacco litigation
settlements with the states of Minnesota, Mississippi and Texas.
Operating companies income for the first six months of 1999 increased $1.0
billion from the comparable 1998 period, due primarily to lower pre-tax tobacco
litigation settlement charges ($1,005 million), price increases, net of cost
increases ($757 million) and lower pre-tax charges for separation programs ($134
million), partially offset by higher marketing, administration and research
costs ($450 million, primarily increased marketing related to consumer
promotions) and lower volume ($465 million). Excluding the impact of the 1998
tobacco litigation settlement charges and the separation programs in each year,
PM Inc.'s operating companies income of $2,244 million for the first six months
of 1999 decreased 5.5% from $2,375 million during the comparable 1998 period.
Domestic tobacco industry shipment volume during the first six months of 1999
declined 10.0% from the first six months of 1998 primarily as a result of
settlement-related price increases and the trade's decisions to lower
inventories. PM Inc. estimates that its year-to-date shipments were adversely
affected by the factors mentioned above and by an unfavorable comparison to the
corresponding period last year when shipments were higher in anticipation of
third-quarter consumer promotions. PM Inc.'s shipment volume for the first six
months of 1999 was 101.1 billion units, a decrease of 9.6% from the comparable
1998 period. However, PM Inc. estimates that, excluding the effects of the
trade's decisions to lower its inventories and the timing of shipments for
consumer promotions, its volume would have decreased by approximately 7.2%. For
the first six months of 1999, PM Inc.'s shipment market share was 49.6%, an
increase of 0.3 share points over the comparable period of 1998. Marlboro
shipment volume declined 5.2 billion units (6.5%) from the first six months of
1998 to 74.4 billion units for a 36.5% share of the total industry, an increase
of 1.3 share points over the comparable period of 1998.
Based on shipments, the premium segment accounted for approximately 73.5% of the
domestic cigarette industry volume in the first six months of 1999, an increase
of 0.6 share points over the comparable period of 1998. In the premium segment,
PM Inc.'s volume decreased 7.7% during the first six months of 1999, compared
with a 9.3% decrease for the industry, resulting in a premium segment share of
59.5%, an increase of 1.0 share points over the first six months of 1998.
-33-
In the discount segment, PM Inc.'s shipments decreased 21.3% to 12.0 billion
units in the first six months of 1999, compared with an industry decline of
12.1%, resulting in a discount segment share of 22.2%, a decrease of 2.6 share
points from the comparable period of 1998. Basic shipment volume for the first
six months of 1999 was down 16.8% to 9.5 billion units, for a 17.7% share of the
discount segment, a decrease of 1.0 share points from the comparable 1998
period.
PM Inc. cannot predict future change or rates of change in domestic tobacco
industry volume, 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 PM Inc.'s shipments may be materially adversely affected by price
increases related to tobacco litigation settlements and, if enacted, by
increased excise taxes or other tobacco legislation discussed under
"Tobacco--Business Environment" above.
In November 1998, PM Inc. announced a price increase of $22.50 per thousand
cigarettes on its domestic premium and discount brands. This followed similar
price increases of $3.00 per thousand in July 1998, $2.50 per thousand in May
1998, $2.50 per thousand in April 1998 and $1.25 per thousand in January 1998.
Each $1.00 per thousand increase by PM Inc. equates to a $0.02 increase in the
price to wholesalers of each pack of twenty cigarettes.
In December 1998, PM Inc. paid $150 million for options to purchase the U.S.
rights to manufacture and market three cigarette trademarks, L&M, Lark and
Chesterfield, the international rights to which are already owned by PMI. During
the second quarter of 1999, PM Inc. substantially completed its acquisition of
these trademarks. Including the $150 million paid in December, the total
acquisition price for these trademarks was approximately $300 million.
International tobacco. During the first six months of 1999, international
tobacco operating revenues, including excise taxes, decreased $8 million (0.1%)
from the first six months of 1998. Excluding excise taxes, operating revenues
decreased $318 million (4.2%), due primarily to unfavorable volume/mix ($373
million), partially offset by price increases ($78 million). Operating companies
income for the first six months of 1999 increased $13 million (0.5%) over the
comparable 1998 period, due primarily to price increases and favorable costs
($116 million) and lower marketing, administration and research costs, partially
offset by unfavorable volume/mix ($181 million) and unfavorable currency
movements.
PMI's volume decreased 33.6 billion units (8.8%) from the first six months of
1998 to 349.6 billion units. PMI's volume decline was due primarily to weaker
economic conditions in Eastern Europe and parts of Latin America as well as
lower worldwide duty-free volume, partially offset by volume increases in
Western Europe and Japan. Volume advanced in a number of important markets,
including Italy, France, Spain, the Benelux and Scandinavian countries, Greece,
Austria, the Czech and Slovak Republics, Romania, Egypt, Turkey, Japan and
Mexico. In Asia, PMI recorded higher volume in the markets of Korea, Singapore,
Malaysia and Thailand. PMI recorded market share gains in virtually all of its
major markets. In Germany, while the second quarter 1998 industry price increase
continued to adversely impact PMI's share and the premium segment as a whole,
PMI has begun to see signs of recovery in its share performance. Volume for
Marlboro declined 1.8% on a reported basis as weakness in Eastern Europe and
worldwide duty-free more than offset volume gains in many of PMI's major
markets. However, on an equal trading day basis and excluding Eastern Europe and
worldwide duty-free, Marlboro volume rose 5.0%.
During the first six months of 1999, PMI accelerated its investment program to
expand local manufacturing capacity in Eastern Europe to address the consumer
affordability of its international brand portfolio, and plans to have additional
capacity in place by the third quarter of 1999.
-34-
For the Three Months Ended June 30,
-------------------------------------------
Operating
Operating Revenues Companies Income
------------------- -------------------
(in millions)
1999 1998 1999 1998
------- ------- ------- -------
Domestic tobacco $ 4,735 $ 3,726 $ 1,151 $ 831
International tobacco 6,926 6,947 1,252 1,252
------- ------- ------- -------
Total tobacco $11,661 $10,673 $ 2,403 $ 2,083
======= ======= ======= =======
Historical operating revenues and operating companies income for the domestic
tobacco and international tobacco operations were reclassified to reflect the
transfer of tobacco sales in certain U.S. territories from the international
tobacco business to the domestic tobacco business, consistent with the terms of
PM Inc.'s settlements of state health care cost recovery and other claims.
Domestic tobacco. During the second quarter of 1999, PM Inc.'s operating
revenues increased $1.0 billion (27.1%) over the comparable 1998 period, due
primarily to pricing ($1.4 billion), partially offset by lower volume ($358
million).
Operating companies income for the second quarter of 1999 increased $320 million
(38.5%) from the comparable 1998 period, due to lower pre-tax charges for
voluntary early retirement and separation programs ($169 million), 1998 pre-tax
tobacco litigation settlement charges ($199 million), price increases, net of
cost increases (aggregating to $323 million), partially offset by lower volume
($249 million) and higher marketing, administration and research costs ($122
million, primarily increased marketing related to consumer promotions).
Excluding the impact of charges for the voluntary early retirement and
separation programs and tobacco litigation settlements, PM Inc.'s operating
companies income of $1,196 million for the second quarter of 1999 decreased $48
million (3.9%) from $1,244 million during the comparable 1998 period.
Domestic tobacco industry shipment volume during the second quarter declined
10.4% from the comparable 1998 period, primarily as a result of
settlement-related price increases and the trade's decisions to lower its
inventories. PM Inc. estimates that its shipments during the quarter were
adversely affected by the factors mentioned above and by an unfavorable
comparison to the corresponding period last year when shipments were higher in
anticipation of third-quarter consumer promotions. PM Inc.'s shipment volume for
the second quarter of 1999 was 51.8 billion units, a decrease of 9.6% from the
second quarter of 1998. However, PM Inc. estimates that, excluding the effects
of the trade's decision to lower their inventories and the timing of shipments
for consumer promotions, its volume would have decreased by approximately 7.6%.
Second-quarter Marlboro shipment volume decreased 3.5 billion units (8.5%) to
37.3 billion units for a 35.2% share of the total industry, an increase of 0.7
share points over the second quarter of 1998. PM Inc.'s second quarter 1999
shipment market share was 48.9%, an increase of 0.4 share points from the
comparable period of 1998.
Based on shipments, the premium segment accounted for approximately 73.1% of
domestic cigarette industry volume in the second quarter of both 1999 and 1998.
In the premium segment, PM Inc.'s second-quarter volume decreased 9.0%, compared
with a 10.4% decrease for the industry, resulting in a premium segment share of
58.5%, an increase of 0.9 share points from the second quarter of 1998.
In the discount segment, PM Inc.'s second quarter shipments decreased 13.3% to
6.4 billion units in 1999, compared with an industry decline of 10.3%, resulting
in a discount segment share of 22.6%, a decrease of 0.8 share points from the
comparable period of 1998. Basic second quarter shipment volume decreased 428
million units to 5.0 billion units, for a 17.7% share of the discount segment,
an increase of 0.5 share points from the comparable 1998 period.
-35-
PM Inc. cannot predict future change or rates of change in domestic tobacco
industry volume, 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 PM Inc.'s shipments may be materially adversely affected by price
increases related to tobacco litigation settlements and, if enacted, by
increased excise taxes or other tobacco legislation discussed under
"Tobacco--Business Environment" above.
International tobacco. During the second quarter of 1999, international tobacco
operating revenues of PMI, including excise taxes, decreased $21 million (0.3%)
from 1998. Excluding excise taxes, operating revenues decreased $131 million
(3.6%) from 1998, due primarily to unfavorable volume/mix ($101 million) and
currency movements ($39 million). Operating companies income was unchanged for
the second quarter of 1999 versus the comparable 1998 period, as favorable costs
($41 million) and lower marketing, administration and research expenses were
offset by unfavorable volume/mix ($79 million) and currency movements ($41
million).
PMI's volume in the second quarter of 1999 decreased 11.3 billion units (6.1%)
from the comparable 1998 period to 172.4 billion units. In its core markets of
Western Europe and Japan, PMI's volume collectively rose 6.7%. However, these
gains were more than offset by a 32.0% decline related to weaker economic
conditions in Eastern Europe and parts of Latin America, as well as lower
worldwide duty-free volume. Volume advanced strongly in a number of important
markets, including Italy, France, Spain, Portugal, the Benelux and Scandinavian
countries, Greece, Austria, the Czech and Slovak Republics, Romania, Turkey,
Egypt and Mexico. In Asia, PMI saw volume recovery in a number of markets.
Double-digit volume gains and share growth were registered in Korea, Malaysia,
Thailand and Indonesia, while volume and share also advanced in Singapore. PMI
recorded market share gains in virtually all major markets. In Germany, while
the second quarter 1998 industry price increase continued to adversely impact
PMI's share and the premium segment as a whole, PMI has begun to see signs of
recovery in its share performance. Volume for Marlboro declined 1.9% during the
second quarter of 1999, as weakness in Eastern Europe and worldwide duty-free
more than offset volume gains in many of PMI's major markets. Excluding Eastern
Europe and worldwide duty-free, Marlboro volume rose 5.5%.
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, currency movements and competitive challenges in various
product categories and markets, including a trend toward increasing
consolidation in the retail trade and changing consumer preferences.
Additionally, 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. To confront these challenges, Kraft,
KFI and PMI continue to take steps to build the value of premium brands with new
product and marketing initiatives, to improve their food business portfolios and
to reduce costs.
Fluctuations in commodity costs can cause retail price volatility, intensify
price competition and influence consumer and trade buying patterns. The North
American and international food businesses are subject to fluctuating commodity
costs, particularly dairy, coffee bean and cocoa prices. During the second half
of 1998, the cost of certain United States dairy commodities reached record high
levels. However, dairy commodity costs moderated in the first half of 1999.
Coffee bean prices were lower during 1998 and the first six months of 1999 after
reaching a twenty-year high in May 1997. Lower coffee bean prices have led to
price reductions by Kraft, KFI and their competitors. More recently, cocoa
prices have also declined.
-36-
During the first six months of 1999, Kraft recorded a pre-tax charge of
approximately $157 million, primarily for voluntary separation programs covering
approximately 1,100 employees.
During 1999 and 1998, KFI sold several small international food businesses. The
operating results of businesses divested were not material to consolidated
operating results in any of the periods presented. Also during 1998, Kraft
entered into a licensing agreement with the Starbucks coffee chain to market,
sell and distribute Starbucks coffee to grocery customers across the United
States. In addition, Kraft entered into a licensing agreement with the
California Pizza Kitchen restaurant chain to manufacture, market and sell
California Pizza Kitchen frozen pizza to grocery customers. Neither of these
agreements had a material impact on Kraft's operating results for the first half
or second quarter of 1999.
Operating Results
For the Six Months Ended June 30,
---------------------------------------------
Operating
Operating Revenues Companies Income
------------------- -------------------
(in millions)
1999 1998 1999 1998
------- ------- ------- -------
North American food $ 9,022 $ 8,905 $ 1,631 $ 1,686
International food 4,446 4,805 521 507
------- ------- ------- -------
Total food $13,468 $13,710 $ 2,152 $ 2,193
======= ======= ======= =======
North American food. During the first six months of 1999, operating revenues
increased $117 million (1.3%) from the first six months of 1998, due primarily
to favorable pricing ($77 million) and higher volume ($56 million). Operating
companies income for the first six months of 1999 decreased $55 million (3.3%)
from the first six months of 1998, due primarily to a 1999 pre-tax charge for
voluntary separation programs ($157 million), higher marketing, administration
and research costs ($133 million, the majority of which related to higher
marketing expense), partially offset by favorable pricing and costs (aggregating
$225 million, driven by lower manufacturing and commodity-related costs) and
higher volume. Excluding the impact of the pre-tax charge for voluntary
separation programs in the first six months of 1999, operating companies income
of $1,788 million in 1999 increased 6.0% over $1,686 million for the first six
months of 1998.
Volume for the first six months increased slightly over the comparable 1998
period. Volume gains were achieved by beverages, from the strength of
ready-to-drink beverages, powdered soft drinks and new product introductions;
frozen pizza, resulting from the continued success of rising crust pizza;
processed meats and cheese, with increases across most product categories; and
meals, primarily as a result of new product introductions during the second half
of 1998. Volume was essentially flat in desserts and snacks. Offsetting the
aforementioned volume gains were volume declines in enhancers, with lower
shipments of spoonable dressings; coffee, as category softness coupled with an
exceptionally strong fourth quarter caused declines across most product
categories, partially offset by new product introductions; and cereals, due to
aggressive competitive activity. In Canada, volume declined due to retailers'
decisions to lower their inventories, as well as aggressive competitive activity
in cereals.
International food. Operating revenues for the first six months of 1999
decreased $359 million (7.5%) from the first six months of 1998, due to
unfavorable volume/mix ($111 million), lower pricing ($153 million, primarily
due to the effect of lower coffee commodity costs), unfavorable currency
movements ($53 million), and the impact of divestitures ($42 million). Operating
companies income for the first six months of 1999 increased $14 million (2.8%)
from the first six months of 1998, due primarily to favorable net pricing
(aggregating to $71 million, primarily related to lower commodity costs),
partially offset by higher marketing, administration and research costs ($29
million), unfavorable volume/mix and unfavorable currency movements. Excluding
the operating results of the international food businesses divested in 1998 and
1999, operating revenues of $4,394 million in the first six months of 1999
decreased $317 million (6.7%) from $4,711 million in 1998, and operating
-37-
companies income of $520 million in 1999 increased $18 million (3.6%) from $502
million in the first six months of 1998.
KFI's coffee volume decreased from the comparable period of 1998, reflecting
continued price competition in Germany and wholesaler-driven trade inventory
reductions in Sweden. Despite an overall decrease in coffee volume, KFI
registered share gains in roast and ground coffees in France, Sweden, Denmark
and Spain, while soluble coffee brands gained share in the United Kingdom,
France and Korea. Confectionery volume was down due to the continued weak
business conditions in Russia and other parts of Eastern Europe; however volume
outside Eastern Europe benefited from new products and line extensions. Volume
grew in KFI's cheese and grocery business, driven by volume and share advances
in cream cheese products in Italy, Sweden and Australia; snack and lunch
combinations volume in the United Kingdom and Germany; and powdered soft drink
volume in Romania, the Middle East, Africa, China and the Philippines. In Latin
America, volume declined from the comparable period of 1998 due primarily to
lower confectionery sales in Brazil and lower powdered soft drink sales in
Argentina, partially offset by higher powdered soft drink sales in Brazil and
Mexico.
For the Three Months Ended June 30,
---------------------------------------------
Operating
Operating Revenues Companies Income
------------------- -------------------
(in millions)
1999 1998 1999 1998
------ ------ ------ ------
North American food $4,626 $4,540 $ 946 $ 884
International food 2,204 2,495 275 272
------ ------ ------ ------
Total food $6,830 $7,035 $1,221 $1,156
====== ====== ====== ======
North American food. During the second quarter of 1999, operating revenues
increased $86 million (1.9%) over the second quarter of 1998, due primarily to
higher volume ($66 million) and favorable pricing ($25 million). Operating
companies income for the second quarter of 1999 increased $62 million, (7.0%)
over the second quarter of 1998, due primarily to volume increases in ongoing
operations and favorable net pricing (aggregating $128 million, primarily driven
by lower manufacturing and commodity-related costs), partially offset by higher
marketing, administration and research costs ($87 million).
Volume for the second quarter of 1999 increased over the comparable 1998 period.
Volume gains were achieved by beverages, led by the continued success of
ready-to-drink beverages, powdered soft drinks and new product introductions;
frozen pizza, resulting from the continued success of all of its major product
lines; and processed meats, due to the strength of lunch combinations, which
reflected the continued success of new product introductions, and to increases
in hot dogs and bacon. In cereals, volume was flat in an aggressive competitive
environment. Coffee volume was essentially flat as the impact of shipments under
the Starbucks licensing agreement offset volume declines from existing products.
Cheese volumes were essentially flat despite share gains in a number of product
lines. Offsetting these volume increases were volume declines in meals, due to
lower rice sales, partially offset by new macaroni and cheese product
introductions; in desserts and snacks, due to softness in dry packaged dessert
consumption and in enhancers, due to increased competitive activity. In Canada,
volume gains were driven by cheese, coffee and salad dressings, as well as new
product introductions in ready-to-drink beverages, dinners and frozen desserts.
International food. Operating revenues for the second quarter of 1999 decreased
$291 million (11.7%) from the second quarter of 1998, due to lower volume/mix
($88 million), lower pricing ($93 million, primarily due to the effect of lower
coffee commodity costs), unfavorable currency movements ($82 million) and the
impact of divestitures ($29 million). Operating companies income for the second
quarter of 1999 increased $3 million (1.1%) from the second quarter of 1998, due
primarily to favorable net pricing (aggregating to $21 million, primarily
related to lower commodity costs), partially offset by lower volume/mix from
ongoing operations. Excluding the operating results of the international food
businesses divested in 1998 and 1999, operating revenues of $2,186 million in
-38-
the second quarter of 1999 decreased $262 million (10.7%) from $2,448 million in
1998, and operating companies income of $276 million in 1999 increased $6
million (2.2%) from $270 million in the second quarter of 1998.
KFI's coffee volume decreased from the comparable period of 1998, reflecting
continued price competition and market softness in Germany and trade inventory
reductions in Sweden. Despite an overall volume decrease in coffee, volume
increased in the established markets of France, Spain, Austria, Denmark and the
developing markets of Central Europe. Confectionery volume declined primarily
due to continued economic softness in Russia and aggressive competition in
chocolate in the United Kingdom and Sweden; however, confectionery volumes
benefited from successful new product launches in several countries and
continued growth in Central Europe. Volume grew in KFI's cheese and grocery
business as a result of recently launched individual portion cheese, lunch
combinations and ready-to-eat snacks in Germany; higher shipments of cream
cheese and the introduction of lunch combinations in Italy; powdered soft drinks
expansion in Poland and Bulgaria, and continuing growth in Egypt, Turkey, the
Philippines and other Southeast Asian markets; and yeast spread, cheese,
spoonable dressings, and peanut butter in Australia. In Latin America, lower
overall volume was driven by significantly lower confectionery volume in Brazil
due to adverse economic conditions, partially offset by volume increases in
powdered soft drinks in Brazil and Mexico.
Beer
During April 1999, Miller purchased four trademarks from the Pabst Brewing
Company ("Pabst") and the Stroh Brewery Company ("Stroh"). Miller also agreed to
increase its contract manufacturing of Pabst products, including brands that
Pabst acquired from Stroh in a separate agreement. Miller began brewing and
shipping the newly acquired brands during the second quarter of 1999. These
agreements are expected to have a positive impact on Miller's revenues and
operating companies income for the remainder of 1999.
Six Months Ended June 30
Miller's operating revenues for the first six months of 1999 increased $32
million (1.5%) over the first six months of 1998, due primarily to the
previously mentioned newly acquired brands and contract manufacturing fees.
Operating companies income for the first six months of 1999 increased $28
million (9.8%) over the first six months of 1998, due primarily to favorable
product costs ($22 million) and the impact of previously mentioned newly
acquired brands and contract manufacturing fees.
Miller's domestic shipment volume of 22.2 million barrels for the first six
months of 1999 increased 1.4% from the comparable 1998 period, reflecting the
commencement of shipments of the newly acquired brands (Olde English 800,
Hamm's, Mickey's and Henry Weinhard's). Excluding the shipments of the acquired
brands, domestic shipment volume declined 0.9% from the first six months of
1998, reflecting lower domestic shipments of premium brands, primarily Miller
Genuine Draft, Molson and Miller Lite, partially offset by increases for
Icehouse and Foster's. Domestic shipments of near-premium brand products
increased on higher shipments of Miller High Life and Southpaw Light, while
budget brand products decreased on lower shipments across all brands.
Wholesalers' sales to retailers in the first six months of 1999 decreased 0.2%
from the comparable 1998 period, excluding the acquired brands. This decline was
due primarily to lower sales of Miller Genuine Draft, Molson and Miller beer,
partially offset by double-digit increases for Icehouse and Foster's and
increased retail sales of Miller Lite. Export volume declined 10.1%, as volume
shifted to sales under Miller's international licensing agreements.
-39-
Three Months Ended June 30
Miller's operating revenues for the second quarter of 1999 increased $26 million
(2.2%) from the second quarter of 1998, due primarily to the previously
mentioned newly acquired brands and contract manufacturing fees. Operating
companies income for the second quarter of 1999 increased $20 million (12.7%)
over the second quarter of 1998, due primarily to favorable product costs ($11
million) and the impact of previously mentioned newly acquired brands and
contract manufacturing fees.
Miller's domestic shipment volume of 12.3 million barrels for the second quarter
of 1999 increased 2.2% from the comparable 1998 period, reflecting the
commencement of shipments of the acquired brands. Excluding the shipments of the
acquired brands, domestic shipment volume declined 2.1% from the second quarter
of 1998, reflecting lower domestic shipments of premium brands, primarily Miller
Genuine Draft, Miller Lite and Molson, partially offset by increased domestic
shipments of Icehouse and Foster's. Domestic shipments of near-premium products
increased slightly on higher shipments of Miller High Life, while budget brand
products decreased on lower shipments across all brands. Wholesalers' sales to
retailers in the second quarter of 1999 increased 0.3% over the comparable 1998
period, excluding the acquired brands. This increase was due primarily to higher
sales of Miller High Life, Miller Lite, Icehouse and Foster's, partially offset
by lower retail sales of Miller Genuine Draft and Molson. Export volume declined
1.9%, as volume shifted to sales under Miller's international licensing
agreements.
Financial Services
Philip Morris Capital Corporation's ("PMCC") financial services operating
revenues and operating companies income for the first half of 1999 increased $31
million (22.3%) and $17 million (18.3%), respectively, over the comparable 1998
period. During the second quarter of 1999, operating revenues and operating
companies income increased $23 million (31.1%) and $9 million (17.6%),
respectively, over the second quarter of 1998. These increases were due
primarily to increased leasing revenues and the continued growth of PMCC's
existing portfolio of finance assets.
Financial Review
Net Cash Provided by Operating Activities
During the first six months of 1999, net cash provided by operating activities
was $5.5 billion compared with $3.7 billion in the comparable 1998 period. The
increase primarily reflects the collection of higher settlement-related domestic
tobacco revenues prior to the remittance of such amounts to state governments
under the terms of the various state settlements negotiated in 1998.
Net Cash Used in Investing Activities
During the first six months of 1999, net cash used in investing activities was
$1.3 billion, up from $980 million in 1998. The increase primarily reflects the
cash used during the first six months of 1999 for the previously mentioned
domestic tobacco and beer acquisitions.
Net Cash Used in Financing Activities
During the first six months of 1999, net cash of $3.7 billion was used in
financing activities, as compared with $341 million used in financing activities
during the comparable 1998 period. This difference was primarily due to higher
stock repurchases and dividends paid during the first six months of 1999, as
well as 1999 net debt repayments of $73 million compared with net debt issuances
of $1,576 million in 1998. Subsequent to June 30, 1999, PMCC completed a debt
issuance of $500 million.
-40-
Debt and Liquidity
The Company's total debt (consumer products and financial services) was $14.4
billion and $14.7 billion at June 30, 1999 and December 31, 1998, respectively.
Total consumer products debt was $13.7 billion and $14.0 billion at June 30,
1999 and December 31, 1998, respectively. The Company's ratio of consumer
products debt to total equity was 0.86 at both June 30, 1999 and December 31,
1998. The ratio of total debt to total equity was 0.90 and 0.91 at June 30, 1999
and December 31, 1998, respectively. Subsequent to June 30, 1999, PMCC completed
a debt issuance of $500 million.
The Company and its subsidiaries maintain credit facilities with a number of
lending institutions, amounting to approximately $12.2 billion. These include
revolving bank credit agreements totaling $10.0 billion, which may be used to
support any commercial paper borrowings by the Company and which are available
for acquisitions and other corporate purposes. Of these revolving bank
agreements an agreement for $8.0 billion expires in 2002, enabling the Company
to reclassify short-term debt on a long-term basis. The remaining $2.0 billion
agreement expires in October 1999. The Company may continue to refinance
long-term and short-term debt from time to time. Based upon the Company's
ability and intent to refinance such debt, $800 million of debt scheduled to
mature in March 2000 was reclassified as long-term debt at June 30, 1999. 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.
The Company's credit ratings by Moody's at June 30, 1999 and December 31, 1998
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 June
30, 1999 and December 31, 1998 were "A-1" in the commercial paper market and "A"
for long-term debt obligations.
As discussed in Note 5, PM Inc., along with other domestic tobacco companies,
has entered into tobacco litigation settlement agreements that will require the
domestic tobacco industry to make substantial annual payments in the following
amounts: 1999, $4.2 billion; 2000, $9.2 billion; 2001, $9.9 billion; 2002, $11.3
billion; 2003, $10.9 billion; 2004 through 2007, $8.4 billion; and thereafter,
$9.4 billion. In addition, the domestic tobacco industry is required to pay
settling plaintiffs' attorneys' fees, subject to an annual cap of $500 million,
as well as additional amounts as follows: 1999, $450 million; 2000, $416
million; and 2001 and 2002, $250 million. The domestic tobacco industry has also
agreed in principle to contribute $5.15 billion over a period of twelve years
into a fund to compensate the domestic tobacco growing community for the
potential adverse economic impact of the foregoing tobacco settlements. PM
Inc.'s portion of the foregoing payments is subject to adjustment for several
factors, including inflation, relative market share and industry volume. While
PM Inc.'s share of future annual payments is not currently determinable, it is
anticipated that such future payments will be funded primarily through price
increases.
As discussed above under "Tobacco--Business Environment," the present
legislative and litigation environment is substantially uncertain and could
result in material adverse consequences for the business, financial condition,
cash flows or results of operations of the Company, PM Inc. and PMI.
Equity and Dividends
During the first six months of 1999, the Company repurchased 35.6 million shares
of its common stock at a cost of $1.4 billion. The repurchases were made under
an existing $8 billion authority that expires in November 2001. At June 30,
1999, cumulative repurchases under the $8 billion authority totaled 43.4 million
shares at an aggregate cost of $1.8 billion. The Company did not repurchase any
of its stock during the first six months of 1998.
-41-
Dividends paid in the first six months of 1999 and 1998 were $2.1 billion and
$1.9 billion, respectively. In August 1998, the Company's Board of Directors
approved a 10% increase in the current quarterly dividend rate to $0.44 per
share. As a result, the present annualized dividend rate is $1.76 per share.
Cash and Cash Equivalents
Cash and cash equivalents were $4.4 billion at June 30, 1999 and $4.1 billion at
December 31, 1998, the increase being largely attributable to higher levels of
cash from operations, partially offset by the resumption of the Company's share
repurchase program.
Market Risk
The Company is exposed to market risk, primarily related to foreign exchange,
commodity prices and interest rates. These exposures are actively monitored by
management. To manage the volatility relating to these exposures, the Company
enters into a variety of derivative financial instruments. The Company's
objective is to reduce, where it is deemed appropriate to do so, fluctuations in
earnings and cash flows associated with changes in interest rates, foreign
currency rates and commodity prices. It is the Company's policy and practice to
use derivative financial instruments only to the extent necessary to manage
exposures. Since the Company uses currency rate-sensitive and commodity
price-sensitive instruments to hedge a certain portion of its existing and
anticipated transactions, the Company expects that any loss in value for those
instruments generally would be offset by increases in the value of those hedged
transactions. The Company does not hold or issue derivative financial
instruments for trading or speculative purposes.
Foreign exchange rates. The Company is exposed to foreign exchange movements,
primarily in European, Japanese, other Asian and Latin American currencies.
Consequently, it enters into various contracts, which change in value as foreign
exchange rates change, to preserve the value of commitments and anticipated
transactions. The Company uses foreign currency option contracts to hedge
certain anticipated foreign currency revenues and raw materials purchases. The
Company also enters into short-term currency forward contracts, primarily to
hedge intercompany transactions denominated in foreign currencies and to hedge
the purchase of commodities. At June 30, 1999, the Company had long and short
forward exchange/option contracts with U.S. dollar equivalent values of $2.9
billion and $3.4 billion, respectively. At December 31, 1998, the Company had
long and short forward exchange/option contracts with U.S. dollar equivalent
values of $3.6 billion and $4.5 billion, respectively.
The Company also seeks to protect its foreign currency net asset exposure,
primarily the Swiss franc and the euro, through the use of foreign-currency
denominated debt or currency swap agreements. At June 30, 1999 and December 31,
1998, the notional amounts of currency swap agreements aggregated $2.7 billion
and $2.5 billion, respectively.
Commodities. The Company is exposed to price risk related to anticipated
purchases of certain commodities used as raw materials by the Company's food
businesses. Accordingly, the Company enters into commodity future, forward and
option contracts to manage fluctuations in prices of anticipated purchases,
primarily coffee, cocoa, sugar, wheat and corn. At June 30, 1999 and December
31, 1998, the Company had net long commodity positions of $224 million and $158
million, respectively. Unrealized gains/losses on net commodity positions were
immaterial at June 30, 1999 and December 31, 1998.
Interest rates. The Company manages its exposure to interest rate risk through
the proportion of fixed rate debt and variable rate debt in its total debt
portfolio. To manage this mix, the Company may enter into interest rate swap
agreements, in which it exchanges the periodic payments, based on a notional
amount and agreed-upon fixed and variable interest rates. At June 30, 1999 and
December 31, 1998, the Company had an interest rate swap agreement which
converted $800 million of fixed rate debt to variable rate debt.
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Use of the above-mentioned derivative financial instruments has not had a
material impact on the Company's financial position at June 30, 1999 and
December 31, 1998, or the Company's results of operations for the three and six
months ended June 30, 1999 or the year ended December 31, 1998.
New Accounting Standards
During 1998, the Financial Accounting Standards Board ("FASB") issued Statement
of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which had an initial adoption date by the
Company of January 1, 2000. During the second quarter of 1999, the FASB
postponed the adoption date of SFAS No. 133 until January 1, 2001. SFAS No. 133
requires that all derivative financial instruments be recorded on the
consolidated balance sheets at their fair value. Changes in the fair value of
derivatives will be recorded each period in earnings or other comprehensive
earnings, depending on whether a derivative is designated as part of a hedge
transaction and, if it is, the type of hedge transaction. Gains and losses on
derivative instruments reported in other comprehensive earnings will be
reclassified as earnings in the periods in which earnings are affected by the
hedged item. The Company has not yet determined the impact that adoption or
subsequent application of SFAS No. 133 will have on its financial position or
results of operations.
Contingencies
See Note 5 to the Condensed Consolidated Financial Statements for a discussion
of certain contingencies.
Forward-Looking and Cautionary Statements
The Company and its representatives may from time to time make written or oral
forward-looking statements, including statements contained in the Company's
filings with the Securities and Exchange Commission and in its reports to
stockholders. In connection with the "safe harbor" provisions of the Private
Securities Litigation Reform Act of 1995, the Company is hereby identifying
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; any such statement is qualified by reference to the following
cautionary statements.
The tobacco industry continues to be subject to health concerns relating to the
use of tobacco products and exposure to ETS, legislation, including actual and
potential excise tax increases, increasing marketing and regulatory
restrictions, governmental regulation, privately imposed smoking restrictions,
governmental and grand jury investigations, litigation, and the effects of price
increases related to concluded tobacco litigation settlements and excise tax
increases on consumption rates. Each of the Company's consumer products
subsidiaries is subject to intense competition, changes in consumer preferences,
the effects of changing prices for its raw materials, local economic conditions
and the potential impact of the CDC issue, and their results are dependant upon
their continued ability to promote brand equity successfully, to anticipate and
respond to new consumer trends, to develop new products and markets and to
broaden brand portfolios, to compete effectively with lower priced products in a
consolidating environment at the retail and manufacturing levels, and to improve
productivity. In addition, PMI, KFI and Kraft are subject to the effects of
foreign economies, particularly the timing of economic recoveries in Asia and
Eastern Europe and related shifts in consumer preferences, currency movements
and the conversion to the euro. Developments in any of these areas, which are
more fully described above and which descriptions are incorporated into this
section by reference, could cause the Company's results to differ materially
from results that have been or may be projected by or on behalf of the Company.
The Company cautions that the foregoing list of important factors is not
exclusive. The Company does not undertake to update any forward-looking
statement that may be made from time to time by or on behalf of the Company.
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Part II - OTHER INFORMATION
Item 1. Legal Proceedings.
See Note 5. Contingencies, of the Notes to the Condensed Consolidated
Financial Statements included in Part I, Item 1 of this report for a discussion
of legal proceedings pending against the Company and its subsidiaries. See also
Exhibits 99.1, 99.2, and 99.3 to this report.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
12 Statement regarding computation of ratios of earnings to fixed
charges.
27 Financial Data Schedule.
99.1 Certain Pending Litigation Matters and Recent Developments.
99.2 Status of Master Settlement Agreement.
99.3 Trial Schedule for Certain Cases.
(b) Reports on Form 8-K. The Registrant filed a Current Report on Form
8-K, dated June 28, 1999, containing information on the Registrant's
meeting with security analysts, investors and bankers.
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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
August 12, 1999
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