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, 1998
OR
( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number 1-8940
Philip Morris Companies Inc.
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(Exact name of registrant as specified in its charter)
VIRGINIA 13-3260245
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
120 Park Avenue, New York, New York 10017
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code (212) 880-5000
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Former name, former address and former fiscal year, if changed since last report
Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months, and (2) has been subject
to such filing requirements for the past 90 days. Yes X No
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At July 31, 1998, there were 2,432,090,598 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, 1998 and December 31, 1997 3 - 4
Condensed Consolidated Statements of Earnings for the
Six Months Ended June 30, 1998 and 1997 5
Three Months Ended June 30, 1998 and 1997 6
Condensed Consolidated Statements of Stockholders'
Equity for the Year Ended December 31, 1997 and the
Six Months Ended June 30, 1998 7
Condensed Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 1998 and 1997 8 - 9
Notes to Condensed Consolidated Financial Statements 10 - 22
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations. 23 - 44
PART II - OTHER INFORMATION
Item 1. Legal Proceedings. 45
Item 6. Exhibits and Reports on Form 8-K. 45
Signature 46
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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,
1998 1997
-------- ------------
ASSETS
CONSUMER PRODUCTS
Cash and cash equivalents $ 4,605 $ 2,282
Receivables, net 5,293 4,294
Inventories:
Leaf tobacco 4,166 4,348
Other raw materials 1,910 1,689
Finished product 3,043 3,002
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9,119 9,039
Other current assets 1,840 1,825
------- -------
Total current assets 20,857 17,440
Property, plant and equipment, at cost 20,595 20,002
Less accumulated depreciation 8,740 8,381
------- -------
11,855 11,621
Goodwill and other intangible assets
(less accumulated amortization of
$5,087 and $4,814) 17,557 17,789
Other assets 3,023 3,211
------- -------
Total consumer products assets 53,292 50,061
FINANCIAL SERVICES
Finance assets, net 5,900 5,712
Other assets 171 174
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Total financial services assets 6,071 5,886
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TOTAL ASSETS $59,363 $55,947
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See notes to condensed consolidated financial statements.
Continued
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Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Continued)
(in millions of dollars, except per share data)
(Unaudited)
June 30, December 31,
1998 1997
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LIABILITIES
CONSUMER PRODUCTS
Short-term borrowings $ 847 $ 157
Current portion of long-term debt 1,577 1,516
Accounts payable 2,505 3,318
Accrued marketing 2,148 2,149
Accrued taxes, except income taxes 1,667 1,234
Accrued settlement charges 1,790 886
Other accrued liabilities 3,467 3,977
Income taxes 1,000 862
Dividends payable 975 972
------- -------
Total current liabilities 15,976 15,071
Long-term debt 12,289 11,585
Deferred income taxes 920 889
Accrued postretirement health care costs 2,506 2,432
Other liabilities 6,630 6,218
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Total consumer products liabilities 38,321 36,195
FINANCIAL SERVICES
Short-term borrowings 103
Long-term debt 838 845
Deferred income taxes 3,933 3,877
Other liabilities 146 110
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Total financial services liabilities 5,020 4,832
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Total liabilities 43,341 41,027
Contingencies (Note 3)
STOCKHOLDERS' EQUITY
Common stock, par value $0.33 1/3 per share
(2,805,961,317 shares issued) 935 935
Earnings reinvested in the business 26,111 24,924
Accumulated other comprehensive earnings:
Currency translation adjustments (1,330) (1,109)
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25,716 24,750
Less cost of repurchased stock
(374,902,778 and 380,474,028 shares) 9,694 9,830
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Total stockholders' equity 16,022 14,920
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TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $59,363 $55,947
======= =======
See notes to condensed consolidated financial statements.
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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,
------------------------
1998 1997
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Operating revenues $37,361 $36,630
Cost of sales 13,590 13,407
Excise taxes on products 8,419 8,247
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Gross profit 15,352 14,976
Marketing, administration and research costs 8,354 8,050
Settlement charges (Note 3) 1,005
Amortization of goodwill 290 296
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Operating income 5,703 6,630
Interest and other debt expense, net 482 566
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Earnings before income taxes 5,221 6,064
Provision for income taxes 2,103 2,455
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Net earnings $ 3,118 $ 3,609
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Per share data:
Basic earnings per share $ 1.28 $ 1.49
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Diluted earnings per share $ 1.28 $ 1.48
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Dividends declared $ 0.80 $ 0.80
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See notes to condensed consolidated financial statements.
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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,
--------------------------
1998 1997
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Operating revenues $18,978 $18,413
Cost of sales 6,883 6,690
Excise taxes on products 4,192 4,123
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Gross profit 7,903 7,600
Marketing, administration and research costs 4,420 4,089
Settlement charges (Note 3) 199
Amortization of goodwill 144 147
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Operating income 3,140 3,364
Interest and other debt expense, net 238 279
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Earnings before income taxes 2,902 3,085
Provision for income taxes 1,166 1,249
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Net earnings $ 1,736 $ 1,836
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Per share data:
Basic earnings per share $ 0.72 $ 0.76
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Diluted earnings per share $ 0.71 $ 0.75
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Dividends declared $ 0.40 $ 0.40
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See notes to condensed consolidated financial statements.
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Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders' Equity
for the Year Ended December 31, 1997 and
the Six Months Ended June 30, 1998
(in millions of dollars, except per share data)
(Unaudited)
Earnings Accumulated Total
Reinvested Currency Other Cost of Stock-
Common in the Translation Comprehensive Repurchased holders'
Stock Business Adjustments Earnings Stock Equity
------ ---------- ----------- ------------- ----------- --------
Balances, January 1, 1997 $ 935 $22,480 $ 192 $ 190 $(9,387) $14,218
Comprehensive earnings:
Net earnings 6,310 6,310
Other comprehensive earnings,
net of income taxes:
Currency translation adjustments (1,301) (1,301) (1,301)
Net unrealized appreciation
on securities 2 2
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Total other comprehensive earnings (1,301) (1,299) (1,299)
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Total comprehensive earnings 5,011
Exercise of stock options and
issuance of other stock awards 14 300 314
Cash dividends
declared($1.60 per share) (3,880) (3,880)
Stock repurchased (743) (743)
----- ------- ------- ------- ------- -------
Balances, December 31, 1997 935 24,924 (1,109) (1,109) (9,830) 14,920
Comprehensive earnings:
Net earnings 3,118 3,118
Other comprehensive earnings,
net of income taxes:
Currency translation adjustments (221) (221) (221)
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Total other comprehensive earnings (221) (221) (221)
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Total comprehensive earnings 2,897
Exercise of stock options and
issuance of other stock awards 12 136 148
Cash dividends
declared($0.80 per share) (1,943) (1,943)
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Balances, June 30, 1998 $ 935 $26,111 $(1,330) $(1,330) $(9,694) $16,022
===== ======= ======= ======= ======= =======
Total comprehensive earnings, which primarily represent net earnings
partially offset by currency translation adjustments, were $1,696 million
and $1,670 million, respectively, for the quarters ended June 30, 1998 and
1997, and $2,761 million for the first six months of 1997.
See notes to condensed consolidated financial statements.
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Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(in millions of dollars)
(Unaudited)
For the Six Months Ended
June 30,
------------------------
1998 1997
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CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
Net earnings - Consumer products $ 3,059 $ 3,541
- Financial services and real estate 59 68
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Net earnings 3,118 3,609
Adjustments to reconcile net earnings to
operating cash flows:
CONSUMER PRODUCTS
Depreciation and amortization 863 855
Deferred income tax provision 121 93
Gain on sale of a business (23)
Cash effects of changes, net of the effects
from acquired and divested companies:
Receivables, net (1,133) (973)
Inventories (63) (147)
Accounts payable (951) (864)
Income taxes 176 201
Other working capital items 778 455
Other 625 151
FINANCIAL SERVICES AND REAL ESTATE
Deferred income tax provision 59 48
Other 66 52
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Net cash provided by operating activities 3,659 3,457
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CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
CONSUMER PRODUCTS
Capital expenditures (806) (745)
Purchases of businesses, net of acquired cash (223)
Proceeds from sales of businesses 164
Other 22 (5)
FINANCIAL SERVICES AND REAL ESTATE
Investments in finance assets (263) (328)
Proceeds from finance assets 67 181
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Net cash used in investing activities (980) (956)
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See notes to condensed consolidated financial statements.
(continued)
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Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Continued)
(in millions of dollars)
(Unaudited)
For the Six Months Ended
June 30,
------------------------
1998 1997
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CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
CONSUMER PRODUCTS
Net issuance(repayment)of short-term borrowings $ 693 $ (149)
Long-term debt proceeds 1,985 1,786
Long-term debt repaid (1,205) (1,277)
FINANCIAL SERVICES AND REAL ESTATE
Net issuance of short-term borrowings 103 252
Long-term debt proceeds 174
Long-term debt repaid (387)
Dividends paid (1,942) (1,946)
Issuance of shares 98 58
Repurchase of outstanding stock (805)
Other (73) (77)
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Net cash used in financing activities (341) (2,371)
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Effect of exchange rate changes on cash and
cash equivalents (15) (53)
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Cash and cash equivalents:
Increase 2,323 77
Balance at beginning of period 2,282 240
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Balance at end of period $ 4,605 $ 317
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See notes to condensed consolidated financial statements.
-9-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
NOTE 1. ACCOUNTING POLICIES:
The interim condensed consolidated financial statements of Philip Morris
Companies Inc. (the "Company") are unaudited. It is the opinion of the Company's
management that all adjustments necessary for a fair statement of the interim
results presented have been reflected therein. All such adjustments were of a
normal recurring nature. Operating revenues and net earnings for any interim
period are not necessarily indicative of results that may be expected for the
entire year.
These statements should be read in conjunction with the consolidated financial
statements and related notes which appear in the Company's annual report to
stockholders and which are incorporated by reference into the Company's Annual
Report on Form 10-K for the year ended December 31, 1997 (the "1997 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:
Effective December 31, 1997, the Company adopted Statement of Financial
Accounting Standards ("SFAS") No. 128, "Earnings per Share" ("EPS") which
establishes standards for computing and presenting EPS and requires the
presentation of both basic and diluted EPS. Prior period EPS have been restated
to conform with the standards established by SFAS No. 128. Basic and diluted EPS
were calculated using the following:
For the Six Months Ended
June 30,
------------------------
1998 1997
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(in millions)
Net earnings $3,118 $3,609
====== ======
Weighted average shares for
basic EPS 2,427 2,418
Plus incremental shares from conversions:
Restricted stock and stock rights 1 1
Stock options 15 21
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Weighted average shares for
diluted EPS 2,443 2,440
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For the Three Months Ended
June 30,
--------------------------
1998 1997
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(in millions)
Net earnings $1,736 $1,836
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Weighted average shares for
basic EPS 2,428 2,414
Plus incremental shares from conversions:
Restricted stock and stock rights 1 1
Stock options 14 21
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Weighted average shares for
diluted EPS 2,443 2,436
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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:
1998 1997
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(in millions)
For the three months ended June 30, 39 16
For the six months ended June 30, 20 8
In 1998, the American Institute of Certified Public Accountants' Accounting
Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP") No.
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use." SOP No. 98-1 requires certain costs incurred in connection with
developing or obtaining internal-use software to be capitalized and other costs
to be expensed. The Company adopted SOP No. 98-1 effective January 1, 1998, and
its application for the three and six month periods ended June 30, 1998 had no
material effect on the Company's financial position or results of operations.
NOTE 3. CONTINGENCIES:
Legal proceedings covering a wide range of matters are pending in various
U.S. and foreign jurisdictions against the Company, its subsidiaries and
affiliates, including Philip Morris Incorporated ("PM Inc."), the Company's
domestic tobacco subsidiary, 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 products
liability, consumer protection, antitrust, securities law, tax, patent
infringement, employment matters and claims for contribution.
OVERVIEW OF TOBACCO-RELATED LITIGATION
TYPES AND NUMBER OF CASES
Pending claims related to tobacco products generally fall within three
categories: (i) smoking and health cases alleging personal injury brought on
behalf of individual plaintiffs, (ii) smoking and health cases alleging personal
injury and purporting to be brought on behalf of a class of individual
plaintiffs, and (iii) health care cost recovery cases brought by state and local
governments seeking reimbursement for Medicaid and/or other health care
expenditures allegedly caused by cigarette smoking, as well as similar cases,
including class actions, brought by non-governmental plaintiffs such as unions,
health maintenance organizations ("HMOs"), federal and state taxpayers, native
American tribes and others. Damages claimed in some of the smoking and health
class actions and health care cost recovery cases range into the billions of
dollars.
In recent years there has been a substantial increase in the number of smoking
and health cases being filed in the United States.
As of August 1, 1998, there were approximately 400 smoking and health cases
filed and served on behalf of individual plaintiffs in the United States against
PM Inc. and, in some cases, the Company (excluding approximately 50 cases in
Texas that were voluntarily dismissed but which may be refiled under certain
conditions), compared with approximately 375 such cases on December 31, 1997,
and 185 such cases on December 31, 1996. Many of the new cases were filed in
Florida and New
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
York. Twenty-two 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, 1998, there were approximately 65 purported smoking
and health 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 50
such cases on December 31, 1997, and 20 such cases on December 31, 1996. 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.
The number of health care cost recovery actions in the United States also
increased, with approximately 140 such cases pending as of August 1, 1998,
compared with approximately 105 such cases on December 31, 1997, and 25 such
cases on December 31, 1996.
There are also a number of tobacco-related actions pending outside the United
States against affiliates and subsidiaries of PMI including, as of August 1,
1998, approximately 20 smoking and health cases initiated by one or more
individuals (Argentina (13), Brazil (1), Canada (1), Italy (1), Japan (1),
Scotland (1) and Turkey (2)), four smoking and health class actions (Brazil (2),
Canada (1) and Nigeria (1)) and one health care cost recovery action (Republic
of the Marshall Islands). In addition, the Republic of Guatemala has filed a
health care cost recovery action in the United States.
LITIGATION SETTLEMENTS
During 1997 and 1998, PM Inc. and other companies in the United States tobacco
industry settled health care cost recovery actions brought by the States of
Mississippi, Florida, Texas and Minnesota, and an ETS smoking and health class
action brought on behalf of airline flight attendants. The Minnesota settlement
is discussed in Note 3 of the Company's Quarterly Report on Form 10-Q for the
quarter ended March 31, 1998. The other settlements are discussed in Part I,
Item 3. Legal Proceedings of the Company's 1997 Form 10-K. Recently, the
Mississippi and Texas settlement agreements were amended pursuant to their "most
favored nation" clause to reflect the terms of the Minnesota settlement
agreement. The amended settlement agreements are discussed below under the
heading "Health Care Cost Recovery Litigation - Most Favored Nation Provisions."
The Mississippi, Florida, Texas and Minnesota health care cost recovery
settlement agreements, the amendments to the Mississippi and Texas settlement
agreements and certain ancillary agreements are filed as exhibits to various of
the Company's reports filed with the Securities and Exchange Commission.
VERDICTS IN INDIVIDUAL CASES
During the last two years, juries have returned verdicts for defendants in three
smoking and health cases in Florida and in one individual ETS smoking and health
case in Indiana. In June 1998, a Florida appeals court reversed a $750,000 jury
verdict awarded in August 1996 against another United States cigarette
manufacturer. Also in June 1998, a Florida jury awarded the estate of a deceased
smoker in a smoking and health case against another United States cigarette
manufacturer $500,000 in compensatory damages, $52,000 for medical expenses and
$450,000 in punitive damages. In Brazil, a court in 1997 awarded plaintiffs in a
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
smoking and health case the Brazilian currency equivalent of $81,000, attorneys'
fees (in an amount to be determined by the court) and a monthly annuity for 35
years equal to two-thirds of the deceased smoker's last monthly salary. Neither
the Company nor its affiliates were parties to that action. Several of the above
verdicts and decisions are under appeal.
TRIAL DATES
Jury selection is currently underway in a smoking and health class action in
Florida in which PM Inc. is a defendant (ENGLE, ET AL. V. R.J. REYNOLDS TOBACCO
COMPANY, ET AL.). The State of Washington's health care cost recovery action is
scheduled for trial in September 1998. As set forth in Exhibit 99 hereto,
approximately 15 health care cost recovery actions and four smoking and health
class actions are scheduled for trial in 1999. During the remainder of 1998,
five individual smoking and health cases are scheduled for trial against PM
Inc., and approximately 15 such cases, including three in which the Company is a
defendant, are scheduled for trial in 1999. Trial dates, however, are subject to
change.
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 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 (the "Labeling Act"). In June 1992, the United States Supreme Court held
that the Labeling Act, as enacted in 1965, does not preempt common law damage
claims, but that the Labeling Act, as amended in 1969, preempts claims arising
after July 1969 against cigarette manufacturers "based on failure to warn and
the neutralization of federally mandated warnings to the extent that those
claims rely on omissions or inclusions in advertising or promotions." The Court
also held that the 1969 Labeling Act does not preempt claims based on express
warranty, fraudulent misrepresentation or conspiracy. The Court further held
that claims for fraudulent concealment were preempted except "insofar as those
claims relied on a duty to disclose...facts through channels of communication
other than advertising or promotion." (The Court did not consider whether such
common law damage claims were valid under state law.) The Court's decision was
announced by a plurality opinion. The effect of the decision on pending and
future cases will be the subject of further proceedings in the lower federal and
state courts. Additional similar litigation could be encouraged if legislation
to eliminate the federal
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Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
preemption defense, proposed in Congress in recent years, were enacted. It is
not possible to predict whether any such legislation will be enacted.
In May 1996, the Fifth Circuit Court of Appeals held that a purported class
consisting of all "addicted" smokers nationwide did not meet the standards and
requirements of the federal rules governing class actions (CASTANO, ET AL. V.
THE AMERICAN TOBACCO COMPANY, ET AL.). 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 and raise "addiction"
claims similar to those raised in the CASTANO case and, in some cases, claims of
physical injury as well. As of August 1, 1998, putative smoking and health class
actions were pending in Alabama, Arkansas, California, the District of Columbia,
Florida, Georgia, Hawaii, Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland,
Michigan, Minnesota, Mississippi, Nevada, New Jersey, New Mexico, New York,
Ohio, Oklahoma, Pennsylvania, Puerto Rico, South Carolina, Tennessee, Texas,
Utah, West Virginia and Wisconsin, as well as in Canada, Brazil and Nigeria. As
of August 1, 1998, class certification had been denied or reversed by courts in
six smoking and health class actions involving PM Inc., in Louisiana, the
District of Columbia, New York (2), Pennsylvania and Puerto Rico, while classes
remained certified in three cases in Florida, Louisiana and Maryland. A number
of the foregoing decisions relating to class certification are under appeal.
Class certification motions are pending in a number of the other purported
smoking and health class actions. One ETS smoking and health class action was
settled in 1997 as discussed in the Company's 1997 Form 10-K.
ENGLE TRIAL
Jury selection began in July 1998. Plaintiffs seek compensatory and punitive
damages ranging into the billions of dollars, as well as equitable relief
including, but not limited to, a medical fund for future health care costs,
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. For a discussion of certain recent rulings
in this case, see Exhibit 99 hereto.
The trial plan currently calls for the case to be tried in three phases.
Phase One will involve three stages. Phase One, Stage One will involve
evidence concerning common issues of liability and causation for all class
members, including scientific and statistical evidence, and common class
issues concerning plaintiffs' causes of action. Entitlement to punitive
damages will be decided at the end of Phase One, Stage Two. If the jury
determines that plaintiffs are entitled to punitive damages, evidence
concerning assessment of punitive damages, by way of a ratio to be applied in
the class members' subsequent individual trials, will be presented in Phase
One, Stage Three.
If plaintiffs prevail in Phase One, Phase Two will involve individual
determination of specific causation and other individual issues regarding
entitlement to compensatory damages for the class representatives. Phase
Three of the trial will be held before separate juries to address absent
class members' determination of specific causation and other individual
issues regarding entitlement to compensatory damages.
-14-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
HEALTH CARE COST RECOVERY LITIGATION
In certain of the pending proceedings, foreign, state and local government
entities, unions, HMOs, federal and state taxpayers, native American tribes and
others seek reimbursement for Medicaid and/or other health care expenditures
allegedly caused by tobacco products and, in some cases, for future expenditures
and damages as well. 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 others, 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 vary. In most
cases, plaintiffs assert the equitable claim that the tobacco industry was
"unjustly enriched" by plaintiffs' payment of health care costs allegedly
attributable to smoking, and seek reimbursement of those costs. Other claims
made by some but not all plaintiffs include the equitable claim of indemnity,
common law claims of negligence, strict liability, breach of express and implied
warranty, violation of a voluntary undertaking or special duty, fraud, negligent
misrepresentation, conspiracy, public nuisance, claims under federal and state
statutes governing consumer fraud, antitrust, deceptive trade practices and
false advertising, and claims under federal and state RICO statutes.
Defenses raised 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 and statute of limitations. In addition, defendants argue that
they should be entitled to "set-off" any alleged damages to the extent the
plaintiff benefits economically from the sale of cigarettes through the receipt
of excise taxes or otherwise. Defendants also argue that these cases are
improper because plaintiffs must proceed under principles of subrogation and
assignment. Under traditional theories of recovery, a payor of medical costs
(such as an insurer or a state) can seek recovery of health care costs from a
third party solely by "standing in the shoes" of the injured party. Defendants
argue that plaintiffs should be required to bring an action on behalf of each
individual health care recipient and should be subject to all defenses available
against the injured party. In certain of these cases, defendants have also
challenged the ability of the plaintiffs to use contingency fee counsel to
prosecute these actions. Further, certain cigarette companies, including PM
Inc., have filed declaratory judgment actions in a number of states seeking to
block the state's health care cost recovery action and/or to prevent the state
from hiring contingency fee counsel.
As discussed in Exhibit 99 hereto, Maryland and Vermont have recently enacted
statutes that are intended to facilitate the state's ability to recover Medicaid
and/or other health care cost expenditures allegedly caused by cigarette
smoking. Other states are considering similar legislation. These statutes and
proposed bills vary by jurisdiction, but generally include provisions that
purport to
-15-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
abrogate certain affirmative defenses, create a direct cause of
action for the state (thus avoiding the need to proceed via subrogation) and
authorize the use of statistical models to prove damages and/or causation. The
legality of the Vermont statute is currently being challenged in court by PM
Inc. and other domestic tobacco manufacturers.
As of August 1, 1998, there were approximately 140 health care cost recovery
cases pending against PM Inc. and, in some cases, the Company. Thirty-seven of
these cases were filed by states, through their attorneys general and/or other
state agencies, in Alaska, Arizona, Arkansas, California, Colorado, Connecticut,
Georgia, Hawaii, Idaho, Illinois, Indiana (dismissed by trial court), Iowa
(dismissal of Medicaid reimbursement claims affirmed by appellate court),
Kansas, Louisiana, Maine, Maryland, Massachusetts, Michigan, Missouri, Montana,
Nevada, New Hampshire, New Jersey, New Mexico, New York, Ohio, Oklahoma, Oregon,
Pennsylvania, Rhode Island, South Carolina, South Dakota, Utah, Vermont,
Washington, West Virginia and Wisconsin, and eight were filed by city and county
governments. Approximately 70 of the pending health care cost recovery actions
were filed by unions (four of which have been dismissed in their entirety by
courts in Florida, Maryland, Pennsylvania and Oregon, but for which appeals are
pending or may yet be filed), six by HMOs, five by federal and state taxpayers
and five by native American tribes. Health care cost recovery actions have also
been brought by the Republic of the Marshall Islands, the Commonwealth of Puerto
Rico and the Republic of Guatemala. In July 1998, the press reported that the
Clinton Administration is reviewing the possibility of filing a Medicare health
care cost recovery action on behalf of the federal government. As discussed
above, under the heading "Overview of Tobacco-Related Litigation--Litigation
Settlements," four health care cost recovery cases have been settled in 1997 and
1998.
WASHINGTON TRIAL
Trial in the Washington health care cost recovery action is scheduled to begin
in September 1998. Plaintiff seeks damages in unspecified amounts, funding of
smoking cessation and public education programs, civil penalties of $2,000 for
each violation of the state's unfair business practices statute, civil penalties
of $100,000 against each individual defendant and $500,000 against each
corporate defendant for each violation of the state's antitrust statute, costs
and attorneys' fees, various forms of non-monetary relief and such other relief
as the court deems appropriate. For a discussion of certain recent rulings in
this case, see Exhibit 99 hereto.
MOST FAVORED NATION PROVISIONS
Following the settlement of Minnesota's health care cost recovery action in May
1998, the States of Texas, Florida and Mississippi contacted PM Inc. to discuss
the issue of what effect, if any, the settlement of the Minnesota action has
upon the terms of the prior settlements with those states pursuant to the "most
favored nation" ("MFN") provision of those prior state settlements. That
provision provides that, in the event the settling defendants enter into a
subsequent pre-verdict settlement with a non-federal governmental entity on
terms more favorable to such entity than the terms of the prior state
settlements (after due consideration of relevant differences in population or
other appropriate factors), the terms of the prior state settlements will be
revised to provide treatment at least as relatively favorable. The Mississippi
and Texas settlement agreements were recently amended pursuant to this
provision, as described in detail below. Discussions with the State of Florida
have not concluded in an agreement. (Copies
-16-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
of the MFN amendments are filed as Exhibits to this Form 10-Q, and the
discussion herein is qualified by reference thereto.)
The Mississippi and Texas MFN amendments to the settlement agreements call for
the industry to make additional payments to Mississippi and Texas over a five-
year period aggregating $550 million and $2.275 billion, respectively. These
amounts are payable in January of the year indicated and, for payments after
1999, are to be adjusted for inflation, changes in domestic sales volume and,
under specified circumstances, increases in net operating profits from domestic
sales:
(in millions)
1999 2000 2001 2002 2003 Total
---- ---- ---- ---- ---- -----
Mississippi $ 41.738 $145.173 $145.173 $145.173 $ 72.743 $ 550.000
Texas 156.530 605.090 605.090 605.090 303.200 2,275.000
-------- -------- -------- -------- -------- ----------
$198.268 $750.263 $750.263 $750.263 $375.943 $2,825.000
======== ======== ======== ======== ======== ==========
These payments will be allocated among the settling defendants in accordance
with their relative unit volume of domestic cigarette shipments in the year
preceding payment.
In the event a settling defendant defaults on its obligation to make timely
payment of the above amounts, the remaining settling defendants may, in their
absolute discretion, pay the missing payment. If they elect not to make up the
missing payment, each settling defendant can be required by the state to pay its
share of the remaining payments scheduled above within 30 days of the default,
subject to inflation and volume adjustments. The obligations of the settling
defendants under the amended settlement agreements are several and not joint;
the amended settlement agreements do not obligate any settling defendant to pay
the share of another settling defendant.
The stated amounts of the ongoing annual payments (the "Ongoing Annual
Payments") contemplated by the original Mississippi and Texas settlement
agreements are unchanged by the MFN amendments.
The MFN amendments modify the provisions of the original settlement agreements
that address the impact that enactment of federal tobacco legislation before
November 30, 2000, would have on such settlements. Under the MFN amendments, the
settling defendants will be entitled to receive a dollar-for-dollar offset
against their Ongoing Annual Payments for amounts that Mississippi or Texas, as
the case may be, could elect to receive pursuant to any such federal tobacco
legislation ("Federal Settlement Funds"), except to the extent that: (i) such
Federal Settlement Funds are required to be used for purposes other than health
care or tobacco-related purposes; (ii) such federal tobacco legislation does not
provide for the abrogation, settlement or relinquishment of state
tobacco-related claims; or (iii) state receipt of such Federal Settlement Funds
is conditioned upon (A) the relinquishment of rights or benefits under that
respective state's settlement (excepting any Ongoing Annual Payment amounts
subject to the offset); or (B) actions or expenditures by such state unrelated
to health care or tobacco (including but not limited to tobacco education,
cessation, control or enforcement).
The MFN amendments also supersede the MFN provisions contained in the original
settlement agreements. Under the MFN amendments, if the settling defendants
enter
-17-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
into any future pre-verdict settlement agreement of similar health care cost
recovery litigation on terms more favorable to a non-federal governmental
plaintiff, the Mississippi and Texas settlements will not otherwise be
revised except to the extent such future settlement provides for: (i) joint
and several liability for monetary payments, (ii) a parent company guaranty
or other credit assurance, (iii) the implementation of different non-economic
tobacco-related public health measures, or (iv) monetary offsets in the event
of federal tobacco legislation that are more favorable to such plaintiff than
those described above.
The settling defendants agreed as part of the MFN amendments to disclose
specified future payments for lobbying or related purposes in Mississippi and
Texas, to support enumerated legislative and regulatory proposals and to not
support legislation, rules or policies that would diminish Mississippi's and
Texas' rights under the amended settlement agreements. The settling defendants
further agreed not to make any payments for tobacco product placement in motion
pictures made in the United States.
The settling defendants also submitted to a Consent Judgment enjoining the
industry from (i) offering or selling non-tobacco services or merchandise (e.g.,
caps, jackets or bags) in Mississippi and Texas bearing the name or logo of a
tobacco brand other than tobacco products or items with the sole function of
advertising; (ii) making any material misrepresentation of fact regarding the
health consequences of using tobacco products; (iii) entering into any contract,
combination or conspiracy to limit health information or research into smoking
and health or product development; and (iv) taking any action to target children
in Mississippi and Texas in the advertising, promotion or marketing of
cigarettes.
In connection with the MFN amendments, the parties executed new agreements
governing settling defendants' payment of attorneys' fees to counsel for
Mississippi and Texas. (Copies of these agreements are filed as Exhibits to this
Form 10-Q, and the discussion herein is qualified by reference thereto.) The
agreements provide that beginning in November 1998, a three-member arbitration
panel will consider and determine the amount of attorneys' fees to be awarded.
These awards will be allocated among the settling defendants in accordance with
their relative unit volume of domestic cigarette shipments. Under the
agreements, there is an annual cap of $500 million on aggregate attorneys' fees
to be paid pursuant to arbitration awards, including those to be paid for
counsel for Mississippi and Texas. A one-time $250 million payment may be paid
for cases that were settled in 1997. This aggregate annual cap includes: (i) all
attorneys' fees paid pursuant to an award by the panel in connection with
settlements of any smoking and health cases (other than individual cases), (ii)
all attorneys' fees paid pursuant to an award by the panel for activities in
connection with smoking and health cases resolved by operation of federal
legislation provided such legislation imposes an obligation on the settling
defendants to pay attorneys' fees, and (iii) all attorneys' and professional
fees paid pursuant to an award by the panel for contributions made toward the
enactment of federal tobacco legislation.
The settling defendants have made payments to counsel for Mississippi and Texas
totaling $200 million as advances against awards of attorneys' fees by the
arbitration panel, such advances to be credited against the annual cap over
several years commencing in 1999.
-18-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
The Company has recorded charges of $199 million in the second quarter of
1998 to accrue for PM Inc.'s share of all fixed and determinable portions of
the obligations described above.
CERTAIN OTHER TOBACCO-RELATED LITIGATION
Since September 1997, a number of suits have been filed by former asbestos
manufacturers and asbestos manufacturers' personal injury settlement trusts
against domestic tobacco manufacturers, including PM Inc., and others
(RAYMARK INDUSTRIES, INC. V. BROWN & WILLIAMSON TOBACCO CORPORATION, ET AL.;
RAYMARK INDUSTRIES, INC. V. R.J. REYNOLDS TOBACCO COMPANY, ET AL.; FIBREBOARD
CORPORATION AND OWENS CORNING V. THE AMERICAN TOBACCO COMPANY, ET AL.; ROBERT
A. FALISE, ET AL., TRUSTEES OF THE MANVILLE PERSONAL INJURY SETTLEMENT TRUST
V. THE AMERICAN TOBACCO COMPANY, ET AL.; KEENE CREDITORS TRUST V. BROWN &
WILLIAMSON TOBACCO CORPORATION, ET AL.; H.K. PORTER COMPANY, INC. V. B.A.T.
INDUSTRIES, PLC, ET al.; RAYMARK INDUSTRIES, INC. V. THE AMERICAN TOBACCO
COMPANY, ET AL.; H.K. PORTER COMPANY, INC. V. THE AMERICAN TOBACCO
COMPANY, ET AL.). These cases seek, among other things, contribution or
reimbursement for amounts expended for 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.
Since June 1998, three class actions have been filed against PM Inc. and the
Company, in Florida, New Jersey and Pennsylvania on behalf of individuals who
purchased and consumed MARLBORO LIGHTS (HOGUE, ET AL. V. PHILIP MORRIS
COMPANIES, INC., ET AL., CIRCUIT COURT, THIRTEENTH JUDICIAL CIRCUIT
HILLSBOROUGH COUNTY, FLORIDA, FILED JUNE 30, 1998; CUMMIS, ET AL. V. PHILIP
MORRIS COMPANIES, INC., ET AL., SUPERIOR COURT OF NEW JERSEY, LAW DIVISION,
MORRIS COUNTY, FILED JULY 9, 1998; MCNAMARA, ET AL. V. PHILIP MORRIS
COMPANIES, INC., ET AL., COURT OF COMMON PLEAS, MONTGOMERY COUNTY,
PENNSYLVANIA, FILED JULY 16, 1998). These cases allege in connection with the
use of the term "Lights," among other things, deceptive and unfair trade
practices, unjust enrichment, and seek injunctive and equitable relief.
Similar class actions have been threatened in Massachusetts.
Since July 1998, two suits have been filed in California courts alleging that
domestic cigarette manufacturers, including PM Inc., and others have violated
the 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, restitution, disgorgement of profits and other relief
(PEOPLE OF THE STATE OF CALIFORNIA, ET AL. V. PHILIP MORRIS INCORPORATED, ET
AL., SUPERIOR COURT, LOS ANGELES, CALIFORNIA, FILED JULY 14, 1998; PEOPLE OF
THE STATE OF CALIFORNIA, ET AL. V. BROWN & WILLIAMSON, ET AL., SUPERIOR
COURT, SAN FRANCISCO, CALIFORNIA, FILED JULY 28, 1998).
CERTAIN OTHER ACTIONS
In March 1994, the Company and certain officers and directors were named as
defendants in a complaint filed as a purported class action in the United
States District Court for the Eastern District of New York (LAWRENCE, ET AL.
V. PHILIP MORRIS COMPANIES INC., ET AL.). Plaintiffs allege that defendants
violated the federal securities laws by maintaining artificially high levels
of profitability through an inventory management practice pursuant to which
PM Inc. allegedly shipped more inventory to customers than was necessary to
satisfy market demand. The plaintiff class consists of all persons who
purchased common stock of the
-19-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Company between July 10, 1991, and April 1, 1993, and who held such stock at
the close of business on April 1, 1993.
In April 1994, the Company and certain officers and directors were named as
defendants in several other purported class actions that were later
consolidated in the United States District Court in the Southern District of
New York (KURZWEIL, ET AL. V. PHILIP MORRIS COMPANIES INC., ET AL.). In those
cases, plaintiffs assert that defendants violated the federal securities laws
by making allegedly false and misleading statements regarding the allegedly
"addictive" qualities of cigarettes. The plaintiff class consists of all
persons who purchased common stock of the Company between June 11, 1991, and
May 6, 1994.
In June 1998, the court gave preliminary approval to an agreement reached by the
parties to settle the KURZWEIL case. Pursuant to the agreement, the Company
deposited into escrow $105 million to create a fund for the benefit of class
members. In July 1998, the court gave preliminary approval to a revision of the
June agreement, pursuant to which the Company has deposited an additional $10.5
million into the escrow fund for the benefit of class members. This $115.5
million fund will also cover any attorneys' fees and other expenses ordered by
the court if the settlement is finally approved. If so approved, the settlement
will also result in a release of all claims in the LAWRENCE action by class
members who do not request exclusion from the KURZWEIL class. If the settlement
is finally approved, the parties to the LAWRENCE action will seek the dismissal
of that action. The settlement is subject to a number of conditions, including
final court approval.
Since April 1996, five purported class action suits have been filed in
Wisconsin alleging that Kraft Foods, Inc. ("Kraft") and others engaged in a
conspiracy to fix and depress the prices of bulk cheese and milk through
their trading activity on the National Cheese Exchange (STUART, ET AL. V.
KRAFT FOODS, INC., ET AL.; SHEEKS, ET AL. V. KRAFT FOODS, INC., ET AL.;
SERVAIS, ET AL. V. KRAFT FOODS, INC. AND THE NATIONAL CHEESE EXCHANGE, INC.;
DODSON, ET AL. V. KRAFT FOODS, INC., ET AL.; and NOLL, ET AL. V. KRAFT FOODS,
INC., ET AL.). Plaintiffs seek injunctive and equitable relief and treble
damages. The court has granted the SHEEKS and STUART plaintiffs' motions for
voluntary dismissal without prejudice. Plaintiffs in the three remaining
cases have filed a consolidated class action complaint in Wisconsin seeking
certification of a class consisting of all milk producers in the United
States. In June 1998, the court in this consolidated action denied Kraft's
motion to dismiss as to the antitrust and tortious interference claims and
granted Kraft's motion to dismiss on breach of contract and false advertising
claims. In October 1997, a purported class action suit was filed in Illinois
against Kraft only (VINCENT, ET AL. V. KRAFT FOODS, INC.), and in April 1998,
a purported class action suit was filed in California against Kraft and
others (KNEVELBOARD DAIRIES, ET AL. V. KRAFT FOODS, INC., ET AL., SUPERIOR
COURT OF CALIFORNIA, LOS ANGELES COUNTY, FILED APRIL 14, 1998). Both of these
suits contain allegations similar to those in the consolidated Wisconsin
class action, but the VINCENT case seeks a class comprising all of Kraft's
milk suppliers, and the KNEVELBOARD case seeks a class comprising all of
defendants' milk suppliers in California. In June 1998, the Illinois court in
the VINCENT case granted Kraft's motion to dismiss, but has allowed
plaintiffs to file an amended complaint.
Tax assessments alleging the nonpayment of taxes in Italy (value-added taxes for
the years 1988 to 1995 and income taxes for the years 1987 to 1995) have been
served upon certain affiliates of the Company. The aggregate amount of unpaid
taxes assessed to date is alleged to be the Italian lira equivalent of $2.5
-20-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
billion. In addition, the Italian lira equivalent of $3.5 billion in interest
and penalties has been assessed (reduced from $6.0 billion to reflect a change
in law). The Company anticipates that value-added and income tax assessments may
also be received in respect of 1996 and 1997. In September 1997, the Italian
administrative tax court in Milan overturned one of the assessments for
value-added taxes, and that decision has been appealed by the tax authorities.
In May and June 1998, the Italian administrative tax court in Milan overturned
42 additional assessments for value-added and income taxes. 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 tax
assessments and pending proceedings.
THE JUNE 1997 PROPOSED RESOLUTION AND PROPOSED FEDERAL TOBACCO LEGISLATION
In June 1997, PM Inc. and other companies in the United States tobacco industry
entered into a Memorandum of Understanding (the "Resolution") to support the
adoption of federal legislation and ancillary undertakings that would resolve
many of the regulatory and litigation issues affecting the United States tobacco
industry and, thereby, reduce uncertainties facing the industry and increase
stability in business and capital markets. (The proposed Resolution is discussed
in the Company's 1997 Form 10-K, and a copy of the proposed Resolution is filed
as Exhibit 10.17 thereto.) Such legislation was never enacted.
In April 1998, the Senate Commerce Committee approved a bill that was
substantially different and significantly more adverse to the domestic tobacco
industry and the Company than the proposed Resolution (the "Commerce Bill").
That Bill, as approved by the Commerce Committee, contemplated industry payments
in excess of one-half trillion dollars over the first twenty-five years,
provided the United States Food and Drug Administration ("FDA") with broad
regulatory control over tobacco products, applied, in certain respects, to
international sales of tobacco products, and eliminated virtually all of the
provisions of the proposed Resolution that would limit liability of the tobacco
industry in civil litigation in the United States. In June 1998, the United
States Senate voted to return the Commerce Bill to the Senate Commerce Committee
for further consideration. Other federal tobacco bills are also under
consideration by Congress. The Company cannot predict whether the Commerce Bill
or any other such federal tobacco legislation will be enacted or the form any
such enactment might take.
-------------------------
It is not possible to predict the outcome of the litigation pending against the
Company and its subsidiaries. Litigation is subject to many uncertainties, and
it is possible that some of these actions could be decided unfavorably. An
unfavorable outcome 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
-21-
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
industry that have received widespread media attention. These developments may
negatively affect the perception of potential triers of fact with respect to the
tobacco industry, possibly to the detriment of certain pending litigation, and
may prompt the commencement of additional similar litigation.
Management is unable to make a meaningful estimate of the amount or range of
loss that could result from an unfavorable outcome of pending litigation. The
present legislative and litigation environment is substantially uncertain and it
is possible that the Company's business, 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 tobacco
legislation discussed above. 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 periodically may enter into
discussions in an attempt to settle various cases when they believe it is in the
best interests of the Company's stockholders to do so. In that regard, PM Inc.
has discussed with certain state attorneys general the possibility of settling
the asserted and unasserted health care cost recovery claims of most states. No
assurance can be given that any cases will be settled or what the terms of any
settlement might be.
Reference is made to Exhibit 99 to this Form 10-Q for a list of pending
smoking and health class actions and health care cost recovery actions, and
for a description of certain developments in such proceedings.
NOTE 4. RECENTLY ISSUED ACCOUNTING STANDARDS:
During the second quarter of 1998, the Financial Accounting Standards Board
issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities," which must be adopted by the Company by January 1, 2000, with early
adoption permitted. SFAS No. 133 requires that all derivative instruments be
recorded on the consolidated balance sheet 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 timing of adoption or the
impact that adoption or subsequent application of SFAS No. 133 will have on its
financial position or results of operations.
In 1998, AcSEC issued SOP No. 98-5, "Reporting on the Costs of Start-Up
Activities." SOP No. 98-5 establishes standards on accounting for start-up
and organization costs and in general, requires such costs to be expensed as
incurred. This standard is required to be adopted on January 1, 1999. The
Company currently estimates that adoption of SOP No. 98-5 will have no
material effect on the Company's financial position or results of operations.
-22-
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)
1998 1997
------- -------
Tobacco $21,336 $20,073
Food 13,710 14,164
Beer 2,176 2,193
Financial services and real estate 139 200
------- -------
Operating revenues $37,361 $36,630
======= =======
OPERATING INCOME
------------------------------
(in millions)
1998 1997
------- -------
Tobacco $ 3,731 $4,672
Food 2,193 2,118
Beer 286 285
Financial services and real estate 93 106
------- -------
Operating companies income 6,303 7,181
Amortization of goodwill (290) (296)
General corporate expenses (248) (222)
Minority interest in earnings of
consolidated subsidiaries (62) (33)
------- -------
Operating income $ 5,703 $ 6,630
======= =======
FOR THE THREE MONTHS ENDED JUNE 30,
OPERATING REVENUES
------------------------------
(in millions)
1998 1997
------- -------
Tobacco $10,673 $10,153
Food 7,035 6,953
Beer 1,196 1,207
Financial services and real estate 74 100
------- -------
Operating revenues $18,978 $18,413
======= =======
OPERATING INCOME
------------------------------
(in millions)
1998 1997
------- -------
Tobacco $ 2,083 $ 2,318
Food 1,156 1,102
Beer 158 166
Financial services and real estate 51 58
------- -------
Operating companies income 3,448 3,644
Amortization of goodwill (144) (147)
General corporate expenses (133) (113)
Minority interest in earnings of
consolidated subsidiaries (31) (20)
------- -------
Operating income $ 3,140 $ 3,364
======= =======
-23-
RESULTS OF OPERATIONS
Operating revenues for the first six months of 1998 increased 2.0% over the
first six months of 1997, and operating revenues for the second quarter of 1998
increased 3.1% over the comparable 1997 period. These increases were primarily
due to domestic tobacco, international tobacco and North American food
operations. Food segment operating revenues were affected by the 1997 sales of
Brazilian ice cream businesses, North American maple-flavored syrup businesses
and a Scandinavian sugar confectionery business. Financial services and real
estate operating revenues decreased due to the 1997 sale of the real estate
business. Excluding the operating revenues of these and other smaller operations
divested in 1997, underlying operating revenues for the first six months of 1998
increased $1.1 billion (3.1%) over the first six months of 1997, and underlying
operating revenues for the second quarter of 1998 increased $724 million (4.0%)
over the comparable 1997 period.
Operating income for the first six months and second quarter of 1998 decreased
14.0% and 6.7%, respectively, from the comparable 1997 periods, reflecting
charges related to voluntary early retirement and separation programs and the
settlement of tobacco litigation. In February 1998, the Company announced
voluntary early retirement and separation programs for salaried and hourly
employees, primarily at PM Inc. The programs resulted in pre-tax charges of $327
million during the first six months of 1998, of which $232 million was recorded
during the second quarter. First-half results also reflect first-quarter pre-tax
charges of $806 million related to settling health care cost recovery litigation
in Minnesota and second quarter charges of $199 million related to "Most Favored
Nation" clauses in previous state settlement agreements with the states of
Mississippi and Texas, as previously discussed in Note 3 to the Condensed
Consolidated Financial Statements. Excluding the charges for voluntary early
retirement and separation programs and for tobacco litigation settlements, as
well as results from operations divested since the beginning of 1997, underlying
operating income increased $484 million (7.4%) and $238 million (7.1%) over the
first six months and second quarter of 1997, respectively, reflecting favorable
results in domestic tobacco, international tobacco and North American food
operations.
Currency movements, primarily the strengthening of the U.S. dollar versus
European and Asian currencies, decreased operating revenues by $1.7 billion
($1.0 billion, excluding excise taxes) and operating income by $224 million in
the first six months of 1998 versus the comparable 1997 period. During the
second quarter, currency movements decreased operating revenues by $645 million
($388 million, excluding excise taxes) and operating income by $91 million
versus the comparable 1997 period. Although the Company cannot predict future
movements in currency rates or economic developments, it anticipates that the
continued strength of the U.S. dollar will have a significant adverse impact on
operating revenues and operating income during the remainder of 1998 and 1999
and that economic instability in Asia will continue to slow the Company's
businesses in that region.
Interest and other debt expense, net, decreased $84 million (14.8%) in the first
six months of 1998 and $41 million (14.7%) in the second quarter from the
respective comparable 1997 periods. These decreases were due primarily to lower
average debt outstanding during 1998 and higher interest income, reflecting
increased cash and cash equivalents.
Effective December 31, 1997, the Company adopted SFAS No. 128, "Earnings per
Share." SFAS No. 128 establishes standards for computing and presenting EPS and
-24-
requires the presentation of both basic and diluted EPS. Prior period EPS have
been restated to conform with the standards established by SFAS No. 128.
Diluted and basic EPS, both of which were $1.28 for the first six months of
1998, decreased by 13.5% and 14.1%, respectively, from the comparable 1997
period due primarily to previously discussed charges for voluntary early
retirement and separation programs and tobacco litigation settlements. Excluding
the after-tax impact of these charges, first-half underlying net earnings
increased 8.9% to $3.9 billion, diluted EPS increased 8.8% to $1.61 and basic
EPS increased 8.7% to $1.62. Reported diluted EPS of $0.71 and basic EPS of
$0.72 in the second quarter of 1998 each decreased by 5.3% from the comparable
1997 period. Excluding the after-tax impact of charges for voluntary early
retirement and separation programs and tobacco litigation settlements, second
quarter underlying net earnings increased 8.9% to $2.0 billion, diluted EPS
increased 9.3% to $0.82 and basic EPS increased 7.9%, to $0.82.
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") issue 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.
The Company and each of its operating subsidiaries are in the process of
implementing a CDC readiness program with the objective of having all of their
significant Business Systems, including those that affect facilities and
manufacturing activities, functioning properly with respect to the CDC before
January 1, 2000. Each operating subsidiary is in a different stage of CDC
readiness. Generally, those subsidiaries with primarily North American
operations (Philip Morris USA, Kraft Foods North America, Miller Brewing Company
and Philip Morris Capital Corporation) are closer to CDC readiness than those
with extensive international operations (Philip Morris International and Kraft
Foods International).
The first component of the CDC readiness program is to identify the 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. This effort is substantially complete with all operating subsidiaries
having identified the Business Systems that may require remediation or
replacement and established priorities for repair or replacement. Those Business
Systems considered most critical to continuing operations are being given the
highest priority.
The second component of the CDC readiness program involves the actual
remediation and replacement of Business Systems. The Company and its operating
subsidiaries are using both internal and external resources to complete this
process. Business Systems ranked highest in priority have either been remediated
or replaced or scheduled for remediation or replacement. Business Systems
previously earmarked for retirement and replacement without regard to the CDC
issue have been evaluated for early replacement with CDC compliant systems or
programs or, in the alternative, remediation. The Company's objective is to
complete substantially all remediation and replacement of internal Business
Systems by March 1999, and to complete final testing and certification for CDC
readiness by September 1999.
-25-
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 business operations after January 1, 2000, have
been identified and steps are being undertaken in an attempt to reasonably
ascertain their stage of CDC readiness through questionnaires, interviews,
on-site visits and other available means. In conjunction with this effort, key
governmental agencies and utilities upon which the Company and its operating
subsidiaries rely are being approached on a worldwide basis to identify their
level of CDC preparedness. In many cases, these entities (particularly outside
North America) have a lower level of CDC awareness and are less willing to
provide information concerning their state of CDC readiness.
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 presently believes that it may experience some disruption in its
business due to the CDC issue. More specifically, 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 risk of disruption
in its businesses exists in certain international markets. The possible
consequences of the Company or Key Business Partners not being fully CDC
compliant by January 1, 2000 include, among other things, temporary plant
closings, delays in the delivery of products, delays in the receipt of supplies,
invoice and collection errors, and inventory and supply obsolescence.
Consequently, the business and results of operations of the Company could be
materially adversely affected by a temporary inability of the Company and its
operating subsidiaries to conduct their businesses in the ordinary course for a
period of time after January 1, 2000. However, the Company believes that its CDC
readiness program, including the contingency planning discussed below, should
significantly reduce the adverse effect any such disruptions may have.
Concurrently with the CDC readiness measures described above, the Company and
its operating subsidiaries are developing contingency plans intended to
mitigate the possible disruption in business operations that may result from
the CDC issue, and are developing cost estimates for such plans. Contingency
plans may include stockpiling raw and packaging materials, increasing
inventory levels, securing alternate sources of supply, adjusting facility
shut-down and start-up schedules and other appropriate measures. Once
developed, contingency plans and related cost estimates will be continually
refined as additional information becomes available.
It is currently estimated that the aggregate cost of the Company's CDC efforts
will be approximately $400 million to $500 million, of which approximately
$150 million has been spent. These costs are being expensed as they are
incurred and are being funded through operating cash flow. These amounts do not
include any costs associated with the implementation of contingency plans,
which are in the process of being developed. The costs associated with the
replacement of computerized systems, hardware or equipment (currently estimated
to be approximately $100 million), substantially all of which would be
capitalized, are not included in the above estimates.
The Company's CDC readiness program is an ongoing process and the estimates
of costs and completion dates for various components of the CDC readiness
program described above are subject to change.
-26-
EURO
On January 1, 1999, eleven of the fifteen member countries of the European Union
are scheduled to establish fixed conversion rates between their existing
currencies ("legacy currencies") and one common currency - the euro. The euro
will then trade on currency exchanges and may be used in business transactions.
Beginning in January 2002, new euro-denominated 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 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 Company anticipates that the euro conversion 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, operating revenues, cash flows, operating income and financial position
of PM Inc., PMI and the Company.
In the United States, these issues include actual and proposed excise tax
increases; proposed federal regulatory controls (including, as discussed
below, the issuance of final regulations by the FDA that regulate cigarettes
as "drugs" or "medical devices"); actual and proposed requirements regarding
disclosure of cigarette ingredients and other proprietary information; actual
and proposed requirements regarding disclosure of the yields of "tar",
nicotine and other constituents found in cigarette smoke; governmental and
grand jury investigations; increased smoking and health litigation, including
private plaintiff class action litigation and health care cost recovery
actions brought by state and local governments, unions and others seeking
reimbursement for Medicaid and/or other health care expenditures allegedly
caused by cigarette smoking; actual and proposed federal, state and local
governmental and private bans and restrictions on smoking (including in
workplaces and in buildings permitting public access); actual and proposed
restrictions on tobacco manufacturing, marketing, advertising (including
decisions by certain companies to limit or not accept tobacco advertising)
and sales; actual and proposed legislation and regulations to require
substantial additional health warnings on cigarette packages and in
advertising, and to eliminate the tax deductibility of tobacco advertising
and promotional costs; proposed legislation to require the establishment of
ignition propensity performance standards for cigarettes; increased
assertions of adverse health effects associated with both smoking and
exposure to ETS; legislation or other governmental action seeking to ascribe
to the industry responsibility and liability for the purported adverse health
effects associated with both smoking and exposure to ETS; the diminishing
social acceptance of smoking; increased pressure from anti-smoking groups;
unfavorable press reports; and federal tobacco legislation under
consideration by Congress.
Cigarettes are subject to substantial excise taxes in the United States and to
similar taxes in most foreign markets. The United States federal excise tax on
-27-
cigarettes is currently $12 per 1,000 cigarettes ($0.24 per pack of 20
cigarettes). In August 1997, legislation was enacted that will raise the federal
excise tax to $17 per 1,000 cigarettes ($0.34 per pack of 20 cigarettes)
starting in the year 2000 and then to $19.50 per 1,000 cigarettes ($0.39 per
pack of 20 cigarettes) in 2002. In general, excise taxes and other
cigarette-related taxes levied by federal, state and local governments 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. Congress has been considering a number of bills that provide for
significant increases in the federal excise tax or other payments from tobacco
manufacturers. Increases in other cigarette-related taxes have been proposed at
the state and local level.
In the opinion of PM Inc. and PMI, past increases in excise and similar taxes
have had an adverse impact on sales of cigarettes. Any future increases, the
extent of which cannot be predicted, could result in volume declines for the
cigarette industry, including PM Inc. and PMI, and might cause sales to shift
from the premium segment to the discount segment.
In August 1996, the FDA issued final regulations pursuant to which it asserts
jurisdiction over cigarettes as "drugs" or "medical devices" under the
provisions of the Food, Drug and Cosmetic Act. The final regulations include
severe restrictions on the distribution, marketing and advertising of
cigarettes, and would require the industry to comply with a wide range of
labeling, reporting, recordkeeping, manufacturing and other requirements
applicable to medical devices and their manufacturers. For the most part, the
regulations were scheduled to become effective on August 28, 1997. The FDA's
exercise of jurisdiction, if not reversed by judicial or legislative action,
could lead to more expansive FDA-imposed restrictions on cigarette operations
than those set forth in the final regulations, and could materially adversely
affect the volume, operating revenues, cash flows and operating income of PM
Inc. and the Company. PM Inc. and others challenged in the courts the FDA's
authority to regulate cigarettes. In April 1997, a U.S. district court ruled
that Congress has not precluded the FDA from regulating cigarettes as "drugs"
or "medical devices" and that the FDA may regulate cigarettes if the facts
asserted in support of the FDA's assertion of jurisdiction are proven to be
correct. The court also ruled, however, that the section of the Food, Drug
and Cosmetic Act relied upon by the agency does not give the FDA authority to
implement its regulations restricting cigarette advertising and promotions.
The court stayed implementation of the FDA's regulations scheduled for August
1997. The court left in effect the specific regulations that took effect in
February 1997 establishing a federal minimum age of 18 for the sale of
tobacco products and requiring proof of age for anyone under age 27. The
tobacco company plaintiffs, including PM Inc., are appealing that portion of
the district court's order relating to the FDA's assertion of jurisdiction.
The FDA is appealing that portion of the order enjoining the advertising and
promotion restrictions. The respective appeals were heard by the U.S. Court
of Appeals for the Fourth Circuit in August 1997. In March 1998, a member of
the Fourth Circuit panel that was considering the appeals died and as a
result the appeals were reargued in June 1998. The outcome of this litigation
cannot be predicted.
In August 1996, the Commonwealth of Massachusetts enacted legislation to require
cigarette manufacturers to disclose to the Massachusetts Department of Public
Health ("DPH") the flavorings and other ingredients used in each brand of
cigarettes sold in the Commonwealth, and to provide "nicotine-yield ratings" for
their products based on standards to be established by the DPH. PM Inc. believes
that enforcement of the ingredient disclosure provisions of the statute could
permit the disclosure by DPH to the public of valuable proprietary information
concerning its brands. PM Inc. and three other domestic cigarette manufacturers
have filed suit in federal district court in Boston challenging the legislation.
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In December 1997, the court granted a preliminary injunction to the tobacco
company plaintiffs and enjoined the Commonwealth from enforcing the ingredient
disclosure provisions of the legislation until further order of the court. In
July 1998, the Commonwealth's appeal of this ruling was argued before the First
Circuit Court of Appeals. In addition, both parties' cross-motions for summary
judgment were argued before the district court earlier this year. The ultimate
outcome of this lawsuit cannot be predicted. The enactment of this legislation
has encouraged efforts to enact, and the enactment of, ingredient disclosure
legislation in other states, such as Texas and Minnesota.
In December 1997, PM Inc. disclosed to the DPH "nicotine-yield ratings" for its
products sold in the Commonwealth based on standards established by the DPH for
determining "nicotine delivery under average smoking conditions." The
"nicotine-yield ratings" produced using the DPH standards are higher than the
yields produced using the standards established by a 1970 voluntary agreement
between the Federal Trade Commission ("FTC") and domestic cigarette
manufacturers, including PM Inc., and which are required to be included in all
cigarette advertising. In September 1997, the FTC issued a request for public
comments on its proposed revision of the "tar" and nicotine testing and
reporting standards established by the 1970 voluntary agreement. In February
1998, PM Inc. and three other domestic cigarette manufacturers filed comments on
the proposed revisions in which they stressed the value of historical continuity
with respect to "tar" and nicotine testing and disclosure; expressed the opinion
that the proposed revisions are unnecessary; but, agreed to assist the FTC in
its efforts to improve consumer understanding of the meaning of routine testing
results.
In June 1995, PM Inc. announced that it had voluntarily undertaken a program to
limit minors' access to cigarettes. Elements of the program include
discontinuing free cigarette sampling to consumers in the United States,
discontinuing the distribution of cigarettes by mail to consumers in the United
States, placing a notice on cigarette cartons and packs for sale in the United
States stating "Underage Sale Prohibited," working with others in support of
state legislation to prevent youth access to tobacco products, taking measures
to encourage retailer compliance with minimum-age laws, and independent auditing
of the program.
In October 1997, at the request of the United States Senate Judiciary Committee,
PM Inc. provided the Committee with a document setting forth the Company's
position on a number of issues. On the issues of the causal 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 alleged 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.
In 1993, the U.S. Environmental Protection Agency ("EPA") issued a report
relating to certain alleged health effects of ETS. The report included, among
other things, a risk assessment relating to the alleged association between ETS
and lung cancer in nonsmokers, and a determination by EPA to classify ETS as a
"Group A" carcinogen. The risk assessment and classification has been one of the
primary sources cited in support of smoking restrictions in workplaces and
public places around the world. PM Inc. and others challenged the risk
assessment and classification on several grounds in a U.S. district court. In
July 1998, the court vacated those sections of the EPA report relating to lung
cancer, finding,
-29-
among other things, that, although the agency has been authorized by Congress
to conduct a risk assessment and classification of ETS, EPA may have reached
different conclusions had it complied with certain relevant statutory
requirements. The federal government has announced that it intends to appeal
the court's ruling. It is not possible to predict what impact, if any, the
ruling will have on existing or proposed regulations banning or restricting
smoking in workplaces and public places.
In late January 1998, the chief executive officers of the four leading domestic
tobacco companies or their parent corporations, including the Company, pledged
to Congress to publicly release millions of pages of industry documents placed
into the document depository established in connection with Minnesota's health
care cost recovery action. The documents comprise a wide range of smoking and
health issues covered in scientific and marketing research reports, memoranda,
executive correspondence, handwritten notes and other materials. They do not
include highly sensitive trade secret information, certain third-party and
personnel information, or documents for which attorney client privilege or work
product doctrine claims have been asserted. Several installments of these
documents have been made available via the Internet. The remaining installments
are expected to be posted on the Internet before year end.
Many foreign countries, as well as the European Union, have also taken a number
of different steps to regulate the manufacture and/or marketing of cigarettes.
Most prominently, these steps include: restricting or prohibiting cigarette
advertising and promotion, banning or severely restricting smoking in workplaces
and public places or otherwise discouraging cigarette smoking and increasing
taxes on cigarettes. Some countries have taken further steps, including
requiring ingredient disclosure, imposing maximum constituent levels,
controlling prices, and restricting imports. It is not possible to predict what,
if any, other foreign governmental legislation or regulations will be adopted
relating to the manufacturing, advertising, sale or use of cigarettes or to the
tobacco industry generally.
In June 1998, a European Communities Directive, effective July 6, 1998, was
published in the Official Journal of the European Communities. The directive
bans virtually all forms of tobacco advertising and sponsorship in the European
Union. Member States must enact implementing legislation by July 2001. However,
Member States may delay full implementation of the ban for additional periods
(one year for print advertising, two years for sponsorships generally, and until
October 1, 2006 for sponsorship of events such as Formula One racing). The
directive does not apply to a few limited types of advertising such as point of
sale displays which may be regulated by Member States as they see fit.
In March 1998, pursuant to a regulation in Thailand that requires manufacturers
and importers of tobacco products to disclose to the Ministry of Public Health
("MPH") the ingredients of their products to be sold in Thailand on a by-brand
basis, a subsidiary of PMI disclosed to the MPH by-brand ingredient lists for
its products imported into Thailand for sale in that country. The disclosure was
accompanied by a claim of confidentiality under applicable Thai and
international law. Although this Thai regulation does not require the MPH to
make public the submitted ingredient lists, there are no assurances that the
confidentiality of the lists submitted will be maintained.
PM Inc. has received requests for information (including grand jury subpoenas)
in connection with governmental investigations of the tobacco industry, and is
cooperating with respect to such requests. Certain present and former employees
of PM Inc. have testified or have been asked to testify in connection with
certain of these matters. The investigations include an investigation by the
United States
-30-
Attorney for the Eastern District of New York relating to The Council for
Tobacco Research-U.S.A., Inc., a research organization of which PM Inc. is a
sponsor; and an investigation by the United States Department of Justice
relating to issues raised in testimony provided by tobacco industry
executives before Congress and other related matters. While the outcomes of
these investigations cannot be predicted, PM Inc. believes it has acted
lawfully.
As further discussed above in Note 3 to the Condensed Consolidated Financial
Statements, there is litigation pending in various U.S. and foreign
jurisdictions related to tobacco products. These cases generally fall within
three categories: (i) smoking and health cases alleging personal injury brought
on behalf of individual plaintiffs, (ii) smoking and health cases alleging
personal injury and purporting to be brought on behalf of a class of individual
plaintiffs, and (iii) health care cost recovery cases brought by state and local
governments seeking reimbursement for Medicaid and/or other health care
expenditures allegedly caused by cigarette smoking, as well as similar cases,
including class actions, brought by non-governmental plaintiffs such as unions,
HMOs, federal and state taxpayers, native American tribes and others. Damages
claimed in some of the smoking and health class actions and health care cost
recovery cases range into the billions of dollars.
In recent years there has been a substantial increase in the number of smoking
and health cases being filed in the United States.
As of August 1, 1998, there were approximately 400 smoking and health cases
filed and served on behalf of individual plaintiffs in the United States against
PM Inc. and, in some cases, the Company (excluding approximately 50 cases in
Texas that were voluntarily dismissed but which may be refiled under certain
conditions), compared with approximately 375 such cases on December 31, 1997,
and 185 such cases on December 31, 1996. Many of the new cases were filed in
Florida and New York. Twenty-two of the individual cases involve allegations of
various personal injuries allegedly related to exposure to ETS.
In addition, as of August 1, 1998, there were approximately 65 purported smoking
and health 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 50
such cases on December 31, 1997, and 20 such cases on December 31, 1996. 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.
The number of health care cost recovery actions in the United States also
increased, with approximately 140 such cases pending as of August 1, 1998,
compared with approximately 105 such cases on December 31, 1997, and 25 such
cases on December 31, 1996.
There are also a number of tobacco-related actions pending outside the United
States against affiliates and subsidiaries of PMI including, as of August 1,
1998, approximately 20 smoking and health cases initiated by one or more
individuals (Argentina (13), Brazil (1), Canada (1), Italy (1), Japan (1),
Scotland (1) and Turkey (2)), four smoking and health class actions (Brazil (2),
Canada (1) and Nigeria (1)) and one health care cost recovery action (Republic
of the Marshall Islands). In addition, the Republic of Guatemala has filed a
health care cost recovery action in the United States.
-31-
During 1997 and the first half of 1998, PM Inc. and other companies in the
United States tobacco industry settled health care cost recovery actions brought
by the States of Mississippi, Florida, Texas and Minnesota and an ETS smoking
and health class action brought on behalf of airline flight attendants. As
discussed above in Note 3, the Mississippi and Texas settlement agreements were
amended recently pursuant to their "most favored nation" clause to reflect the
terms of the Minnesota settlement.
THE JUNE 1997 PROPOSED RESOLUTION AND PROPOSED FEDERAL TOBACCO LEGISLATION
In June 1997, PM Inc. and other companies in the United States tobacco industry
entered into a Memorandum of Understanding (the "Resolution") to support the
adoption of federal legislation and ancillary undertakings that would resolve
many of the regulatory and litigation issues affecting the United States tobacco
industry and, thereby, reduce uncertainties facing the industry and increase
stability in business and capital markets. (The proposed Resolution is discussed
in the Company's 1997 Form 10-K and a copy of the proposed Resolution is filed
as Exhibit 10.17 thereto.) Such legislation was never enacted.
In April 1998, the Senate Commerce Committee approved a bill that was
substantially different and significantly more adverse to the domestic tobacco
industry and the Company than the proposed Resolution (the "Commerce Bill").
That Bill, as approved by the Commerce Committee, contemplated industry payments
in excess of one-half trillion dollars over the first twenty-five years,
provided the FDA with broad regulatory control over tobacco products, applied,
in certain respects, to international sales of tobacco products, and eliminated
virtually all of the provisions of the proposed Resolution that would limit
liability of the tobacco industry in civil litigation in the United States. In
June 1998, the United States Senate voted to return the Commerce Bill to the
Senate Commerce Committee for further consideration. Other federal tobacco bills
are also under consideration by Congress. The Company cannot predict whether the
Commerce Bill or any other such federal tobacco legislation will be enacted or
the form any such enactment might take.
-------------------------
It is not possible to predict the outcome of the litigation pending against the
Company and its subsidiaries. Litigation is subject to many uncertainties, and
it is possible that some of these actions could be decided unfavorably. An
unfavorable outcome 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 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, 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 tobacco
legislation discussed above. 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,
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the Company and its subsidiaries periodically may enter into discussions in
an attempt to settle various cases when they believe it is in the best
interests of the Company's stockholders to do so. In that regard, PM Inc. has
discussed with certain state attorneys general the possibility of settling
the asserted and unasserted health care cost recovery claims of most states.
No assurance can be given that any cases will be settled or what the terms of
any settlement might be.
OPERATING RESULTS
FOR THE SIX MONTHS ENDED JUNE 30,
------------------------------------------------------
OPERATING REVENUES OPERATING INCOME
------------------------------------------------------
(in millions)
1998 1997 1998 1997
------ ------- ------ -----
Domestic tobacco $ 7,011 $ 6,369 $1,049 $2,259
International tobacco 14,325 13,704 2,682 2,413
------- ------- ------ ------
Total $21,336 $20,073 $3,731 $4,672
======= ======= ====== ======
DOMESTIC TOBACCO. During the first six months of 1998, PM Inc.'s operating
revenues increased 10.1% over the comparable 1997 period, due to pricing
($765 million) and improved product mix ($27 million), partially offset by
lower volume ($150 million).
During the first six months of 1998, PM Inc. recorded pre-tax charges of $1,005
million related to tobacco litigation settlements, as discussed in Note 3 to the
Condensed Consolidated Financial Statements. In addition, PM Inc. recorded
pre-tax charges of $309 million related to voluntary early retirement and
separation programs for salaried and hourly employees.
Operating income for the first six months of 1998 decreased 53.6% from the
comparable 1997 period, due primarily to tobacco litigation settlement charges
($1,005 million), higher marketing, administration and research costs ($327
million), charges for the voluntary early retirement and separation programs
($309 million) and lower volume ($99 million), partially offset by price
increases, net of cost increases (aggregating to $514 million) and improved
product mix ($17 million). Excluding the impact of the voluntary early
retirement and separation programs and the tobacco litigation settlement
charges, PM Inc.'s underlying operating income for the first six months of 1998
increased 4.6% over the comparable 1997 period.
Domestic tobacco industry shipment volume during the first six months of 1998
declined 3.2% from the first six months of 1997. PM Inc. estimates that
second-quarter, and to a lesser extent, year-to-date industry shipments were
affected by a second-quarter reduction in trade inventories, which wholesalers
had increased in late 1997 in anticipation of price increases. PM Inc. further
estimates that its second-quarter, and to a lesser extent, its year-to-date
shipments and resultant shipment market shares were adversely affected by the
timing of its consumer promotions and a disproportionate reduction in its trade
inventories. While PM Inc. cannot predict future rates of change in industry
shipments, it believes that, over the long term, industry shipments should
continue to decline in line with historical trends, subject to the effects of
price increases related to tobacco litigation settlements or the possible
enactment of federal tobacco legislation discussed under "Tobacco--Business
Environment" above.
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PM Inc.'s shipment volume for the first six months of 1998 was 111.8 billion
units, a decrease of 2.1% from the first six months of 1997. However, PM Inc.
estimates that, excluding the factors mentioned above, its volume would have
decreased by less than 0.5%. MARLBORO shipment volume for the first six months
of 1998 increased 0.3 billion units (0.4%) over the comparable 1997 period to
79.6 billion units for a 35.2% share of the total industry, an increase of 1.3
share points over 1997. For the first six months of 1998, PM Inc.'s shipment
market share was 49.4%, an increase of 0.5 share points over the comparable
period of 1997. However, PM Inc. estimates that, excluding the factors mentioned
above, its shipment share grew by more than 1.0 point to approximately 49.7%.
This increase is consistent with consumer purchases as measured by retail data
from an independent market research company.
Based on shipments, the premium segment accounted for approximately 72.9% of the
domestic cigarette industry volume in the first six months of 1998, an increase
of 0.9 share points over the comparable period of 1997. This reflects a
continued shift toward higher-margin premium cigarettes and away from the
discount segment, a trend which began in the second half of 1993. In the premium
segment, PM Inc.'s volume decreased 0.8% in the first half of 1998, compared
with a 2.0% decrease for the industry, resulting in a premium segment share of
58.5%, an increase of 0.7 share points over the comparable period of 1997.
In the discount segment, PM Inc.'s shipments decreased 9.7% to 15.2 billion
units in the first six months of 1998, compared with an industry decline of
6.3%, resulting in a discount segment share of 24.8%, a decrease of 0.9 share
points from the comparable period of 1997. BASIC shipment volume for the first
six months of 1998 was flat at 11.5 billion units, for an 18.7% share of the
discount segment, an increase of 1.1 share points over the comparable 1997
period.
PM Inc. cannot predict future change or rates of change in the relative sizes of
the premium and discount segments or in PM Inc.'s shipments, shipment market
share or retail market share; however, it believes that PM Inc.'s shipments
would be materially adversely affected by price increases related to tobacco
litigation settlements or the possible enactment of federal tobacco legislation
discussed under "Tobacco--Business Environment" above.
Subsequent to the end of the second quarter, PM Inc. announced a price increase
of $3.00 per thousand cigarettes on its premium and discount brands in August
1998. This increase follows similar announcements of price increases of $2.50
per thousand cigarettes in May 1998, $2.50 per thousand cigarettes in April
1998, $1.25 per thousand cigarettes in January 1998, $3.50 per thousand
cigarettes in September 1997 and $2.50 per thousand cigarettes in March 1997.
Each $1.00 per thousand increase by PM Inc. equates to a $.02 increase to the
wholesale price of each pack of twenty cigarettes.
INTERNATIONAL TOBACCO. During the first six months of 1998, international
tobacco operating revenues of PMI increased 4.5% over 1997, including excise
taxes. Excluding excise taxes, operating revenues increased 5.8%, due primarily
to price increases ($331 million), favorable volume/mix ($254 million) and the
consolidation of previously unconsolidated subsidiaries ($273 million),
partially offset by unfavorable currency movements ($584 million). Operating
income for the first six months of 1998 increased 11.1% over the comparable 1997
period, due primarily to price increases, net of cost increases ($285 million),
favorable volume/mix ($117 million), the consolidation of previously
unconsolidated subsidiaries ($53 million) and lower marketing, administration
and research costs, partially offset by unfavorable currency movements ($192
million).
-34-
PMI's volume in the first six months of 1998 grew 16.1 billion units (4.4%) over
the comparable 1997 period to 384.1 billion units. PMI's volume growth was
impeded by weaker business conditions in Asia, particularly in Korea, Indonesia
and the Philippines. Volume advanced strongly in a number of important markets,
including Germany, Italy, France, the Benelux countries, Spain, Greece, Austria,
Poland, Hungary, Turkey, Eastern Europe, Japan, Mexico and Argentina. However,
volume growth in the Eastern Europe region slowed during the second quarter as a
result of adverse economic developments in Russia. PMI recorded market share
gains in virtually all major markets. Overall volume growth was driven by
aggregate gains for PMI's portfolio of major international brands, including
MARLBORO, which grew strongly over the first half of 1997.
FOR THE THREE MONTHS ENDED JUNE 30,
-----------------------------------------------------------
OPERATING REVENUES OPERATING INCOME
------------------------- -----------------------
(in millions)
1998 1997 1998 1997
------- ------- ------ ------
Domestic tobacco $ 3,700 $ 3,457 $ 825 $1,185
International tobacco 6,973 6,696 1,258 1,133
------- ------- ------ ------
Total $10,673 $10,153 $2,083 $2,318
======= ======= ====== ======
DOMESTIC TOBACCO. During the second quarter of 1998, PM Inc.'s operating
revenues increased 7.0% over the comparable 1997 period, due to pricing
($437 million) and improved product mix ($9 million), partially offset by
lower volume ($203 million).
Operating income for the second quarter of 1998 decreased 30.4% from the
comparable 1997 period, due to charges for voluntary early retirement and
separation programs ($214 million), tobacco litigation settlement charges ($199
million), higher marketing, administration and research costs ($127 million),
lower volume ($133 million), partially offset by price increases, net of cost
increases (aggregating to $299 million), lower fixed manufacturing costs ($9
million) and improved product mix ($5 million). Excluding the impact of charges
for the voluntary early retirement and separation programs and tobacco
litigation settlements, PM Inc.'s underlying operating income for the second
quarter of 1998 increased 4.5% over the comparable 1997 period.
Domestic tobacco industry shipment volume during the second quarter declined
4.4% from the comparable 1997 period. However, PM Inc. estimates that industry
shipments during the quarter were significantly affected by a reduction in trade
inventories, which wholesalers had increased in late 1997 in anticipation of
price increases. PM Inc. also estimates that its shipments and resultant
shipment market share were adversely affected by the timing of consumer
promotions and a disproportionate impact of the reduction in trade inventories.
While PM Inc. cannot predict future rates of change in industry shipments, it
believes that, over the long term, industry shipments should continue to decline
in line with historical trends, subject to the effects of price increases
related to tobacco litigation settlements or the possible enactment of federal
tobacco legislation discussed under "Tobacco--Business Environment" above.
PM Inc.'s shipment volume for the second quarter of 1998 was 57.3 billion units,
a decrease of 5.8% from the second quarter of 1997, reflecting the factors
mentioned above. Second-quarter MARLBORO shipment volume decreased 1.8 billion
units (4.1%) to 40.8 billion units for a 34.5% share of the total industry, an
-35-
increase of 0.1 share points over the second quarter of 1997. PM Inc.'s second
quarter 1998 shipment market share was 48.5%, a decrease of 0.7 share points
from the comparable period of 1997. PM Inc. estimates that, excluding the
factors mentioned above, its shipment share grew by approximately 1.2 share
points to 50%. This increase is consistent with the trend of consumer purchases
as measured by retail data from an independent market research company.
Based on shipments, the premium segment accounted for approximately 73.1% of
domestic cigarette industry volume in the second quarter of 1998, an increase of
0.7 share points over the comparable 1997 period. This reflects a continued
shift toward higher-margin premium cigarettes and away from the discount
segment, a trend which began in the second half of 1993. In the premium segment,
PM Inc.'s second-quarter volume decreased 4.4%, compared with a 3.4% decrease
for the industry, resulting in a premium segment share of 57.6%, a decrease of
0.6 share points from the second quarter of 1997.
In the discount segment, PM Inc.'s second quarter shipments decreased 14.2% to
7.4 billion units in 1998, compared with an industry decline of 6.9%, resulting
in a discount segment share of 23.4%, a decrease of 2.0 share points from the
comparable period of 1997. BASIC second quarter shipment volume decreased 528
million units to 5.5 billion units, for a 17.2% share of the discount segment, a
decrease of 0.4 share points from the comparable 1997 period.
PM Inc. cannot predict future change or rates of change in the relative sizes of
the premium and discount segments or in PM Inc.'s shipments, shipment market
share or retail market share; however, it believes that PM Inc.'s shipments
would be materially adversely affected by price increases related to tobacco
litigation settlements or the possible enactment of federal tobacco legislation
discussed under "Tobacco--Business Environment" above.
INTERNATIONAL TOBACCO. During the second quarter of 1998, international tobacco
operating revenues of PMI increased 4.1% over 1997, including excise taxes.
Excluding excise taxes, operating revenues increased 4.8%, due primarily to
price increases ($122 million), favorable volume/mix ($109 million) and the
consolidation of previously unconsolidated subsidiaries ($61 million), partially
offset by unfavorable currency movements ($228 million). Operating income for
the second quarter of 1998 increased 11.0% over the comparable 1997 period, due
primarily to price increases ($122 million), favorable volume/mix ($78 million)
and the consolidation of previously unconsolidated subsidiaries ($25 million),
partially offset by unfavorable currency movements ($81 million).
PMI's volume in the second quarter of 1998 grew 7.1 billion units (4.0%) over
the comparable 1997 period to 184.2 billion units. PMI's volume growth was
impeded by weaker business conditions in Asia, particularly in Korea, Indonesia
and the Philippines. Volume advanced strongly in a number of important markets,
including Germany, Italy, France, the Benelux countries, Spain, Greece, Austria,
Poland, Hungary, Turkey, Eastern Europe, Japan, Mexico and Argentina. However,
volume growth in the Eastern Europe region has slowed during the quarter as a
result of adverse economic developments in Russia. In Japan, volume growth
reflects, in part, a favorable comparison to the second quarter of 1997, when
volume declined following first-quarter trade purchases in advance of an April
1, 1997 tax-driven retail price increase. PMI recorded market share gains in
virtually all major markets. Overall volume growth was driven by aggregate gains
for PMI's portfolio of major international brands, including MARLBORO, which
grew strongly over the second quarter of 1997.
-36-
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. 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.
Increases in commodity costs can cause retail price volatility and influence
consumer and trade buying patterns, leading to price competition in some
markets. The North American and international food businesses are subject to
fluctuating commodity costs, particularly coffee bean and cocoa prices. Coffee
bean prices reached a twenty-year high in May 1997, leading to price increases
by Kraft, KFI and their competitors. In 1998, coffee bean prices have declined
from their 1997 levels.
During 1997, PMI sold its Brazilian ice cream businesses in the fourth quarter,
Kraft sold North American maple-flavored syrup businesses in the third quarter
and KFI sold a Scandinavian sugar confectionery business in the first quarter.
Kraft and KFI also sold several smaller non-strategic businesses in 1997. The
operating results of businesses divested in 1997 were not material to operating
results in any of the periods presented.
In the fourth quarter of 1997, KFI and the food operations of PMI recorded
realignment charges related primarily to the downsizing or closure of
manufacturing and other facilities, as well as the discontinuance of certain
low-margin product lines. Included in the charges were provisions for
incremental postemployment benefits, primarily related to severance.
OPERATING RESULTS
FOR THE SIX MONTHS ENDED JUNE 30,
------------------------------------------------------
OPERATING REVENUES OPERATING INCOME
----------------------- ----------------------
(in millions)
1998 1997 1998 1997
------- ------- ------ ------
North American food $ 8,905 $ 8,731 $1,686 $1,558
International food 4,805 5,433 507 560
------- ------- ------ ------
Total $13,710 $14,164 $2,193 $2,118
======= ======= ====== ======
NORTH AMERICAN FOOD. During the first six months of 1998, operating revenues
increased 2.0% over the first six months of 1997, due primarily to favorable
volume ($293 million) and pricing ($92 million), partially offset by unfavorable
product mix ($77 million), the impact of divestitures ($90 million) and
unfavorable currency movements ($44 million). Operating income for the first six
-37-
months of 1998 increased 8.2% over the first six months of 1997, due
primarily to volume increases in ongoing operations ($167 million) and
pricing ($92 million), partially offset by unfavorable product mix ($76
million), higher marketing, administration and research costs ($31 million)
and the impact of divestitures ($22 million).
Excluding operating results of the divested North American food businesses
discussed above, underlying operating revenues and underlying operating income
increased 3.1% and 9.8%, respectively, in the first six months of 1998 versus
the comparable 1997 period.
Strong underlying volume gains were achieved by frozen pizza, resulting from the
continued success of rising crust pizza; meals, due to the growth of Taco Bell
grocery products as well as strength in macaroni and cheese dinners; beverages,
from the strength of ready-to-drink products and new product introductions,
partially offset by declines in higher-margin powdered soft drinks; and cereals,
aided by new products. Volume also grew in cheese, across all major product
lines; processed meats, due to the strength lunch combinations, which reflected
the continued success of new product introductions, and to increases in hot dogs
and bacon; and desserts and snacks on the strength of refrigerated ready-to-eat
desserts and shelf-stable puddings and new product introductions. Enhancers
volume grew slightly, reflecting strong growth in spoonable dressings, partially
offset by lower barbecue sauce shipments. Coffee volume in the first half of
1998 declined from the comparable 1997 period due largely to market contraction
resulting from higher retail prices in the first quarter of 1998. In Canada,
volume was essentially flat, reflecting the solid performance in retail branded
products, offset by the planned reduction of low margin products.
INTERNATIONAL FOOD. Operating revenues for the first six months of 1998
decreased 11.6% from the first six months of 1997, due to unfavorable currency
movements ($407 million), lower volume/mix ($142 million) and the impact of
divestitures ($230 million), partially offset by pricing ($117 million) and the
consolidation of a previously unconsolidated subsidiary ($34 million). Operating
income for the first six months of 1998 decreased 9.5% from the first six months
of 1997, due primarily to cost increases net of price increases (netting to $57
million, primarily related to higher coffee costs), lower volume/mix ($22
million), the impact of divestitures ($29 million) and unfavorable currency
movements ($26 million), partially offset by lower marketing, administration and
research costs ($75 million) and the consolidation of a previously
unconsolidated subsidiary.
Excluding the operating results of the divested international food businesses
discussed above, underlying operating revenues decreased 7.6% and underlying
operating income decreased 4.5% in the first six months of 1998 from the first
six months of 1997.
KFI's coffee volume continued to be adversely affected by soft consumption and
trade de-stocking in anticipation of price declines in certain markets, as well
as a difficult comparison against the prior year, when shipments were heavy in
advance of rising prices. Confectionery volume increased on the strength of
continued growth and new product introductions in Central and Eastern Europe.
These increases more than offset volume declines due to the contraction of
several key European chocolate markets, as well as higher prices in Germany.
Volume also increased in KFI's cheese and grocery business as a result of higher
shipments of cheese in the United Kingdom, snacks in Scandinavia, powdered soft
drinks in the Middle East and China and processed cheese slices and peanut
butter in Australia. Cheese and grocery volume in Germany was down due primarily
to the impact of retail price increases. Cheese and grocery volume was also down
in
-38-
Southeast Asia, reflecting the current economic instability of the region. In
Latin America, volume grew solidly due primarily to powdered soft drinks in
Brazil and ready-to-drink beverages in Puerto Rico.
FOR THE THREE MONTHS ENDED JUNE 30,
-------------------------------------------------------
OPERATING REVENUES OPERATING INCOME
---------------------- ----------------------
(in millions)
1998 1997 1998 1997
------ ------ ------ ------
North American food $4,540 $4,331 $ 884 $ 815
International food 2,495 2,622 272 287
------ ------ ------ ------
Total $7,035 $6,953 $1,156 $1,102
====== ====== ====== ======
NORTH AMERICAN FOOD. During the second quarter of 1998, operating revenues
increased 4.8% over the second quarter of 1997, due primarily to favorable
volume ($299 million), partially offset by the impact of divestitures ($40
million), unfavorable product mix ($27 million) and unfavorable currency
movements ($21 million). Operating income for the second quarter of 1998
increased 8.5% over the second quarter of 1997, due primarily to volume
increases in ongoing operations ($155 million) and cost decreases, net of price
decreases (aggregating to $8 million), partially offset by higher marketing,
administration and research costs ($60 million), unfavorable product mix ($26
million) and the impact of divestitures ($11 million).
Excluding operating results of the divested North American food businesses
discussed above, underlying operating revenues and underlying operating income
increased 5.8% and 10.0%, respectively, in the second quarter of 1998 versus the
comparable 1997 period.
Coffee volume in the second quarter of 1998 increased strongly over the
comparable 1997 period when coffee shipments were unusually low following
accelerated purchases in the first quarter of 1997 in advance of
commodity-driven price increases. Strong coffee volume in the second quarter of
1998 also reflects the favorable impact of reductions in retail prices as green
coffee bean costs declined. Strong underlying volume gains were also achieved by
frozen pizza, resulting from the continued success of rising crust pizza; meals,
due to the growth of Taco Bell grocery products, as well as strength in macaroni
and cheese dinners; 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, cold cuts and bacon; cheese due to
strength across all major product categories; and enhancers due to growth in
spoonable and pourable salad dressings, reflecting new advertising and a new
line of pourable salad dressings. Cheese and enhancers volumes were also
favorably affected by the timing of the Easter holiday. Volume also grew in
desserts and snacks on the strength of refrigerated ready-to-eat desserts and
shelf-stable puddings, as well as new products; cereals, aided by new products;
and beverages, from the strength of ready-to-drink products and new product
introductions, partially offset by lower shipments of higher-margin powdered
soft drinks. In Canada, volume decreased slightly due to the planned reduction
of low margin products.
INTERNATIONAL FOOD. Operating revenues for the second quarter of 1998 decreased
4.8% from the second quarter of 1997, due to unfavorable currency movements
($139 million) and the impact of divestitures ($85 million), partially offset by
higher ongoing volume/mix ($64 million), pricing ($19 million) and the
consolidation of
-39-
a previously unconsolidated subsidiary ($14 million). Operating income for
the second quarter of 1998 decreased 5.2% from the second quarter of 1997,
due primarily to cost increases net of price increases (aggregating to $26
million, primarily related to higher coffee costs), higher marketing,
administration and research costs ($13 million), and unfavorable currency
movements ($7 million), partially offset by higher volume/mix from ongoing
operations ($29 million).
Excluding the operating results of the divested international food businesses
discussed above, underlying operating revenues decreased 1.7% and underlying
operating income decreased 5.9% in the second quarter of 1998 from the second
quarter of 1997.
KFI's coffee volume continued to be adversely affected by soft consumption and
trade de-stocking in anticipation of price declines in certain markets.
Confectionery volume increased on the strength of successful promotions in
Germany, continued growth and new product introductions in Central and Eastern
Europe and the timing of Easter shipments. Volume also grew in KFI's cheese and
grocery business as a result of higher shipments of cheese in the United
Kingdom; snacks in Scandinavia; cheese, cream cheese and meats in Italy;
powdered soft drinks in the Middle East and China; and processed cheese slices
and peanut butter in Australia. Cheese and grocery volume was down in Southeast
Asia, reflecting the current economic instability of the region. In Latin
America, volume increased strongly due primarily to powdered soft drinks in
Brazil and Mexico, as well as higher shipments of ready-to-drink beverages in
Puerto Rico.
BEER
SIX MONTHS ENDED JUNE 30
Operating revenues of the Miller Brewing Company ("Miller") for the first six
months of 1998 decreased $17 million (0.8%) from the first six months of 1997,
due primarily to lower volume ($15 million) and unfavorable price/mix ($2
million). Operating income for the first six months of 1998 increased $1 million
(0.4%) over the first six months of 1997, due primarily to lower marketing,
administration and research costs ($20 million, primarily lower marketing),
partially offset by lower volume ($8 million), unfavorable price/mix ($6
million) and higher fixed manufacturing costs ($5 million). Excluding the 1997
results of then 20%-owned Molson Breweries of Canada, underlying operating
income increased 1.1%.
Miller's domestic shipment volume of 21.9 million barrels for the first six
months of 1998 increased 0.1% from the comparable 1997 period, reflecting
increases in near-premium brands and steady performance in premium and budget
brands. Export volume decreased 28.2%, as volume shifted to sales under
international licensing agreements. Domestic shipments of premium products were
even with 1997 as higher shipments of MILLER LITE and double-digit gains in
ICEHOUSE and FOSTER'S were offset by lower shipments of MILLER beer and MILLER
GENUINE DRAFT. Domestic shipments of near-premium products increased slightly on
the performance of RED DOG. Domestic shipments of budget brands were even with
1997, despite volume growth in the MILWAUKEE'S BEST FAMILY OF BEERS.
Wholesalers' sales to retailers in the first six months of 1998 decreased
slightly from the comparable 1997 period, reflecting lower sales of MILLER LITE,
MILLER GENUINE DRAFT and MILLER beer, partially offset by double-digit increases
for ICEHOUSE and FOSTER'S, as well as solid increases for the MILWAUKEE'S BEST
FAMILY OF BEERS.
-40-
THREE MONTHS ENDED JUNE 30
Miller's operating revenues for the second quarter of 1998 decreased $11 million
(0.9%) from the second quarter of 1997, due primarily to lower volume ($14
million), partially offset by favorable price/mix ($3 million). Operating income
for the second quarter of 1998 decreased $8 million (4.8%) from the second
quarter of 1997, due primarily to the impact of a divested equity investment ($9
million), lower volume ($7 million), unfavorable price/mix ($2 million) and
higher fixed manufacturing costs ($3 million), partially offset by lower
marketing, administration and research costs ($13 million). Excluding the 1997
results of then 20%-owned Molson Breweries of Canada, underlying operating
income increased 0.6%.
Miller's domestic shipment volume of 12.0 million barrels for the second quarter
of 1998 decreased 0.3% from the comparable 1997 period, reflecting slight
decreases in near-premium and budget brands. Domestic shipments of premium
brands were essentially even with the comparable 1997 period, as higher MILLER
LITE shipments, coupled with double-digit increases for ICEHOUSE and FOSTER'S,
were offset by lower domestic shipments of MILLER beer and MILLER GENUINE DRAFT,
which continues to be adversely affected by intense competition in the key
markets of California and Texas. Domestic shipments of near-premium products
decreased slightly on lower shipments of RED DOG. Domestic budget brand volume
decreased slightly, despite increases for the MILWAUKEE'S BEST FAMILY OF BEERS.
Wholesalers' sales to retailers in the second quarter of 1998 decreased slightly
from the comparable 1997 period, reflecting lower sales of MILLER LITE, MILLER
GENUINE DRAFT and MILLER beer, partially offset by double-digit increases for
ICEHOUSE and Foster's, as well as higher sales of the MILWAUKEE'S BEST FAMILY OF
BEERS.
During the second quarter of 1998, Miller announced an agreement with S&P
Company to contract manufacture certain Pabst brands, as well as the brands of
other S&P subsidiaries, in several states. The five-year contract, which is
renewable in its fourth year, will result in manufacturing fee income for
Miller, which is not expected to materially affect Miller's operating income in
1998. Miller's shipments of Pabst brands are expected to begin in the third
quarter of 1998.
FINANCIAL SERVICES AND REAL ESTATE
Philip Morris Capital Corporation's ("PMCC") financial services and real estate
operating revenues and operating income declined in the first six months and the
second quarter of 1998 from the comparable 1997 periods, reflecting the sale of
its real estate subsidiary, Mission Viejo Company, in the third quarter of 1997.
Operating revenues and operating income from PMCC's financial services business
increased in the first six months and second quarter of 1998 over the comparable
1997 periods due to increased leasing and structured finance investments and the
continued profitability of PMCC's existing portfolio of finance assets.
FINANCIAL REVIEW
NET CASH PROVIDED BY OPERATING ACTIVITIES
During the first six months of 1998, net cash provided by operating activities
was $3.7 billion compared with $3.5 billion in the comparable 1997 period. The
increase primarily reflects higher underlying net earnings, partially offset by
the payment of tobacco litigation settlements charged to earnings in the second
half of 1997. Included in net earnings for the first six months of 1998 were
previously discussed charges for voluntary early retirement programs and the
-41-
settlement of tobacco litigation (aggregating to $814 million on an after-tax
basis), payments for the majority of which will be made in future periods.
NET CASH USED IN INVESTING ACTIVITIES
During the first six months of 1998, net cash used in investing activities was
$980 million, substantially unchanged from $956 million used during the
comparable 1997 period. During the first six months of 1997, cash used by PMI
for the purchase of a controlling interest in a cigarette manufacturer in
Portugal more than offset cash provided by KFI from the sale of a Scandinavian
sugar confectionery business.
NET CASH USED IN FINANCING ACTIVITIES
During the first six months of 1998, net cash of $341 million was used in
financing activities, as compared with $2.4 billion used in financing activities
during the comparable 1997 period. This difference was primarily due to higher
net issuance of debt in 1998 and to stock repurchases during the first half of
1997.
DEBT
The Company's total debt (consumer products and financial services) was $15.7
billion and $14.1 billion at June 30, 1998 and December 31, 1997, respectively.
Total consumer products debt was $14.7 billion and $13.3 billion at June 30,
1998 and December 31, 1997, respectively. At June 30, 1998 and December 31,
1997, the Company's ratio of consumer products debt to total equity was 0.92 and
0.89, respectively. The ratio of total debt to total equity was 0.98 and 0.95 at
June 30, 1998 and December 31, 1997, respectively.
The Company and its subsidiaries maintain credit facilities with a number of
lending institutions, amounting to approximately $12.0 billion at June 30, 1998.
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. An agreement that
enables the Company to borrow $2.0 billion for short-term purposes expires in
October 1998. The Company intends to negotiate a new short-term agreement to
replace the current agreement. An agreement for $8.0 billion expires in 2002,
enabling the Company to refinance short-term debt on a long-term basis. The
Company expects to refinance long-term and short-term debt from time to time.
The nature and amount of the Company's long-term and short-term debt and the
proportionate amount of each can be expected to vary as a result of future
business requirements, market conditions and other factors.
The Company operates internationally, with manufacturing and sales facilities in
various locations around the world. The Company continually evaluates its
foreign currency net asset exposure (primarily the Swiss franc, German mark,
Netherlands guilder, Swedish krona and Canadian dollar) based on current market
conditions and business strategies, and it acts to manage such exposure, when
deemed prudent, through various hedging transactions. The Company has entered
into currency and related interest rate swap agreements to manage a portion of
its exposure to currency movements. The U.S. dollar value of aggregate notional
principal amounts for these agreements outstanding was equivalent to $2.5
billion and $1.4 billion, respectively, at June 30, 1998 and December 31, 1997.
Of these amounts, $1.8 billion and $736 million related to consumer products
debt at June 30, 1998 and December 31, 1997, respectively. In addition, during
the first half of 1998, the Company entered into a swap agreement that
effectively converts $800 million of fixed rate debt to variable rate debt.
-42-
The Company enters into forward exchange and option contracts, for purposes
other than trading, to reduce the effects of fluctuating foreign currency on
foreign currency denominated current assets, liabilities, commitments and
short-term intercompany transactions. At June 30, 1998 and December 31, 1997,
the Company had entered into contracts, with maturities of less than one year
and U.S. dollar equivalents of $2.4 billion (including $873 million in option
contracts) and $2.5 billion (including $1.1 billion in option contracts),
respectively.
Use of the above-mentioned derivative financial instruments has not had a
material impact on the Company's financial position at June 30, 1998 or
results of operations for the three or six months then ended.
The Company's credit ratings by Moody's at June 30, 1998 and December 31, 1997
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, 1998 and December 31, 1997 were "A-1" in the commercial paper market and "A"
for long-term debt obligations. The debt ratings of the Company remain on S&P's
CreditWatch list, as S&P monitors tobacco litigation and legislation
developments.
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 quarter of 1997, the Board of Directors announced an $8.0
billion share repurchase program. The Company repurchased common stock at an
aggregate cost of $51 million under this program prior to its suspension in
April 1997.
Dividends paid in the first six months of 1998 were substantially unchanged
from the comparable 1997 period. The current quarterly dividend rate of $0.40
per share was established by the Company's Board of Directors in the third
quarter of 1996, resulting in an annualized dividend rate of $1.60 per share.
During the first six months of 1998, currency translation adjustments reduced
stockholders' equity by $221 million due to the strengthening of the U.S.
dollar versus European currencies, primarily the Swiss franc, Swedish krona,
German mark, Norwegian krone and Netherlands guilder.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents were $4.6 billion at June 30, 1998 and $2.3 billion
at December 31, 1997, the increase being largely attributable to the 1997
suspension of the Company's share repurchase program and 1998 debt issuances
discussed above.
NEW ACCOUNTING STANDARDS
During the second quarter of 1998, the Financial Accounting Standards Board
issued SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities", which must be adopted by the Company by January 1, 2000, with early
adoption permitted. SFAS No. 133 requires that all derivative instruments be
recorded on the consolidated balance sheet at their fair value. Changes in the
-43-
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 timing of adoption or the
impact that adoption or subsequent application of SFAS No. 133 will have on its
financial position or results of operations.
In 1998, the American Institute of Certified Public Accountants' Accounting
Standards Executive Committee ("AcSEC") issued Statement of Position ("SOP")
No. 98-1, "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use." SOP No. 98-1 requires certain costs incurred in
connection with developing or obtaining internal-use software to be
capitalized and other costs to be expensed. The Company adopted SOP No. 98-1
effective January 1, 1998, and its application for the three and six month
periods ended June 30, 1998 had no material effect on the Company's financial
position or results of operations.
In 1998, AcSEC issued SOP No. 98-5, "Reporting on the Costs of Start-Up
Activities." SOP No. 98-5 establishes standards on accounting for start-up
and organization costs and in general, requires such costs to be expensed as
incurred. This standard is required to be adopted on January 1, 1999. The
Company currently estimates that adoption of SOP No. 98-5 will have no
material effect on the Company's financial position or results of operations.
CONTINGENCIES
See Note 3 to the Condensed Consolidated Financial Statements for a discussion
of 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 tax
increases, governmental regulation, privately imposed smoking restrictions,
governmental and grand jury investigations, litigation, and the effects of price
increases related to tobacco litigation settlements and, if implemented, federal
tobacco legislation discussed above. Each of the Company's operating
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. The performance of each of PMI and
KFI is affected by foreign economies and currency movements. 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.
Reference is made to Note 3, "Contingencies," of the Notes to the
Condensed Consolidated Financial Statements included in Part I, Item 1 of
this report, and to "Tobacco--Business Environment," of the Management's
Discussion and Analysis of Financial Condition and Results of Operations
included in Part I, Item 2 of this report.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits
10.1 Stipulation of Amendment to Settlement Agreement and For Entry
of Agreed Order, dated July 2, 1998, regarding the settlement
of the Mississippi health care cost recovery action.
10.2 Mississippi Fee Payment Agreement, dated July 2, 1998,
regarding the payment of attorneys' fees.
10.3 Mississippi MFN Escrow Agreement, dated July 2, 1998.
10.4 Stipulation of Amendment to Settlement Agreement and For Entry
of Consent Decree, dated July 24, 1998, regarding the
settlement of the Texas health care recovery action.
10.5 Texas Fee Payment Agreement, dated July 24, 1998, regarding the
payment of attorneys' fees.
12 Statement regarding computation of ratios of earnings to fixed
charges.
27 Financial Data Schedule.
99 Certain Pending Litigation Matters and Recent Developments.
(b) Reports on Form 8-K. During the quarter for which this report is
filed, the Registrant filed a Current Report on Form 8-K, dated
April 20, 1998, containing a letter to stockholders describing the
Company's view of a federal tobacco bill sponsored by Senator John
McCain.
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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 14, 1998
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