SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
(X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 (917) 663-5000
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Former name, former address and former fiscal year, if changed since last report
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months, and (2) has been subject to such filing
requirements for the past 90 days. Yes X No
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At October 30, 1998, there were 2,434,668,752 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
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PART I - FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited).
Condensed Consolidated Balance Sheets at
September 30, 1998 and December 31, 1997 3 - 4
Condensed Consolidated Statements of Earnings for the
Nine Months Ended September 30, 1998 and 1997 5
Three Months Ended September 30, 1998 and 1997 6
Condensed Consolidated Statements of Stockholders'
Equity for the Year Ended December 31, 1997 and the
Nine Months Ended September 30, 1998 7
Condensed Consolidated Statements of Cash Flows for the
Nine Months Ended September 30, 1998 and 1997 8 - 9
Notes to Condensed Consolidated Financial Statements 10 - 23
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations. 24 - 46
PART II - OTHER INFORMATION
Item 1. Legal Proceedings. 47
Item 6. Exhibits and Reports on Form 8-K. 47
Signature 48
2
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements.
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(in millions of dollars)
(Unaudited)
September 30, December 31,
1998 1997
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ASSETS
Consumer products
Cash and cash equivalents $ 5,524 $ 2,282
Receivables, net 5,122 4,294
Inventories:
Leaf tobacco 4,257 4,348
Other raw materials 1,950 1,689
Finished product 3,039 3,002
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9,246 9,039
Other current assets 1,846 1,825
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Total current assets 21,738 17,440
Property, plant and equipment, at cost 21,158 20,002
Less accumulated depreciation 9,045 8,381
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12,113 11,621
Goodwill and other intangible assets
(less accumulated amortization of
$5,277 and $4,814) 17,653 17,789
Other assets 3,083 3,211
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Total consumer products assets 54,587 50,061
Financial services
Finance assets, net 6,127 5,712
Other assets 161 174
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Total financial services assets 6,288 5,886
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TOTAL ASSETS $60,875 $55,947
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See notes to condensed consolidated financial statements.
Continued
3
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Continued)
(in millions of dollars)
(Unaudited)
September 30, December 31,
1998 1997
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LIABILITIES
Consumer products
Short-term borrowings $ 681 $ 157
Current portion of long-term debt 1,623 1,516
Accounts payable 2,692 3,318
Accrued marketing 2,354 2,149
Accrued taxes, except income taxes 1,476 1,234
Accrued settlement charges 1,375 886
Other accrued liabilities 3,324 3,977
Income taxes 1,494 862
Dividends payable 1,073 972
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Total current liabilities 16,092 15,071
Long-term debt 12,412 11,585
Deferred income taxes 918 889
Accrued postretirement health care costs 2,528 2,432
Other liabilities 6,685 6,218
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Total consumer products liabilities 38,635 36,195
Financial services
Long-term debt 880 845
Deferred income taxes 3,984 3,877
Other liabilities 142 110
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Total financial services liabilities 5,006 4,832
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Total liabilities 43,641 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 27,033 24,924
Accumulated other comprehensive earnings:
Currency translation adjustments (1,096) (1,109)
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26,872 24,750
Less cost of repurchased stock
(372,648,588 and 380,474,028 shares) 9,638 9,830
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Total stockholders' equity 17,234 14,920
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TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $60,875 $55,947
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See notes to condensed consolidated financial statements.
4
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions of dollars, except per share data)
(Unaudited)
For the Nine Months Ended
September 30,
-------------------------------
1998 1997
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Operating revenues $55,948 $54,722
Cost of sales 20,119 19,978
Excise taxes on products 12,635 12,348
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Gross profit 23,194 22,396
Marketing, administration and research costs 12,440 11,904
Settlement charges (Note 3) 1,116 812
Amortization of goodwill 433 438
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Operating income 9,205 9,242
Interest and other debt expense, net 682 815
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Earnings before income taxes 8,523 8,427
Provision for income taxes 3,425 3,412
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Net earnings $ 5,098 $ 5,015
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Per share data:
Basic earnings per share $ 2.10 $ 2.07
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Diluted earnings per share $ 2.09 $ 2.05
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Dividends declared $ 1.24 $ 1.20
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See notes to condensed consolidated financial statements.
5
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions of dollars, except per share data)
(Unaudited)
For the Three Months Ended
September 30,
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1998 1997
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Operating revenues $18,587 $18,092
Cost of sales 6,529 6,571
Excise taxes on products 4,216 4,101
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Gross profit 7,842 7,420
Marketing, administration and research costs 4,086 3,854
Settlement charges (Note 3) 111 812
Amortization of goodwill 143 142
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Operating income 3,502 2,612
Interest and other debt expense, net 200 249
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Earnings before income taxes 3,302 2,363
Provision for income taxes 1,322 957
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Net earnings $ 1,980 $ 1,406
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Per share data:
Basic earnings per share $ 0.81 $ 0.58
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Diluted earnings per share $ 0.81 $ 0.58
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Dividends declared $ 0.44 $ 0.40
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See notes to condensed consolidated financial statements.
6
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders' Equity
for the Year Ended December 31, 1997 and
the Nine Months Ended September 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)
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Balances, December 31, 1997 935 24,924 (1,109) (1,109) (9,830) 14,920
Comprehensive earnings:
Net earnings 5,098 5,098
Other comprehensive earnings,
net of income taxes:
Currency translation adjustments 13 13 13
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Total other comprehensive earnings 13 13 13
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Total comprehensive earnings 5,111
Exercise of stock options and
issuance of other stock awards 25 192 217
Cash dividends
declared($1.24 per share) (3,014) (3,014)
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Balances, September 30, 1998 $ 935 $27,033 $(1,096) $(1,096) $(9,638) $17,234
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Total comprehensive earnings, which primarily represent net earnings partially
offset by currency translation adjustments, were $2,214 million and $1,117
million, respectively, for the quarters ended September 30, 1998 and 1997, and
$3,878 million for the first nine months of 1997.
See notes to condensed consolidated financial statements.
7
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(in millions of dollars)
(Unaudited)
For the Nine Months Ended
September 30,
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1998 1997
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CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES
Net earnings - Consumer products $ 5,010 $ 4,881
- Financial services and real estate 88 134
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Net earnings 5,098 5,015
Adjustments to reconcile net earnings to
operating cash flows:
Consumer products
Depreciation and amortization 1,291 1,246
Deferred income tax provision 135 130
Gains on sales of businesses (182)
Cash effects of changes, net of the effects
from acquired and divested companies:
Receivables, net (875) (942)
Inventories (28) (331)
Accounts payable (811) (972)
Income taxes 656 (40)
Other working capital items 136 663
Other 633 335
Financial services and real estate
Deferred income tax provision 111 113
Gain on sale of business (103)
Other 70 156
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Net cash provided by operating activities 6,416 5,088
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CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES
Consumer products
Capital expenditures (1,228) (1,176)
Purchases of businesses, net of acquired cash (13) (628)
Proceeds from sales of businesses 6 402
Other 40
Financial services and real estate
Investments in finance assets (568) (501)
Proceeds from finance assets 133 256
Proceeds from sale of a business 427
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Net cash used in investing activities (1,630) (1,220)
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See notes to condensed consolidated financial statements.
Continued
8
Philip Morris Companies Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Continued)
(in millions of dollars)
(Unaudited)
For the Nine Months Ended
September 30,
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1998 1997
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CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES
Consumer products
Net issuance(repayment)of short-term borrowings $ 526 $(1,006)
Long-term debt proceeds 2,037 2,852
Long-term debt repaid (1,244) (1,330)
Financial services and real estate
Net issuance of short-term borrowings 146
Long-term debt proceeds 175
Long-term debt repaid (387)
Dividends paid (2,913) (2,916)
Issuance of shares 157 97
Repurchase of outstanding stock (805)
Other (166) (72)
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Net cash used in financing activities (1,603) (3,246)
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Effect of exchange rate changes on cash and
cash equivalents 59 (83)
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Cash and cash equivalents:
Increase 3,242 539
Balance at beginning of period 2,282 240
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Balance at end of period $5,524 $ 779
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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:
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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:
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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 Nine Months Ended
September 30,
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1998 1997
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(in millions)
Net earnings $5,098 $5,015
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Weighted average shares for
basic EPS 2,428 2,419
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 2,444 2,441
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For the Three Months Ended
September 30,
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1998 1997
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(in millions)
Net earnings $1,980 $1,406
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Weighted average shares for
basic EPS 2,430 2,421
Plus incremental shares from conversions:
Restricted stock and stock rights 1 1
Stock options 17 21
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Weighted average shares for
diluted EPS 2,448 2,443
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10
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 September 30, 15 16
For the nine months ended September 30, 15 11
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 nine month periods ended September 30, 1998
had no material effect on the Company's financial position or results of
operations.
Note 3. Contingencies:
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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
other reimbursement cases, including class actions, brought by
non-governmental plaintiffs such as unions, health maintenance organizations
("HMOs"), native American tribes, federal and state taxpayers 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. Exhibit 99.1
hereto lists the smoking and health class actions and the health care cost
recovery cases pending as of November 1, 1998, and discusses certain
developments in these cases since July 1, 1998.
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 November 1, 1998, there were approximately 450 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
11
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
conditions), compared with approximately 375 such cases on December 31, 1997,
and 185 such cases on December 31, 1996. Many of these cases are pending in
Florida, West Virginia and New York. Seventeen of the individual cases involve
allegations of various personal injuries allegedly related to exposure to
environmental tobacco smoke ("ETS").
In addition, as of November 1, 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 nine 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 November 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 November
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)) and four smoking and health class actions
(Brazil (2), Canada (1) and Nigeria (1)). In addition, health care cost
recovery actions have been brought in Israel and by the Republic of the
Marshall Islands, the Commonwealth of Puerto Rico, and British Columbia,
Canada in their respective jurisdictions and by the Republic of Guatemala and
the Republic of Panama in the United States.
Litigation Settlements
During 1997 and 1998, PM Inc. and other companies in the United States tobacco
industry settled an ETS smoking and health class action brought on behalf of
airline flight attendants and health care cost recovery actions brought by the
States of Mississippi, Florida, Texas and Minnesota. The Florida health care
cost recovery settlement agreement was recently amended pursuant to its "most
favored nations" ("MFN") clause to reflect the terms of the Minnesota health
care cost recovery settlement. The Florida MFN amendment, which is similar to
MFN amendments previously entered into with Mississippi and Texas, is discussed
below under the heading "Health Care Cost Recovery Litigation - Most Favored
Nation Provisions." The Mississippi and Texas MFN amendments are discussed in
Note 3 of the Company's Quarterly Report on Form 10-Q for the quarter ended June
30, 1998. The Minnesota settlement agreement is discussed in Note 3 of the
Company's Quarterly Report on Form 10-Q for the quarter ended March 31, 1998.
The health care cost recovery settlement agreements, the MFN amendments thereto
and certain ancillary agreements are filed as exhibits to various of the
Company's reports filed with the Securities and Exchange Commission.
Since the beginning of the third quarter of 1997, PM Inc. has recorded charges
totaling $2.573 billion to accrue for its share of all fixed and determinable
portions of its obligations under the foregoing settlements. $1.116 billion of
these charges were taken during the first nine months of 1998, of which $111
million were taken during the third quarter. Accrued settlement costs for which
12
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
payments have not yet been made, totaling $1.598 billion, are payable
principally before the end of the year 2000.
As discussed in the last paragraph of this Note 3, PM Inc. and other
companies in the United States tobacco industry have discussed with a number
of state attorneys general an agreement that could settle the asserted and
unasserted health care cost recovery claims of all of the states. Discussions
have reached the stage where those attorneys general are reporting to the
remaining states the terms of a proposed agreement. The proposed agreement is
contingent upon a sufficient number of states accepting the agreement. No
assurance can be given that the proposed agreement will be accepted by a
sufficient number of states as to cause the industry to conclude an
agreement. (A copy of the proposed agreement is filed as Exhibit 99.3 hereto
and is incorporated herein by reference thereto.)
Verdicts in Individual Cases
During the last two and one-half 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 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.
Pending Trials
Trial is underway in a smoking and health class action in Florida (Engle, et al.
v. R.J. Reynolds Tobacco Company, et al.) and in the State of Washington's
health care cost recovery action. These cases are discussed below.
13
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Upcoming Trial Dates
Exhibit 99.2 hereto lists the smoking and health class actions and health care
cost recovery actions that are currently scheduled for trial through 2000.
Except for the Engle and State of Washington trials, no other smoking and health
cases or health care cost recovery actions are scheduled for trial during 1998.
As noted in Exhibit 99.2, four smoking and health class actions and 14 health
care cost recovery actions, including three brought on behalf of unions, are
scheduled for trial in 1999 against PM Inc. and, in some cases, the Company.
During 1999, 15 individual smoking and health cases are scheduled for trial
against PM Inc., including two in which the Company is a defendant. 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 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
14
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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 November 1, 1998, 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, North Carolina, Ohio, Oklahoma, Pennsylvania,
Puerto Rico, South Carolina, Tennessee, Texas, Utah, Virginia, West Virginia
and Wisconsin, as well as in Canada, Brazil and Nigeria. As of November 1,
1998, class certification had been denied or reversed by courts in 11 smoking
and health class actions involving PM Inc., in Louisiana, the District of
Columbia, New York (2), Pennsylvania, Puerto Rico and New Jersey (5), 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
- -----------
Trial in this Florida class action case 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.
The current trial plan calls for the case to be tried in three "Phases." The
court has stated, however, that the trial plan may be modified. Phase One will
involve two "Stages." Phase One, Stage One will involve evidence concerning
common issues of liability and general 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, but no amount will be set at that
time. If the jury determines that plaintiffs are entitled to punitive damages,
the assessment of punitive damages will be addressed in Phase Two.
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.
HEALTH CARE COST RECOVERY LITIGATION
In certain of the pending proceedings, foreign, state and local government
entities, unions, HMOs, native American tribes, federal and state taxpayers 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
15
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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.
Certain states have enacted, and others are considering enacting, 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. These statutes and proposed bills vary by jurisdiction, but
generally include provisions that purport to 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. These statutes are being challenged in
court by PM Inc. and other domestic tobacco manufacturers.
As of November 1, 1998, there were approximately 140 health care cost recovery
cases pending against PM Inc. and, in some cases, the Company. Thirty-nine
16
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
health care cost recovery cases were filed by states, through their attorneys
general and/or other state agencies, in Alabama, Alaska, Arizona, Arkansas,
California, Colorado, Connecticut, Georgia, Hawaii, Idaho, Illinois, Indiana,
Iowa, Kansas, Louisiana, Maine, Maryland, Massachusetts, Michigan, Missouri,
Montana, Nebraska, 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, six by HMOs, six by
native American tribes and five by federal and state taxpayers. Health care
cost recovery actions have also been brought in Israel and by the Republic of
the Marshall Islands, the Commonwealth of Puerto Rico, and British Columbia,
Canada in their respective jurisdictions and by the Republic of
Guatemala and the Republic of Panama in the United States. The press
has reported that the Clinton Administration is reviewing the possibility of
filing a Medicare health care cost recovery action on behalf of the federal
government.
Courts have ruled on preliminary motions to dismiss various claims in
approximately 45 of the health care cost recovery actions brought by or on
behalf of governmental entities and unions. Although many of these rulings have
been favorable to the industry, a number have been adverse, including recent
rulings in union cases pending in Ohio and New York (Iron Workers Local Union
No. 17 Insurance Fund, et al. and National Asbestos Workers Medical Fund, et
al.), which are scheduled for trial in February 1999 and May 1999,
respectively. Recent rulings in these cases are further discussed in
Exhibit 99.1.
Washington Trial
- ----------------
Trial in the Washington health care cost recovery action is currently underway.
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 99.1 hereto.
Most Favored Nation Provisions
- ------------------------------
Following the settlement of Minnesota's health care cost recovery action in May
1998, previous health care cost recovery settlements with the States of
Mississippi, Texas and Florida were amended pursuant to the MFN provision
of those settlements. The MFN provision provided that, in the event the settling
defendants entered 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 would be revised to provide treatment at least as relatively
favorable. The Mississippi and Texas settlement agreements were amended pursuant
to this provision in July 1998. These MFN amendments are described in the
Company's June 30, 1998 Form 10-Q. The Florida MFN amendment was signed in
September 1998 and is
17
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
described below. (A copy of the Florida MFN amendment is filed as an Exhibit to
this Form 10-Q, and the discussion herein is qualified by reference thereto.)
The Florida MFN amendment calls for the industry to make additional payments to
Florida over a five-year period aggregating $1.75 billion. 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
---- ---- ---- ---- ---- -----
$ 123.470 $ 464.590 $ 464.590 $ 464.590 $ 232.760 $ 1,750.000
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 agreement are several and not joint; the
amended settlement agreement does 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 Florida settlement agreement are
unchanged by the MFN amendment.
The MFN amendment modifies the provision of the original settlement agreement
that address the impact that enactment of federal tobacco legislation before
November 30, 2000, would have on such settlement. Under the MFN amendment, the
settling defendants will be entitled to receive a dollar-for-dollar offset
against their Ongoing Annual Payments for amounts that Florida 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 amendment also supersedes the MFN provision contained in the original
settlement agreement. Under the MFN amendment, if the settling defendants enter
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 Florida settlement 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
18
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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 amendment to disclose
specified future payments for lobbying or related purposes in Florida, to
support enumerated legislative and regulatory proposals and not to support
legislation, rules or policies that would diminish Florida's rights under the
amended settlement agreement. 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 have also agreed to submit to a Consent Judgment
enjoining the industry from (i) offering or selling non-tobacco services or
merchandise (e.g., caps, jackets or bags) in Florida 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 Florida in the advertising, promotion or marketing of cigarettes.
In connection with the MFN amendment, the parties executed an agreement
governing settling defendants' payment of attorneys' fees to counsel for
Florida. (A copy of this agreement is filed as an Exhibit to this Form 10-Q, and
the discussion herein is qualified by reference thereto.) The agreement provides
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 in the period immediately preceding the
period with respect to which such payment is made. Under the agreement, 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 Florida. A
one-time $250 million payment may be paid for cases that were settled in 1997.
The 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 certain federal tobacco legislation.
The settling defendants have made payments on account of counsel for Florida
totaling $100 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.
The Company has recorded charges of $111 million in the third quarter of 1998 to
accrue for PM Inc.'s share of all fixed and determinable portions of the
obligations with respect to the Florida MFN amendment.
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
19
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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.; 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). In October 1998, the court denied
defendants' motion to dismiss the complaint in People of the State of
California, et al. v. Brown & Williamson, et al.
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
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,
20
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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.
On November 13, 1998, the United States District Court for the Southern
District of New York approved a settlement agreement relating to the Kurzweil
class action. Pursuant to the agreement, the Company deposited into escrow
$115.5 million to create a fund for the benefit of class members. This fund
will also cover any attorneys' fees and other expenses ordered by the court.
The settlement will also result in a release of all claims in the Lawrence
action by class members who have not requested exclusion from the Kurzweil
class. The parties to the Lawrence action intend to seek the dismissal of
that action in the fourth quarter of 1998.
In September 1997, a purported class action suit consolidating several
previously filed class actions was 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 (Servais, et al. v. Kraft Foods, Inc., et al.).
Plaintiffs seek injunctive and equitable relief and treble damages. In June
1998, the court 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.). Both of these suits contain allegations similar to
those in the 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 $2.7
billion. In addition, the Italian lira equivalent of $3.7 billion in interest
and penalties has been assessed. The Company anticipates that value-added and
income tax assessments may also be received in respect of 1996 and 1997. All of
the assessments are being vigorously contested. To date, the Italian
administrative tax court in Milan has overturned 65 of the assessments. The
decisions to overturn two assessments have been appealed by the tax authorities.
In a separate proceeding in Naples, in October 1997, a court dismissed charges
of criminal association against certain present and former officers and
directors of affiliates of the Company, but permitted charges of tax evasion to
remain pending. In February 1998, the tax evasion charges were dismissed by the
criminal court in Naples following a determination that jurisdiction was not
proper, and the case file was transmitted to the public prosecutor in Milan, who
will determine whether to bring charges, in which case a preliminary
investigations judge will make a new
21
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
finding as to whether there should be a trial on these charges. The Company, its
affiliates and the officers and directors who are subject to the proceedings
believe they have complied with applicable Italian tax laws and are vigorously
contesting the pending assessments and proceedings.
-------------------------
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 has not been enacted. Bills
substantially different and significantly more adverse to the domestic tobacco
industry and the Company than the proposed Resolution have been introduced in
Congress. The Company cannot predict whether 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. 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. and other companies in the United States tobacco industry
have discussed with a number of state attorneys general an agreement that
could settle the asserted and unasserted health care cost recovery claims of
all of the states. Discussions have reached the stage where those attorneys
general are reporting to the remaining states the terms of a proposed
agreement. The proposed agreement is contingent upon a sufficient number of
states accepting the agreement. No assurance can be given that the proposed
agreement will be accepted by a sufficient number of states as to cause the
industry to conclude an agreement. The proposed agreement would effect
significant changes in the advertising and marketing of tobacco products. It
would also require the industry to pay more than $206 billion through 2025,
including (i) more than $12.7 billion in initial payments over the first five
years (including $2.4 billion immediately); (ii) annual payments commencing
in 2000 in the original amount of $4.5 billion and increasing periodically to
$9 billion in 2018 and thereafter in perpetuity, and (iii) $1.7 billion over
ten years, the great preponderance of which is due during the first five
years. PM Inc.'s share of the $2.4 billion payment due immediately would be
68% (based on relative market capitalization). All other payments would be
allocated among the original participating manufacturers based on their
relative unit volume of domestic cigarette shipments and would be subject to
adjustment for inflation and volume changes and for participation by less
than all the states and for other adjustments and offsets described in the
proposed agreement. The Company anticipates that its share of the $2.4
billion payment due immediately would be charged to expense in the fiscal
quarter and year during which the agreement is concluded and would be paid
from available cash or through commercial paper borrowings as the Company
deems appropriate. The Company further anticipates that PM Inc.'s share of
future annual industry payments related to cigarette sales would be charged
to expense as the related sales occur and would be funded through price
increases. Any such agreement would have a material adverse effect on the
operating income and cash flows of the Company and PM Inc. in the fiscal
quarter and year the agreement was concluded and would likely materially
adversely affect the business, volume, cash flows and/or operating income and
financial position of the Company and PM Inc. in future years. The degree of
the adverse impact would depend, among other things, on the rates of decline
in United States cigarette sales in the premium and discount segments, PM
Inc.'s shares of the domestic premium and discount segments, and the effect
of any resulting cost advantage of manufacturers not subject to the
agreement. The proposed agreement is filed as an Exhibit to this Quarterly
Report on Form 10-Q and the foregoing discussion is qualified by reference
thereto.
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,"
22
Philip Morris Companies Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
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. Adoption
of SOP No. 98-5 will have no material effect on the Company's financial position
or results of operations.
23
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Consolidated Operating Results
- ------------------------------
For the Nine Months Ended September 30,
Operating Revenues
-------------------------------------
(in millions)
1998 1997
------- -------
Tobacco $32,457 $30,506
Food 20,036 20,619
Beer 3,247 3,318
Financial services and real estate 208 279
------- -------
Operating revenues $55,948 $54,722
------- -------
------- -------
Operating Income
-------------------------------------
(in millions)
1998 1997
------- -------
Tobacco $ 6,384 $ 6,339
Food 3,177 3,065
Beer 404 410
Financial services and real estate 137 256
------- -------
Operating companies income 10,102 10,070
Amortization of goodwill (433) (438)
General corporate expenses (370) (334)
Minority interest in earnings of
consolidated subsidiaries (94) (56)
------- -------
Operating income $ 9,205 $ 9,242
------- -------
------- -------
For the Three Months Ended September 30,
Operating Revenues
-------------------------------------
(in millions)
1998 1997
------- -------
Tobacco $11,121 $10,433
Food 6,326 6,455
Beer 1,071 1,125
Financial services and real estate 69 79
------- -------
Operating revenues $18,587 $18,092
------- -------
------- -------
Operating Income
-------------------------------------
(in millions)
1998 1997
------- -------
Tobacco $ 2,653 $ 1,667
Food 984 947
Beer 118 125
Financial services and real estate 44 150
------- -------
Operating companies income 3,799 2,889
Amortization of goodwill (143) (142)
General corporate expenses (122) (112)
Minority interest in earnings of
consolidated subsidiaries (32) (23)
------- -------
Operating income $ 3,502 $ 2,612
------- -------
------- -------
24
Results of Operations
Operating revenues for the first nine months of 1998 increased 2.2% over the
first nine months of 1997, and operating revenues for the third quarter of 1998
increased 2.7% over the comparable 1997 period. These increases were primarily
due to the domestic and international tobacco operations. Operating revenues
were affected by the 1998 sale of an Italian pasta business and 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 and 1998, underlying operating revenues for the
first nine months of 1998 increased $1.7 billion (3.2%) over the first nine
months of 1997, and underlying operating revenues for the third quarter of 1998
increased $583 million (3.2%) over the comparable 1997 period.
Operating income decreased 0.4% for the first nine months of 1998 and increased
34.1% for the third quarter of 1998 from the comparable 1997 periods. Both
comparisons were affected by charges for the settlement of tobacco litigation
("Tobacco Settlements"), separation charges and the 1997 pre-tax gain on the
sale of real estate operations ($103 million). Nine-month results for 1998
reflect first-quarter pre-tax charges of $806 million related to settling health
care cost recovery litigation in Minnesota, second quarter charges of $199
million and a third quarter charge of $111 million related to "Most Favored
Nation" clauses in previous settlement agreements with the states of Mississippi
and Texas and Florida, respectively, as previously discussed in Note 3 to the
Condensed Consolidated Financial Statements. 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 nine months of 1998. In addition to the
voluntary programs, a pre-tax charge of $10 million related to severance at the
Company's domestic tobacco operation was recorded during the third quarter of
1998. During the third quarter of 1997, PM Inc. recorded Tobacco Settlements of
$812 million related to health care cost recovery litigation in Mississippi and
Florida, as well as a class action settlement.
Excluding the aforementioned items, as well as results from operations divested
since the beginning of 1997 and the 1997 gain on sale of real estate
operations, underlying operating income increased $809 million (8.2%) and
$325 million (9.9%) over the first nine months and third quarter of 1997,
respectively, reflecting favorable results in domestic tobacco, international
tobacco and North American food during the first nine months and favorable
results in all operations during the third quarter.
Currency movements, primarily the strengthening of the U.S. dollar versus
European and Asian currencies, decreased operating revenues by $2.2 billion
($1.4 billion, excluding excise taxes) and operating income by $331 million in
the first nine months of 1998 versus the comparable 1997 period. During the
third quarter, currency movements decreased operating revenues by $485 million
($328 million, excluding excise taxes) and operating income by $107 million
versus the comparable 1997 period. However, early in the fourth quarter of 1998,
the dollar began to weaken against certain European currencies and the Japanese
yen. Although the Company cannot predict future movements in currency rates, the
weakening of the dollar, if sustained over the fourth quarter, may partially
mitigate unfavorable currency movements in that quarter. In addition, the
Company's businesses in certain Asian markets and, more recently, in Russia have
been adversely affected by economic instability in those areas. Although the
25
Company cannot predict future economic developments, the Company anticipates
that economic instability will continue to slow its businesses in those markets.
Interest and other debt expense, net, decreased $133 million (16.3%) in the
first nine months of 1998 and $49 million (19.7%) in the third quarter of 1998
from the respective comparable 1997 periods. These decreases were due primarily
to higher interest income, reflecting increased cash and cash equivalents and
lower average debt outstanding during 1998.
Effective December 31, 1997, the Company adopted SFAS No. 128, "Earnings per
Share." SFAS No. 128 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.
Diluted and basic EPS, which were $2.09 and $2.10, respectively, for the first
nine months of 1998, increased by 2.0% and 1.4%, respectively, from the
comparable 1997 period. These results include previously discussed Tobacco
Settlements, voluntary early retirement and separation programs and severance,
as well as the 1997 gain on sale of real estate operations. Excluding the
after-tax impact of these items, underlying net earnings increased 9.3% to $6.0
billion, diluted EPS increased 9.4% to $2.45 and basic EPS increased 9.3% to
$2.47. Reported diluted and basic EPS of $0.81 in the third quarter of 1998 each
increased by 39.7% from the comparable 1997 period due primarily to lower
Tobacco Settlements in 1998. Excluding the after-tax impact of Tobacco
Settlements, and charges for severance as well as the 1997 gain on sale of the
real estate operations, third quarter underlying net earnings increased 10.0% to
$2.1 billion, diluted EPS increased 10.5% to $0.84 and basic EPS increased
10.4%, to $0.85.
Year 2000
- ---------
As many computer systems and other equipment with embedded chips or processors
(collectively, "Business Systems") use only two digits to represent the year,
they may be unable to process accurately certain data before, during or after
the year 2000. As a result, business and governmental entities are at risk for
possible miscalculations or systems failures causing disruptions in their
business operations. This is commonly known as the Year 2000 ("Y2K") 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 objectives of having all of their
significant Business Systems, including those that affect facilities and
manufacturing activities, functioning properly with respect to the CDC issue
before January 1, 2000, and taking other appropriate measures to minimize
disruptions to their business operations due to the CDC issue. This program is
well underway. Generally, however, 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 phase of the CDC readiness program is to identify and assess 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.
26
The second phase 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 its internal Business
Systems by March 1999, although further remediation efforts may be required
thereafter to address CDC issues discovered during the testing and certification
process discussed below.
Individual Business Systems are being tested and certified for CDC readiness as
they are being remediated and replaced. The Company's goal is substantially to
complete this process by September 1999. Integration testing and certification
(i.e., the testing and certification of the interfaces between individual
Business Systems previously certified as Year 2000 ready as well as the testing
and certification of the external linkages between the Company's systems with
those of third parties) will commence in early 1999 and is expected to be
substantially completed by September 1999.
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 many cases, governmental agencies
and utilities (particularly outside North America) have a lower level of CDC
awareness and are less willing to provide information concerning their state of
CDC readiness. The CDC readiness of Key Business Partners will continue to be
monitored and contingency plans will be developed, as appropriate, for those
considered to have a significant risk of CDC failure.
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 risks of disruption
in its businesses exist in certain international markets and with respect to the
CDC readiness of certain of its Key Business Partners. Each of the Company's
operating subsidiaries is developing its own risk assessment of the possible
impact of the CDC issue on its business operations. Although it is not currently
possible to quantify the most reasonably likely worst case scenario, the
possible consequences of the Company or Key Business Partners not being fully
CDC ready in a timely manner 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
periods of time due to the CDC issue. However, the Company believes that its CDC
readiness program,
27
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. Contingency plans may include stockpiling raw and packaging
materials, increasing inventory levels, securing alternate sources of supply
and distribution, adjusting facility shut-down and start-up schedules, manual
workarounds, additional staffing and other appropriate measures. The
Company's objective is to substantially complete its initial contingency
planning effort by March 1999. These plans will continue to be evaluated and
modified throughout the Year 2000 transition period as additional information
becomes available.
It is currently estimated that the aggregate cost of the Company's CDC efforts
will be approximately $550 million. Approximately $250 million of this amount
has been spent. Generally, 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 $150 million), substantially all of which would be capitalized,
are not included in the above estimates. Other non-Year 2000 information
technology projects have not been materially delayed or impacted by the
Company's Year 2000 initiatives.
The Company's CDC readiness program is an ongoing process and the risk
assessments and estimates of costs and completion dates for various components
of the CDC readiness program described above are forward looking statements and
are subject to change. Factors that may cause such changes include, among
others, the continued availability of qualified personnel and other information
technology resources; the ability to identify and remediate all date sensitive
lines of computer code and embedded chips; the timely receipt and installation
of CDC-ready replacement systems; the actions of governmental agencies,
utilities and other third parties with respect to the Year 2000 issue; the
ability to implement contingency plans (for example, the availability of
additional warehouse space); and the occurrence of broad-based or systemic
economic failures.
Euro
- ----
On January 1, 1999, eleven of the fifteen member countries of the European Union
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 currently anticipates that the euro conversion will not have a
material adverse impact on its financial condition or results of operations.
28
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, health care cost recovery actions brought by
state and local governments, unions and others seeking reimbursement for
Medicaid and/or other health care expenditures allegedly caused by cigarette
smoking and suits on behalf of former asbestos manufacturers for amounts
expended in connection with asbestos claims that were allegedly caused in whole
or in part 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 that may be considered 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
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.
29
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 August 1998, the U.S. Fourth Circuit Court
of Appeals ruled that the FDA does not have the authority to regulate tobacco
products, and declared the FDA's regulations invalid. In September 1998, the FDA
filed a petition for a rehearing before the full Fourth Circuit Court of
Appeals. In November 1998, the court denied the FDA's petition for rehearing.
The ultimate 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.
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. The
Commonwealth appealed this ruling and in November 1998 the First Circuit Court
of Appeals affirmed the district court's decision granting the preliminary
injunction. 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"
30
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, 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 appealed 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.
31
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 disclosure of cigarette ingredients and of yields of "tar" and other
constituents found in cigarette smoke, 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 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 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 four grand jury
investigations being conducted by: the United States Attorney for the Eastern
District of New York relating to The Council for Tobacco Research-U.S.A., Inc.,
a research organization of which PM Inc. was a sponsor; the United States
Department of Justice in Washington, D.C. relating to issues raised in testimony
provided by tobacco industry executives before Congress and other related
matters; the United States Department of Justice Antitrust Division in the
Eastern District of Pennsylvania relating to tobacco leaf purchases; and the
United States Attorney for the Northern District of New York relating to alleged
contraband transactions in primarily Canadian-brand tobacco products. PMI and
its subsidiary, PM Duty Free Inc., have also received subpoenas in the last
referenced investigation. While the outcomes of these investigations cannot be
predicted, PM Inc., PMI and PM Duty Free Inc. believe they have 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)
32
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 other reimbursement cases, including
class actions, brought by non-governmental plaintiffs such as unions, HMOs,
native American tribes, federal and state taxpayers 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 November 1, 1998, there were approximately 450 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 these cases are pending in
Florida, West Virginia and New York. Seventeen of the individual cases involve
allegations of various personal injuries allegedly related to exposure to ETS.
In addition, as of November 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 nine 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 November 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 November 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)) and four smoking and health class actions
(Brazil (2), Canada (1) and Nigeria (1)). In addition, health care cost
recovery actions have been brought in Israel and by the Republic of the
Marshall Islands, the Commonwealth of Puerto Rico, and British Columbia,
Canada in their respective jurisdictions and by the Republic of Guatemala
and the Republic of Panama in the United States.
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. As discussed above in
Note 3, the Mississippi, Texas and Florida settlement agreements have been
amended pursuant to their "most favored nation" clause to reflect the terms of
the Minnesota settlement.
-------------------------
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
33
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 has not been enacted. Bills
substantially different and significantly more adverse to the domestic tobacco
industry and the Company than the proposed Resolution have been introduced in
Congress. The Company cannot predict whether 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. 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. and other companies in the United States tobacco industry
have discussed with a number of state attorneys general an agreement that
could settle the asserted and unasserted health care cost recovery claims of
all of the states. Discussions have reached the stage where those attorneys
general are reporting to the remaining states the terms of a proposed
agreement. The proposed agreement is contingent upon a sufficient number of
states accepting the agreement. No assurance can be given that the proposed
agreement will be accepted by a sufficient number of states as to cause the
industry to conclude an agreement. The proposed agreement would effect
significant changes in the advertising and marketing of tobacco products. It
would also require the industry to pay more than $206 billion through 2025,
including (i) more than $12.7 billion in initial payments over the first five
years (including $2.4 billion immediately); (ii) annual payments commencing
in 2000 in the original amount of $4.5 billion and increasing periodically to
$9 billion in 2018 and thereafter in perpetuity, and (iii) $1.7 billion over
ten years, the great preponderance of which is due during the first five
years. PM Inc.'s share of the $2.4 billion payment due immediately would be
68% (based on relative market capitalization). All other payments would be
allocated among the original participating manufacturers based on their
relative unit volume of domestic cigarette shipments and would be subject to
adjustment for inflation and volume changes and for participation by less
than all the states and for other adjustments and offsets described in the
proposed agreement. The Company anticipates that its share of the $2.4
billion payment due immediately would be charged to expense in the fiscal
quarter and year during which the agreement is concluded and would be paid
from available cash or through commercial paper borrowings as the Company
deems appropriate. The Company further anticipates that PM Inc.'s share of
future annual industry payments related to cigarette sales would be charged
to expense as the related sales occur and would be funded through price
increases. Any such agreement would have a material adverse effect on the
operating income and cash flows of the Company and PM Inc. in the fiscal
quarter and year the agreement was concluded and would likely materially
adversely affect the business, volume, cash flows and/or operating income and
financial position of the Company and PM Inc. in future years. The degree of
the adverse impact would depend, among other things, on the rates of decline
in United States cigarette sales in the premium and discount segments, PM
Inc.'s shares of the domestic premium and discount segments, and the effect
of any resulting cost advantage of manufacturers not subject to the
agreement. The proposed agreement is filed as an Exhibit to this Quarterly
Report on Form 10-Q and the foregoing discussion is qualified by reference
thereto.
Operating Results
For the Nine Months Ended September 30,
-----------------------------------------------------------------------
Operating Revenues Operating Income
------------------------- ------------------------
(in millions)
1998 1997 1998 1997
------- ------- ------ -----
Domestic tobacco $11,130 $ 9,959 $2,324 $2,685
International tobacco 21,327 20,547 4,060 3,654
------- ------- ------ ------
Total $32,457 $30,506 $6,384 $6,339
------- ------- ------ ------
------- ------- ------ ------
Domestic tobacco. During the first nine months of 1998, PM Inc.'s operating
revenues increased 11.8% over the comparable 1997 period, due to pricing ($1,377
million) and improved product mix ($35 million), partially offset by lower
volume ($241 million).
During the first nine months of 1998, PM Inc. recorded pre-tax charges of $1,116
million related to Tobacco Settlements, as discussed in Note 3 to the Condensed
34
Consolidated Financial Statements. In addition, PM Inc. recorded pre-tax charges
of $319 million primarily related to voluntary early retirement and separation
programs for salaried and hourly employees.
PM Inc.'s operating income for the first nine months of 1998 decreased 13.4%
from the comparable 1997 period, due primarily to higher Tobacco Settlements
($304 million), charges for voluntary early retirement and separation
programs and severance ($319 million), higher marketing, administration and
research costs ($563 million), and lower volume ($160 million), partially
offset by price increases, net of cost increases ($965 million) and improved
product mix ($25 million). Excluding the impact of the Tobacco Settlements
and the voluntary early retirement and separation programs, PM Inc.'s
underlying operating income for the first nine months of 1998 increased 7.5%
over the comparable 1997 period.
Domestic tobacco industry shipment volume during the first nine months of
1998 declined 3.7% from the first nine months of 1997 primarily as a result
of price increases. PM Inc. estimates year-to-date industry shipments were
affected by a 1997 increase in wholesaler inventories in anticipation of price
increases. While PM Inc. cannot predict future rates of change in industry
shipments, it believes that industry shipments should continue to decline in
line with historical trends of 1.0% to 2.0% per annum, subject to the effects
of price increases related to tobacco litigation settlements or the possible
enactment of increased excise taxes or other tobacco legislation discussed
under "Tobacco--Business Environment" above.
PM Inc.'s shipment volume for the first nine months of 1998 was 173.0 billion
units, a decrease of 2.2% from the first nine months of 1997. However, PM Inc.
estimates that, excluding the effect of the 1997 wholesaler inventory increase
mentioned above, its volume would have decreased by less than 1.0%. For the
first nine months of 1998, PM Inc.'s shipment market share was 49.6%, an
increase of 0.7 share points over the comparable period of 1997. However, PM
Inc. estimates that, excluding the factors mentioned above, its shipment share
grew by 1.0 points to approximately 49.9%. This increase is consistent with
consumer purchasing trends as measured by retail data from an independent market
research company. Marlboro shipment volume for the first nine months of 1998
increased 0.4 billion units (0.3%) over the comparable 1997 period to 124.1
billion units for a 35.6% share of the total industry, an increase of 1.5 share
points over the comparable period of 1997.
Based on shipments, the premium segment accounted for approximately 73.3% of the
domestic cigarette industry volume in the first nine months of 1998, an increase
of 0.9 share points over the comparable period of 1997, reflecting a continued
shift toward higher-margin premium cigarettes and away from the discount
segment. In the premium segment, PM Inc.'s volume decreased 1.1% during the
first nine months of 1998, compared with a 2.5% decrease for the industry,
resulting in a premium segment share of 58.7%, an increase of 0.9 share points
over the comparable period of 1997.
In the discount segment, PM Inc.'s shipments decreased 9.2% to 23.1 billion
units in the first nine months of 1998, compared with an industry decline of
6.7%, resulting in a discount segment share of 24.7%, a decrease of 0.7 share
points from the comparable period of 1997. Basic shipment volume for the first
nine months of 1998 was down 1.0% at 17.4 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
35
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 increased excise taxes or
other tobacco legislation discussed under "Tobacco--Business Environment"
above.
During July 1998, PM Inc. announced a price increase of $3.00 per thousand
cigarettes on its premium and discount brands. 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 $0.02 increase to the wholesale price of each pack of twenty
cigarettes.
International tobacco. During the first nine months of 1998, international
tobacco operating revenues of PMI increased 3.8% over 1997, including excise
taxes. Excluding excise taxes, operating revenues increased 3.9%, due primarily
to price increases ($469 million), favorable volume/mix ($155 million) and the
consolidation of previously unconsolidated subsidiaries ($425 million),
partially offset by unfavorable currency movements ($803 million). Operating
income for the first nine months of 1998 increased 11.1% over the comparable
1997 period, due primarily to price increases, net of cost increases ($430
million), favorable volume/mix ($42 million), the consolidation of previously
unconsolidated subsidiaries ($99 million), and lower fixed manufacturing
expenses and marketing, administration and research costs, partially offset by
unfavorable currency movements ($290 million).
PMI's volume in the first nine months of 1998 grew 12.1 billion units (2.2%)
over the comparable 1997 period to 570.2 billion units. PMI's volume growth was
impeded by continued weaker business conditions in a number of Asian and Eastern
European markets and, PMI presently anticipates a continued slowdown of
shipments to these markets in the fourth quarter. Excluding these markets, PMI's
volume grew by 4.1%, primarily in higher-margin established markets.
Volume advanced strongly in a number of important markets, including Italy,
France, the Benelux countries, Spain, Greece, Austria, Poland, Hungary, Turkey,
the Middle East, Japan and Mexico. PMI recorded market share gains in virtually
all major markets.
For the Three Months Ended September 30,
-----------------------------------------------------------------------
Operating Revenues Operating Income
------------------------- ------------------------
(in millions)
1998 1997 1998 1997
------- ------- ------ -----
Domestic tobacco $ 4,119 $ 3,590 $1,275 $ 426
International tobacco 7,002 6,843 1,378 1,241
------- ------- ------ ------
Total $11,121 $10,433 $2,653 $1,667
------- ------- ------ ------
------- ------- ------ ------
Domestic tobacco. During the third quarter of 1998, PM Inc.'s operating revenues
increased 14.7% over the comparable 1997 period, due to pricing ($612 million)
and improved product mix ($8 million), partially offset by lower volume ($91
million).
36
Operating income for the third quarter of 1998 increased by more than 100.0%
from the comparable 1997 period, due primarily to lower charges for Tobacco
Settlements ($701 million), higher prices, net of cost increases (aggregating to
$450 million) and favorable mix ($8 million), partially offset by higher
marketing, administration and research costs ($236 million), lower volume ($61
million) and a charge for severance ($10 million). Excluding the impact of
Tobacco Settlements and severance, PM Inc.'s underlying operating income for the
third quarter of 1998 increased 12.8% over the comparable 1997 period.
Domestic tobacco industry shipment volume during the third quarter declined
4.7% from the comparable 1997 period primarily as a result of price
increases. 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 of 1.0% to 2.0% per annum,
subject to the effects of price increases related to tobacco litigation
settlements or the possible enactment of increased excise taxes or other
tobacco legislation discussed under "Tobacco--Business Environment" above.
PM Inc.'s shipment volume for the third quarter of 1998 was 61.3 billion units,
a decrease of 2.5% from the third quarter of 1997, reflecting the price
increases mentioned above. PM Inc.'s third quarter 1998 shipment market share
was 50.0%, an increase of 1.1 share points from the comparable period of 1997.
This increase is consistent with the trend of consumer purchases as measured by
retail data from an independent market research company. Third-quarter Marlboro
shipment volume increased 0.1 billion units (0.2%) to 44.5 billion units for a
36.3% share of the total industry, an increase of 1.8 share points over the
third quarter of 1997.
Based on shipments, the premium segment accounted for approximately 73.9% of
domestic cigarette industry volume in the third quarter of 1998, an increase of
0.8 share points over the comparable 1997 period reflecting a continued shift
toward higher-margin premium cigarettes and away from the discount segment. In
the premium segment, PM Inc.'s third-quarter volume decreased 1.6%, compared
with a 3.6% decrease for the industry, resulting in a premium segment share of
59.0%, an increase of 1.2 share points from the third quarter of 1997.
In the discount segment, PM Inc.'s third quarter shipments decreased 8.3% to 7.8
billion units in 1998, compared with an industry decline of 7.6%, resulting in a
discount segment share of 24.5%, a decrease of 0.2 share points from the
comparable period of 1997. Basic's third-quarter shipment volume decreased 156.0
million units to 6.0 billion units, for an 18.7% share of the discount segment,
an increase of 1.0 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 increased
excise taxes or other tobacco legislation discussed under "Tobacco--Business
Environment" above.
International tobacco. During the third quarter of 1998, international tobacco
operating revenues of PMI increased 2.3% over 1997, including excise taxes.
Excluding excise taxes, operating revenues increased 0.3%, due primarily to
price increases ($139 million) and the consolidation of previously
unconsolidated subsidiaries ($152 million), partially offset by unfavorable
volume/mix ($100 million) and unfavorable currency movements ($218 million).
Operating income for the third quarter of 1998 increased 11.0% over the
comparable 1997 period, due primarily to price increases ($139 million), the
consolidation of previously
37
unconsolidated subsidiaries ($47 million) and lower fixed manufacturing expenses
and marketing, administration and research costs, partially offset by
unfavorable volume/mix ($75 million) and currency movements ($98 million).
PMI's volume in the third quarter of 1998 declined 3.9 billion units (2.1%) from
the comparable 1997 period to 186.1 billion units. PMI's volume decline was due
primarily to continued weaker business conditions in a number of Asian and
Eastern European markets, and PMI presently anticipates a continued slowdown of
shipments to these markets in the fourth quarter. Excluding these markets, PMI's
volume grew by 4.9%, primarily in higher-margin established markets.
Volume advanced strongly in a number of important markets during the third
quarter, including Italy, France, Spain, the Netherlands, Belgium, Austria,
Hungary, Turkey, the Middle East, Japan and Mexico. PMI recorded market share
gains in virtually all major markets.
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.
Fluctuations in commodity costs can cause retail price volatility, price
competition and can influence consumer and trade buying patterns. 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 the third quarter of 1998, the cost of United States cheese and butter
commodities reached near record high levels. Such high costs had an adverse
impact on Kraft's operating results in the third quarter and may continue to
have an adverse impact on Kraft's results of operations during the fourth
quarter.
During the third quarter of 1998, KFI sold a small Italian pasta dinners
business. During 1997, PMI sold its Brazilian ice cream businesses in the fourth
quarter, Kraft sold its 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 and 1998 were not
material to consolidated operating results in any of the periods presented.
During the third quarter of 1998, Kraft announced a licensing agreement with the
California Pizza Kitchen ("CPK") restaurant chain to manufacture, market and
sell CPK frozen pizza to grocery customers. In addition, Kraft announced a
licensing agreement with the Starbucks Coffee chain to market, sell and
distribute Starbucks Coffee to grocery customers across the United States.
Neither of these agreements is expected to have a material impact on Kraft's
operating results for the fourth quarter of 1998.
38
Operating Results
For the Nine Months Ended September 30,
-----------------------------------------------------------------------
Operating Revenues Operating Income
------------------------- ------------------------
(in millions)
1998 1997 1998 1997
------- ------- ------ -----
North American food $12,921 $12,779 $2,408 $2,245
International food 7,115 7,840 769 820
------- ------- ------ ------
Total $20,036 $20,619 $3,177 $3,065
------- ------- ------ ------
------- ------- ------ ------
North American food. During the first nine months of 1998, operating revenues
increased 1.1% over the first nine months of 1997, due primarily to favorable
volume ($294 million) and pricing ($76 million), partially offset by unfavorable
product mix ($67 million), the impact of divestitures ($90 million) and
unfavorable currency movements ($71 million). Operating income for the first
nine months of 1998 increased 7.3% over the first nine months of 1997, due to
volume increases in ongoing operations ($168 million), net pricing ($129
million, including the impact of lower manufacturing and overhead costs which
more than offset the impact of higher cheese costs) and favorable marketing,
administration and research costs ($6 million), partially offset by unfavorable
product mix ($109 million), the impact of divestitures ($22 million) and
unfavorable currency movements ($9 million).
Excluding operating results of the divested North American food businesses
discussed above, underlying operating revenues and underlying operating income
increased 1.8% and 8.3%, respectively, in the first nine months of 1998 versus
the comparable 1997 period.
Volume gains were achieved by frozen pizza, resulting from the continued success
of rising crust pizza; beverages, from the strength of ready-to-drink products
and new product introductions, partially offset by declines in higher-margin
powdered soft drinks; meals, due to the growth of Taco Bell grocery products as
well as strength in macaroni and cheese dinners; cheese, across most product
lines; cereals, from the success of new products; and processed meats, due to
the strength of lunch combinations, which reflected the continued success of new
product introductions, and to increases in bacon and hot dogs. Volume was lower
in coffee, due largely to market contraction resulting from higher retail prices
in the first quarter of 1998; desserts and snacks, reflecting declines in dry
packaged desserts and frozen toppings, partially offset by an increase in
shelf-stable puddings; and enhancers, due primarily to lower shipments of
barbecue sauce, spoonable dressings and pourable dressings. In Canada, volume
was down reflecting lower shipments of retail branded products and the planned
reduction of low margin products.
International food. Operating revenues for the first nine months of 1998
decreased 9.2% from the first nine months of 1997, due to unfavorable currency
movements ($490 million), lower volume/mix ($62 million) and the impact of
divestitures ($299 million), partially offset by pricing ($80 million) and the
consolidation of a previously unconsolidated subsidiary ($46 million). Operating
income for the first nine months of 1998 decreased 6.2% from the first nine
months of 1997, due primarily to net pricing ($31 million, primarily related to
39
higher coffee costs earlier in 1998), the impact of divestitures ($35 million)
and unfavorable currency movements ($34 million), partially offset by lower
marketing, administration and research costs ($36 million) and higher volume/mix
($7 million, primarily favorable mix).
Excluding the operating results of the divested international food businesses
discussed above, underlying operating revenues decreased 5.7% and underlying
operating income decreased 2.0% in the first nine months of 1998 from the first
nine months of 1997.
KFI's coffee volume for the first nine months of 1998 continued to lag the
comparable period of 1997 as volume in the first half of the year was 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 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 unfavorable
volume related to higher retail prices in Germany and lower shipments into
Russia. Volume also increased in KFI's cheese and grocery business as a result
of higher shipments of cheese snacks and lunch combinations 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 Southeast Asia, reflecting
the current economic instability of the region. In Latin America, volume was
essentially flat as softness and consumer down-trading to lower priced
competitor brands in the confectionery markets of Brazil and Argentina, as well
as lower powdered soft drink volume in Argentina were offset by higher shipments
of powdered soft drinks in Brazil and Mexico and ready-to-drink beverages in
Puerto Rico.
For the Three Months Ended September 30,
-----------------------------------------------------------------------
Operating Revenues Operating Income
------------------------- ------------------------
(in millions)
1998 1997 1998 1997
------- ------- ------ -----
North American food $4,016 $4,048 $ 722 $ 687
International food 2,310 2,407 262 260
------ ------ ------ ------
Total $6,326 $6,455 $ 984 $ 947
------ ------ ------ ------
------ ------ ------ ------
North American food. During the third quarter of 1998, operating revenues
decreased 0.8% from the third quarter of 1997, due primarily to pricing ($16
million, a result of commodity driven price decreases in coffee, partially
offset by commodity driven price increases in cheese) and unfavorable currency
movements ($27 million). Operating income for the third quarter of 1998
increased 5.1% over the third quarter of 1997, due primarily to cost decreases
(aggregating to $38 million, driven by lower manufacturing and overhead costs
which more than offset the impact of higher cheese costs) and lower marketing,
administration and research costs ($32 million, the majority of which related to
lower marketing expense), partially offset by unfavorable product mix ($33
million) and unfavorable currency movements ($3 million).
40
Volume for the third quarter increased slightly over the comparable 1997 period.
Volume gains were achieved by frozen pizza, resulting from the continued success
of rising crust pizza; beverages, from the strength of both ready-to-drink and
powdered soft drink products and new product introductions; coffee, reflecting
the favorable impact of reductions in retail prices as green coffee bean costs
were lower in the third quarter of 1998 versus the comparable 1997 period;
cheese, due to strength in natural and cottage cheese as well as sour cream and
new product introductions, partially offset by lower shipments of processed
cheese. Volume for cereals was essentially flat. Offsetting the aforementioned
volume gains were volume declines in processed meats, with declines across most
major product categories, partially offset by volume gains in lunch
combinations; meals, primarily reflecting softness in macaroni and cheese and
rice; desserts and snacks, due to declines in dry packaged desserts and frozen
toppings; and enhancers, due to lower shipments of spoonables and barbecue
sauce. In Canada, volume decreased due to lower shipments of retail branded
products.
International food. Operating revenues for the third quarter of 1998 decreased
4.0% from the third quarter of 1997, due to unfavorable currency movements ($83
million) and the impact of divestitures ($69 million) and unfavorable pricing
($37 million), partially offset by higher ongoing volume/mix ($80 million) and
the consolidation of a previously unconsolidated subsidiary ($12 million).
Operating income for the third quarter of 1998 increased 0.8% from the third
quarter of 1997, due primarily to cost decreases, net of price decreases
(aggregating to $26 million, primarily related to lower coffee costs) and higher
volume/mix ($29 million), partially offset by higher marketing, administration
and research costs ($40 million), and unfavorable currency movements ($8
million).
Excluding the operating results of the divested international food businesses
discussed above, underlying operating revenues decreased 1.2% and underlying
operating income increased 3.2% in the third quarter of 1998 from the third
quarter of 1997.
KFI's coffee volume increased over the comparable period of 1997 due primarily
to gains in Germany, France, Italy, Sweden and Denmark reflecting both a
favorable comparison against soft results in 1997 when high commodity costs
disrupted the marketplace and the beginning of a recovery spurred by recent
price declines. Confectionery volume declined due to higher retail pricing in
Germany and the impact of the economic crisis in Russia. Volume also grew in
KFI's cheese and grocery business as a result of higher shipments of lunch
combinations in the United Kingdom; snacks in Scandinavia; cheese and cream
cheese in Italy; and powdered soft drinks in the Middle East, Africa, Romania,
the Philippines and China. In Latin America, volume decreased due primarily to
soft confectionery markets in Brazil and Argentina and lower powdered soft drink
volume in Argentina, partially offset by higher shipments of powdered soft
drinks in Brazil and Mexico, as well as higher shipments of ready-to-drink
beverages in Puerto Rico.
Beer
- ----
Nine Months Ended September 30
Operating revenues of the Miller Brewing Company ("Miller") for the first nine
months of 1998 decreased $71 million (2.1%) from the first nine months of 1997,
due primarily to lower volume ($61 million) and unfavorable price/mix ($12
million), partially offset by income received in accordance with the terms of a
contract manufacturing agreement with S&P Company. Operating income for the
first nine months of 1998 decreased $6 million (1.5%) from the first nine
months
41
of 1997, due primarily to lower volume ($25 million), unfavorable price/mix
($22 million) and the impact of a divested equity investment ($11 million),
partially offset by lower fixed manufacturing expenses and marketing,
administration and research costs ($52 million). Excluding the 1997 results
of then 20%-owned Molson Breweries of Canada, underlying operating income
increased 1.3%.
Miller's domestic shipment volume of 32.9 million barrels for the first nine
months of 1998 decreased 1.4% from the comparable 1997 period, reflecting
decreases in premium, near-premium and budget brands. Domestic shipments of
premium products were below 1997 as lower shipments of Miller beer, Miller Lite
and Miller Genuine Draft more than offset double-digit gains in Icehouse and
Foster's. Domestic shipments of near-premium products were essentially even with
1997 as increased shipments of Red Dog nearly offset declines in the Miller High
Life family. Domestic shipments of budget brands were below 1997, despite volume
growth in the Milwaukee's Best family of beers. Wholesalers' sales to retailers
in the first nine months of 1998 also decreased 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. Export
volume decreased 21.4%, as volume shifted to sales under international licensing
agreements.
Three Months Ended September 30
Miller's operating revenues for the third quarter of 1998 decreased $54 million
(4.8%) from the third quarter of 1997, due primarily to lower volume ($46
million) and unfavorable price/mix ($10 million), partially offset by income
received in accordance with the terms of the previously mentioned agreement with
S&P Company. Operating income for the third quarter of 1998 decreased $7 million
(5.6%) from the third quarter of 1997, due primarily to the impact of a divested
equity investment ($9 million), lower volume ($17 million) and unfavorable
price/mix ($16 million), partially offset by lower fixed manufacturing costs and
marketing, administration and research costs ($33 million). Excluding the 1997
results of then 20%-owned Molson Breweries of Canada, underlying operating
income increased 1.7%.
Miller's domestic shipment volume of 11.0 million barrels for the third quarter
of 1998 decreased 4.2% from the comparable 1997 period, reflecting decreases in
premium, near-premium and budget brands. Domestic shipments of premium brands
were below the comparable 1997 period, due primarily to lower domestic shipments
of Miller Lite and Miller Genuine Draft, both of which continue to be adversely
affected by intense competition in the key markets of California and Texas, and
to lower shipments of Miller beer, partially offset by double-digit increases
for Icehouse and Foster's. Domestic shipments of near-premium and budget brand
products decreased slightly on lower shipments across all brands. Wholesalers'
sales to retailers in the third quarter of 1998 decreased 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 Miller High Life family. Export volume
declined 7.3%, as volume shifted to sales under international licensing
agreements.
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 nine months and
the third 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 for a pre-tax gain of $103 million. Operating revenues and operating income
from
42
PMCC's financial services business increased in the first nine months and third
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 nine months of 1998, net cash provided by operating activities
was $6.4 billion compared with $5.1 billion in the comparable 1997 period. The
increase primarily reflects higher underlying net earnings, partially offset by
the payment of Tobacco Settlements. Included in net earnings for the first nine
months of 1998 were previously discussed charges for voluntary early retirement
programs, severance and the Tobacco Settlements (aggregating to $888 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 nine months of 1998, net cash used in investing activities was
$1.6 billion compared with $1.2 billion in 1997. The increase primarily reflects
the lower level of cash received from the sales of businesses during the first
nine months of 1998.
Net Cash Used in Financing Activities
- -------------------------------------
During the first nine months of 1998, net cash of $1.6 billion was used in
financing activities, as compared with $3.2 billion used in financing activities
during the comparable 1997 period. This difference was primarily due to higher
net issuances of debt in 1998 and to higher stock repurchases during the first
nine months of 1997.
Debt
- ----
The Company's total debt (consumer products and financial services) was $15.6
billion and $14.1 billion at September 30, 1998 and December 31, 1997,
respectively. Total consumer products debt was $14.7 billion and $13.3 billion
at September 30, 1998 and December 31, 1997, respectively. At September 30, 1998
and December 31, 1997, the Company's ratio of consumer products debt to total
equity was 0.85 and 0.89, respectively. The ratio of total debt to total equity
was 0.90 and 0.95 at September 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 September 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. During
October 1998, the Company entered into a $2.0 billion revolving credit agreement
expiring in October 1999 which replaced an existing facility that expired in
October 1998. An agreement for $8.0 billion expires in 2002, enabling the
Company to refinance short-term debt on a long-term basis. 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.
43
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 $2.6
billion and $1.4 billion, respectively, at September 30, 1998 and December 31,
1997. Of these amounts, $2.0 billion and $736 million related to consumer
products debt at September 30, 1998 and December 31, 1997, respectively. In
addition, during 1998, the Company entered into a swap agreement that
effectively converts $800 million of fixed rate debt to variable rate debt.
The Company enters into forward exchange and option contracts, for purposes
other than trading, to reduce the effects of fluctuating foreign currency on
foreign currency denominated current assets, liabilities, commitments and
short-term intercompany transactions. At September 30, 1998 and December 31,
1997, the Company had entered into contracts, with maturities of less than one
year and U.S. dollar equivalents of $4.4 billion (including $2.8 billion 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 September 30, 1998 or
results of operations for the three or nine months then ended.
The Company's credit ratings by Moody's at September 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
September 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 nine months of 1998 were substantially unchanged
from the comparable 1997 period. During the third quarter, the Company's Board
of Directors approved a 10% increase in the current quarterly dividend rate to
$0.44 per share. As a result, the present annualized dividend rate is $1.76 per
share.
Cash and Cash Equivalents
- -------------------------
Cash and cash equivalents were $5.5 billion at September 30, 1998 and $2.3
billion at December 31, 1997, the increase being largely attributable to the
1997
44
suspension of the Company's share repurchase program and higher 1998 debt
issuances.
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
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 nine month periods ended September 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. 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 concluded Tobacco Settlements and, if implemented,
federal tobacco legislation and the proposed settlement of the asserted and
unasserted health care cost recovery claims of all states as discussed above.
Each of the
45
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 or the
conversion to the Euro. 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.
46
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 Consent Decree, dated September 11, 1998,
regarding the settlement of the Florida health care
cost recovery action.
10.2 Florida Fee Payment Agreement, dated September 11,
1998, regarding the payment of attorneys' fees.
12 Statement regarding computation of ratios of earnings
to fixed charges.
27 Financial Data Schedule.
99.1 Certain Pending Litigation Matters and Recent
Developments.
99.2 Trial Schedule.
99.3 Proposed Master Settlement Agreement relating to state
health care cost recovery claims.
(b) Reports on Form 8-K. The registrant has not filed a Current Report
on Form 8-K since the beginning of the quarter for which this
report is filed.
47
Signature
Pursuant to the requirements of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
PHILIP MORRIS COMPANIES INC.
/s/ LOUIS C. CAMILLERI
Louis C. Camilleri, Senior Vice President and
Chief Financial Officer
November 16, 1998
48