Exhibit 13
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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Consolidated Operating Results
(in millions) Operating Revenues
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1998 1997 1996
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Operating Revenues
Domestic tobacco $15,310 $13,584 $12,462
International tobacco 27,390 26,240 24,087
North American food 17,312 16,838 16,447
International food 9,999 10,852 11,503
Beer 4,105 4,201 4,327
Financial services 275 340 378
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Operating revenues $74,391 $72,055 $69,204
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(in millions) Operating Income
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1998 1997 1996
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Operating Income
Domestic tobacco $ 1,489 $ 3,287 $ 4,206
International tobacco 5,029 4,572 4,078
North American food 3,055 2,873 2,628
International food 1,127 1,326 1,303
Beer 451 459 440
Financial services 183 297 193
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Operating companies income 11,334 12,814 12,848
General corporate expenses (645) (479) (442)
Minority interest (128) (87) (43)
Amortization of goodwill (584) (585) (594)
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Operating income $ 9,977 $11,663 $11,769
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Amortization of goodwill is primarily attributable to the North American food
segment.
1998 compared with 1997: Operating revenues for 1998 increased $2.3
billion (3.2%) from 1997, primarily due to domestic and international tobacco
operations. The comparison of operating revenues was affected by the 1998 sales
of several international food businesses and the 1997 sales of Brazilian ice
cream businesses, North American maple-flavored syrup businesses and a
Scandinavian sugar confectionery business. Financial services operating revenues
in 1998 decreased due to the 1997 sale of its real estate business. Excluding
the 1998 and 1997 divested operations, operating revenues increased $2.9 billion
(4.1%) from 1997.
Operating income for 1998 decreased $1.7 billion (14.5%) from 1997.
Operating income was reduced in 1998 and 1997 as a result of pre-tax charges of
$3.4 billion and $1.5 billion, respectively, taken by Philip Morris Incorporated
("PM Inc."), the Company's domestic tobacco subsidiary, for its share of all
fixed and determinable portions of its obligations related primarily to the
settlement of certain tobacco-related litigation. Operating income was further
reduced in 1998 by pre-tax charges of $337 million primarily related to
voluntary early retirement and separation programs at PM Inc. and $116 million
related to the Company's settlement of shareholder litigation. During 1997,
operating income was reduced by a $630 million pre-tax charge to realign the
international food operations. In addition, 1997 operating income was increased
by $877 million of pre-tax gains on the sales of ice cream businesses in Brazil
and real estate operations in the United States. Excluding the foregoing pre-tax
charges and gains and results of operations from businesses sold in 1998 and
1997, operating income increased $1.1 billion (8.3%) from 1997, reflecting
favorable results of operations in domestic tobacco, international tobacco and
North American food operations. Operating companies income, which is defined as
operating income before general corporate expenses, minority interest and
amortization of goodwill, decreased $1.5 billion (11.5%) from 1997 due primarily
to the items noted above. Excluding these items, operating companies income
increased 8.1% on higher earnings from domestic tobacco, international tobacco
and North American food operations.
Currency movements, primarily the strengthening of the U.S. dollar versus
European and Asian currencies, decreased operating revenues by $2.2 billion
($1.4 billion, excluding excise taxes) and operating companies income by $365
million in 1998 versus 1997. In January of 1999, the U.S. dollar began to
strengthen against the euro, the new common currency established by eleven of
the fifteen member countries of the European Union. Although the Company cannot
predict future movements in currency rates, strengthening of the dollar against
the euro, if sustained during 1999, could have an unfavorable impact on
operating revenues and operating companies income comparisons with 1998. In
addition, the Company's businesses in certain Asian markets and, more recently,
in Russia and Brazil have been adversely affected by economic instability in
those areas. Although the Company cannot predict future economic developments,
the Company anticipates that economic instability will continue to adversely
affect its businesses in those markets during 1999.
Interest and other debt expense, net, for 1998 decreased $162 million
(15.4%) from 1997. This decline was due primarily to higher interest income,
reflecting higher cash and cash equivalent balances and to lower average debt
outstanding during 1998.
Net earnings of $5.4 billion in 1998 decreased 14.9% from 1997, and basic
EPS of $2.21 in 1998 decreased by 15.3% from 1997. Similarly, diluted EPS
decreased 14.7% to $2.20 from $2.58 in 1997. Net earnings, basic EPS and diluted
EPS in 1998 and 1997 were affected by the after-tax impact of the litigation
settlement charges, voluntary early retirement and separation program charges,
international food realignment charges and gains on divestitures, as previously
noted. Excluding the impact of these items, net earnings increased 9.2% to $7.8
billion, basic
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EPS increased 8.9% to $3.19 and diluted EPS increased 8.9% to $3.17,
respectively, from $7.1 billion, $2.93 and $2.91, respectively, in 1997.
1997 compared with 1996: Operating revenues for 1997 increased $2.9
billion (4.1%) and operating companies income decreased $34 million (0.3%) from
1996. Operating revenues were higher due primarily to increases in domestic and
international tobacco and North American food operations.
Operating companies income was reduced as a result of pre-tax charges of
$1.5 billion taken by PM Inc., for its share of all fixed and determinable
portions of its obligations related to settling health care cost recovery
litigation in Mississippi, Florida and Texas and a one-time charge for settling
the Broin case, a Florida class action brought on behalf of airline flight
attendants. Operating companies income was further reduced by pre-tax charges of
$630 million to realign the international food operations. Operating companies
income was increased by a $774 million pre-tax gain on the sale of ice cream
businesses in Brazil and a $103 million pre-tax gain on the sale of real estate
operations. Excluding these items, operating companies income increased 10.9%,
reflecting favorable results of operations in domestic tobacco, international
tobacco, North American food and beer operations.
Currency movements, primarily the strengthening of the U.S. dollar versus
European, Japanese and other Asian currencies, decreased operating revenues by
$3.2 billion ($1.9 billion, excluding excise taxes) and operating companies
income by $470 million in 1997 versus 1996.
Year 2000: As many computer systems and other equipment with embedded
chips or processors (collectively, "Business Systems") use only two digits to
represent the year, they may be unable to process accurately certain data
before, during or after the year 2000. As a result, business and governmental
entities are at risk for possible miscalculations or systems failures causing
disruptions in their business operations. This is commonly known as the Year
2000 ("Y2K") issue or Century Date Change ("CDC") issue. The CDC issue can arise
at any point in the Company's supply, manufacturing, processing, distribution
and financial chains.
The Company and each of its operating subsidiaries are in the process of
implementing a CDC readiness program with the objective of having all of their
significant Business Systems, including those that affect facilities and
manufacturing activities, functioning properly with respect to the CDC issue
before January 1, 2000, and taking other appropriate measures to minimize
possible disruptions to their business operations due to the CDC issue. This
program is well underway. Generally, however, those subsidiaries with primarily
North American operations (PM Inc., 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
("PMI") and Kraft Foods International ("KFI")).
During the first phase of the CDC readiness program, those internal
Business Systems of the Company and its operating subsidiaries that are
susceptible to system failures or processing errors as a result of the CDC issue
were identified and assessed. This effort is complete.
The second phase of the CDC readiness program involves the actual
remediation and replacement of internal Business Systems. The Company and its
operating subsidiaries are using both internal and external resources to
complete this process. The Company's objective is to substantially complete this
effort, as well as the testing and certification of individual systems for CDC
readiness, by June 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) 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
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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,
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, packaging and
promotional materials, increasing inventory levels at the operating company,
wholesale and retail levels, adjusting the timing of promotional programs,
securing alternate sources of supply, distribution and warehousing, adjusting
facility shut-down and start-up schedules, manual workarounds, procuring back-up
power generators and heat supply for key plants, hiring additional staff and
other appropriate measures. The Company's objective is to substantially complete
its contingency planning effort by June 1999. These plans will continue to be
evaluated and modified as additional information becomes available. While the
Company cannot reasonably estimate at this time the cost of implementing
contingency plans (since such costs will depend on the nature and extent of
future Year 2000 events), it currently does not believe that such costs should
have a material adverse effect on the Company's future consolidated results of
operations. However, in any given reporting period, such costs may be a factor
in describing changes in operating companies income for the Company's business
segments.
It is currently estimated that the aggregate cost of the Company's CDC
compliance/remediation efforts will be approximately $550 million, of which
approximately $325 million has been spent. The remaining costs relate to
remediation efforts, the final testing and certification of Business Systems and
other CDC-related efforts. Generally, the above 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.
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 also not included in the above estimates.
Other non-Year 2000 information technology projects have not been materially
affected by the Company's Year 2000 initiatives.
The Company's CDC readiness program is an ongoing process and the risk
assessments and estimates of costs and completion dates for various components
of the CDC readiness program described above are forward looking statements and
are subject to change. Factors that may cause such changes include, among
others, the continued availability of qualified personnel and other information
technology resources; the ability to identify and remediate all date-sensitive
lines of computer code and embedded chips; the 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 established fixed conversion rates between their existing
currencies ("legacy currencies") and one common currency - the euro. At that
time, the euro began trading on currency exchanges and could be used in business
transactions. Beginning in January 2002, new euro-denominated currency will be
issued, and legacy currencies will be withdrawn from circulation. The Company's
operating subsidiaries affected by the euro conversion have established and,
where required, implemented plans to address the systems and business issues
raised by the euro currency conversion. These issues include, among others, (1)
the need to adapt computer and other business systems and equipment to
accommodate euro-denominated transactions; and (2) the competitive impact of
cross-border price transparency, which may make it more difficult for businesses
to charge different prices for the same products on a country-by-country basis,
particularly once the euro currency is issued in 2002. The Company currently
anticipates that the euro conversion will not have a material adverse impact on
its financial condition or results of operations.
Operating Results by Business Segment
Tobacco
Business Environment
The tobacco industry, both in the United States and abroad, has faced, and
continues to face, a number of issues that may adversely affect the business,
volume, results of operations, cash flows and financial position of PM Inc., PMI
and the Company.
These issues, some of which are more fully discussed below, include
legislation or other governmental action seeking to ascribe to the industry
responsibility and liability for the purported adverse health effects associated
with both smoking and exposure to environmental tobacco smoke ("ETS"); increased
smoking and health litigation; price increases in the United States related to
the settlement of certain tobacco litigation; actual and proposed excise tax
increases; the issuance of final regulations by the United States Food and Drug
Administration ("FDA") that, if upheld by the courts, would regulate cigarettes
as "drugs" or "medical devices"; governmental and grand jury investigations;
actual and proposed requirements regarding disclosure of cigarette ingredients
and other proprietary information as well as the testing and reporting of the
yields of "tar," nicotine and other constituents found in cigarette smoke;
governmental and private bans and restrictions on smoking; actual and proposed
price controls and restrictions on imports in certain jurisdictions outside the
United States; actual and proposed restrictions on tobacco manufacturing,
marketing, advertising and sales (including two European Union directives that,
if implemented, will (i) ban virtually all forms of
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tobacco advertising and sponsorship in the European Union other than at the
retail point of sale, and (ii) will abolish duty-free tobacco sales among the
member states of the European Union); proposed legislation to eliminate the U.S.
tax deductibility of tobacco advertising and promotional costs; proposed
legislation in the United States to require the establishment of ignition
propensity performance standards for cigarettes; the diminishing social
acceptance of smoking and increased pressure from anti-smoking groups and
unfavorable press reports; and other tobacco legislation that may be considered
by the Congress, the states and other countries.
Excise taxes: Cigarettes are subject to substantial federal and state
excise taxes in the United States and to similar taxes in most foreign markets.
The United States federal excise tax on cigarettes is currently $0.24 per pack
of 20 cigarettes and is scheduled to increase to $0.34 per pack in the year 2000
and then to $0.39 per pack in 2002. In general, excise taxes and other taxes on
cigarettes have been increasing. These taxes vary considerably and, when
combined with sales taxes and the current federal excise tax, may be as high as
$1.50 per pack in a given locality in the United States. Congress has been
considering significant increases in the federal excise tax or other payments
from tobacco manufacturers, and the Clinton Administration's fiscal year 2000
budget proposal includes an additional increase of $0.55 per pack in the federal
excise tax. Increases in other cigarette-related taxes have been proposed at the
state and local level and in many jurisdictions outside the United States.
In the opinion of PM Inc. and PMI, increases in excise and similar taxes
have had an adverse impact on sales of cigarettes. Any future increases, the
extent of which cannot be predicted, could result in volume declines for the
cigarette industry, including PM Inc. and PMI, and might cause sales to shift
from the premium segment to the discount segment.
Federal Trade Commission ("FTC"): In September 1997, the FTC issued a
request for public comments on its proposed revision of the "tar" and nicotine
testing and reporting standards established by a 1970 voluntary agreement
between the FTC and domestic cigarette manufacturers. In February 1998, PM Inc.
and three other domestic cigarette manufacturers filed comments on the proposed
revisions. In November 1998, the FTC wrote to the Department of Health and Human
Services requesting its assistance in developing specific recommendations on the
future of the FTC's program for testing the "tar," nicotine and carbon monoxide
content of cigarettes.
FDA regulations: The FDA has promulgated regulations asserting
jurisdiction over cigarettes as "drugs" or "medical devices" under the
provisions of the Food, Drug and Cosmetic Act. These regulations include severe
restrictions on the distribution, marketing and advertising of cigarettes, and
would require the industry to comply with a wide range of labeling, reporting,
recordkeeping, manufacturing and other requirements. The FDA's exercise of
jurisdiction, if not reversed by judicial or legislative action, could lead to
more expansive FDA-imposed restrictions on cigarette operations than those set
forth in the regulations, and could materially adversely affect the business,
volume, results of operations, cash flows and financial position of PM Inc. and
the Company. In August 1998, the Fourth Circuit Court of Appeals ruled that the
FDA does not have the authority to regulate tobacco products, and declared the
FDA's regulations invalid and, in November 1998, that court denied the FDA's
petition for rehearing. The FDA is now petitioning the U.S. Supreme Court to
review the judgment of the Fourth Circuit Court of Appeals in this case. The
ultimate outcome of this litigation cannot be predicted.
Ingredient disclosure laws: The Commonwealth of Massachusetts has enacted
legislation to require cigarette manufacturers to report yearly the flavorings
and other ingredients used in each brand of cigarettes sold in the Commonwealth,
and on a qualified, by-brand basis to provide "nicotine-yield ratings" for their
products based on standards to be established by the Commonwealth. Enforcement
of the ingredient disclosure provisions of the statute could result in the
public disclosure of valuable proprietary information. In December 1997, a
federal district court in Boston granted the tobacco company plaintiffs a
preliminary injunction and enjoined the Commonwealth from enforcing the
ingredient disclosure provisions of the legislation. In November 1998, the First
Circuit Court of Appeals affirmed this ruling. In addition, both parties'
cross-motions for summary judgment are pending before the district court. The
ultimate outcome of this lawsuit cannot be predicted. Similar legislation has
been enacted or proposed in other states, such as Texas. Some jurisdictions
outside the United States, including Thailand, have also enacted or proposed
ingredient disclosure laws or regulations.
The U.S. Environmental Protection Agency's report on ETS: In 1993, the
U.S. Environmental Protection Agency (the "EPA") issued a report relating to
certain alleged health effects of ETS. The report included a risk assessment
relating to the alleged association between ETS and lung cancer in nonsmokers,
and a determination by the EPA to classify ETS as a "Group A" carcinogen. In
July 1998, a federal district court vacated those sections of the report
relating to lung cancer, finding that the EPA may have reached different
conclusions had it complied with certain relevant statutory requirements. The
federal government has appealed the court's ruling. The ultimate outcome of this
litigation cannot be predicted.
----------------------------------
It is not possible to predict the outcome of the above-described matters, or to
predict what, if any, other foreign or domestic governmental legislation or
regulations will be adopted relating to the manufacturing, advertising, sale or
use of cigarettes, or to the tobacco industry generally. However, if any or all
of the foregoing were to be implemented, the business, volume, results of
24
operations, cash flows and financial position of PM Inc., PMI and the Company
could be materially adversely affected.
----------------------------------
Governmental and grand jury investigations: PM Inc. has received requests
for information (including grand jury subpoenas) in connection with governmental
investigations of the tobacco industry, and is cooperating with respect to such
requests. Present and former employees of PM Inc. have testified or have been
asked to testify in connection with certain of these matters. The investigations
include four grand jury investigations being conducted by: the United States
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 primarily in Canadian-brand
tobacco products. PMI and its subsidiary, Philip Morris 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 Philip Morris Duty
Free Inc. believe they have acted lawfully.
Smoking and health litigation: As further discussed in Note 16 of the
Notes to Consolidated Financial Statements ("Note 16"), there is litigation
pending in various United States and foreign jurisdictions related to tobacco
products. These cases generally fall within three categories: (i) smoking and
health cases alleging personal injury brought on behalf of individual
plaintiffs, (ii) smoking and health cases alleging personal injury and
purporting to be brought on behalf of a class of individual plaintiffs, and
(iii) health care cost recovery cases brought by governmental and
non-governmental plaintiffs seeking reimbursement for health care expenditures
allegedly caused by cigarette smoking. Governmental plaintiffs have included
local, state and certain foreign governmental entities. Non-governmental
plaintiffs in these cases include union health and welfare trust funds, Blue
Cross/Blue Shield groups, health maintenance organizations, hospitals, native
American tribes, 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.
There have been a number of jury verdicts in individual smoking and health
cases over the past three years. In February 1999, a California jury awarded
$1.5 million in compensatory damages and $50.0 million in punitive damages
against PM Inc. PM Inc. has announced that it will appeal the verdict and the
damage award. Prior to that, juries had returned verdicts for defendants in
three individual smoking and health cases and in one individual ETS smoking and
health case. In January 1999, a Florida court set aside a $1.0 million jury
award in a smoking and health case against another United States cigarette
manufacturer and ordered a new trial in the case. In June 1998, a Florida
appeals court reversed a $750,000 jury verdict awarded in August 1996 against
another United States cigarette manufacturer. Plaintiff is seeking an appeal of
this ruling to the Florida Supreme Court. In Brazil, a court in 1997 awarded
plaintiffs in a smoking and health case the Brazilian currency equivalent of
$81,000, attorneys' fees and a monthly annuity for 35 years equal to two-thirds
of the deceased smoker's last monthly salary. Neither the Company nor its
affiliates were parties to that action.
In recent years, there has been a substantial increase in the number of
smoking and health cases being filed.
As of December 31, 1998, there were approximately 510 smoking and health
cases filed and served on behalf of individual plaintiffs in the United States
against PM Inc. and, in some cases, the Company, compared with approximately 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. Fifteen of
the individual cases involve allegations of various personal injuries allegedly
related to exposure to ETS.
In addition, as of December 31, 1998, there were approximately 60 smoking
and health putative class actions pending in the United States against PM Inc.
and, in some cases, the Company (including eight that involve allegations of
various personal injuries related to exposure to ETS), compared with
approximately 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.
As of December 31, 1998, there were approximately 95 health care cost
recovery actions pending in the United States (excluding the cases covered by
the State Settlement Agreements discussed below), compared with approximately
105 health care cost recovery cases pending on December 31, 1997, and 25 such
cases on December 31, 1996. In January 1999, President Clinton announced that
the United States Department of Justice is preparing a litigation plan to take
tobacco companies to court and to use recovered funds to strengthen Medicare.
There are also a number of tobacco-related actions pending outside the
United States against PMI and its affiliates and subsidiaries including,
approximately 28 smoking and health cases initiated by one or more individuals
(Argentina (20), Brazil (1), Canada (1), Italy (1), Japan (1), the Philippines
(1), Scotland (1) and Turkey (2)), and six smoking and health class actions
(Brazil (2), Canada (3) and Nigeria (1)). In addition, health care cost recovery
actions have been brought in Israel, the Republic of the Marshall Islands and
British Columbia, Canada, and, in the United States, by Thailand, Venezuela and
the Republics of Bolivia, Guatemala, Panama and Nicaragua. Other foreign
entities, including a local agency of the French social security
25
health insurance system, have stated that they are considering filing health
care cost recovery actions.
In addition to the foregoing smoking and health cases, a number of suits
have been filed by former asbestos manufacturers, asbestos manufacturers'
personal injury settlement trusts and, in one case, by an insurance company
seeking contribution or reimbursement for amounts expended in connection with
the defense and payment of asbestos claims that were allegedly caused in whole
or in part by cigarette smoking. Damages claimed in some of these cases range
into the billions of dollars.
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, volume, results of operations, cash
flows or financial position could be materially affected by an unfavorable
outcome or settlement of certain pending litigation or by the enactment of
federal or state tobacco legislation. The Company and each of its subsidiaries
named as a defendant believe, and each has been so advised by counsel handling
the respective cases, that it has a number of valid defenses to all litigation
pending against it. All such cases are, and will continue to be, vigorously
defended. However, the Company and its subsidiaries may enter into discussions
in an attempt to settle particular cases if they believe it is in the best
interests of the Company's stockholders to do so.
Litigation settlements: In November 1998, PM Inc. and certain other United
States tobacco product manufacturers entered into a Master Settlement Agreement
(the "MSA") with 46 states, the District of Columbia, the Commonwealth of Puerto
Rico, Guam, the United States Virgin Islands, American Samoa and the Northern
Marianas to settle asserted and unasserted health care cost recovery and other
claims. PM Inc. and certain other United States tobacco product manufacturers
had previously settled similar claims brought by Mississippi, Florida, Texas and
Minnesota (together with the MSA, the "State Settlement Agreements") and an ETS
smoking and health class action brought on behalf of airline flight attendants.
The State Settlement Agreements and certain ancillary agreements are filed as
exhibits to various of the Company's reports filed with the Securities and
Exchange Commission, and such agreements and the ETS settlement are discussed in
detail therein, and the discussion herein is qualified by reference thereto.
PM Inc. recorded pre-tax charges of $3.1 billion and $1.5 billion during
1998 and 1997, respectively, to accrue for its share of all fixed and
determinable portions of its obligations under the tobacco settlements, as well
as $300 million during 1998 for its unconditional obligation under an agreement
in principle to contribute to a tobacco growers trust fund, discussed in Note
16. As of December 31, 1998, PM Inc. had accrued costs of its obligations under
the settlements and to tobacco growers aggregating $1.4 billion, payable
principally before the end of the year 2000. The settlement agreements require
that the domestic tobacco industry make substantial annual payments in the
following amounts (excluding future annual payments contemplated by the
agreement in principle with tobacco growers discussed in Note 16), subject to
adjustment for several factors, including inflation, market share and industry
volume: 1999, $4.2 billion (of which $2.7 billion related to the MSA and has
already been paid by the industry); 2000, $9.2 billion; 2001, $9.9 billion;
2002, $11.3 billion; 2003, $10.9 billion; 2004 through 2007, $8.4 billion; and
thereafter, $9.4 billion. In addition, the domestic tobacco industry is required
to pay settling plaintiffs' attorneys' fees, subject to an annual cap of $500
million, as well as additional amounts as follows: 1999, $450 million; 2000,
$416 million; and 2001 through 2002, $250 million. These payment obligations are
the several and not joint obligations of each settling defendant. PM Inc.'s
portion of the future adjusted payments and legal fees, which is not currently
estimable, will be based on its share of domestic cigarette shipments in the
year preceding that in which the payment is made. PM Inc.'s shipment share in
1998 was approximately 50%.
The State Settlement Agreements also include provisions relating to
advertising and marketing restrictions, public disclosure of certain industry
documents, limitations on challenges to tobacco control and underage use laws
and other provisions. Among other things, the MSA:
(i) prohibits the targeting of youth in the advertising, promotion or
marketing of tobacco products;
(ii) bans the use of cartoon characters in all tobacco advertising and
promotion;
(iii) limits each participating manufacturer in the MSA to one tobacco brand
name sponsorship during any twelve-month period (except for wind-down of
existing contracts). The single permitted sponsorship may not include
major team sports or events in which the intended audience includes a
significant percentage of youth. The agreement limits the advertising and
promotion in connection with such permitted sponsorship, and bans
agreements to name any stadium or arena in the name of a tobacco brand
name;
(iv) bans all outdoor advertising of tobacco products (including, but not
limited to, billboards and tobacco advertising in transportation
facilities, vehicles, enclosed stadia and
26
shopping malls), with the exception of signs fourteen square feet or less
in dimension at retail establishments that sell tobacco products (other
than solely through vending machines). The settling states may use
removed billboards for anti-tobacco advertising for the duration of the
existing lease period at the expense of the applicable participating
manufacturer;
(v) bars participating manufacturers from entering into agreements that
prohibit a third party from selling, purchasing or displaying
anti-tobacco advertising;
(vi) prohibits payments for tobacco product placement in various media;
(vii) bans participating manufacturers from offering or selling non-tobacco
apparel and other merchandise that bears a tobacco brand name, subject to
specified exceptions;
(viii) prohibits the distribution of free samples of tobacco products except
within an adult-only facility;
(ix) bans gift offers based on the purchase of tobacco products without
sufficient proof that the intended gift recipient is an adult;
(x) prohibits each participating manufacturer from licensing or expressly
authorizing third parties to advertise such manufacturer's tobacco brand
names in any manner prohibited under the agreement to that manufacturer
itself;
(xi) prohibits participating manufacturers from using as a tobacco product
brand name any nationally recognized non-tobacco brand or trade name or
the names of sports teams, entertainment groups or individual
celebrities, subject to specified exceptions;
(xii) prohibits participating manufacturers from selling or manufacturing packs
containing fewer than twenty cigarettes through December 31, 2001, and
bars participating manufacturers from opposing proposed legislation to
prohibit the sale of packs containing fewer than twenty cigarettes;
(xiii) requires participating manufacturers to affirm corporate principles to
comply with the agreement and to reduce underage usage of tobacco
products;
(xiv) imposes requirements applicable to lobbying activities conducted on
behalf of participating manufacturers;
(xv) prohibits participating manufacturers from agreeing to limit or suppress
smoking and health information or research or product development
research;
(xvi) prohibits participating manufacturers from making any material
misrepresentation of fact regarding the health consequences of using
tobacco products; and
(xvii) provides for the dissolution of the Council for Tobacco Research--U.S.A.,
Inc., The Tobacco Institute, Inc. and the Center for Indoor Air Research,
Inc. and establishes rules for the regulation and oversight of any new
tobacco-related trade association.
As of January 22, 1999, the MSA had been approved by courts in 41 states and in
the District of Columbia, Puerto Rico, Guam, the United States Virgin Islands,
American Samoa and Northern Marianas. If a jurisdiction does not obtain final
judicial approval of the MSA by December 31, 2001, the agreement will be
terminated with respect to such jurisdiction.
The Company believes that the State Settlement Agreements may materially
adversely affect the business, volume, results of operations, cash flows or
financial position of PM Inc. and the Company in future years. The degree of the
adverse impact will depend, among other things, on the rates of decline in
United States cigarette sales in the premium and discount segments, PM Inc.'s
share of the domestic premium and discount cigarette segments, and the effect of
any resulting cost advantage of manufacturers not subject to the MSA and the
other State Settlement Agreements. As of January 22, 1999, manufacturers
representing almost all domestic shipments in 1998 had agreed to become subject
to the terms of the MSA.
Operating Results
Operating
(in millions) Operating Revenues Companies Income
- --------------------------------------------------------------------------------
1998 1997 1996 1998 1997 1996
- --------------------------------------------------------------------------------
Domestic tobacco $15,310 $13,584 $12,462 $1,489 $3,287 $4,206
International tobacco 27,390 26,240 24,087 5,029 4,572 4,078
- --------------------------------------------------------------------------------
Total $42,700 $39,824 $36,549 $6,518 $7,859 $8,284
================================================================================
In 1998, current year and historical operating revenues and operating companies
income of the Company's domestic tobacco and international tobacco operations
were reclassified to reflect the transfer of tobacco sales in certain U.S.
territories from the international tobacco business to the domestic tobacco
business, consistent with the terms of PM Inc.'s settlements of state health
care cost recovery and other claims.
1998 Compared with 1997
Domestic tobacco: During 1998, PM Inc.'s operating revenues increased $1.7
billion (12.7%) over 1997, due primarily to pricing ($2.1 billion) and improved
product mix ($33 million), partially offset by lower volume ($450 million).
As discussed above, during 1998 and 1997, PM Inc. recorded pre-tax charges
totaling $3.1 billion and $1.5 billion, respectively, as PM Inc. and other
companies in the United States tobacco industry settled tobacco-related
litigation. PM Inc. also recorded an additional pre-tax charge of $300 million
in 1998 for a contribution to be made into a fund to compensate domestic tobacco
growers for the economic impact that they may experience as a result of the
settlement agreements. In addition, PM Inc. recorded pre-tax charges of $319
million related primarily to voluntary early retirement and separation programs
for salaried and hourly employees. On February 24, 1999, PM Inc. announced that
it plans to phase out cigarette production at its Louisville, Kentucky
manufacturing plant by December 2000. PM Inc. estimates that this will result in
a pre-tax charge of approximately $200 million, principally for severance, in
the first half of 1999.
Operating companies income for 1998 decreased $1.8 billion (54.7%) from
1997, due primarily to higher tobacco-related settlement charges ($1.9 billion),
charges for voluntary early retirement and separation programs and severance
27
($319 million), higher marketing, administration and research costs ($989
million, primarily higher marketing expenses as competition intensified), and
lower volume ($295 million), partially offset by price increases, net of cost
increases ($1.8 billion) and improved product mix. Excluding the impact of
tobacco-related settlements and the voluntary early retirement and separation
programs, PM Inc.'s operating companies income of $5,189 million in 1998
increased 9.4% over $4,744 million in 1997.
Domestic tobacco industry shipment volume during 1998 declined 4.6% from
1997 primarily as a result of settlement-related price increases and
wholesalers' decisions to lower their inventories at the end of the year as
compared with a 1997 increase in wholesaler inventories, which PM Inc. believes
was partially in anticipation of price increases.
PM Inc.'s shipment volume for 1998 was 227.6 billion units, a decrease of
3.2% from 1997. For 1998, PM Inc.'s shipment market share was 49.4%, an increase
of 0.7 share points over 1997. Marlboro shipment volume declined 1.5 billion
units (0.9%) to 162.5 billion units for a 35.3% share of the total industry, an
increase of 1.3 share points over 1997.
Based on shipments, the premium segment accounted for approximately 73.0%
of the domestic cigarette industry volume in 1998, an increase of 0.7 share
points over 1997; however, during the fourth quarter the premium segment
accounted for approximately 72.3% of domestic cigarette industry volume, an
increase of 0.1 share points over the fourth quarter of 1997. In the premium
segment, PM Inc.'s volume decreased 2.4% during 1998, compared with a 3.7%
decrease for the industry, resulting in a premium segment share of 58.4%, an
increase of 0.8 share points over 1997.
In the discount segment, PM Inc.'s shipments decreased 8.1% to 31.0
billion units in 1998, compared with an industry decline of 6.9%, resulting in a
discount segment share of 25.0%, a decrease of 0.3 share points from 1997. Basic
shipment volume declined 111 million units to 23.4 billion units, for an 18.8%
share of the discount segment, an increase of 1.2 share points over 1997.
PM Inc. cannot predict future change or rates of change in domestic
tobacco industry volume, the relative sizes of the premium and discount segments
or in PM Inc.'s shipments, shipment market share or retail market share;
however, it believes that PM Inc.'s shipments may be materially adversely
affected by price increases related to tobacco litigation settlements and, if
enacted, by increased excise taxes or other tobacco legislation discussed under
"Tobacco--Business Environment" above.
In November 1998, PM Inc. announced a price increase of $22.50 per
thousand cigarettes on its domestic premium and discount brands. This
announcement followed similar announcements of price increases of $3.00 per
thousand in July 1998, $2.50 per thousand in May 1998, $2.50 per thousand in
April 1998, $1.25 per thousand in January 1998, $3.50 per thousand in September
1997 and $2.50 per thousand in March 1997. Each $1.00 per thousand increase by
PM Inc. equates to a $.02 increase in the wholesale price of each pack of twenty
cigarettes.
In December 1998, PM Inc. paid $150 million for options to purchase the
U.S. rights to manufacture and market three cigarette trademarks, L&M, Lark and
Chesterfield, the international rights to which are already owned by PMI. The
exercise of the options is subject to certain conditions. Including the $150
million paid in December, the total acquisition price for these trademarks will
be $300 million. L&M, Lark and Chesterfield represented less than 0.2% of
domestic cigarette industry volume in 1998.
International tobacco: During 1998, international tobacco operating
revenues of PMI increased $1.2 billion (4.4%) over 1997, including excise taxes.
Excluding excise taxes, operating revenues increased 2.9%, due primarily to
price increases ($529 million), the consolidation of previously unconsolidated
subsidiaries ($406 million) and favorable volume/mix ($126 million), partially
offset by unfavorable currency movements ($857 million). Operating companies
income for 1998 increased 10.0% over 1997, due primarily to price increases, net
of cost increases ($460 million), favorable volume/mix ($96 million), the
consolidation of previously unconsolidated subsidiaries ($40 million) and lower
fixed manufacturing expenses and marketing, administration and research costs,
partially offset by unfavorable currency movements ($336 million).
PMI's volume increased 7.2 billion units (1.0%) from 1997 to 716.9 billion
units, due primarily to volume gains in the higher-margin markets of Western
Europe and Japan, partially offset by volume declines in certain lower-margin
markets of Asia and Eastern Europe due to weaker business conditions. In PMI's
established markets of Western Europe and Japan, 1998 volume grew a collective
5.8%. Volume advanced strongly in a number of important markets including Italy,
France, the Benelux countries, Spain, Switzerland, the Middle East, Turkey,
Poland, Hungary, Japan, Australia, Argentina and Mexico. In addition, PMI
recorded market share gains in most major markets. In the Czech Republic,
industry and PMI volumes were down, and in Germany, PMI's volume was essentially
flat as a result of a tax-driven price increase. Overall volume growth was led
by Marlboro, which increased 3.8% over 1997, partially offset by volume declines
for L&M in Eastern Europe. Local brands also grew by 4.7% during 1998.
1997 Compared with 1996
Domestic tobacco: PM Inc.'s 1997 operating revenues increased $1.1 billion
(9.0%) over 1996, due primarily to pricing ($783 million), higher volume ($222
million, including excise taxes) and improved product mix. Operating companies
income for 1997 decreased $919 million (21.8%) from 1996, due primarily to
previously discussed tobacco-related litigation settlement charges ($1.5
billion), higher marketing, administration and research costs ($195 million,
primarily higher marketing expense) and higher fixed manufacturing costs ($79
million), partially offset by pricing ($625 million), higher volume ($142
million) and improved product mix. Excluding the impact of litigation settlement
charges, PM Inc.'s operating companies income of $4,744 million in 1997
increased 12.8% over $4,206 million in 1996.
28
PM Inc.'s 1997 shipment volume was 235.2 billion units, an increase of
1.9% over 1996 on higher Marlboro volume and increased wholesaler purchases,
which PM Inc. believes was partially in anticipation of price increases.
Marlboro shipment volume increased 7.8 billion units (5.0%) to 164.0 billion
units for a 34.0% share of the total industry, an increase of 1.8 share points
over 1996. Domestic tobacco industry volume declined 0.6%; however, PM Inc.
estimates that, excluding the effects of increased wholesaler buying mentioned
above and one less shipping day in 1997, the industry's volume declined by more
than 2.0% from 1996.
Based on shipments, the premium and discount segments accounted for
approximately 72.3% and 27.7%, respectively, of domestic cigarette industry
volume in 1997, versus approximately 71.4% and 28.6%, respectively, in 1996,
reflecting a continued shift to the higher-margin premium segment.
PM Inc.'s 1997 shipment market share was 48.7%, an increase of 1.2 share
points over 1996. In the premium segment, PM Inc.'s volume increased 3.4%,
compared with a 0.6% increase for the industry, resulting in a premium segment
share of 57.6%, an increase of 1.5 share points from 1996, reflecting higher
Marlboro volume. In the discount segment, PM Inc.'s shipments decreased 6.4% to
33.7 billion units in 1997 compared with an industry decline of 4.0%, resulting
in a discount segment share of 25.3%, a decrease of 0.6 share points from 1996.
Within the discount segment, Basic shipment volume increased 355 million units
to 23.5 billion units for a 17.6% share of the discount segment, an increase of
1.0 share point over 1996.
International tobacco: During 1997, tobacco operating revenues of PMI
increased $2.2 billion (8.9%) over 1996, including excise taxes. Excluding
excise taxes, operating revenues increased 7.3%, due primarily to price
increases ($679 million), favorable volume/mix ($618 million) and the
consolidation of previously unconsolidated and newly acquired subsidiaries ($577
million), partially offset by unfavorable currency movements ($961 million).
Operating companies income for 1997 increased 12.1% over 1996, due primarily to
price increases, net of cost increases ($550 million), favorable volume/mix
($371 million) and the consolidation of previously unconsolidated and newly
acquired subsidiaries ($114 million), partially offset by unfavorable currency
movements ($408 million) and higher marketing, administration and research
costs.
PMI's volume grew 49.6 billion units (7.5%) in 1997 over 1996 to 709.7
billion units, including local brands manufactured by Tabaqueira-Empresa
Industrial de Tabacos, S.A., Portugal's leading tobacco company in which PMI
acquired a controlling interest in January 1997. Volume advanced in most major
markets, including Germany, Italy, the Benelux countries, Spain, Central and
Eastern Europe, the Middle East, Turkey, the Asia/Pacific region, Argentina and
Mexico. In addition, PMI recorded market share gains in most major markets. In
France, industry and PMI volumes were down, and in Brazil and Australia, PMI
lost volume and share. However, volume and market share for Marlboro increased
in France and Brazil. Overall volume growth was driven by PMI's portfolio of
international brands, including Marlboro, which increased 5.5% over 1996, and
Bond Street, Parliament, Chesterfield and Virginia Slims, each of which recorded
double-digit volume increases.
Food
Business Environment
Kraft Foods, Inc. ("Kraft"), the largest processor and marketer of retail
packaged food in the United States, and its subsidiary KFI, which markets
coffee, confectionery and grocery products in Europe and the Asia/Pacific
region, are subject to fluctuating commodity costs, currency movements and
competitive challenges in various product categories and markets, including a
trend toward increasing consolidation in the retail trade. Additionally, certain
subsidiaries and affiliates of PMI that manufacture and sell food products in
Latin America are also subject to competitive challenges in various product
categories and markets. To confront these challenges, Kraft, KFI and PMI
continue to take steps to build the value of premium brands with new product and
marketing initiatives, to improve their food business portfolios and to reduce
costs.
Fluctuations in commodity costs can cause retail price volatility, can
intensify price competition and can influence consumer and trade buying
patterns. The North American and international food businesses are subject to
fluctuating commodity costs, particularly dairy, coffee bean and cocoa prices.
During the second half of 1998, the cost of certain United States dairy
commodities reached record high levels. Despite increased retail prices of
certain products during 1998, high dairy commodity costs had an adverse impact
on Kraft's operating results during the latter half of the year. However, dairy
commodity costs began to moderate early in 1999. Coffee bean prices declined
during the last three quarters of 1998, as compared with 1997, after reaching a
twenty-year high in May 1997. Lower coffee bean prices in 1998 led to price
reductions by Kraft, KFI and their competitors.
During 1998, KFI sold four international food businesses. During 1997, PMI
sold its Brazilian ice cream businesses, Kraft sold North American
maple-flavored syrup businesses and KFI sold a Scandinavian sugar confectionery
business. During 1996, Kraft sold its bagel business and KFI sold margarine
businesses in the U.K. and Italy.
In the fourth quarter of 1997, KFI and the food operations of PMI recorded
realignment charges related primarily to the downsizing or closure of
manufacturing and other facilities, as well as the discontinuance of certain
low-margin product lines. Included in the charges were provisions for
incremental postemployment benefits, primarily related to severance. During
1998, the Company undertook certain actions contemplated by the charges,
including the divestiture or closure of four businesses, the commencement of two
manufacturing facilities closures and consolidation of certain sales force and
headquarters functions, and began to make periodic postemployment payments to
29
severed employees, the duration of such payments being dictated by the severed
employees' salary grades, years of service and the customs of the respective
countries in which actions were taken. KFI anticipates that the majority of the
remaining postemployment payments will be made by the end of the year 2000.
During January 1999, Kraft announced that it will take a pre-tax charge of
approximately $150 million during 1999, primarily for voluntary retirement
incentive and separation programs for employees in the United States.
During 1998, Kraft entered into a licensing agreement with the Starbucks
coffee chain to market, sell and distribute Starbucks coffee to grocery
customers across the United States. In addition, Kraft entered into a licensing
agreement with the California Pizza Kitchen restaurant chain to manufacture,
market and sell California Pizza Kitchen frozen pizza to grocery customers.
Kraft acquired the Taco Bell grocery business during 1996. In Latin America, PMI
acquired nearly all of the remaining voting shares of Industrias de Chocolate
Lacta S.A. ("Lacta"), a Brazilian confectionery company, in the second quarter
of 1996.
Operating Results
Operating
(in millions) Operating Revenues Companies Income
- --------------------------------------------------------------------------------
1998 1997 1996 1998 1997 1996
- --------------------------------------------------------------------------------
North American food $17,312 $16,838 $16,447 $3,055 $2,873 $2,628
International food 9,999 10,852 11,503 1,127 1,326 1,303
- --------------------------------------------------------------------------------
Total $27,311 $27,690 $27,950 $4,182 $4,199 $3,931
================================================================================
1998 Compared with 1997
North American food: During 1998, operating revenues increased $474
million (2.8%) over 1997, due primarily to favorable volume ($510 million) and
pricing ($212 million, primarily due to commodity-driven price increases),
partially offset by the impact of divestitures ($90 million), unfavorable
product mix ($56 million) and unfavorable currency movements ($103 million).
Operating companies income for 1998 increased $182 million (6.3%) over 1997, due
primarily to volume increases in ongoing operations ($284 million), price
increases, net of cost increases ($166 million, including the impact of lower
manufacturing and overhead costs which moderated the impact of higher cheese
costs), partially offset by unfavorable marketing, administration and research
costs ($118 million, due primarily to higher marketing), unfavorable product mix
($115 million), the impact of divestitures ($22 million) and unfavorable
currency movements ($13 million).
Excluding operating results of the North American food businesses divested
in 1997, operating revenues of $17,312 million in 1998 increased 3.4% over
$16,748 million in 1997, and operating companies income of $3,055 million in
1998 increased 7.2% over $2,851 million in 1997.
Volume gains were driven by beverages, from the strength of ready-to-drink
products, while powdered products decreased slightly; frozen pizza, from the
continued success of rising crust pizza; meals, due to the growth of Taco Bell
grocery products, as well as continued strength in macaroni and cheese dinners;
cereals, aided by new product introductions; cheese, due to volume gains in most
product lines and the introduction of new products; and processed meats, driven
by continued growth of lunch combinations (including new product introductions)
and growth in bacon. Coffee volume was slightly higher in 1998 due in part to
commodity-driven price decreases. Enhancers volume was flat as increases in
spoonable and pourable dressings were offset by declines in meat enhancements.
Desserts and snacks volume was slightly lower, due to declines in dry packaged
desserts and frozen toppings, partially offset by gains in ready-to-eat
puddings. In Canada, volume decreased due to a planned reduction of trade
promotions to more closely align them with business performance.
International food: Operating revenues for 1998 decreased $853 million
(7.9%) from 1997, due to unfavorable currency movements ($463 million), the
impact of divestitures ($403 million), lower volume/mix ($39 million) and
unfavorable pricing, partially offset by the impact of newly acquired and
previously unconsolidated subsidiaries ($57 million). Operating companies income
for 1998 decreased $199 million (15.0%) from 1997, due primarily to higher
marketing, administration and research costs ($179 million), the impact of
divestitures ($46 million) and unfavorable currency movements ($20 million),
partially offset by favorable volume/mix ($24 million) and favorable pricing
($15 million, primarily related to lower coffee costs). The increase in
marketing, administration and research costs reflects an unfavorable comparison
to 1997 due primarily to a 1997 gain of $774 million on the divestiture of the
Brazilian ice cream businesses, partially offset by 1997 charges totaling $630
million for the previously discussed realignment of international food
operations and related incremental postemployment costs.
Excluding the operating results of the divested international food
businesses, the gain on the sale of the Brazilian ice cream businesses and the
charges for realignment of international food operations, discussed above,
operating revenues of $9,963 million in 1998 decreased 4.3% from $10,413 million
in 1997, and operating companies income of $1,126 million in 1998 decreased 0.8%
from $1,135 million in 1997.
KFI's coffee volume decreased during 1998, 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 to 1997 when shipments were heavy in advance of rising retail prices.
KFI's confectionery volume decreased due to market conditions in Russia and
higher retail pricing in Germany. KFI's cheese and grocery volumes increased due
primarily to higher shipments of cream cheese in Italy, Spain and Australia;
cheese snacks and lunch combinations in the United Kingdom; snacks in
Scandinavia; and powdered soft drinks in the Middle East and China. PMI's food
volume in Latin America for 1998 decreased from 1997, due primarily to lower
powdered soft drink volume in Argentina and lower confectionery volume in
Brazil, 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.
30
1997 Compared with 1996
North American food: During 1997, operating revenues increased $391
million (2.4%) over 1996, due to volume increases ($576 million), pricing ($275
million, primarily due to commodity-driven cost increases) and the impact of
acquisitions ($93 million), partially offset by the impact of divestitures ($372
million), unfavorable product mix ($155 million) and unfavorable currency
movements ($26 million). Operating companies income for 1997 increased $245
million (9.3%) over 1996, due primarily to price increases and net cost
decreases (aggregating $377 million, aided by productivity-driven cost savings
and lower cheese commodity costs) and volume increases ($335 million), partially
offset by unfavorable product mix ($97 million), the impact of divestitures ($61
million), and higher marketing, administration and research costs ($304 million,
due primarily to higher marketing expense, which included additional marketing
activities for new products). Included in 1997 marketing, administration and
research costs was a gain of $159 million on the sale of maple-flavored syrup
businesses, as well as charges of $64 million related to the discontinuation of
several small operations, Year 2000 systems conversion costs of $38 million and
the above-mentioned additional marketing expense for new product initiatives.
Excluding operating results of the divested North American food businesses
discussed above, operating revenues of $16,748 million in 1997 increased 4.8%
over $15,985 million in 1996, and operating companies income of $2,851 million
in 1997 increased 12.0% over $2,545 million in 1996.
Strong ongoing volume gains were driven by frozen pizza, resulting from
geographic expansion and new products; beverages, from the strength of
ready-to-drink products; meals, due to the acquisition and subsequent growth of
Taco Bell grocery products as well as strength in macaroni and cheese dinners;
cereals, aided by new product introductions; and desserts and snacks, due to new
product introductions and strength in refrigerated ready-to-eat desserts,
shelf-stable puddings and dry packaged desserts. Cheese volume also increased,
benefiting from lower prices due to lower commodity costs, new products and
marketing initiatives. Volume gains were also realized in processed meats,
driven by continued growth of lunch combinations (including new product
introductions) and growth in hot dogs and cold cuts. Coffee volume in 1997
declined from 1996 as customers reacted negatively to commodity-driven price
increases. Volume for pourable salad dressings increased despite intense
competition. In Canada, volume decreased due to a planned exit of lower-margin
foodservice product lines; however, retail volume increased.
International food: Operating revenues for 1997 decreased $651 million
(5.7%) from 1996, due to unfavorable currency movements ($955 million), lower
volume/mix ($70 million) and the impact of divestitures ($295 million),
partially offset by pricing ($397 million) and the impact of newly acquired and
previously unconsolidated subsidiaries ($272 million). Operating companies
income for 1997 increased $23 million (1.8%) over 1996, due primarily to lower
marketing, administration and research costs ($52 million), the impact of newly
acquired and previously unconsolidated subsidiaries ($41 million) and the gain
on the sale of PMI's Brazilian ice cream businesses ($774 million), partially
offset by unfavorable currency movements ($62 million), cost increases, net of
price increases (aggregating $59 million, primarily related to higher coffee and
cocoa costs), the impact of divestitures ($108 million) and charges recorded
during 1997 for the realignment of international food operations ($630 million).
Marketing, administration and research costs included the previously discussed
gain on the divestiture of the Brazilian ice cream businesses and international
food realignment charges.
Excluding the operating results of the divested international food
businesses, the gain on the sale of the Brazilian ice cream businesses and the
charges for realignment of international food operations, discussed above,
operating revenues of $10,578 million in 1997 decreased 3.3% from $10,934
million in 1996, and operating companies income of $1,145 million in 1997
decreased 1.1% from $1,158 million in 1996.
KFI's coffee volume decreased during 1997, reflecting customers' adverse
reactions to commodity-driven price increases. KFI's confectionery volume,
excluding the impact of divestitures, increased slightly due to volume increases
in Ukraine and the former Yugoslavia, partially offset by lower Scandinavian
volume, due to an exceptionally warm summer, and lower volume in Romania and
Bulgaria, reflecting poor economic environments. KFI's cheese and grocery
volumes, excluding the impact of divestitures, increased due primarily to gains
in KFI's Asia/Pacific region, principally China, the Philippines and Australia.
PMI's food volume in Latin America for 1997 increased over 1996, due primarily
to the acquisition of Lacta and higher beverage volume.
Beer
1998 compared with 1997: Operating revenues of the Miller Brewing Company
("Miller") for 1998 decreased $96 million (2.3%) from 1997, due primarily to
lower volume ($97 million). Operating companies income for 1998 decreased $8
million (1.7%) from 1997, due primarily to lower volume ($40 million), the
impact of divestitures ($14 million) and unfavorable price/mix ($10 million),
partially offset by lower manufacturing expenses and marketing, administration
and research costs ($51 million). Excluding the 1997 results of then 20%-owned
Molson Breweries of Canada, operating companies income of $451 million in 1998
increased 1.3% over $445 million in 1997.
Miller's domestic shipment volume of 41.7 million barrels for 1998
decreased 1.8% from 1997, due to decreases in premium and budget brands.
Domestic shipments of premium products were below 1997 as lower shipments of
Miller, Miller Lite and Miller Genuine Draft more than offset double-digit gains
in Icehouse and Foster's. Domestic shipments of near-premium products were
slightly higher than 1997 on increased shipments of the Miller High Life family
and Red Dog. Shipments of budget products declined across all brands. Miller's
estimated market share
31
of the U.S. malt beverage industry (based on shipments, including exports) was
21.0%, a decline of 0.7 share points from the prior year. Wholesalers' sales to
retailers in 1998 decreased 1.3% from 1997, reflecting lower sales of Miller
Lite, Miller and Miller Genuine Draft, partially offset by increased shipments
of Icehouse and Foster's. Export shipments declined 18.6% from 1997, reflecting
a shift toward international licensing agreements. The increase in international
sales of Miller's products under such agreements more than offset the decrease
in export shipments.
On February 8, 1999, Miller announced an agreement to acquire four
trademarks from the Pabst Brewing Company and the Stroh Brewery Company, subject
to regulatory review. Miller also agreed to increase its contract manufacturing
of Pabst products, including brands that Pabst has agreed to acquire from Stroh
in a separate agreement. Miller estimates that the acquisition and increased
contract manufacturing could result in incremental 1999 operating companies
income, depending upon the timing of regulatory review and the subsequent
beginning of production.
1997 compared with 1996: Miller's operating revenues for 1997 decreased
$126 million (2.9%) from 1996, due to unfavorable price/mix ($114 million) and
lower volume ($12 million). Operating companies income for 1997 increased $19
million (4.3%) over 1996, due primarily to lower marketing, administration and
research costs ($67 million) and lower manufacturing costs ($25 million),
partially offset by unfavorable price/mix ($71 million) and lower volume ($5
million). Included in marketing, administration and research costs was a $12
million gain on the sale of Miller's 20% equity interest in Molson Breweries of
Canada along with a 49% interest in Molson USA, LLC, a beer import operation.
Miller's domestic shipment volume of 42.5 million barrels for 1997
increased 0.8% over 1996, reflecting higher shipments of both premium and budget
brands. Volume for domestic premium products increased on higher shipments of
Miller Lite, Icehouse and Foster's, partially offset by lower shipments of
Miller. Near-premium products grew on higher shipments of Miller High Life and
Red Dog, while budget brands grew on higher shipments of Milwaukee's Best.
Miller's estimated market share of the U.S. malt beverage industry (based on
shipments, including exports) was 21.7%, as compared with 21.8% in the prior
year. Wholesalers' sales to retailers in 1997 increased slightly from 1996,
reflecting higher sales of Miller Lite. Export shipments decreased in 1997,
reflecting a shift toward international licensing and contract brewing
arrangements. International sales of Miller products under such arrangements
more than offset the 1997 decrease in export shipments.
Financial Services
Philip Morris Capital Corporation ("PMCC"): Operating revenues and
operating companies income declined from 1997 due to the sale of Mission Viejo
Company in the third quarter of 1997 for a pre-tax gain of $103 million.
Excluding the impact of the divestiture, operating revenues and operating
companies income increased by 14.1% and 14.4%, respectively, reflecting
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 1998, net cash provided
by operating activities was $8.1 billion compared with $8.3 billion in 1997. The
decrease was due primarily to tobacco settlement payments of $3.5 billion during
1998, partially offset by higher underlying net earnings (net earnings excluding
previously mentioned settlement charges, voluntary early retirement and
separation program charges, 1997 gains on sales of two businesses and the
international food realignment charges). During 1997, net cash provided by
operating activities was $8.3 billion compared with $7.6 billion in 1996. The
increase was due primarily to higher net earnings, excluding litigation
settlement charges.
Net cash used in investing activities: During 1998, 1997 and 1996, net
cash used in investing activities was $2.6 billion, $619 million and $2.1
billion, respectively. The increase from 1997 to 1998 and the decrease from 1996
to 1997 are both primarily attributable to $2.2 billion of cash proceeds from
sales of businesses in 1997. Also affecting the comparison of 1998 to 1997 was
lower cash spent on the acquisition of businesses ($613 million), partially
offset by PM Inc.'s purchase of options to acquire three U.S. trademarks ($150
million).
During 1997, $2.2 billion was provided by the sales of PMI's Brazilian ice
cream businesses, Mission Viejo real estate operations and several other food
and beer businesses. Also during 1997, PMI acquired a controlling interest in a
Portuguese tobacco company and increased its ownership interest in a Mexican
cigarette business for an aggregate cost of $620 million. During 1996, PMI
acquired a controlling interest in a Polish tobacco company and nearly all of
the remaining voting shares of a Brazilian confectionery company for an
aggregate cost of $599 million.
During 1996, the Company sold several domestic and international food
businesses, including the North American bagel business, for proceeds of $612
million.
Capital expenditures for 1998 decreased 3.7%, to $1.8 billion, of which
45% related to tobacco operations and 47% related to food operations, primarily
for modernization and consolidation of manufacturing facilities and expansion of
certain production capacity. Capital expenditures are expected to be
approximately the same amount in 1999 and are currently expected to be funded
from operations.
Net cash used in financing activities: During 1998, the Company's net cash
used in financing operations decreased to $3.9 billion from $5.5 billion in
1997. The decrease was primarily due to a $962 million net repayment of
short-term borrowings and long-term debt during 1997 versus a net issuance of
$332 mil-
32
lion in 1998 and lower cash paid for the repurchase of common stock in 1998
($498 million).
During 1997, the Company's net cash used in financing activities decreased
to $5.5 billion, compared with $6.4 billion used in 1996, due primarily to lower
stock repurchases, partially offset by higher dividends paid and an increase in
net repayments of short-term borrowings and long-term debt.
Debt and liquidity: The Company's total debt (consumer products and
financial services) was $14.7 billion, $14.1 billion and $15.2 billion at
December 31, 1998, 1997 and 1996, respectively. Total consumer products debt was
$14.0 billion, $13.3 billion and $13.9 billion at December 31, 1998, 1997 and
1996, respectively. At December 31, 1998 and 1997, the Company's ratio of
consumer products debt to total equity was 0.86 and 0.89, respectively. The
ratio of total debt to total equity was 0.91 and 0.95 at December 31, 1998 and
1997, respectively.
Fixed rate debt constituted approximately 91% and 98% of total consumer
products debt at December 31, 1998 and 1997, respectively. The decrease reflects
an interest rate swap agreement entered into by the Company during 1998. The
agreement effectively converts $800 million of fixed rate debt to variable rate
debt. The average interest rate on total consumer products debt, including the
impact of currency and interest rate swap agreements discussed in Market Risk
below, was approximately 7.2% and 7.6% at December 31, 1998 and 1997,
respectively.
The Company and its subsidiaries maintain credit facilities with a number
of lending institutions, amounting to approximately $12.2 billion at December
31, 1998. Approximately $12.0 billion of these facilities were unused at
December 31, 1998. These include revolving bank credit agreements totaling $10.0
billion, which may be used to support commercial paper borrowings by the Company
and are available for acquisitions and other corporate purposes. Of these
revolving bank agreements, an agreement for $2.0 billion expires in October
1999, and 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 that it may
refinance long-term and short-term debt from time to time. The nature and amount
of the Company's long-term and short-term debt and the proportionate amount of
each can be expected to vary as a result of future business requirements, market
conditions and other factors.
The Company's credit ratings by Moody's at December 31, 1998 and 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 December 31, 1998
and 1997 were "A-1" in the commercial paper market and "A" for long-term debt
obligations.
As discussed in Note 16, PM Inc., along with other domestic tobacco
companies, has entered into tobacco litigation settlement agreements that will
require the domestic tobacco industry to make substantial future annual payments
in the following amounts: 1999, $4.2 billion (of which $2.7 billion had already
been paid by the industry at December 31, 1998); 2000, $9.2 billion; 2001, $9.9
billion; 2002, $11.3 billion; 2003, $10.9 billion; 2004 through 2007, $8.4
billion; and thereafter, $9.4 billion. In addition, the domestic tobacco
industry is required to pay settling plaintiffs' attorneys' fees, subject to an
annual cap of $500 million, as well as additional amounts as follows: 1999, $450
million; 2000, $416 million; and 2001 and 2002, $250 million. The domestic
tobacco industry has also agreed in principle to contribute $5.15 billion over a
period of twelve years into a fund to compensate domestic tobacco growers for
the potential adverse economic impact of the foregoing tobacco settlements. PM
Inc.'s portion of the foregoing payments is subject to adjustment for several
factors, including inflation, market share and industry volume. While PM Inc.'s
share of future annual payments is not currently determinable, it is anticipated
that such future payments will be funded primarily through price increases.
Equity and dividends: During 1998 and 1997, the Company repurchased 6.5
million and 18.2 million shares of its common stock, respectively, at a cost of
$350 million and $743 million, respectively. Purchases in 1998 were made in the
fourth quarter when the Company resumed repurchases under an existing,
three-year $8 billion authority approved by the Board of Directors in the first
quarter of 1997, the duration of which was extended to November 2001 by the
Board of Directors in the fourth quarter of 1998. Cumulative purchases under the
$8 billion authority totaled $401 million at December 31, 1998.
Dividends paid in 1998 were 2.5% higher than in 1997, reflecting a higher
dividend rate in 1998. During the third quarter of 1998, the Company's Board of
Directors approved a 10% increase in the quarterly dividend rate to $0.44. As a
result, the annualized dividend rate increased to $1.76 from $1.60.
Return on average stockholders' equity decreased to 34.5% in 1998 from
43.3% in 1997. The decrease from 1997 primarily reflects higher average
stockholders' equity and the effect of litigation settlements in 1998.
Cash and cash equivalents: Cash and cash equivalents increased to $4.1
billion at December 31, 1998 from $2.3 billion at December 31, 1997. The
increase primarily reflects cash provided by operations, lower cash spent on
acquisitions and lower common share repurchases, partially offset by litigation
settlement payments and higher dividends.
Market Risk
The Company is exposed to market risk, primarily related to foreign exchange,
commodity prices and interest rates. These exposures are actively monitored by
management. To manage the volatility relating to these exposures, the Company
enters into a variety of derivative financial instruments. The Company's
objective is to reduce, where it is deemed appropriate to do so, fluctuations in
earnings and cash flows associated with changes in interest rates, foreign
currency rates and commodity prices. It is the Company's policy and practice to
use derivative financial instruments only to the extent necessary to manage
exposures.
33
Since the Company uses currency rate-sensitive and commodity price-sensitive
instruments to hedge a certain portion of its existing and anticipated
transactions, the Company expects that any loss in value for those instruments
generally would be offset by increases in the value of those hedged
transactions. The Company does not hold or issue derivative financial
instruments for trading or speculative purposes.
Foreign exchange rates: The Company is exposed to foreign exchange
movements, primarily in European, Japanese, other Asian and Latin American
currencies. Consequently, it enters into various contracts, which change in
value as foreign exchange rates change, to preserve the value of commitments and
anticipated transactions. The Company uses foreign currency option contracts to
hedge certain anticipated foreign currency revenues and raw materials purchases.
The Company also enters into short-term currency forward contracts, primarily to
hedge intercompany transactions denominated in foreign currencies and to hedge
the purchase of commodities. At December 31, 1998, the Company had long and
short forward exchange/option contracts with U.S. dollar equivalent values of
$3.6 billion and $4.5 billion, respectively. At December 31, 1997, the Company
had long and short forward exchange/option contracts with U.S. dollar equivalent
values of $1.3 billion and $1.2 billion, respectively.
The Company also seeks to protect its foreign currency net asset exposure,
primarily the Swiss franc and German mark, through the use of foreign-currency
denominated debt or currency swap agreements. At December 31, 1998 and 1997, the
notional amounts of currency swap agreements aggregated $2.5 billion and $1.4
billion, respectively.
Commodities: The Company is exposed to price risk related to anticipated
purchases of certain commodities used as raw materials by the Company's food
businesses. Accordingly, the Company enters into commodity future, forward and
option contracts to manage fluctuations in prices of anticipated purchases,
primarily coffee, cocoa, sugar, wheat and corn. At December 31, 1998 and 1997,
the Company had net long commodity positions of $158 million and $266 million,
respectively. Unrealized losses on net commodity positions were immaterial at
December 31, 1998 and 1997.
Interest rates: The Company manages its exposure to interest rate risk
through the proportion of fixed rate debt and variable rate debt in its total
debt portfolio. To manage this mix, the Company may enter into interest rate
swap agreements, in which it exchanges the periodic payments, based on a
notional amount and agreed-upon fixed and variable interest rates. The Company's
percentage of fixed rate debt to total debt (consumer products and financial
services) was 93% and 98% at December 31, 1998 and 1997, respectively. The
decrease reflects an interest rate swap agreement entered into by the Company
during 1998. The agreement effectively converts $800 million of fixed rate debt
to variable rate debt. The Company had no interest rate swap agreements at
December 31, 1997.
Use of the above-mentioned derivative financial instruments has not had a
material impact on the Company's financial position at December 31, 1998 and
1997 or the Company's results of operations for the years ended December 31,
1998, 1997 and 1996.
Value at risk: The Company uses a value at risk ("VAR") computation to
estimate the potential one-day loss in the fair value of its interest
rate-sensitive financial instruments and to estimate the one-day loss in pre-tax
earnings of its foreign currency and commodity price-sensitive derivative
financial instruments. The VAR computation includes the Company's debt;
short-term investments; foreign currency forwards, swaps and options; and
commodity futures, forwards and options. Anticipated transactions, foreign
currency trade payables and receivables, and net investments in foreign
subsidiaries, which the foregoing instruments are intended to hedge, were
excluded from the computation.
The VAR estimates were made assuming normal market conditions, using a 95%
confidence interval. The Company used a "variance/co-variance" model to
determine the observed interrelationships between movements in interest rates
and various currencies. These interrelationships were determined by observing
interest rate and forward currency rate movements over the preceding quarter for
the calculation of VAR amounts at December 31, 1998 and 1997 and over each of
the four preceding quarters for the calculation of average VAR amounts during
each year. The values of foreign currency and commodity options do not change on
a one-to-one basis with the underlying currency or commodity and were valued
accordingly in the VAR computation.
The estimated potential one-day loss in fair value of the Company's
interest rate-sensitive instruments, primarily debt, under normal market
conditions and the estimated potential one-day loss in pre-tax earnings from
foreign currency and commodity instruments under normal market conditions, as
calculated in the VAR model, follow:
Earnings Impact
----------------------------------------------
At
(in millions) 12/31/98 Average High Low
- --------------------------------------------------------------------------------
Instruments sensitive to:
Foreign currency rates $41 $17 $41 $ 7
Commodity prices $ 2 $ 4 $ 6 $ 2
- --------------------------------------------------------------------------------
Fair Value Impact
----------------------------------------------
At
(in millions) 12/31/98 Average High Low
- --------------------------------------------------------------------------------
Instruments sensitive to:
Interest rates $47 $45 $60 $36
- --------------------------------------------------------------------------------
34
Earnings Impact
----------------------------------------------
At
(in millions) 12/31/97 Average High Low
- --------------------------------------------------------------------------------
Instruments sensitive to:
Foreign currency rates $5 $7 $15 $3
Commodity prices $7 $8 $17 $5
- --------------------------------------------------------------------------------
Fair Value Impact
----------------------------------------------
At
(in millions) 12/31/97 Average High Low
- --------------------------------------------------------------------------------
Instruments sensitive to:
Interest rates $37 $40 $47 $37
- --------------------------------------------------------------------------------
The VAR computation is a risk analysis tool designed to statistically estimate
the maximum probable daily loss from adverse movements in interest rates,
foreign currency rates and commodity prices under normal market conditions. The
computation does not purport to represent actual losses in fair value or
earnings to be incurred by the Company, nor does it consider the effect of
favorable changes in market rates. The Company cannot predict actual future
movements in such market rates and does not present these VAR results to be
indicative of future movements in such market rates or to be representative of
any actual impact that future changes in market rates may have on its future
results of operations or financial position.
New Accounting Standards
During 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which must be adopted by the Company by
January 1, 2000. SFAS No. 133 requires that all derivative financial instruments
be recorded on the consolidated balance sheets at their fair value. Changes in
the fair value of derivatives will be recorded each period in earnings or other
comprehensive earnings, depending on whether a derivative is designated as part
of a hedge transaction and, if it is, the type of hedge transaction. Gains and
losses on derivative instruments reported in other comprehensive earnings will
be reclassified as earnings in the periods in which earnings are affected by the
hedged item. The Company has not yet determined the impact that adoption or
subsequent application of SFAS No. 133 will have on its financial position or
results of operations.
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 year ended December 31, 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 16 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 litigation settlements. Each of the
Company's operating subsidiaries is subject to intense competition, changes in
consumer preferences, the effects of changing prices for its raw materials,
local economic conditions and the potential impact of the CDC issue or the
conversion to the euro. The performance of each of PMI, KFI and Kraft 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.
35
SELECTED FINANCIAL DATA--ELEVEN-YEAR REVIEW
(in millions of dollars, except per share data)
- --------------------------------------------------------------------------------------------------------------
1998 1997 1996 1995
- --------------------------------------------------------------------------------------------------------------
Summary of Operations:
Operating revenues $ 74,391 $ 72,055 $ 69,204 $ 66,071
United States export sales 6,005 6,705 6,476 5,920
Cost of sales 26,820 26,689 26,560 26,685
Federal excise taxes on products 3,438 3,596 3,544 3,446
Foreign excise taxes on products 13,140 12,345 11,107 9,486
- --------------------------------------------------------------------------------------------------------------
Operating income 9,977 11,663 11,769 10,526
Interest and other debt expense, net 890 1,052 1,086 1,179
Earnings before income taxes and cumulative effect
of accounting changes 9,087 10,611 10,683 9,347
Pre-tax profit margin 12.2% 14.7% 15.4% 14.1%
Provision for income taxes 3,715 4,301 4,380 3,869
- --------------------------------------------------------------------------------------------------------------
Earnings before cumulative effect of accounting changes 5,372 6,310 6,303 5,478
Cumulative effect of accounting changes (28)
Net earnings 5,372 6,310 6,303 5,450
Basic EPS before cumulative effect
of accounting changes 2.21 2.61 2.57 2.18
Per share cumulative effect of accounting changes (0.01)
- --------------------------------------------------------------------------------------------------------------
Basic EPS 2.21 2.61 2.57 2.17
Diluted EPS before cumulative effect
of accounting changes 2.20 2.58 2.54 2.16
Per share cumulative effect of accounting changes (0.01)
Diluted EPS 2.20 2.58 2.54 2.15
Dividends declared per share 1.68 1.60 1.47 1.22
Weighted average shares (millions)--Basic 2,429 2,420 2,456 2,517
Weighted average shares (millions)--Diluted 2,446 2,442 2,482 2,538
- --------------------------------------------------------------------------------------------------------------
Capital expenditures 1,804 1,874 1,782 1,621
Depreciation 1,106 1,044 1,037 1,024
Property, plant and equipment, net (consumer products) 12,335 11,621 11,751 11,116
Inventories (consumer products) 9,445 9,039 9,002 7,862
Total assets 59,920 55,947 54,871 53,811
Total long-term debt 12,615 12,430 12,961 13,107
Total debt--consumer products 13,953 13,258 13,933 14,372
--financial services and real estate 709 845 1,307 1,454
- --------------------------------------------------------------------------------------------------------------
Total deferred income taxes 3,638 3,382 3,336 2,827
Stockholders' equity 16,197 14,920 14,218 13,985
Common dividends declared as a % of Basic EPS 76.0% 61.3% 57.2% 56.2%
Common dividends declared as a % of Diluted EPS 76.4% 62.0% 57.9% 56.7%
Book value per common share outstanding 6.66 6.15 5.85 5.61
Market price per common share--high/low 59.50-34.75 48.13-36.00 39.67-28.54 31.46-18.58
- --------------------------------------------------------------------------------------------------------------
Closing price of common share at year end 53.50 45.25 37.67 30.08
Price/earnings ratio at year end--Basic 24 17 15 14
Price/earnings ratio at year end--Diluted 24 18 15 14
Number of common shares outstanding at
year end (millions) 2,431 2,425 2,430 2,493
Number of employees 144,000 152,000 154,000 151,000
==============================================================================================================
See notes to the consolidated financial statements regarding acquisitions and
divestitures in 1998, 1997 and 1996; the international food realignment in 1997;
tobacco and other litigation settlement charges in 1998 and 1997; and 1998
charges for early retirement and separation programs for domestic tobacco and
corporate employees.
36
- -----------------------------------------------------------------------------------------
1994 1993 1992 1991 1990 1989 1988
- -----------------------------------------------------------------------------------------
$ 65,125 $ 60,901 $ 59,131 $ 56,458 $ 51,169 $ 44,080 $ 31,273
4,942 4,105 3,797 3,061 2,928 2,288 1,863
28,351 26,771 26,082 25,612 24,430 21,868 13,565
3,431 3,081 2,879 2,978 2,159 2,140 2,127
7,918 7,199 6,157 5,416 4,687 3,608 3,755
- -----------------------------------------------------------------------------------------
9,449 7,587 10,059 8,622 7,946 6,789 4,397
1,233 1,391 1,451 1,651 1,635 1,731 670
8,216 6,196 8,608 6,971 6,311 5,058 3,727
12.6% 10.2% 14.6% 12.3% 12.3% 11.5% 11.9%
3,491 2,628 3,669 3,044 2,771 2,112 1,663
- -----------------------------------------------------------------------------------------
4,725 3,568 4,939 3,927 3,540 2,946 2,064
(477) (921) 273
4,725 3,091 4,939 3,006 3,540 2,946 2,337
1.82 1.35 1.82 1.41 1.28 1.06 0.74
(0.18) (0.33) 0.10
- -----------------------------------------------------------------------------------------
1.82 1.17 1.82 1.08 1.28 1.06 0.84
1.81 1.35 1.80 1.40 1.27 1.05 0.73
(0.18) (0.33) 0.10
1.81 1.17 1.80 1.07 1.27 1.05 0.83
1.01 0.87 0.78 0.64 0.52 0.42 0.34
2,597 2,633 2,717 2,773 2,774 2,778 2,796
2,610 2,645 2,741 2,798 2,792 2,797 2,805
- -----------------------------------------------------------------------------------------
1,726 1,592 1,573 1,562 1,355 1,246 1,024
1,025 1,042 963 938 876 755 608
11,171 10,463 10,530 9,946 9,604 8,457 8,648
7,987 7,358 7,785 7,445 7,153 5,751 5,384
52,649 51,205 50,014 47,384 46,569 38,528 36,960
14,975 15,221 14,583 14,213 16,121 14,551 16,812
14,978 16,364 16,269 15,289 17,182 14,887 16,442
1,494 1,792 1,934 1,611 1,560 1,538 1,504
- -----------------------------------------------------------------------------------------
2,496 2,168 2,248 1,803 2,083 1,732 1,559
12,786 11,627 12,563 12,512 11,947 9,571 7,679
55.5% 74.4% 42.9% 59.3% 40.6% 39.6% 40.5%
55.8% 74.4% 43.3% 59.8% 40.9% 40.0% 41.0%
5.00 4.42 4.69 4.53 4.30 3.43 2.77
21.50-15.75 25.88-15.00 28.88-23.17 27.25-16.08 17.33-12.00 15.17-8.33 8.50-6.71
- -----------------------------------------------------------------------------------------
19.17 18.54 25.71 26.75 17.25 13.88 8.50
11 16 14 25 13 13 10
11 16 14 25 14 13 10
2,559 2,631 2,679 2,760 2,778 2,787 2,772
165,000 173,000 161,000 166,000 168,000 157,000 155,000
=========================================================================================
37
CONSOLIDATED BALANCE SHEETS
(in millions of dollars, except per share data)
at December 31,
- --------------------------------------------------------------------------------
1998 1997
- --------------------------------------------------------------------------------
Assets
Consumer products
Cash and cash equivalents $ 4,081 $ 2,282
Receivables, net 4,691 4,294
Inventories:
Leaf tobacco 4,729 4,348
Other raw materials 1,728 1,689
Finished product 2,988 3,002
- --------------------------------------------------------------------------------
9,445 9,039
Other current assets 2,013 1,825
- --------------------------------------------------------------------------------
Total current assets 20,230 17,440
Property, plant and equipment, at cost:
Land and land improvements 655 666
Buildings and building equipment 5,386 5,114
Machinery and equipment 13,771 12,667
Construction in progress 1,422 1,555
- --------------------------------------------------------------------------------
21,234 20,002
Less accumulated depreciation 8,899 8,381
- --------------------------------------------------------------------------------
12,335 11,621
Goodwill and other intangible assets
(less accumulated amortization of $5,436 and $4,814) 17,566 17,789
Other assets 3,309 3,211
- --------------------------------------------------------------------------------
Total consumer products assets 53,440 50,061
Financial services
Finance assets, net 6,324 5,712
Other assets 156 174
- --------------------------------------------------------------------------------
Total financial services assets 6,480 5,886
- --------------------------------------------------------------------------------
Total Assets $59,920 $55,947
================================================================================
See notes to consolidated financial statements.
38
- -----------------------------------------------------------------------------------------------------
1998 1997
- -----------------------------------------------------------------------------------------------------
Liabilities
Consumer products
Short-term borrowings $ 225 $ 157
Current portion of long-term debt 1,822 1,516
Accounts payable 3,359 3,318
Accrued liabilities:
Marketing 2,637 2,149
Taxes, except income taxes 1,408 1,234
Employment costs 968 1,083
Settlement charges 1,135 886
Other 2,608 2,894
Income taxes 1,144 862
Dividends payable 1,073 972
- -----------------------------------------------------------------------------------------------------
Total current liabilities 16,379 15,071
Long-term debt 11,906 11,585
Deferred income taxes 929 889
Accrued postretirement health care costs 2,543 2,432
Other liabilities 7,019 6,218
- -----------------------------------------------------------------------------------------------------
Total consumer products liabilities 38,776 36,195
Financial services
Long-term debt 709 845
Deferred income taxes 4,151 3,877
Other liabilities 87 110
- -----------------------------------------------------------------------------------------------------
Total financial services liabilities 4,947 4,832
- -----------------------------------------------------------------------------------------------------
Total liabilities 43,723 41,027
Contingencies (Note 16)
Stockholders' Equity
Common stock, par value $0.33 1/3 per share (2,805,961,317 shares issued) 935 935
Earnings reinvested in the business 26,261 24,924
Accumulated other comprehensive earnings
(including currency translation of $1,081 and $1,109) (1,106) (1,109)
Cost of repurchased stock (375,426,742 and 380,474,028 shares) (9,893) (9,830)
- -----------------------------------------------------------------------------------------------------
Total stockholders' equity 16,197 14,920
- -----------------------------------------------------------------------------------------------------
Total Liabilities and Stockholders' Equity $ 59,920 $ 55,947
=====================================================================================================
See notes to consolidated financial statements.
39
CONSOLIDATED STATEMENTS OF EARNINGS
(in millions of dollars, except per share data)
for the years ended December 31,
- --------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------
Operating revenues $74,391 $72,055 $69,204
Cost of sales 26,820 26,689 26,560
Excise taxes on products 16,578 15,941 14,651
- --------------------------------------------------------------------------------
Gross profit 30,993 29,425 27,993
Marketing, administration and research costs 17,051 15,720 15,630
Settlement charges (Note 16) 3,381 1,457
Amortization of goodwill 584 585 594
- --------------------------------------------------------------------------------
Operating income 9,977 11,663 11,769
Interest and other debt expense, net 890 1,052 1,086
- --------------------------------------------------------------------------------
Earnings before income taxes 9,087 10,611 10,683
Provision for income taxes 3,715 4,301 4,380
- --------------------------------------------------------------------------------
Net earnings $ 5,372 $ 6,310 $ 6,303
================================================================================
Per share data:
Basic earnings per share $ 2.21 $ 2.61 $ 2.57
================================================================================
Diluted earnings per share $ 2.20 $ 2.58 $ 2.54
================================================================================
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in millions of dollars)
for the years ended December 31,
- ------------------------------------------------------------------------------------------------------
1998 1997 1996
- ------------------------------------------------------------------------------------------------------
Cash Provided By (Used In) Operating Activities
Net earnings--Consumer products $5,255 $6,152 $6,180
--Financial services 117 158 123
- ------------------------------------------------------------------------------------------------------
Net earnings 5,372 6,310 6,303
Adjustments to reconcile net earnings to operating cash flows:
Consumer products
Depreciation and amortization 1,690 1,629 1,631
International food realignment 630
Deferred income tax provision (benefit) 11 (188) 163
Gain on sale of Brazilian ice cream businesses (774)
Gains on sales of other businesses (196) (320)
Cash effects of changes, net of the effects from acquired and divested
companies:
Receivables, net (352) (168) 35
Inventories (192) (531) (952)
Accounts payable (150) 37 60
Income taxes 565 48 373
Accrued liabilities and other current assets 254 726 (448)
Other 671 653 527
======================================================================================================
See notes to consolidated financial statements.
40
CONSOLIDATED STATEMENTS OF CASH FLOWS
(continued)
for the years ended December 31,
- --------------------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------------------
Financial services
Deferred income tax provision $ 265 $ 257 $ 224
Gain on sale of business (103)
Other (14) 10 38
- --------------------------------------------------------------------------------------------
Net cash provided by operating activities 8,120 8,340 7,634
- --------------------------------------------------------------------------------------------
Cash Provided By (Used In) Investing Activities
Consumer products
Capital expenditures (1,804) (1,874) (1,782)
Purchase of businesses, net of acquired cash (17) (630) (616)
Proceeds from sales of businesses 16 1,784 612
Other (154) 42 (47)
Financial services
Investments in finance assets (736) (652) (439)
Proceeds from finance assets 141 287 217
Proceeds from sale of business 424
- --------------------------------------------------------------------------------------------
Net cash used in investing activities (2,554) (619) (2,055)
- --------------------------------------------------------------------------------------------
Cash Provided By (Used In) Financing Activities
Consumer products
Net issuance (repayment) of short-term borrowings 61 (1,482) (1,119)
Long-term debt proceeds 2,065 2,893 2,699
Long-term debt repaid (1,616) (1,987) (1,979)
Financial services
Net repayment of short-term borrowings (173) (498)
Long-term debt proceeds 174 363
Long-term debt repaid (178) (387)
Repurchase of common stock (307) (805) (2,770)
Dividends paid (3,984) (3,885) (3,462)
Issuance of common stock 265 205 448
Other (200) (74) (88)
- --------------------------------------------------------------------------------------------
Net cash used in financing activities (3,894) (5,521) (6,406)
- --------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash and cash equivalents 127 (158) (71)
- --------------------------------------------------------------------------------------------
Cash and cash equivalents:
Increase (decrease) 1,799 2,042 (898)
Balance at beginning of year 2,282 240 1,138
- --------------------------------------------------------------------------------------------
Balance at end of year $ 4,081 $ 2,282 $ 240
============================================================================================
Cash paid: Interest--Consumer products $ 1,141 $ 1,219 $ 1,244
============================================================================================
--Financial services $ 79 $ 79 $ 95
============================================================================================
Income taxes $ 2,644 $ 3,794 $ 3,424
============================================================================================
See notes to consolidated financial statements.
41
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in millions of dollars, except per share data)
Accumulated
Other Comprehensive Earnings
---------------------------------
Earnings
Reinvested Currency Cost of Total
Common in the Translation Repurchased Stockholders'
Stock Business Adjustments Other Total Stock Equity
- -----------------------------------------------------------------------------------------------------------------------------------
- -----------------------------------------------------------------------------------------------------------------------------------
Balances, January 1, 1996 $ 935 $19,811 $ 467 $ (32) $ 435 $(7,196) $13,985
Comprehensive earnings:
Net earnings 6,303 6,303
Other comprehensive earnings, net of income taxes:
Currency translation
adjustments (275) (275) (275)
Net unrealized appreciation
on securities 30 30 30
- -----------------------------------------------------------------------------------------------------------------------------------
Total other comprehensive earnings (245)
- -----------------------------------------------------------------------------------------------------------------------------------
Total comprehensive earnings 6,058
- -----------------------------------------------------------------------------------------------------------------------------------
Exercise of stock options and issuance
of other stock awards (28) 609 581
Cash dividends declared ($1.47 per share) (3,606) (3,606)
Stock repurchased (2,800) (2,800)
- -----------------------------------------------------------------------------------------------------------------------------------
Balances, December 31, 1996 935 22,480 192 (2) 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 2
- -----------------------------------------------------------------------------------------------------------------------------------
Total other comprehensive earnings (1,299)
- -----------------------------------------------------------------------------------------------------------------------------------
Total comprehensive earnings 5,011
- -----------------------------------------------------------------------------------------------------------------------------------
Exercise of stock options and issuance
of other stock awards 14 300 314
Cash dividends declared ($1.60 per share) (3,880) (3,880)
Stock repurchased (743) (743)
- -----------------------------------------------------------------------------------------------------------------------------------
Balances, December 31, 1997 935 24,924 (1,109) (1,109) (9,830) 14,920
Comprehensive earnings:
Net earnings 5,372 5,372
Other comprehensive earnings, net of income taxes:
Currency translation
adjustments 28 28 28
Additional minimum pension
liability (25) (25) (25)
- -----------------------------------------------------------------------------------------------------------------------------------
Total other comprehensive earnings 3
- -----------------------------------------------------------------------------------------------------------------------------------
Total comprehensive earnings 5,375
- -----------------------------------------------------------------------------------------------------------------------------------
Exercise of stock options and issuance
of other stock awards 50 287 337
Cash dividends declared ($1.68 per share) (4,085) (4,085)
Stock repurchased (350) (350)
- -----------------------------------------------------------------------------------------------------------------------------------
Balances, December 31, 1998 $ 935 $26,261 $(1,081) $ (25) $(1,106) $(9,893) $16,197
===================================================================================================================================
See notes to consolidated financial statements.
42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
Note 1. Summary of Significant Accounting Policies:
Basis of presentation: The consolidated financial statements include all
significant subsidiaries. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities, the disclosure of contingent assets and liabilities at the dates of
the financial statements and the reported amounts of operating revenues and
expenses during the reporting periods. Actual results could differ from those
estimates.
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.
Certain prior years' amounts have been reclassified to conform with the
current year's presentation.
Cash and cash equivalents: Cash equivalents include demand deposits with
banks and all highly liquid investments with original maturities of three months
or less.
Inventories: Inventories are stated at the lower of cost or market. The
last-in, first-out ("LIFO") method is used to cost substantially all domestic
inventories. The cost of other inventories is determined by the average cost or
first-in, first-out methods. It is a generally recognized industry practice to
classify leaf tobacco inventory as a current asset although part of such
inventory, because of the duration of the aging process, ordinarily would not be
utilized within one year.
Impairment of long-lived assets: The Company reviews long-lived assets for
impairment whenever events or changes in business circumstances indicate that
the carrying amount of the assets may not be fully recoverable. The Company
performs undiscounted cash flow analyses to determine if an impairment exists.
If an impairment is determined to exist, any related impairment loss is
calculated based on fair value. Impairment losses on assets to be disposed, if
any, are based on the estimated proceeds to be received, less costs of disposal.
Depreciation, amortization and goodwill valuation: Depreciation is
recorded by the straight-line method. Goodwill and other intangible assets
substantially comprise brand names purchased through acquisitions, which are
amortized on the straight-line method over 40 years. The Company periodically
evaluates the recoverability of its intangible assets and measures any
impairment by comparison to estimated undiscounted cash flows from future
operations.
Advertising costs: Advertising costs are expensed as incurred.
Revenue recognition: The Company recognizes operating revenues upon
shipment of goods to customers.
Hedging instruments: The Company utilizes certain financial instruments to
manage its foreign currency, commodity and interest rate exposures. The Company
does not engage in trading or other speculative use of these financial
instruments. To qualify as a hedge, the Company must be exposed to price,
currency or interest rate risk and the financial instrument must reduce the
exposure and be designated as a hedge. Additionally, for hedges of anticipated
transactions, the significant characteristics and expected terms of the
anticipated transaction must be identified and it must be probable that the
anticipated transaction will occur. Financial instruments qualifying for hedge
accounting must maintain a high correlation between the hedging instrument and
the item being hedged, both at inception and throughout the hedged period.
The Company uses forward contracts, options and swap agreements to
mitigate its foreign currency exposure. The corresponding gains and losses on
those contracts are deferred and included in the basis of the underlying hedged
transactions when settled. Options are used to hedge anticipated transactions.
Option premiums are recorded generally as other current assets on the
consolidated balance sheets and amortized to interest and other debt expense,
net over the lives of the related options. The values of options, excluding
their time values, are
43
recognized as adjustments to the related hedged items. If anticipated
transactions were not to occur, any gains or losses would be recognized in
earnings currently. Foreign currency and related interest rate swap agreements
are used to hedge certain foreign currency net investments. Realized and
unrealized gains and losses on foreign currency swap agreements that are
effective as hedges of net assets in foreign subsidiaries are offset against
currency translation adjustments as a component of stockholders' equity. The
interest differential to be paid or received under the currency and related
interest rate swap agreements is recognized over the life of the related debt
and is included in interest and other debt expense, net. Gains and losses on
terminated foreign currency swap agreements, if any, are recorded as currency
translation adjustments, which is a component of stockholders' equity.
Commodity futures and forward contracts are used by the Company to procure
raw materials, primarily coffee, cocoa, sugar, wheat and corn. Commodity futures
and options are also used to hedge the price of certain commodities, primarily
coffee and cocoa. Realized gains and losses on commodity futures, forward
contracts and options are deferred as a component of inventories and are
recognized when related raw material costs are charged to cost of sales. If the
anticipated transaction were not to occur, the gains and losses would be
recognized in earnings currently.
Interest rate swap agreements are accounted for on an accrual basis with
the net receivable or payable recognized as an adjustment to interest expense.
Gains and losses on terminated interest rate swaps, if any, are recognized over
the remaining life of the arrangement, or immediately, if the hedged items do
not remain outstanding. The fair value of the interest rate swap agreements and
changes in these fair values as a result of changes in market interest rates are
not recognized in the consolidated financial statements.
During 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative
Instruments and Hedging Activities," which must be adopted by the Company by
January 1, 2000. SFAS No. 133 requires that all derivative financial instruments
be recorded on the consolidated balance sheets at their fair value. Changes in
the fair value of derivatives will be recorded each period in earnings or other
comprehensive earnings, depending on whether a derivative is designated as part
of a hedge transaction and, if it is, the type of hedge transaction. Gains and
losses on derivative instruments reported in other comprehensive earnings will
be reclassified as earnings in the periods in which earnings are affected by the
hedged item. The Company has not yet determined the impact that adoption or
subsequent application of SFAS No. 133 will have on its financial position or
results of operations.
Stock-based compensation: The Company accounts for employee stock
compensation plans in accordance with the intrinsic value-based method permitted
by SFAS No. 123, "Accounting for Stock-Based Compensation," which generally does
not result in compensation cost.
Software costs: The Company capitalizes certain computer software and
software development costs incurred in connection with developing or obtaining
computer software for internal use in accordance with Statement of Position No.
98-1 ("SOP 98-1"), "Accounting for the Costs of Computer Software Developed or
Obtained for Internal Use," which was adopted by the Company as of January 1,
1998. The adoption of SOP 98-1 had no material effect on the Company's financial
position or results of operations.
Capitalized costs are amortized on a straight-line basis over the
estimated useful lives of the software.
Note 2. Divestitures:
During 1997, the Company sold several domestic and international food
businesses, including its Brazilian ice cream businesses and its North American
maple-flavored syrup businesses, for total proceeds of $1.5 billion and net
pre-tax gains of $958 million. In addition, the Company sold its equity interest
in a Canadian beer operation and sold a minority interest in a beer import
operation for proceeds of $306 million and a pre-tax gain of $12 million. The
Company also sold its real estate operations for total proceeds of $424 million
and a pre-tax gain of $103 million.
During 1996, the Company sold several domestic and international food
businesses, including its North American bagel business, for total proceeds of
$612 million and net pre-tax gains of $320 million.
44
The operating results of these businesses were not material to the
Company's consolidated operating results in any of the periods presented.
Pre-tax gains on these divestitures were included in marketing, administration
and research costs on the Company's consolidated statements of earnings.
Note 3. Acquisitions:
During December 1998, the Company's domestic tobacco subsidiary paid $150
million for options to purchase the voting and non-voting common stock of a
company ("the acquiree"), the sole assets of which are three U.S. cigarette
brands. The exercise of the options is subject to regulatory approval. Upon
exercise of these options, the Company will acquire all the common stock of the
acquiree for an additional $150 million.
During 1997, the Company acquired a controlling interest in a Portuguese
tobacco company at a cost of $217 million and increased its ownership interest
in a Mexican cigarette business from 28.8% to 50.0% at a cost of $403 million.
During 1996, the Company acquired a controlling interest in a Polish
tobacco company, at a cost of $285 million and nearly all of the remaining
voting shares of a Brazilian confectionery company, at a cost of $314 million.
The effects of these and other smaller acquisitions were not material to
the Company's financial position or results of operations in any of the periods
presented.
Note 4. Food Realignment Charges:
In the fourth quarter of 1997, the Company's international food operations
recorded a charge of $342 million related primarily to the downsizing or closure
of manufacturing and other facilities, as well as the discontinuance of certain
low-margin product lines. The Company also recorded a charge of $288 million for
incremental postemployment benefits, primarily related to severance.
In 1996, the Company's North American food and international food
operations charged $252 million and $68 million, respectively, to marketing,
administration and research costs. These charges related primarily to the
downsizing and closure of certain food manufacturing facilities, related
incremental postemployment costs, primarily severance, and an early retirement
program.
These charges, which were recorded to marketing, administration and
research costs, reduced earnings before income taxes by $630 million and $320
million in 1997 and 1996, respectively.
Note 5. Inventories:
The cost of approximately 50% of inventories in 1998 and 1997 was determined
using the LIFO method. The stated LIFO values of inventories were approximately
$1.1 billion and $1.0 billion lower than the current cost of inventories at
December 31, 1998 and 1997, respectively.
Note 6. Short-Term Borrowings and Borrowing Arrangements:
At December 31, the Company's short-term borrowings and related average interest
rates consisted of the following:
(in millions)
- -------------------------------------------------------------------------------
1998 1997
- -------------------------------------------------------------------------------
Average Average
Amount Year-End Amount Year-End
Outstanding Rate Outstanding Rate
===============================================================================
Consumer products:
Bank loans $260 10.3% $194 8.8%
Amount reclassified
as long-term debt (35) (37)
- -------------------------------------------------------------------------------
$225 $157
===============================================================================
The fair values of the Company's short-term borrowings at December 31, 1998 and
1997, based upon market rates, approximate the amounts disclosed above.
The Company and its subsidiaries maintain credit facilities with a number
of lending institutions, amounting to approximately $12.2 billion at December
31, 1998. Approximately $12.0 billion of these facilities were unused at
December 31, 1998. Certain of these facilities are used to support commercial
paper borrowings, are available for acquisitions and other corporate purposes
and require the maintenance of a fixed charges coverage ratio.
The Company's credit facilities include revolving bank credit agreements
totaling $10.0 billion. Included in this total are an agreement for $2.0
billion, which expires in October 1999, and an agreement for $8.0 billion,
expiring in 2002, which enable the Company to refinance short-term debt on a
long-term basis. Accordingly, short-term borrowings intended to be refinanced
were reclassified as long-term debt.
45
Note 7. Long-Term Debt:
At December 31, 1998 and 1997 the Company's long-term debt consisted of
the following:
(in millions)
- -------------------------------------------------------------------------------
1998 1997
- -------------------------------------------------------------------------------
Consumer products:
Short-term borrowings, reclassified $ 35 $ 37
Notes, 6.15% to 9.25% (average
effective rate 7.39%), due
through 2008 9,615 9,735
Debentures, 6.00% to 8.50%
(average effective rate 9.90%),
$1.9 billion face amount, due
through 2027 1,691 1,830
Foreign currency obligations:
Swiss franc, 1.39% to 5.50%
(average effective rate 4.96%),
due through 2000 463 857
German mark, 5.63% to 6.38%
(average effective rate 5.63%),
due through 2008 1,566 341
Other foreign 122 61
Other 236 240
- -------------------------------------------------------------------------------
13,728 13,101
Less current portion of long-term debt (1,822) (1,516)
- -------------------------------------------------------------------------------
$11,906 $11,585
===============================================================================
Financial services:
Eurodollar note, 6.63%, due 1999 $ 200 $ 200
Foreign currency obligations:
French franc, 6.88%, due 2006 179 169
German mark, 6.50% and 5.38%,
(average effective rate
5.89%) due 2003 and 2004 330 311
ECU note, 8.50%, due 1998 165
- -------------------------------------------------------------------------------
$ 709 $ 845
===============================================================================
Aggregate maturities of long-term debt, excluding short-term borrowings
reclassified as long-term debt, are as follows:
Consumer Financial
(in millions) Products Services
- --------------------------------------------------------------------------------
1999 $1,822 $200
2000 1,662
2001 1,843
2002 1,402
2003 1,251 150
2004-2008 4,795 359
2009-2013 248
Thereafter 815
- --------------------------------------------------------------------------------
Based on market quotes, where available, or interest rates currently available
to the Company for issuance of debt with similar terms and remaining maturities,
the aggregate fair value of consumer products and financial services long-term
debt, including current portion of long-term debt, at December 31, 1998 and 1997
was $15.4 billion and $14.6 billion, respectively.
Note 8. Capital Stock:
In 1997, the Company's Board of Directors declared a three-for-one split of the
Company's common stock, changed the common stock's par value from $1.00 to
$0.33 1/3 per share and increased the number of authorized shares of common
stock from 4 billion to 12 billion shares. All references in the consolidated
financial statements to shares and related prices, weighted average number of
shares, per share amounts and stock plan data have been adjusted to reflect the
split.
Shares of common stock issued, repurchased and outstanding were as
follows:
Shares Shares Net Shares
Issued Repurchased Outstanding
===============================================================================
Balances,
January 1, 1996 2,805,961,317 (312,451,299) 2,493,510,018
Exercise of stock options
and issuance of other
stock awards 23,672,505 23,672,505
Repurchased (85,836,249) (85,836,249)
- -------------------------------------------------------------------------------
Balances,
December 31, 1996 2,805,961,317 (374,615,043) 2,431,346,274
Exercise of stock options
and issuance of other
stock awards 12,345,228 12,345,228
Repurchased (18,204,213) (18,204,213)
- -------------------------------------------------------------------------------
Balances,
December 31, 1997 2,805,961,317 (380,474,028) 2,425,487,289
Exercise of stock options
and issuance of other
stock awards 11,501,286 11,501,286
Repurchased (6,454,000) (6,454,000)
- -------------------------------------------------------------------------------
Balances,
December 31, 1998 2,805,961,317 (375,426,742) 2,430,534,575
===============================================================================
At December 31, 1998, 173,607,574 shares of common stock were reserved for stock
options and other stock awards under the Company's stock plans and 10 million
shares of Serial Preferred Stock, $1.00 par value, were authorized, none of
which have been issued.
Note 9. Stock Plans:
Under the Philip Morris 1997 Performance Incentive Plan (the "Plan"), the
Company may grant to eligible employees stock options, stock appreciation
rights, restricted stock, and other stock-based awards, as well as cash-based
annual and long-term incentive awards. Up to 120 million shares of common stock
may be issued under the Plan, of which no more than 36 million shares may be
awarded as restricted stock. Shares available to be granted at December 31, 1998
were 85,883,360.
46
Stock options are granted at an exercise price of not less than fair value
on the date of the grant. Stock options granted under the Plan generally become
exercisable on the first anniversary of the grant date and have a maximum term
of ten years.
Effective January 1, 1996, the Company adopted SFAS No. 123, "Accounting
for Stock-Based Compensation." The Company applies the intrinsic value-based
methodology permitted by SFAS No. 123 in accounting for the Plan. Accordingly,
no compensation expense has been recognized other than for restricted stock
awards. Had compensation cost for stock option awards under the Plan been
determined on the fair value at the grant date, the Company's net earnings,
basic EPS and diluted EPS would have been $5,280 million, $2.17 and $2.16,
respectively, for the year ended December 31, 1998; $6,218 million, $2.57 and
$2.55, respectively, for the year ended December 31, 1997; and $6,235 million,
$2.54 and $2.51, respectively, for the year ended December 31, 1996. The
foregoing impact of compensation cost, calculated in accordance with the fair
value method prescribed by SFAS No. 123, was determined using a modified
Black-Scholes methodology and the following assumptions:
Weighted
Average Expected
Risk-Free Expected Expected Dividend Fair Value at
Interest Rate Life Volatility Yield Grant Date
================================================================================
1998 5.52% 5 23.83% 4.03% $ 7.78
1997 6.38 5 27.86 3.65 10.83
1996 6.70 5 23.80 3.83 7.73
================================================================================
Option activity was as follows for the years ended December 31, 1996, 1997
and 1998:
Weighted
Shares Subject Options Average
to Option Exercisable Exercise Price
================================================================================
Balance at
January 1, 1996 85,224,372 62,102,802 $20.09
Options granted 22,627,215 36.08
Options exercised (25,310,940) 18.94
Options canceled (1,327,266) 26.21
- --------------------------------------------------------------------------------
Balance at
December 31, 1996 81,213,381 58,949,796 24.81
Options granted 16,105,390 43.88
Options exercised (12,782,568) 19.86
Options canceled (890,644) 34.75
- --------------------------------------------------------------------------------
Balance at
December 31, 1997 83,645,559 67,827,399 29.13
Options granted 18,652,100 39.74
Options exercised (12,042,497) 22.56
Options canceled (3,051,498) 31.74
- --------------------------------------------------------------------------------
Balance at
December 31, 1998 87,203,664 68,864,594 $32.21
================================================================================
The weighted average exercise prices of options exercisable at December 31,
1998, 1997 and 1996 were $30.21, $25.69 and $20.56, respectively.
The following table summarizes the status of stock options outstanding and
exercisable as of December 31, 1998, by range of exercise price:
Options Outstanding Options Exercisable
---------------------------------- -----------------------
Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life Price Exercisable Price
================================================================================
$11.80-$17.23 10,965,163 3 years $15.70 10,965,163 $15.70
18.35- 26.28 24,813,444 5 years 24.16 24,813,444 24.16
28.27- 40.00 36,608,512 8 years 37.89 18,291,382 36.06
41.62- 58.72 14,816,545 8 years 43.89 14,794,605 43.88
- --------------------------------------------------------------------------------
87,203,664 68,864,594
========== ==========
The Company may grant shares of restricted stock and rights to receive shares of
stock to eligible employees, giving them in most instances all of the rights of
stockholders, except that they may not sell, assign, pledge or otherwise
encumber such shares and rights. Such shares and rights are subject to
forfeiture if certain employment conditions are not met. During 1998, 1997 and
1996 the Company granted 603,650, 692,100 and 180,000 shares, respectively, of
restricted stock to eligible U.S. based employees and also issued to eligible
non-U.S. employees rights to receive 120,500 and 392,400 like shares,
respectively, during 1998 and 1997. At December 31, 1998, restrictions on the
stock, net of forfeitures, lapse as follows: 1999-120,300 shares; 2000-654,000
shares; 2002-1,263,450 shares; 2003-290,250 shares; and 2004 and
thereafter-636,000 shares.
The fair value of the restricted shares and rights at the date of grant is
amortized to expense ratably over the restriction period. The Company recorded
compensation expense related to restricted stock and other stock awards of $34
million, $29 million and $37 million for the years ended December 31, 1998, 1997
and 1996, respectively. The unamortized portion is reported as a reduction of
earnings reinvested in the business and was $59 million and $49 million at
December 31, 1998 and 1997, respectively.
47
Note 10. Earnings per Share:
Effective December 31, 1997, the Company adopted SFAS No. 128, "Earnings per
Share," which established standards for computing and presenting both basic and
diluted earnings per share ("EPS"). Basic and diluted EPS were calculated using
the following for the years ended December 31, 1998, 1997 and 1996:
(in millions)
- --------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------
Net earnings $5,372 $6,310 $6,303
================================================================================
Weighted average shares for
basic EPS 2,429 2,420 2,456
Plus incremental shares from conversions:
Restricted stock and stock rights 1 1 8
Stock options 16 21 18
- --------------------------------------------------------------------------------
Weighted average shares for
diluted EPS 2,446 2,442 2,482
================================================================================
In 1998, 1997 and 1996, options on 14,797,260, 11,988,118 and 18,737,224 shares
of common stock, respectively, were not included in the calculation of weighted
average shares for diluted EPS because their effects would be antidilutive.
Note 11. Pre-tax Earnings and Provision for Income Taxes:
Pre-tax earnings and provision for income taxes consisted of the following for
the years ended December 31, 1998, 1997 and 1996:
(in millions)
- -------------------------------------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------
Pre-tax earnings:
United States $5,134 $ 7,515 $ 7,399
Outside United States 3,953 3,096 3,284
- -------------------------------------------------------------------------------
Total pre-tax earnings $9,087 $10,611 $10,683
================================================================================
Provision for income taxes:
United States federal:
Current $1,614 $ 2,027 $ 1,836
Deferred 171 12 438
- -------------------------------------------------------------------------------
1,785 2,039 2,274
State and local 350 354 430
- -------------------------------------------------------------------------------
Total United States 2,135 2,393 2,704
- -------------------------------------------------------------------------------
Outside United States:
Current 1,475 1,851 1,727
Deferred 105 57 (51)
- -------------------------------------------------------------------------------
Total outside
United States 1,580 1,908 1,676
- -------------------------------------------------------------------------------
Total provision for
income taxes $3,715 $ 4,301 $ 4,380
================================================================================
At December 31, 1998, applicable United States federal income taxes and foreign
withholding taxes have not been provided on approximately $3.4 billion of
accumulated earnings of foreign subsidiaries that are expected to be permanently
reinvested. If these amounts were not considered permanently reinvested,
additional deferred income taxes of approximately $173 million would have been
provided.
The Company and its subsidiaries are subject to tax examinations in
various U.S. and foreign jurisdictions. The Company believes that adequate tax
payments have been made and accruals recorded for all years.
The effective income tax rate on pre-tax earnings differed from the U.S.
federal statutory rate for the following reasons for the years ended December
31, 1998, 1997 and 1996:
- ------------------------------------------------------------------------------
1998 1997 1996
- ------------------------------------------------------------------------------
U.S. federal statutory rate 35.0% 35.0% 35.0%
Increase (decrease) resulting from:
State and local income taxes,
net of federal tax benefit 2.5 2.2 2.6
Rate differences--foreign
operations 0.6 3.7 3.3
Goodwill amortization 2.0 1.7 1.8
Other 0.8 (2.1) (1.7)
- ------------------------------------------------------------------------------
Effective tax rate 40.9% 40.5% 41.0%
==============================================================================
The tax effects of temporary differences which gave rise to consumer products
deferred income tax assets and liabilities consisted of the following at
December 31, 1998 and 1997:
(in millions)
- -------------------------------------------------------------------------------
1998 1997
- -------------------------------------------------------------------------------
Deferred income tax assets:
Accrued postretirement and
postemployment benefits $ 1,104 $ 1,084
Accrued liabilities 568 577
Realignment and other reserves 356 427
Settlement charges 476 261
Other 154 167
- -------------------------------------------------------------------------------
Total deferred income tax assets 2,658 2,516
- -------------------------------------------------------------------------------
Deferred income tax liabilities:
Property, plant and equipment (1,866) (1,695)
Prepaid pension costs (279) (326)
- -------------------------------------------------------------------------------
Total deferred income tax liabilities (2,145) (2,021)
- -------------------------------------------------------------------------------
Net deferred income tax assets $ 513 $ 495
===============================================================================
Financial services deferred income tax liabilities are primarily attributable to
temporary differences from investments in finance leases.
48
Note 12. Segment Reporting:
Effective December 31, 1998, the Company adopted SFAS No. 131, "Disclosures
about Segments of an Enterprise and Related Information." SFAS No. 131
supersedes previously issued segment reporting disclosure rules and requires
reporting of segment information that is consistent with the way in which
management operates the Company. The adoption of SFAS No. 131 at December 31,
1998 did not have any impact on the Company's financial position or the results
of operations. The segment disclosures presented for prior years have been
restated to conform with the presentation adopted for the current year.
The Company's products include cigarettes, food (consisting principally of
coffee, cheese, chocolate confections, processed meat products and various
packaged grocery products) and beer. A subsidiary of the Company, Philip Morris
Capital Corporation, invests in leveraged and direct finance leases, other
tax-oriented financing transactions and third-party financial instruments. These
products and services constitute the Company's reportable segments of domestic
tobacco, international tobacco, North American food, international food, beer
and financial services.
The Company's management reviews operating companies income to evaluate
segment performance and allocate resources. Operating companies income for the
reportable segments excludes general corporate expenses, minority interest and
amortization of goodwill. Interest and other debt expense, net (consumer
products) and provision for income taxes are centrally managed at the corporate
level and accordingly, such items are not presented by segment since they are
excluded from the measure of segment profitability reviewed by the Company's
management. The Company's assets are managed on a worldwide basis by major
products and accordingly, asset information is reported for the tobacco, food,
beer and financial services segments. Goodwill and amortization of goodwill is
principally attributable to the North American food segment. Other assets
consist primarily of cash and cash equivalents. The accounting policies of the
segments are the same as those described in the Summary of Significant
Accounting Policies.
Reportable segment data were as follows:
For the years ended December 31,
(in millions)
- -------------------------------------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------
Operating revenues:
Domestic tobacco $15,310 $13,584 $12,462
International tobacco 27,390 26,240 24,087
North American food 17,312 16,838 16,447
International food 9,999 10,852 11,503
Beer 4,105 4,201 4,327
Financial services 275 340 378
- -------------------------------------------------------------------------------
Total operating revenues $74,391 $72,055 $69,204
===============================================================================
Operating companies income:
Domestic tobacco $ 1,489 $ 3,287 $ 4,206
International tobacco 5,029 4,572 4,078
North American food 3,055 2,873 2,628
International food 1,127 1,326 1,303
Beer 451 459 440
Financial services 183 297 193
- -------------------------------------------------------------------------------
Total operating companies
income 11,334 12,814 12,848
General corporate expenses (645) (479) (442)
Minority interest (128) (87) (43)
Amortization of goodwill (584) (585) (594)
- -------------------------------------------------------------------------------
Total operating income 9,977 11,663 11,769
Interest and other debt
expense, net (890) (1,052) (1,086)
- -------------------------------------------------------------------------------
Total earnings before
income taxes $ 9,087 $10,611 $10,683
===============================================================================
Operating companies income for the domestic tobacco segment included pre-tax
tobacco litigation settlement charges of $3,381 million and $1,457 million for
the years ended December 31, 1998 and 1997, respectively. General corporate
expenses for the year ended December 31, 1998 included a pre-tax charge of $116
million related to the settlement of shareholder litigation. In addition, during
1998 pre-tax charges of $319 million and $18 million were recorded for voluntary
separation and early retirement and severance programs by the domestic tobacco
operations and the Company's corporate headquarters, respectively. See Notes 2,
3 and 4 regarding divestitures, acquisitions and food realignment charges.
49
For the years ended December 31,
(in millions)
- --------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------
Depreciation expense:
Domestic tobacco $ 216 $ 171 $ 172
International tobacco 267 236 206
North American food 267 268 268
International food 227 246 270
Beer 108 104 104
- --------------------------------------------------------------------------------
1,085 1,025 1,020
Other 21 19 17
- --------------------------------------------------------------------------------
Total depreciation expense $ 1,106 $ 1,044 $ 1,037
================================================================================
Assets:
Tobacco $16,395 $15,012 $13,545
Food 31,397 31,170 33,241
Beer 1,503 1,451 1,705
Financial services 6,480 5,886 5,917
- --------------------------------------------------------------------------------
55,775 53,519 54,408
Other 4,145 2,428 463
- --------------------------------------------------------------------------------
Total assets $59,920 $55,947 $54,871
================================================================================
Capital expenditures:
Domestic tobacco $ 217 $ 483 $ 457
International tobacco 588 455 372
North American food 534 440 430
International food 307 297 382
Beer 129 115 122
- --------------------------------------------------------------------------------
1,775 1,790 1,763
Other 29 84 19
- --------------------------------------------------------------------------------
Total capital expenditures $ 1,804 $ 1,874 $ 1,782
================================================================================
The Company's operations outside the United States, which are principally in the
tobacco and food businesses, are organized into geographic regions within each
segment, with Europe being the most significant. Total tobacco and food segment
revenues attributable to customers located in Germany were $9.2 billion, $9.5
billion and $10.4 billion for the years ended December 31, 1998, 1997 and 1996,
respectively.
Geographic data for operating revenues and long-lived assets (which
consist of all financial services assets and non-current consumer products
assets other than goodwill and other intangible assets) were as follows:
For the years ended December 31,
(in millions)
- --------------------------------------------------------------------------------
1998 1997 1996
- --------------------------------------------------------------------------------
Operating revenues:
United States--domestic $35,432 $33,208 $31,993
--export 6,005 6,705 6,476
Europe 25,169 24,796 24,232
Other 7,785 7,346 6,503
- --------------------------------------------------------------------------------
Total operating revenues $74,391 $72,055 $69,204
================================================================================
Long-lived assets:
United States $15,616 $14,533 $13,985
Europe 4,159 4,057 4,575
Other 2,349 2,128 2,123
- --------------------------------------------------------------------------------
Total long-lived assets $22,124 $20,718 $20,683
================================================================================
Note 13. Benefit Plans:
The Company and its subsidiaries sponsor noncontributory defined benefit pension
plans covering substantially all U.S. employees. Pension coverage for employees
of the Company's non-U.S. subsidiaries is provided, to the extent deemed
appropriate, through separate plans, many of which are governed by local
statutory requirements. In addition, the Company and its U.S. and Canadian
subsidiaries provide health care and other benefits to substantially all retired
employees. Health care benefits for retirees outside the United States and
Canada are generally covered through local government plans.
Effective December 31, 1998, the Company adopted SFAS No. 132, "Employers'
Disclosures about Pensions and Other Postretirement Benefits." SFAS No. 132 does
not change the measurement or recognition of those plans, but revises the
disclosure requirements for pension and other postretirement benefit plans for
all years presented.
Pension Plans: Net pension cost (income) consisted of the following for
the years ended December 31, 1998, 1997 and 1996:
(in millions) U.S. Plans Non-U.S. Plans
- -------------------------------------------------------------------------------
1998 1997 1996 1998 1997 1996
- -------------------------------------------------------------------------------
Service cost $ 156 $ 137 $ 143 $ 91 $ 83 $ 80
Interest cost 406 382 373 165 163 166
Expected return on
plan assets (615) (564) (533) (150) (135) (131)
Amortization:
Net gain on
adoption of
SFAS No. 87 (24) (24) (25)
Unrecognized net
loss (gain) from
experience
differences 9 (4) (1)
Prior service cost 15 14 14 6 6 3
Termination,
settlement and
curtailment 251 (22) (35)
- -------------------------------------------------------------------------------
Net pension cost
(income) $ 189 $ (77) $ (54) $ 108 $ 116 $ 118
===============================================================================
During 1998, 1997 and 1996, the Company instituted early retirement and
workforce reduction programs and, during 1997 and 1996, the Company also sold
businesses. These actions resulted in additional termination benefits and
curtailment losses of $279 million, net of settlement gains of $28 million in
1998, settlement gains of $22 million in 1997 and settlement gains of $69
million, net of additional termination benefits of $34 million in 1996.
50
The changes in benefit obligations and plan assets, as well as the funded
status of the Company's pension plans at December 31, 1998 and 1997 were as
follows:
(in millions) U.S. Plans Non-U.S. Plans
- -------------------------------------------------------------------------------
1998 1997 1998 1997
- -------------------------------------------------------------------------------
Benefit obligation at
January 1 $ 5,523 $ 4,880 $ 2,701 $ 2,642
Service cost 156 137 91 83
Interest cost 406 382 165 163
Benefits paid (396) (309) (129) (79)
Termination, settlement
and curtailment 305 (22)
Actuarial losses 238 461 263 80
Currency 95 (188)
Other (12) (6) 15
- -------------------------------------------------------------------------------
Benefit obligation at
December 31 6,220 5,523 3,201 2,701
- -------------------------------------------------------------------------------
Fair value of plan assets at
January 1 8,085 7,101 2,189 1,927
Actual return on plan assets 973 1,308 116 269
Contributions 14 15 53 49
Benefits paid (372) (292) (93) (70)
Currency 39 (26)
Actuarial (losses) gains 3 (47) (56) 40
- -------------------------------------------------------------------------------
Fair value of plan assets at
December 31 8,703 8,085 2,248 2,189
- -------------------------------------------------------------------------------
Excess (Deficit) of plan assets
versus benefit obligations
at December 31 2,483 2,562 (953) (512)
Unrecognized actuarial
(gains) losses (1,718) (1,659) 171 (187)
Unrecognized prior
service cost 107 121 37 40
Unrecognized net transition
obligation (58) (83) 12 11
- -------------------------------------------------------------------------------
Net prepaid pension asset
(liability) $ 814 $ 941 $ (733) $ (648)
===============================================================================
The combined domestic and foreign pension plans resulted in a net prepaid
pension asset of $81 million and $293 million at December 31, 1998 and 1997,
respectively. These amounts were recognized in the Company's consolidated
balance sheets at December 31, 1998 and 1997 as other assets of $1.9 billion and
$1.7 billion, respectively, for those plans in which plan assets exceeded their
accumulated benefit obligations and other liabilities of $1.8 billion and $1.4
billion, respectively, for those plans in which the accumulated benefit
obligations exceeded their plan assets.
For domestic plans with accumulated benefit obligations in excess of plan
assets, the projected benefit obligation, accumulated benefit obligation and
fair value of plan assets were $1,484 million, $1,374 million and $1,123
million, respectively, as of December 31, 1998 and $297 million, $229 million
and $54 million, respectively, as of December 31, 1997. For foreign plans with
accumulated benefit obligations in excess of plan assets, the projected benefit
obligation, accumulated benefit obligation and fair value of plan assets were
$1,111 million, $996 million and $155 million, respectively, as of December 31,
1998 and $935 million, $814 million and $115 million, respectively, as of
December 31, 1997.
The following weighted-average assumptions were used to determine the
Company's obligations under the plans:
U.S. Plans Non-U.S. Plans
- -------------------------------------------------------------------------------
1998 1997 1998 1997
- -------------------------------------------------------------------------------
Discount rate 7.00% 7.25% 5.37% 6.30%
Expected rate of return on
plan assets 9.00 9.00 7.63 7.18
Rate of compensation
increase 4.50 4.50 3.73 4.18
===============================================================================
The Company and certain of its subsidiaries sponsor deferred profit-sharing
plans covering certain salaried, nonunion and union employees. Contributions and
costs are determined generally as a percentage of pre-tax earnings, as defined
by the plans. Certain other subsidiaries of the Company also maintain defined
contribution plans. Amounts charged to expense for defined contribution plans
totaled $201 million, $200 million and $199 million in 1998, 1997 and 1996,
respectively.
Postretirement Benefit Plans: Net postretirement health care costs
consisted of the following for the years ended December 31, 1998, 1997 and 1996:
(in millions)
- -------------------------------------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------
Service cost $ 56 $ 54 $ 59
Interest cost 182 182 180
Amortization:
Unrecognized net (gain) loss from
experience differences (3) (3) 4
Unrecognized prior service cost (12) (12) (12)
Other expense (income) 30 (8)
- -------------------------------------------------------------------------------
Net postretirement health
care costs $253 $221 $223
===============================================================================
During 1998, 1997 and 1996 the Company instituted early retirement and workforce
reduction programs and, in 1996, the Company also sold businesses. These actions
resulted in additional postretirement health care costs of $20 million and
curtailment losses of $10 million in 1998 and curtailment gains in 1996, all of
which are included in other expense (income) above.
51
The Company's postretirement health care plans currently are not funded.
The changes in the benefit obligations of the plans at December 31, 1998 and
1997 were as follows:
(in millions)
- -------------------------------------------------------------------------------
1998 1997
- -------------------------------------------------------------------------------
Accumulated postretirement benefit obligation
at January 1 $2,627 $2,426
Service cost 56 54
Interest cost 182 182
Benefits paid (135) (136)
Termination, settlement and curtailment 107
Plan amendments 1 6
Actuarial (gains) losses (67) 95
- -------------------------------------------------------------------------------
Accumulated postretirement benefit obligation
at December 31 2,771 2,627
Unrecognized actuarial losses (201) (173)
Unrecognized prior service cost 96 109
- -------------------------------------------------------------------------------
Accrued postretirement health care costs $2,666 $2,563
===============================================================================
The assumed health care cost trend rate used in measuring the accumulated
postretirement benefit obligation for U.S. plans was 8.0% in 1997, 7.5% in 1998
and 7.0% in 1999, gradually declining to 5.0% by the year 2003 and remaining at
that level thereafter. For Canadian plans, the assumed health care cost trend
rate was 13.0% in 1997, 12.0% in 1998 and 11.0% in 1999, gradually declining to
4.0% by the year 2005 and remaining at that level thereafter. A
one-percentage-point increase in the assumed health care cost trend rates for
each year would increase the accumulated postretirement benefit obligation as of
December 31, 1998 and postretirement health care cost (service cost and interest
cost) for the year then ended by approximately 9.6% and 13.9%, respectively. A
one-percentage-point decrease in the assumed health care cost trend rates for
each year would decrease the accumulated postretirement benefit obligation as of
December 31, 1998 and postretirement health care cost (service cost and interest
cost) for the year then ended by approximately 7.9% and 10.9%, respectively.
The accumulated postretirement benefit obligations for U.S. plans at
December 31, 1998 and 1997 were determined using assumed discount rates of 7.0%
and 7.25%, respectively. The accumulated postretirement benefit obligation at
December 31, 1998 and 1997 for Canadian plans was determined using an assumed
discount rate of 6.50%.
Note 14. Additional Information:
For the years ended December 31,
(in millions)
- -------------------------------------------------------------------------------
1998 1997 1996
- -------------------------------------------------------------------------------
Research and
development expense $ 506 $ 533 $ 515
===============================================================================
Advertising expense $2,416 $2,530 $2,605
===============================================================================
Interest and other debt expense, net:
Interest expense $1,144 $1,184 $1,183
Interest income (254) (132) (97)
- -------------------------------------------------------------------------------
$ 890 $1,052 $1,086
===============================================================================
Interest expense of financial
services operations included
in cost of sales $ 77 $ 67 $ 80
===============================================================================
Rent expense $ 429 $ 443 $ 430
===============================================================================
Note 15. Financial Instruments:
Derivative financial instruments: The Company operates internationally,
with manufacturing and sales facilities in various locations around the world.
Derivative financial instruments are used by the Company for purposes other than
trading, principally to reduce exposures to market risks resulting from
fluctuations in interest rates and foreign exchange rates by creating offsetting
exposures. The Company is not a party to leveraged derivatives.
The Company has foreign currency and related interest rate swap agreements
which were executed to reduce the Company's borrowing costs and serve as hedges
of the Company's net assets in foreign subsidiaries, principally those
denominated in Swiss francs. At December 31, 1998 and 1997, the notional
principal amounts of these agreements were $3.3 billion and $1.4 billion,
respectively. Aggregate maturities at December 31, 1998 were as follows (in
millions): 1999, $371; 2000, $1,015; 2002, $182; 2003, $150; and 2004 and
thereafter $1,604. The notional amount is used to calculate interest payments
which are exchanged over the life of the swap transaction and is equal to the
amount of foreign currency or dollar principal exchanged at maturity.
Forward exchange contracts and foreign currency options are used by the
Company to reduce the effect of fluctuating foreign currencies on foreign
currency denominated intercompany and third party transactions. At December 31,
1998, the Company had long and short forward exchange/option contracts with U.S.
dollar equivalent values of $3.6 billion and $4.5 billion, respectively. At
December 31, 1997, the Company had long and short forward exchange/option
contracts with U.S. dollar equivalent values of $1.3 billion and $1.2 billion,
respectively.
52
Credit exposure and credit risk: The Company is exposed to credit loss in
the event of nonperformance by counterparties. However, the Company does not
anticipate nonperformance and such exposure was not material at December 31,
1998.
Fair value: The aggregate fair value, based on market quotes, of the
Company's total debt at December 31, 1998 was $15.6 billion as compared to its
carrying value of $14.7 billion. The aggregate fair value of the Company's total
debt at December 31, 1997 was $14.7 billion as compared to its carrying value of
$14.1 billion.
The carrying values of the foreign currency and related interest rate swap
agreements, the forward currency contracts and the currency option contracts,
which did not differ materially from their fair values, were not material.
See Notes 6 and 7 for additional disclosures of fair value for short-term
borrowings and long-term debt.
Note 16. Contingencies:
Legal proceedings covering a wide range of matters are pending in various United
States 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 product
liability, consumer protection, antitrust, 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 governmental and non-governmental plaintiffs seeking reimbursement
for health care expenditures allegedly caused by cigarette smoking. Governmental
plaintiffs have included local, state and certain foreign governmental entities.
Non-governmental plaintiffs in these cases include union health and welfare
trust funds ("unions"), Blue Cross/Blue Shield groups, health maintenance
organizations ("HMOs"), hospitals, native American tribes, 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. Plaintiffs' theories of
recovery and the defenses raised in those cases are discussed below.
In recent years, there has been a substantial increase in the number of
smoking and health cases being filed.
As of December 31, 1998, there were approximately 510 smoking and health
cases filed and served on behalf of individual plaintiffs in the United States
against PM Inc. and, in some cases, the Company, compared with approximately 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. Fifteen of
the individual cases involve allegations of various personal injuries allegedly
related to exposure to environmental tobacco smoke ("ETS").
In addition, as of December 31, 1998, there were approximately 60 smoking
and health putative class actions pending in the United States against PM Inc.
and, in some cases, the Company (including eight that involve allegations of
various personal injuries related to exposure to ETS), compared with
approximately 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.
During 1997 and 1998, PM Inc. and certain other United States tobacco
product manufacturers entered into agreements settling the asserted and
unasserted health care cost recovery and other claims of all 50 states and
several commonwealths and territories of the United States. The settlements are
in the process of being approved by the courts, and some of the settlements are
being challenged by various third parties. As of December 31, 1998, there were
approximately 95 health care cost recovery actions pending in the United States
(excluding the cases covered by the settlements), compared with approximately
105 health care cost recovery cases pending 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 PMI and its affiliates and subsidiaries including, as of
December 31, 1998, approximately 27 smoking and health cases initiated by one or
more individuals (Argentina (20), Brazil (1), Canada (1), Italy (1), Japan (1),
Scotland (1) and Turkey (2)), and six smoking and health class
53
actions (Brazil (2), Canada (3) and Nigeria (1)). In addition, health care cost
recovery actions have been brought in Israel, the Republic of the Marshall
Islands and British Columbia, Canada, and, in the United States, by the
Republics of Bolivia, Guatemala, Panama and Nicaragua.
Pending and upcoming trials: As of January 22, 1999, trials against PM
Inc. and, in one case, the Company, were underway in the Engle smoking and
health class action in Florida (discussed below) and in individual smoking and
health cases in California and Tennessee.
Additional cases are scheduled for trial during 1999, including three
health care cost recovery actions brought by unions in Ohio (February),
Washington (September) and New York (September), and two smoking and health
class actions in Illinois (August) and Alabama (August). Also, twelve individual
smoking and health cases against PM Inc. and, in some cases, the Company, are
currently scheduled for trial during 1999. Trial dates, however, are subject to
change.
Verdicts in individual cases: During the past three years, juries have
returned verdicts for defendants in three individual smoking and health cases
and in one individual ETS smoking and health case. In June 1998, a Florida
appeals court reversed a $750,000 jury verdict awarded in August 1996 against
another United States cigarette manufacturer. Plaintiff is seeking an appeal of
this ruling to the Florida Supreme Court. 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. A Florida appeals
court has ruled that this case was tried in the wrong venue and, accordingly,
defendants are seeking to set aside the verdict and retry the case in the
correct venue. In Brazil, a court in 1997 awarded plaintiffs in a smoking and
health case the Brazilian currency equivalent of $81,000, attorneys' fees and a
monthly annuity for 35 years equal to two-thirds of the deceased smoker's last
monthly salary. Neither the Company nor its affiliates were parties to that
action.
Litigation settlements: In November 1998, PM Inc. and certain other United
States tobacco product manufacturers entered into a Master Settlement Agreement
(the "MSA") with 46 states, the District of Columbia, the Commonwealth of Puerto
Rico, Guam, the United States Virgin Islands, American Samoa and the Northern
Marianas to settle asserted and unasserted health care cost recovery and other
claims. PM Inc. and certain other United States tobacco product manufacturers
had previously settled similar claims brought by Mississippi, Florida, Texas and
Minnesota (together with the MSA, the "State Settlement Agreements") and an ETS
smoking and health class action brought on behalf of airline flight attendants.
The State Settlement Agreements and certain ancillary agreements are filed as
exhibits to various of the Company's reports filed with the Securities and
Exchange Commission, and such agreements and the ETS settlement are discussed in
detail therein.
PM Inc. recorded pre-tax charges of $3,081 million and $1,457 million
during 1998 and 1997, respectively, to accrue for its share of all fixed and
determinable portions of its obligations under the tobacco settlements, as well
as $300 million during 1998 for its unconditional obligation under an agreement
in principle to contribute to a tobacco growers trust fund, discussed below. As
of December 31, 1998, PM Inc. had accrued costs of its obligations under the
settlements and to tobacco growers aggregating $1,359 million, payable
principally before the end of the year 2000. The settlement agreements require
that the domestic tobacco industry make substantial annual payments in the
following amounts (excluding future annual payments contemplated by the
agreement in principle with tobacco growers discussed below), subject to
adjustment for several factors, including inflation, market share and industry
volume: 1999, $4.2 billion (of which $2.7 billion related to the MSA and has
already been paid by the industry); 2000, $9.2 billion; 2001, $9.9 billion;
2002, $11.3 billion; 2003, $10.9 billion; 2004 through 2007, $8.4 billion; and
thereafter, $9.4 billion. In addition, the domestic tobacco industry is required
to pay settling plaintiffs' attorneys' fees, subject to an annual cap of $500
million, as well as additional amounts as follows: 1999, $450 million; 2000,
$416 million; and 2001 through 2002, $250 million. These payment obligations are
the several and not joint obligations of each settling defendant. PM Inc.'s
portion of the future adjusted payments and legal fees, which is not currently
estimable, will be based on its share of domestic cigarette shipments in the
year preceding that in which the payment is made. PM Inc.'s shipment share in
1998 was approximately 50%.
The State Settlement Agreements also include provisions relating to
advertising and marketing restrictions, public disclosure of certain industry
documents, limitations on challenges to tobacco control and underage use laws
and other provisions.
54
As of January 22, 1999, the MSA had been approved by courts in 41 states
and in the District of Columbia, Puerto Rico, Guam, the United States Virgin
Islands, American Samoa and Northern Marianas. If a jurisdiction does not obtain
final judicial approval of the MSA by December 31, 2001, the agreement will be
terminated with respect to such jurisdiction.
As part of the MSA, the settling defendants committed to work
cooperatively with the tobacco grower community to address concerns about the
potential adverse economic impact of the MSA on that community. To that end, in
January 1999, the four major domestic tobacco product manufacturers, including
PM Inc., agreed in principle to participate in the establishment of a $5.15
billion trust fund to be administered by the tobacco growing states. It is
currently contemplated that the trust will be funded by industry participants
over twelve years, beginning in 1999. PM Inc. has agreed to pay $300 million
into the trust in 1999, which amount has been charged to 1998 operating income.
Subsequent annual industry payments are to be adjusted for several factors,
including inflation and United States cigarette consumption, and are to be
allocated based on each manufacturer's market share.
The Company believes that the State Settlement Agreements may materially
adversely affect the business, volume, results of operations, cash flows or
financial position of PM Inc. and the Company in future years. The degree of the
adverse impact will depend, among other things, on the rates of decline in
United States cigarette sales in the premium and discount segments, PM Inc.'s
share of the domestic premium and discount cigarette segments, and the effect of
any resulting cost advantage of manufacturers not subject to the MSA and the
other State Settlement Agreements. As of January 22, 1999, manufacturers
representing almost all domestic shipments in 1998 had agreed to become subject
to the terms of the MSA.
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.
In May 1996, the Fifth Circuit Court of Appeals held that a putative class
consisting of all "addicted" smokers nationwide did not meet the standards and
requirements of the federal rules governing class actions (Castano, et al. v.
The American Tobacco Company, et al.). Since this class decertification, lawyers
for plaintiffs have filed numerous smoking and health class action suits in
various state and federal courts. In general, these cases purport to be brought
on behalf of residents of a particular state or states and raise "addiction"
claims similar to those raised in the Castano case and, in some cases, claims of
physical injury as well. As of December 31, 1998, smoking and health class
actions were pending in Alabama, Arkansas, California, the District of Columbia,
Florida, Hawaii, Illinois, Indiana, Iowa, Kansas, Louisiana, Maryland,
Massachusetts, Michigan, Minnesota, Mississippi, Missouri, 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. Class certification has been denied or
reversed by courts in 13 smoking and health class actions involving PM Inc. in
Louisiana, the District of Columbia, New York (2), Pennsylvania, Puerto Rico,
New Jersey (5), Wisconsin and Kansas, while classes remain certified in three
cases in Florida, Louisiana and Maryland. A number of these class certification
decisions are on appeal. Class certification motions are pending in a number of
the other putative smoking and health class actions. As mentioned above, one ETS
smoking and health class action was settled in 1997.
55
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 claim
to 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 further.
Phase One, which is currently underway, involves evidence concerning certain
"common" class issues relating to the plaintiff class's causes of action.
Entitlement to punitive damages will be decided at the end of Phase One, but no
amount will be set at that time.
If plaintiffs prevail in Phase One, the first two stages of Phase Two will
involve individual determination of specific causation and other individual
issues regarding entitlement to compensatory damages for the class
representatives. Stage three of Phase Two will involve an assessment of the
amount of punitive damages, if any, that individual class representatives will
be awarded. Stage four of Phase Two will involve the setting of a percentage or
ratio of punitive damages for absent class members, assuming entitlement was
found at the end of Phase One.
Phase Three of the trial will be held before separate juries to address
absent class members' claims, including issues of specific causation and other
individual issues regarding entitlement to compensatory damages.
Health Care Cost Recovery Litigation
In certain of the pending proceedings, domestic and foreign governmental
entities and non-governmental plaintiffs, including unions, Blue Cross/Blue
Shield groups, HMOs, hospitals, native American tribes, taxpayers and others are
seeking reimbursement of health care cost expenditures allegedly caused by
tobacco products and, in some cases, for future expenditures and damages as
well. Certain of these cases purport to be brought on behalf of a class of
plaintiffs and, in some cases, the class has been certified by the court. In one
health care cost recovery case, private citizens seek recovery of alleged
tobacco-related health care expenditures incurred by the federal Medicare
program. In 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 include the
equitable claim that the tobacco industry was "unjustly enriched" by plaintiffs'
payment of health care costs allegedly attributable to smoking, the equitable
claim of indemnity, common law claims of negligence, strict liability, breach of
express and implied warranty, violation of a voluntary undertaking or special
duty, fraud, negligent misrepresentation, conspiracy, public nuisance, claims
under federal and state statutes governing consumer fraud, antitrust, deceptive
trade practices and false advertising, and claims under federal and state RICO
statutes.
Defenses raised include failure to state a valid claim, lack of benefit,
adequate remedy at law, "unclean hands" (namely, that plaintiffs cannot obtain
equitable relief because they participated in, and benefited from, the sale of
cigarettes), lack of antitrust injury, federal preemption, lack of proximate
cause, remoteness of injury, lack of statutory authority to bring suit and
statute of limitations. In addition, defendants argue that they should be
entitled to "set-off" any alleged damages to the extent the plaintiff benefits
economically from the sale of cigarettes through the receipt of excise taxes or
otherwise. Defendants also argue that these cases are improper because
plaintiffs must proceed under principles of subrogation and assignment. Under
traditional theories of recovery, a payor of medical costs (such as an insurer)
can seek recovery of health care costs from a third party solely by "standing in
the shoes" of the injured party. Defendants argue that plaintiffs should be
required to bring any actions as subrogees of individual health care recipients
and should be subject to all defenses available against the injured party.
Excluding the cases covered by the State Settlement Agreements described
above, as of December 31, 1998, there were approximately 95 health care cost
recovery cases pending against PM Inc. and, in some cases, the Company, of which
approximately 75 were filed by unions. Health care cost recovery actions have
also been brought in Israel, the Republic of the
56
Marshall Islands, and British Columbia, Canada, and, in the United States, by
the Republics of Bolivia, Guatemala, Panama and Nicaragua. Other foreign
governmental entities have stated that they are considering filing health care
cost recovery actions. In addition, in January 1999, President Clinton announced
that the United States Department of Justice is preparing a litigation plan to
take tobacco companies to court and to use recovered funds to strengthen
Medicare.
Courts have ruled on preliminary motions to dismiss various claims in
approximately 50 health care cost recovery actions. Although many of the rulings
in cases not settled by the State Settlement Agreements have been favorable to
the industry, a number have been adverse, including rulings in the three union
cases currently scheduled for trial in 1999. In late January and in February of
1999, the Third and Second Circuit Courts of Appeal are scheduled to hear oral
argument on appeals from lower court rulings on motions to dismiss various
claims in health care cost recovery actions filed by unions. The Company cannot
predict the ultimate outcome of such appeals.
Certain Other Tobacco-Related Litigation
Since September 1997, a number of suits have been filed by former asbestos
manufacturers, asbestos manufacturers' personal injury settlement trusts and an
insurance company against domestic tobacco manufacturers, including PM Inc. and
others. These cases seek, among other things, contribution or reimbursement for
amounts expended in connection with the defense and payment of asbestos claims
that were allegedly caused in whole or in part by cigarette smoking. Plaintiffs
in most of these cases also seek punitive damages.
Since June 1998, five class actions have been filed against PM Inc. and
the Company, in Florida, New Jersey, Pennsylvania, Massachusetts and Tennessee,
on behalf of individuals who purchased and consumed Marlboro Lights and, in one
case, Marlboro Ultra Lights, as well. These cases allege, in connection with the
use of the term "Lights" and/or "Ultra Lights," among other things, deceptive
and unfair trade practices, unjust enrichment, and seek injunctive and equitable
relief.
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. The courts have denied defendants' motions to dismiss in both of these
cases.
In December 1998, a putative class action was filed against PM Inc. and
certain other domestic tobacco manufacturers on behalf of a class consisting of
citizens of the United States who consume tobacco products manufactured by
defendants. One count of the complaint alleges that defendants conspired to
raise the prices of their tobacco products in order to pay the costs of the MSA
in violation of the federal antitrust laws. The other two counts allege that the
actions of defendants amount to an unconstitutional deprivation of property
without due process of law and an unlawful burdening of interstate trade. The
complaint seeks unspecified damages (to be trebled under the antitrust count),
injunctive and declaratory relief, costs and attorneys' fees.
Certain Other Actions
In September 1997, a putative 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. 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 putative class action
suit was filed in Illinois against Kraft only and, in April 1998, a putative
class action suit was filed in California against Kraft and others. Both of
these suits contain allegations similar to those in the Wisconsin class action,
but the Illinois case seeks a class comprising all of Kraft's milk suppliers,
and the California case seeks a class comprising all of defendants' milk
suppliers in California. In December 1998, the courts in both the Illinois and
California cases granted Kraft's motions to dismiss the complaints.
57
In November 1998, the United States District Court in the Southern
District of New York approved an agreement settling a class action suit filed on
behalf of all persons who purchased common stock of the Company between June 11,
1991 and May 6, 1994 (Kurzweil, et al. v. Philip Morris Companies Inc., et al.).
It is anticipated that the settlement will also result in the dismissal of
another class action suit that was filed on behalf of certain persons who
purchased common stock of the Company between July 10, 1991, and April 1, 1993
(Lawrence, et al. v. Philip Morris Companies Inc., et al.). The Company recorded
a pre-tax charge of $116 million in the fourth quarter of 1998 in connection
with these matters.
-------------------------------
One hundred eighty-eight tax assessments alleging the nonpayment of taxes
in Italy (value-added taxes for the years 1988 to 1995 and income taxes for the
years 1987 to 1995) have been served upon certain affiliates of the Company. The
aggregate amount of 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
with respect to subsequent years. All of the assessments are being vigorously
contested. To date, the Italian administrative tax court in Milan has overturned
eighty-one of the assessments. The decisions to overturn forty-three assessments
have been appealed by the tax authorities. In a separate proceeding in Naples,
in October 1997, a court dismissed charges of criminal association against
certain present and former officers and directors of affiliates of the Company,
but permitted charges of tax evasion to remain pending. In February 1998, the
tax evasion charges were dismissed by the criminal court in Naples following a
determination that jurisdiction was not proper, and the case file was
transmitted to the public prosecutor in Milan, who will determine whether to
bring charges, in which case a preliminary investigations judge will make a new
finding as to whether there should be a trial on these charges. The Company, its
affiliates and the officers and directors who are subject to the proceedings
believe they have complied with applicable Italian tax laws and are vigorously
contesting the pending assessments and proceedings.
-------------------------------
It is not possible to predict the outcome of the litigation pending
against the Company and its subsidiaries. Litigation is subject to many
uncertainties, 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, volume, results of operations, cash
flows or financial position could be materially affected by an unfavorable
outcome or settlement of certain pending litigation or by the enactment of
federal or state tobacco legislation. The Company and each of its subsidiaries
named as a defendant believe, and each has been so advised by counsel handling
the respective cases, that it has a number of valid defenses to all litigation
pending against it. All such cases are, and will continue to be, vigorously
defended. However, the Company and its subsidiaries may enter into discussions
in an attempt to settle particular cases if they believe it is in the best
interests of the Company's stockholders to do so.
58
Note 17. Quarterly Financial Data (Unaudited):
(in millions, except per share data) 1998 Quarters
- --------------------------------------------------------------------------------
1st 2nd 3rd 4th
- --------------------------------------------------------------------------------
Operating revenues $18,383 $18,978 $18,587 $18,443
================================================================================
Gross profit $ 7,449 $ 7,903 $ 7,842 $ 7,799
================================================================================
Net earnings $ 1,382 $ 1,736 $ 1,980 $ 274
================================================================================
Per share data:
Basic EPS $ 0.57 $ 0.72 $ 0.81 $ 0.11
================================================================================
Diluted EPS $ 0.57 $ 0.71 $ 0.81 $ 0.11
================================================================================
Dividends declared $ 0.40 $ 0.40 $ 0.44 $ 0.44
================================================================================
Market price--high $ 47.88 $ 41.56 $ 48.13 $ 59.50
--low $ 39.06 $ 34.75 $ 38.06 $ 45.00
================================================================================
During 1998, the Company recorded the following pre-tax charges for tobacco and
shareholder litigation settlements, voluntary early retirement and separation
programs ("VERS") and severance.
(in millions) 1998 Quarters
- --------------------------------------------------------------------------------
1st 2nd 3rd 4th
- --------------------------------------------------------------------------------
Tobacco settlements $806 $199 $111 $2,265
Shareholder settlement 116
VERS and severance 95 232 10
- --------------------------------------------------------------------------------
$901 $431 $121 $2,381
================================================================================
1997 Quarters
----------------------------------------
(in millions, except per share data) 1st 2nd 3rd 4th
================================================================================
Operating revenues $18,217 $18,413 $18,092 $17,333
================================================================================
Gross profit $ 7,376 $ 7,600 $ 7,420 $ 7,029
================================================================================
Net earnings $ 1,773 $ 1,836 $ 1,406 $ 1,295
================================================================================
Per share data:
Basic EPS $ 0.73 $ 0.76 $ 0.58 $ 0.54
================================================================================
Diluted EPS $ 0.72 $ 0.75 $ 0.58 $ 0.53
================================================================================
Dividends declared $ 0.40 $ 0.40 $ 0.40 $ 0.40
================================================================================
Market price--high $ 46.58 $ 48.13 $ 46.56 $ 45.88
--low $ 36.00 $ 37.25 $ 39.94 $ 36.94
================================================================================
During the fourth quarter of 1997, the Company sold several international food
businesses, including its Brazilian ice cream businesses, for total proceeds of
$1.1 billion and net pre-tax gains of $775 million. In addition, the Company
sold its equity interest in a Canadian beer operation and sold a minority
interest in a beer import operation for proceeds of $306 million and a pre-tax
gain of $12 million.
During the fourth quarter of 1997, the Company recorded a charge of $342
million related primarily to the downsizing or closure of manufacturing and
other facilities, as well as the discontinuance of certain low-margin product
lines of its international food operations. The Company also recorded a charge
of $288 million for incremental postemployment benefits, primarily related to
severance.
During the third and fourth quarters of 1997, the Company recorded
litigation settlement charges of $812 million and $645 million, respectively.
-------------------------------
The principal stock exchange, on which the Company's common stock (par value
$0.33 1/3 per share) is listed, is the New York Stock Exchange. At January 31,
1999, there were approximately 144,900 holders of record of the Company's common
stock.
59
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of
Philip Morris Companies Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of earnings, stockholders' equity and cash flows present
fairly, in all material respects, the consolidated financial position of Philip
Morris Companies Inc. and its subsidiaries at December 31, 1998 and 1997, and
the consolidated results of their operations and their cash flows for each of
the three years in the period ended December 31, 1998, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express an
opinion on these financial statements based on our audits. We conducted our
audits of these statements in accordance with generally accepted auditing
standards which require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements, assessing the
accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for the opinion expressed above.
/s/ PricewaterhouseCoopers LLP
New York, New York
January 25, 1999
COMPANY REPORT ON FINANCIAL STATEMENTS
The consolidated financial statements and all related financial information
herein are the responsibility of the Company. The financial statements, which
include amounts based on judgments, have been prepared in accordance with
generally accepted accounting principles. Other financial information in the
annual report is consistent with that in the financial statements.
The Company maintains a system of internal controls that it believes
provides reasonable assurance that transactions are executed in accordance with
management's authorization and properly recorded, that assets are safeguarded,
and that accountability for assets is maintained. The system of internal
controls is characterized by a control-oriented environment within the Company,
which includes written policies and procedures, careful selection and training
of personnel, and audits by a professional staff of internal auditors.
PricewaterhouseCoopers LLP, independent accountants, have audited and
reported on the Company's consolidated financial statements. Their audits were
performed in accordance with generally accepted auditing standards.
The Audit Committee of the Board of Directors, composed of six
non-management directors, meets periodically with PricewaterhouseCoopers LLP,
the Company's internal auditors and management representatives to review
internal accounting control, auditing and financial reporting matters. Both
PricewaterhouseCoopers LLP and the internal auditors have unrestricted access to
the Audit Committee and may meet with it without management representatives
being present.
60