UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the quarterly period ended September 30, 2007
OR
¨ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
Commission file number 1-8940
Altria Group, Inc.
(Exact name of registrant as specified in its charter)
Virginia | 13-3260245 | |
(State or other jurisdiction of incorporation or organization) |
(I.R.S. Employer Identification No.) | |
120 Park Avenue, New York, New York | 10017 | |
(Address of principal executive offices) | (Zip Code) |
Registrants telephone number, including area code (917) 663-4000
Former name, former address and former fiscal year, if changed since last report
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant is required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act.
Large accelerated filer x Accelerated filer ¨ Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
At October 31, 2007, there were 2,106,319,958 shares outstanding of the registrants common stock, par value $0.33 1/3 per share.
TABLE OF CONTENTS
Page No. | ||||
PART I - |
FINANCIAL INFORMATION | |||
Item 1. |
Financial Statements (Unaudited) | |||
Condensed Consolidated Balance Sheets at September 30, 2007 and December 31, 2006 |
3 4 | |||
Condensed Consolidated Statements of Earnings for the |
5 | |||
6 | ||||
7 | ||||
8 9 | ||||
10 47 | ||||
Item 2. |
Managements Discussion and Analysis of Financial Condition and Results of Operations |
48 86 | ||
Item 4. |
87 | |||
PART II - |
||||
Item 1. |
88 | |||
Item 1A. |
88 90 | |||
Item 2. |
90 | |||
Item 6. |
91 | |||
92 |
-2-
PART I FINANCIAL INFORMATION
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets
(in millions of dollars)
(Unaudited)
September 30, 2007 |
December 31, 2006 | |||||
ASSETS |
||||||
Consumer products |
||||||
Cash and cash equivalents |
$ | 7,309 | $ | 4,781 | ||
Receivables (less allowances of $17 in 2007 and 2006) |
2,523 | 2,808 | ||||
Inventories: |
||||||
Leaf tobacco |
4,241 | 4,383 | ||||
Other raw materials |
1,228 | 1,109 | ||||
Finished product |
3,463 | 3,188 | ||||
8,932 | 8,680 | |||||
Current assets of discontinued operations |
7,647 | |||||
Other current assets |
1,983 | 2,236 | ||||
Total current assets |
20,747 | 26,152 | ||||
Property, plant and equipment, at cost |
16,171 | 14,882 | ||||
Less accumulated depreciation |
8,097 | 7,301 | ||||
8,074 | 7,581 | |||||
Goodwill |
6,700 | 6,197 | ||||
Other intangible assets, net |
1,874 | 1,908 | ||||
Prepaid pension assets |
1,287 | 761 | ||||
Investment in SABMiller |
3,911 | 3,674 | ||||
Long-term assets of discontinued operations |
48,805 | |||||
Other assets |
2,693 | 2,402 | ||||
Total consumer products assets |
45,286 | 97,480 | ||||
Financial services |
||||||
Finance assets, net |
6,376 | 6,740 | ||||
Other assets |
66 | 50 | ||||
Total financial services assets |
6,442 | 6,790 | ||||
TOTAL ASSETS |
$ | 51,728 | $ | 104,270 | ||
See notes to condensed consolidated financial statements.
Continued
-3-
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Balance Sheets (Continued)
(in millions of dollars, except share and per share data)
(Unaudited)
September 30, 2007 |
December 31, 2006 |
|||||||
LIABILITIES |
||||||||
Consumer products |
||||||||
Short-term borrowings |
$ | 512 | $ | 420 | ||||
Current portion of long-term debt |
3,973 | 648 | ||||||
Accounts payable |
1,166 | 1,414 | ||||||
Accrued liabilities: |
||||||||
Marketing |
863 | 824 | ||||||
Taxes, except income taxes |
3,869 | 3,620 | ||||||
Employment costs |
639 | 849 | ||||||
Settlement charges |
3,681 | 3,552 | ||||||
Other |
1,651 | 1,641 | ||||||
Income taxes |
1,242 | 782 | ||||||
Dividends payable |
1,588 | 1,811 | ||||||
Current liabilities of discontinued operations |
9,866 | |||||||
Total current liabilities |
19,184 | 25,427 | ||||||
Long-term debt |
3,040 | 6,298 | ||||||
Deferred income taxes |
1,649 | 1,391 | ||||||
Accrued pension costs |
554 | 541 | ||||||
Accrued postretirement health care costs |
1,937 | 2,009 | ||||||
Long-term liabilities of discontinued operations |
19,629 | |||||||
Other liabilities |
2,185 | 2,658 | ||||||
Total consumer products liabilities |
28,549 | 57,953 | ||||||
Financial services |
||||||||
Long-term debt |
500 | 1,119 | ||||||
Deferred income taxes |
5,185 | 5,530 | ||||||
Other liabilities |
255 | 49 | ||||||
Total financial services liabilities |
5,940 | 6,698 | ||||||
Total liabilities |
34,489 | 64,651 | ||||||
Contingencies (Note 11) |
||||||||
STOCKHOLDERS EQUITY |
||||||||
Common stock, par value $0.33 1/3 per share (2,805,961,317 shares issued) |
935 | 935 | ||||||
Additional paid-in capital |
6,839 | 6,356 | ||||||
Earnings reinvested in the business |
33,822 | 59,879 | ||||||
Accumulated other comprehensive losses |
(836 | ) | (3,808 | ) | ||||
40,760 | 63,362 | |||||||
Less cost of repurchased stock (700,278,240 shares in 2007 and 708,880,389 shares in 2006) |
(23,521 | ) | (23,743 | ) | ||||
Total stockholders equity |
17,239 | 39,619 | ||||||
TOTAL LIABILITIES AND STOCKHOLDERS EQUITY |
$ | 51,728 | $ | 104,270 | ||||
See notes to condensed consolidated financial statements.
-4-
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions of dollars, except per share data)
(Unaudited)
For the Nine Months Ended September 30, | |||||||
2007 | 2006 | ||||||
Net revenues |
$ | 55,572 | $ | 51,024 | |||
Cost of sales |
12,499 | 11,704 | |||||
Excise taxes on products |
26,774 | 23,670 | |||||
Gross profit |
16,299 | 15,650 | |||||
Marketing, administration and research costs |
5,751 | 5,703 | |||||
Italian antitrust charge |
61 | ||||||
Asset impairment and exit costs |
545 | 123 | |||||
(Recoveries) provision (from) for airline industry exposure |
(214 | ) | 103 | ||||
Amortization of intangibles |
18 | 17 | |||||
Operating income |
10,199 | 9,643 | |||||
Interest and other debt expense, net |
187 | 325 | |||||
Earnings from continuing operations before income taxes, and equity earnings and minority interest, net |
10,012 | 9,318 | |||||
Provision for income taxes |
3,234 | 2,540 | |||||
Earnings from continuing operations before equity earnings and minority interest, net |
6,778 | 6,778 | |||||
Equity earnings and minority interest, net |
195 | 145 | |||||
Earnings from continuing operations |
6,973 | 6,923 | |||||
Earnings from discontinued operations, net of income taxes and minority interest |
625 | 2,140 | |||||
Net earnings |
$ | 7,598 | $ | 9,063 | |||
Per share data: |
|||||||
Basic earnings per share: |
|||||||
Continuing operations |
$ | 3.32 | $ | 3.32 | |||
Discontinued operations |
0.30 | 1.02 | |||||
Net earnings |
$ | 3.62 | $ | 4.34 | |||
Diluted earnings per share: |
|||||||
Continuing operations |
$ | 3.30 | $ | 3.29 | |||
Discontinued operations |
0.29 | 1.02 | |||||
Net earnings |
$ | 3.59 | $ | 4.31 | |||
Dividends declared |
$ | 2.30 | $ | 2.46 | |||
See notes to condensed consolidated financial statements.
-5-
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Statements of Earnings
(in millions of dollars, except per share data)
(Unaudited)
For the Three Months Ended September 30, | |||||||
2007 | 2006 | ||||||
Net revenues |
$ | 19,207 | $ | 17,642 | |||
Cost of sales |
4,325 | 4,022 | |||||
Excise taxes on products |
9,243 | 8,229 | |||||
Gross profit |
5,639 | 5,391 | |||||
Marketing, administration and research costs |
1,907 | 1,961 | |||||
Asset impairment and exit costs |
28 | 68 | |||||
Recoveries from airline industry exposure |
(7 | ) | |||||
Amortization of intangibles |
6 | 6 | |||||
Operating income |
3,705 | 3,356 | |||||
Interest and other debt expense, net |
11 | 59 | |||||
Earnings from continuing operations before income taxes, and equity earnings and minority interest, net |
3,694 | 3,297 | |||||
Provision for income taxes |
1,117 | 1,125 | |||||
Earnings from continuing operations before equity earnings and minority interest, net |
2,577 | 2,172 | |||||
Equity earnings and minority interest, net |
56 | 42 | |||||
Earnings from continuing operations |
2,633 | 2,214 | |||||
Earnings from discontinued operations, net of income taxes and minority interest |
661 | ||||||
Net earnings |
$ | 2,633 | $ | 2,875 | |||
Per share data: |
|||||||
Basic earnings per share: |
|||||||
Continuing operations |
$ | 1.25 | $ | 1.06 | |||
Discontinued operations |
0.32 | ||||||
Net earnings |
$ | 1.25 | $ | 1.38 | |||
Diluted earnings per share: |
|||||||
Continuing operations |
$ | 1.24 | $ | 1.05 | |||
Discontinued operations |
0.31 | ||||||
Net earnings |
$ | 1.24 | $ | 1.36 | |||
Dividends declared |
$ | 0.75 | $ | 0.86 | |||
See notes to condensed consolidated financial statements.
-6-
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Statements of Stockholders Equity
for the Year Ended December 31, 2006 and
the Nine Months Ended September 30, 2007
(in millions of dollars, except per share data)
(Unaudited)
Accumulated Other Comprehensive Earnings (Losses) |
||||||||||||||||||||||||||||||
Common Stock |
Addi- tional Paid-in |
Earnings Reinvested in the Business |
Currency Translation Adjustments |
Other | Total | Cost of Repurchased Stock |
Total Stock- holders Equity |
|||||||||||||||||||||||
Balances, January 1, 2006 |
$ | 935 | $ | 6,061 | $ | 54,666 | $ | (1,317 | ) | $ | (536 | ) | $ | (1,853 | ) | $ | (24,102 | ) | $ | 35,707 | ||||||||||
Comprehensive earnings: |
||||||||||||||||||||||||||||||
Net earnings |
12,022 | 12,022 | ||||||||||||||||||||||||||||
Other comprehensive earnings (losses), |
||||||||||||||||||||||||||||||
Currency translation adjustments |
1,220 | 1,220 | 1,220 | |||||||||||||||||||||||||||
Additional minimum pension liability |
233 | 233 | 233 | |||||||||||||||||||||||||||
Change in fair value of derivatives accounted for as hedges |
(11 | ) | (11 | ) | (11 | ) | ||||||||||||||||||||||||
Other |
(11 | ) | (11 | ) | (11 | ) | ||||||||||||||||||||||||
Total other comprehensive earnings |
1,431 | |||||||||||||||||||||||||||||
Total comprehensive earnings |
13,453 | |||||||||||||||||||||||||||||
Initial adoption of FASB Statement No. 158, net of income taxes |
(3,386 | ) | (3,386 | ) | (3,386 | ) | ||||||||||||||||||||||||
Exercise of stock options and issuance of other stock awards |
295 | 145 | 359 | 799 | ||||||||||||||||||||||||||
Cash dividends declared ($3.32 per share) |
(6,954 | ) | (6,954 | ) | ||||||||||||||||||||||||||
Balances, December 31, 2006 |
935 | 6,356 | 59,879 | (97 | ) | (3,711 | ) | (3,808 | ) | (23,743 | ) | 39,619 | ||||||||||||||||||
Comprehensive earnings: |
||||||||||||||||||||||||||||||
Net earnings |
7,598 | 7,598 | ||||||||||||||||||||||||||||
Other comprehensive earnings (losses), |
||||||||||||||||||||||||||||||
Currency translation adjustments |
344 | 344 | 344 | |||||||||||||||||||||||||||
Change in net loss and prior service cost |
512 | 512 | 512 | |||||||||||||||||||||||||||
Change in fair value of derivatives accounted for as hedges |
7 | 7 | 7 | |||||||||||||||||||||||||||
Total other comprehensive earnings |
863 | |||||||||||||||||||||||||||||
Total comprehensive earnings |
8,461 | |||||||||||||||||||||||||||||
Adoption of FIN 48 and FAS 13-2 |
711 | 711 | ||||||||||||||||||||||||||||
Exercise of stock options and issuance of other stock awards (1) |
483 | 222 | 705 | |||||||||||||||||||||||||||
Cash dividends declared ($2.30 per share) |
(4,846 | ) | (4,846 | ) | ||||||||||||||||||||||||||
Spin-off of Kraft Foods Inc. |
(29,520 | ) | 89 | 2,020 | 2,109 | (27,411 | ) | |||||||||||||||||||||||
Balances, September 30, 2007 |
$ | 935 | $ | 6,839 | $ | 33,822 | $ | 336 | $ | (1,172 | ) | $ | (836 | ) | $ | (23,521 | ) | $ | 17,239 | |||||||||||
(1) | Includes $179 million increase to additional paid-in capital for the reimbursement from Kraft for Altria stock awards. See Note 1. |
Total comprehensive earnings were $2,564 million and $2,999 million, respectively, for the quarters ended September 30, 2007 and 2006, and $9,999 million for the first nine months of 2006.
See notes to condensed consolidated financial statements.
-7-
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(in millions of dollars)
(Unaudited)
For the Nine Months Ended September 30, |
||||||||
2007 | 2006 | |||||||
CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES |
||||||||
Earnings from continuing operations - Consumer products |
$ | 6,763 | $ | 6,835 | ||||
- Financial services |
210 | 88 | ||||||
Earnings from discontinued operations, net of income taxes and minority interest |
625 | 2,140 | ||||||
Net earnings |
7,598 | 9,063 | ||||||
Impact of earnings from discontinued operations, net of income taxes and minority interest |
(625 | ) | (2,140 | ) | ||||
Adjustments to reconcile net earnings to operating cash flows: |
||||||||
Consumer products |
||||||||
Depreciation and amortization |
704 | 685 | ||||||
Deferred income tax provision (benefit) |
148 | (240 | ) | |||||
Equity earnings and minority interest, net |
(195 | ) | (145 | ) | ||||
U.S. tobacco headquarters relocation charges, net of cash paid |
(1 | ) | (1 | ) | ||||
Escrow bond for the Price U.S. tobacco case |
1,850 | |||||||
Asset impairment and exit costs, net of cash paid |
392 | 57 | ||||||
Income tax reserve reversal |
(1,006 | ) | ||||||
Cash effects of changes, net of the effects from acquired and divested companies: |
||||||||
Receivables, net |
(41 | ) | 48 | |||||
Inventories |
91 | (253 | ) | |||||
Accounts payable |
(75 | ) | (132 | ) | ||||
Income taxes |
86 | 80 | ||||||
Accrued liabilities and other current assets |
(291 | ) | 274 | |||||
U.S. tobacco accrued settlement charges |
129 | (158 | ) | |||||
Pension plan contributions |
(83 | ) | (367 | ) | ||||
Pension provisions and postretirement, net |
226 | 320 | ||||||
Other |
353 | 489 | ||||||
Financial services |
||||||||
Deferred income tax benefit |
(253 | ) | (295 | ) | ||||
Provision for airline industry exposure |
103 | |||||||
Other |
(39 | ) | 116 | |||||
Net cash provided by operating activities, continuing operations |
8,124 | 8,348 | ||||||
Net cash provided by operating activities, discontinued operations |
161 | 2,796 | ||||||
Net cash provided by operating activities |
8,285 | 11,144 | ||||||
See notes to condensed consolidated financial statements.
Continued
-8-
Altria Group, Inc. and Subsidiaries
Condensed Consolidated Statements of Cash Flows (Continued)
(in millions of dollars)
(Unaudited)
For the Nine Months Ended September 30, |
||||||||
2007 | 2006 | |||||||
CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES |
||||||||
Consumer products |
||||||||
Capital expenditures |
$ | (924 | ) | $ | (814 | ) | ||
Purchases of businesses, net of acquired cash |
(426 | ) | ||||||
Proceeds from sales of businesses |
4 | 85 | ||||||
Other |
66 | 46 | ||||||
Financial services |
||||||||
Investments in finance assets |
(4 | ) | (13 | ) | ||||
Proceeds from finance assets |
363 | 339 | ||||||
Net cash used in investing activities, continuing operations |
(921 | ) | (357 | ) | ||||
Net cash provided by investing activities, discontinued operations |
26 | 69 | ||||||
Net cash used in investing activities |
(895 | ) | (288 | ) | ||||
CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES |
||||||||
Consumer products |
||||||||
Net issuance (repayment) of short-term borrowings |
78 | (1,957 | ) | |||||
Long-term borrowings by PMI |
1,110 | |||||||
Long-term debt repaid |
(1,230 | ) | (2,136 | ) | ||||
Financial services |
||||||||
Long-term debt repaid |
(617 | ) | (1,015 | ) | ||||
Dividends paid on Altria Group, Inc. common stock |
(5,069 | ) | (5,012 | ) | ||||
Issuance of Altria Group, Inc. common stock |
357 | 421 | ||||||
Kraft Foods Inc. dividends paid to Altria Group, Inc. |
728 | 1,005 | ||||||
Other |
(196 | ) | (283 | ) | ||||
Net cash used in financing activities, continuing operations |
(4,839 | ) | (8,977 | ) | ||||
Net cash used in financing activities, discontinued operations |
(176 | ) | (2,556 | ) | ||||
Net cash used in financing activities |
(5,015 | ) | (11,533 | ) | ||||
Effect of exchange rate changes on cash and cash equivalents: |
||||||||
Continuing operations |
164 | 84 | ||||||
Discontinued operations |
1 | 30 | ||||||
Cash and cash equivalents, continuing operations: |
||||||||
Increase (decrease) |
2,528 | (902 | ) | |||||
Balance at beginning of period |
4,781 | 5,942 | ||||||
Balance at end of period |
$ | 7,309 | $ | 5,040 | ||||
See notes to condensed consolidated financial statements.
-9-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 1. Basis of Presentation and Kraft Spin-Off
Basis of Presentation
The interim condensed consolidated financial statements of Altria Group, Inc. and subsidiaries (Altria Group, Inc.) are unaudited. It is the opinion of Altria Group, Inc.s management that all adjustments necessary for a fair statement of the interim results presented have been reflected therein. All such adjustments were of a normal recurring nature. Net revenues and net earnings for any interim period are not necessarily indicative of results that may be expected for the entire year. Throughout this Form 10-Q, the term Altria Group, Inc. refers to the consolidated financial position, results of operations and cash flows of the Altria family of companies and the term ALG refers solely to the parent company.
These statements should be read in conjunction with the consolidated financial statements and related notes, which appear in Altria Group, Inc.s Current Report on Form 8-K filed with the Securities and Exchange Commission on October 3, 2007. This Form 8-K revised certain information disclosed in Altria Group, Inc.s Annual Report on Form 10-K for the year ended December 31, 2006 in order to reflect Kraft Foods Inc. (Kraft) as a discontinued operation and to reflect the change in reportable segments, both of which are discussed further below.
Balance sheet accounts are segregated by two broad types of businesses. 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.
On March 30, 2007, Altria Group, Inc. distributed all of its remaining interest in Kraft on a pro-rata basis to Altria Group, Inc. stockholders in a tax-free distribution. For further discussion, please refer to the Kraft Spin-Off discussion below. Altria Group, Inc. has reflected the results of Kraft prior to the distribution date as discontinued operations on the condensed consolidated statements of earnings and the condensed consolidated statements of cash flows. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the condensed consolidated balance sheet at December 31, 2006.
The products of ALGs subsidiaries include cigarettes and other tobacco products sold in the United States by Philip Morris USA Inc. (PM USA) and outside the United States by Philip Morris International Inc. (PMI). Beginning with the second quarter of 2007, Altria Group, Inc. revised its reportable segments to reflect PMIs operations by geographic region. Altria Group, Inc.s revised segments, which are reflected in these financial statements, are U.S. tobacco; European Union; Eastern Europe, Middle East and Africa; Asia; Latin America; and Financial Services. Accordingly, prior period segment results have been revised.
Certain prior year amounts have been reclassified to conform with the current years presentation, due primarily to the classification of Kraft as a discontinued operation and revised segment information.
Kraft Spin-Off
On March 30, 2007 (the Distribution Date), Altria Group, Inc. distributed all of its remaining interest in Kraft on a pro-rata basis to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 (the Record Date) in a tax-free distribution. The distribution ratio was 0.692024 of a share of Kraft for each share of Altria Group, Inc. common stock outstanding. Altria Group, Inc. stockholders received cash in lieu of fractional shares of Kraft. Following the distribution, Altria Group, Inc. does not own any shares of Kraft. During the second quarter of 2007, Altria Group, Inc. adjusted its quarterly dividend to $0.69 per share, so that its stockholders who retained their Altria Group, Inc. and Kraft shares would receive, in the aggregate, the same
-10-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
dividend rate as before the distribution. In August 2007, Altria Group, Inc. increased its quarterly dividend to $0.75 per share.
Holders of Altria Group, Inc. stock options were treated similarly to public stockholders and accordingly, had their stock awards split into two instruments. Holders of Altria Group, Inc. stock options received the following stock options, which, immediately after the spin-off, had an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:
| a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Distribution Date and (b) the distribution ratio of 0.692024 mentioned above; and |
| an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price. |
The new Kraft option has an exercise price equal to the Kraft market price at the time of the distribution ($31.66) multiplied by the Option Conversion Ratio, which represents the exercise price of the original Altria Group, Inc. option divided by the Altria Group, Inc. market price immediately before the distribution ($87.81). The reduced exercise price of the adjusted Altria Group, Inc. option is determined by multiplying the Altria Group, Inc. market price immediately following the distribution ($65.90) by the Option Conversion Ratio.
Holders of Altria Group, Inc. restricted stock or stock rights awarded prior to January 31, 2007, retained their existing award and received restricted stock or stock rights of Kraft Class A common stock. The amount of Kraft restricted stock or stock rights awarded to such holders was calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and stock rights will vest at the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. stock rights awarded on January 31, 2007, did not receive restricted stock or stock rights of Kraft. Rather, they received additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
To the extent that employees of the remaining Altria Group, Inc. received Kraft stock options, Altria Group, Inc. reimbursed Kraft in cash for the Black-Scholes fair value of the stock options received. To the extent that Kraft employees held Altria Group, Inc. stock options, Kraft reimbursed Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. stock rights received Kraft stock rights, Altria Group, Inc. paid to Kraft the fair value of the Kraft stock rights less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at the Distribution Date, the net amount of these reimbursements resulted in a payment of $179 million from Kraft to Altria Group, Inc. in April 2007. The reimbursement from Kraft is reflected as an increase to the additional paid-in capital of Altria Group, Inc. on the September 30, 2007 condensed consolidated balance sheet.
Kraft was previously included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies were recorded as liabilities on the balance sheet of ALG. As part of the intercompany account settlement discussed below, ALG reimbursed Kraft in cash for these liabilities, which as of March 30, 2007, were approximately $305 million, plus pre-tax interest of $63 million. ALG also reimbursed Kraft in cash for the federal income tax consequences of the adoption of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (FIN 48) (approximately $70 million plus pre-tax interest of $14 million). See Note 12. Income Taxes for a discussion of the FIN 48 adoption and the Tax Sharing Agreement between Altria Group, Inc. and Kraft.
-11-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
A subsidiary of ALG previously provided Kraft with certain services at cost plus a 5% management fee. After the Distribution Date, Kraft undertook these activities, and any remaining limited services provided to Kraft will cease in 2007. All intercompany accounts were settled in cash within 30 days of the Distribution Date. The settlement of the intercompany accounts (including the amounts discussed above related to stock awards and tax contingencies) resulted in a net payment from Kraft to ALG of $85 million in April 2007.
The distribution resulted in a net decrease to Altria Group, Inc.s stockholders equity of $27.4 billion on the Distribution Date.
PMI Spin-Off
On August 29, 2007, Altria Group, Inc.s Board of Directors announced its intention to pursue the tax-free spin-off of PMI to Altria Group, Inc.s stockholders. The Board of Directors anticipates that it will be in a position to finalize its decision and announce the precise timing of the spin-off at its regularly scheduled meeting on January 30, 2008. In addition to a final determination by Altria Group, Inc.s Board of Directors, the spin-off will be subject to the receipt of a favorable ruling from the U.S. Internal Revenue Service, the receipt of an opinion of tax counsel and the effectiveness of a registration statement with the Securities and Exchange Commission, as well as the execution of several intercompany agreements and finalization of other matters.
Note 2. Asset Impairment and Exit Costs:
Pre-tax asset impairment and exit costs consisted of the following:
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, | |||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||
(in millions) | ||||||||||||||
Separation program |
U.S. tobacco | $ | 293 | $ | | $ | 10 | $ | | |||||
Separation program |
European Union | 101 | 78 | 13 | 56 | |||||||||
Separation program |
Eastern Europe, |
12 | ||||||||||||
Separation program |
Asia | 22 | 7 | 2 | 6 | |||||||||
Separation program |
Latin America | 18 | ||||||||||||
Separation program |
General corporate | 17 | 33 | 3 | ||||||||||
Total separation programs |
463 | 118 | 25 | 65 | ||||||||||
Asset impairment |
U.S. tobacco | 35 | ||||||||||||
Asset impairment |
European Union | 3 | 3 | |||||||||||
Asset impairment |
General corporate | 2 | ||||||||||||
Total asset impairments |
35 | 5 | 3 | |||||||||||
Spin-off fees |
General corporate | 47 | 3 | |||||||||||
Asset impairment and exit costs |
$ | 545 | $ | 123 | $ | 28 | $ | 68 | ||||||
-12-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
The movement in the asset impairment and exit cost liabilities for Altria Group, Inc. for the nine months ended September 30, 2007 was as follows:
Severance | Asset write-downs |
Other | Total | |||||||||||||
(in millions) | ||||||||||||||||
Liability balance, January 1, 2007 |
$ | 131 | $ | | $ | | $ | 131 | ||||||||
Charges |
431 | 35 | 79 | 545 | ||||||||||||
Cash spent |
(105 | ) | (48 | ) | (153 | ) | ||||||||||
Charges against assets |
(35 | ) | (35 | ) | ||||||||||||
Currency/other |
2 | (31 | ) | (29 | ) | |||||||||||
Liability balance, September 30, 2007 |
$ | 459 | $ | | $ | | $ | 459 | ||||||||
Manufacturing Optimization Program
In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMIs decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. PMI is expected to shift sourcing of approximately 57 billion cigarettes from U.S. manufacturing to PMI facilities in Europe by the third quarter of 2008 and PM USA will close its Cabarrus manufacturing facility by the end of 2010.
As a result of this program, from 2007 through 2011, PM USA expects to incur total pre-tax charges of approximately $670 million, comprised of accelerated depreciation of $143 million (including the above mentioned asset impairment charge of $35 million recorded for the nine months ended September 30, 2007), employee separation costs of $353 million and other charges of $174 million, primarily related to the relocation of employees and equipment, net of estimated gains on sales of land and buildings. Approximately $440 million, or 66% of the total pre-tax charges, will result in cash expenditures. PM USA recorded an initial pre-tax asset impairment and exit cost charge for the program of $318 million or $0.10 per diluted share in the second quarter of 2007 related primarily to employee separation programs. During the third quarter of 2007, PM USA recorded pre-tax asset impairment and exit cost charges for the program of $10 million related to employee separation programs. In addition, during the third quarter of 2007, PM USA incurred $12 million of pre-tax implementation costs associated with the program. These costs were primarily related to accelerated depreciation and were reflected as cost of sales on the condensed consolidated statements of earnings. Additional pre-tax charges of approximately $35 million are expected during the remainder of 2007.
Philip Morris International Asset Impairment and Exit Costs
During 2007, 2006 and 2005, PMI announced plans for the streamlining of various administrative functions and operations. These plans resulted in the announced closure or partial closure of 9 production facilities through September 30, 2007. As a result of these announcements, PMI recorded pre-tax charges of $153 million and $15 million during the nine months and three months ended September 30, 2007, respectively, and $88 million and $65 million during the nine months and three months ended September 30, 2006, respectively. These pre-tax charges primarily related to severance costs. Additional pre-tax charges of approximately $47 million are expected during the remainder of 2007. The 2006 third quarter charges included $51 million of costs related to PMIs Munich factory closure.
Cash payments related to exit costs at PMI were $89 million and $16 million for the nine months and three months ended September 30, 2007, respectively. Future cash payments for exit costs incurred to date are expected to be approximately $170 million.
-13-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
The streamlining of these various functions and operations is expected to result in the elimination of approximately 2,400 positions. As of September 30, 2007, approximately 1,800 of these positions have been eliminated.
Corporate Asset Impairment and Exit Costs
General corporate charges primarily related to investment banking fees associated with the Kraft spin-off in 2007 and charges related to the streamlining of various corporate functions in 2007 and 2006.
Note 3. Benefit Plans:
Altria Group, Inc. sponsors noncontributory defined benefit pension plans covering substantially all U.S. employees. Pension coverage for employees of ALGs 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, ALG and its U.S. subsidiaries provide health care and other benefits to substantially all retired employees. Health care benefits for retirees outside the United States are generally covered through local government plans.
Pension Plans
Components of Net Periodic Benefit Cost
Net periodic pension cost consisted of the following:
U.S. Plans | Non-U.S. Plans | |||||||||||||||
For the Nine Months Ended September 30, |
For the Nine Months Ended September 30, |
|||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
(in millions) | ||||||||||||||||
Service cost |
$ | 80 | $ | 89 | $ | 101 | $ | 94 | ||||||||
Interest cost |
229 | 215 | 96 | 84 | ||||||||||||
Expected return on plan assets |
(316 | ) | (297 | ) | (159 | ) | (121 | ) | ||||||||
Amortization: |
||||||||||||||||
Net loss |
78 | 114 | 21 | 18 | ||||||||||||
Prior service cost |
7 | 11 | 4 | 4 | ||||||||||||
Other |
31 | 5 | ||||||||||||||
Net periodic pension cost |
$ | 109 | $ | 137 | $ | 63 | $ | 79 | ||||||||
-14-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
U.S. Plans | Non-U.S. Plans | |||||||||||||||
For the Three Months Ended September 30, |
For the Three Months Ended September 30, |
|||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
(in millions) | ||||||||||||||||
Service cost |
$ | 26 | $ | 31 | $ | 33 | $ | 32 | ||||||||
Interest cost |
76 | 73 | 32 | 28 | ||||||||||||
Expected return on plan assets |
(105 | ) | (97 | ) | (54 | ) | (40 | ) | ||||||||
Amortization: |
||||||||||||||||
Net loss |
28 | 40 | 7 | 6 | ||||||||||||
Prior service cost |
1 | 5 | 2 | 1 | ||||||||||||
Other |
7 | |||||||||||||||
Net periodic pension cost |
$ | 33 | $ | 52 | $ | 20 | $ | 27 | ||||||||
Other, above, was due primarily to curtailment losses and an early retirement program related to PM USAs announced closure of its Cabarrus, North Carolina manufacturing facility in 2007, and a workforce reduction program within Altria corporate headquarters in 2006. In conjunction with the 2007 curtailment, as of June 30, 2007, Altria Group, Inc. remeasured its benefit obligation and plan assets for its U.S. pension plans. This remeasurement resulted in an increase in prepaid pension assets of approximately $500 million and a corresponding increase, net of income taxes, to stockholders equity.
Employer Contributions
Altria Group, Inc. presently makes, and plans to make, contributions, to the extent that they are tax deductible and do not generate an excise tax liability, in order to maintain plan assets in excess of the accumulated benefit obligation of its funded U.S. and non-U.S. plans. Employer contributions of $27 million and $56 million were made to U.S. plans and non-U.S. plans, respectively, during the nine months ended September 30, 2007. Currently, Altria Group, Inc. anticipates making additional contributions during the remainder of 2007 of approximately $5 million to its U.S. plans and approximately $45 million to its non-U.S. plans, based on current tax law. However, these estimates are subject to change as a result of changes in tax and other benefit laws, as well as asset performance significantly above or below the assumed long-term rate of return on pension assets, or changes in interest rates.
Postretirement Benefit Plans
Net postretirement health care costs consisted of the following:
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, |
|||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
(in millions) | ||||||||||||||||
Service cost |
$ | 36 | $ | 42 | $ | 12 | $ | 15 | ||||||||
Interest cost |
93 | 91 | 30 | 30 | ||||||||||||
Amortization: |
||||||||||||||||
Net loss |
25 | 27 | 8 | 9 | ||||||||||||
Prior service cost |
(6 | ) | (3 | ) | (2 | ) | (2 | ) | ||||||||
Other |
(4 | ) | 3 | |||||||||||||
Net postretirement health care costs |
$ | 144 | $ | 160 | $ | 48 | $ | 52 | ||||||||
-15-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Other, above, was due primarily to curtailment gains related to PM USAs announced closure of its Cabarrus, North Carolina manufacturing facility in 2007 and a workforce reduction program within Altria corporate headquarters in 2006.
Note 4. Goodwill and Other Intangible Assets, net:
Goodwill and other intangible assets, net, by segment were as follows (in millions):
Goodwill | Other Intangible Assets, net | |||||||||||
September 30, 2007 |
December 31, 2006 |
September 30, 2007 |
December 31, 2006 | |||||||||
U.S. tobacco |
$ | | $ | | $ | 281 | $ | 281 | ||||
European Union |
1,394 | 1,307 | 66 | 65 | ||||||||
Eastern Europe, |
685 | 657 | 164 | 164 | ||||||||
Asia |
4,117 | 3,778 | 1,303 | 1,339 | ||||||||
Latin America |
504 | 455 | 60 | 59 | ||||||||
Total |
$ | 6,700 | $ | 6,197 | $ | 1,874 | $ | 1,908 | ||||
Intangible assets were as follows (in millions):
September 30, 2007 | December 31, 2006 | |||||||||||
Gross Carrying |
Accumulated Amortization |
Gross Carrying Amount |
Accumulated Amortization | |||||||||
Non-amortizable intangible assets |
$ | 1,539 | $ | 1,566 | ||||||||
Amortizable intangible assets |
401 | $ | 66 | 388 | $ | 46 | ||||||
Total intangible assets |
$ | 1,940 | $ | 66 | $ | 1,954 | $ | 46 | ||||
Non-amortizable intangible assets substantially consist of brand names from PMIs 2005 acquisition of a business in Indonesia. Amortizable intangible assets consist primarily of certain trademark licenses and non-compete agreements. Pre-tax amortization expense for intangible assets during the nine months ended September 30, 2007 and 2006, was $18 million and $17 million, respectively, and $6 million for the three months ended September 30, 2007 and 2006. Amortization expense for each of the next five years is estimated to be $25 million or less, assuming no additional transactions occur that require the amortization of intangible assets.
Goodwill is due primarily to PMIs acquisitions in Indonesia, Greece, Serbia, Colombia and Pakistan. The movement in goodwill and gross carrying amount of intangible assets from December 31, 2006, is as follows (in millions):
Goodwill | Intangible Assets |
||||||
Balance at December 31, 2006 |
$ | 6,197 | $ | 1,954 | |||
Changes due to: |
|||||||
Currency |
33 | (14 | ) | ||||
Acquisitions |
437 | ||||||
Other |
33 | ||||||
Balance at September 30, 2007 |
$ | 6,700 | $ | 1,940 | |||
-16-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
The increase in goodwill from acquisitions is primarily related to the preliminary allocation of the purchase price for PMIs acquisition in Pakistan. The allocation is based upon preliminary estimates and assumptions and is subject to revision when appraisals are finalized, which will be completed in the first quarter of 2008.
During the first quarter of 2007, Altria Group, Inc. completed its annual review of goodwill and intangible assets, and no charges resulted from this review.
Note 5. Financial Instruments:
During the nine months and three months ended September 30, 2007 and 2006, ineffectiveness related to fair value hedges and cash flow hedges was not material. Altria Group, Inc. is hedging forecasted transactions for periods not exceeding the next fifteen months and expects gains of approximately $19 million reported in accumulated other comprehensive earnings (losses) to be reclassified to the consolidated statement of earnings within the next twelve months.
Within currency translation adjustments at September 30, 2007 and 2006, Altria Group, Inc. recorded gains of $2 million, net of income taxes, and losses of $134 million, net of income taxes, respectively, which represented effective hedges of net investments.
Hedging activity affected accumulated other comprehensive earnings (losses), net of income taxes, as follows:
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, |
||||||||||||||
2007 | 2006 | 2007 | 2006 | ||||||||||||
(in millions) | |||||||||||||||
Gain at beginning of period |
$ | 13 | $ | 24 | $ | 8 | $ | 17 | |||||||
Derivative (gains) losses transferred to earnings |
(38 | ) | (51 | ) | 3 | (33 | ) | ||||||||
Change in fair value |
45 | 6 | 11 | (5 | ) | ||||||||||
Kraft spin-off |
2 | ||||||||||||||
Gain (loss) as of September 30 |
$ | 22 | $ | (21 | ) | $ | 22 | $ | (21 | ) | |||||
Note 6. Acquisitions:
On July 18, 2007, PMI announced that it had reached an agreement in principle to acquire an additional 30% stake in its Mexican tobacco business from its joint venture partner, Grupo Carso, S.A.B. de C.V. (Grupo Carso). PMI currently holds a 50% stake in its Mexican tobacco business and this transaction would bring PMIs stake to 80%. Grupo Carso would retain a 20% stake in the business. The transaction has a value of approximately $1.1 billion and was completed on November 1, 2007.
During the first quarter of 2007, PMI acquired an additional 50.2% stake in a Pakistan cigarette manufacturer, Lakson Tobacco Company Limited (Lakson Tobacco), and completed a mandatory tender offer for the remaining shares, which increased PMIs total ownership interest in Lakson Tobacco from 40% to approximately 98%, for $388 million. The effect of this acquisition was not material to Altria Group, Inc.s consolidated financial position, results of operations or operating cash flows in any of the periods presented.
-17-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Note 7. Divestitures:
Discontinued Operations:
As further discussed in Note 1. Basis of Presentation and Kraft Spin-Off, on March 30, 2007, Altria Group, Inc. completed the spin-off of all of its remaining interest in Kraft on a pro-rata basis to Altria Group, Inc. stockholders in a tax-free distribution. Altria Group, Inc. stockholders received 0.692024 of a share of Kraft for every share of Altria Group, Inc. common stock outstanding. Altria Group, Inc. stockholders received cash in lieu of fractional shares of Kraft. The distribution was accounted for as a dividend and as such resulted in a net decrease to Altria Group, Inc.s stockholders equity of $27.4 billion on March 30, 2007.
Altria Group, Inc. has reflected the results of Kraft prior to the distribution date as discontinued operations on the condensed consolidated statements of earnings and the condensed consolidated statements of cash flows. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the condensed consolidated balance sheet at December 31, 2006.
Summarized financial information for discontinued operations for the nine months and three months ended September 30, 2007 and 2006 were as follows (in millions):
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, |
||||||||||||||
2007 | 2006 | 2007 | 2006 | ||||||||||||
Net revenues |
$ | 8,586 | $ | 24,985 | $ | | $ | 8,243 | |||||||
Earnings before income taxes and minority interest |
$ | 1,059 | $ | 3,175 | $ | | $ | 1,223 | |||||||
Provision for income taxes |
(356 | ) | (735 | ) | (473 | ) | |||||||||
Minority interest in earnings from discontinued operations, net |
(78 | ) | (300 | ) | (89 | ) | |||||||||
Earnings from discontinued operations, net of income taxes and minority interest |
$ | 625 | $ | 2,140 | $ | | $ | 661 | |||||||
-18-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Summarized assets and liabilities of discontinued operations as of December 31, 2006 were as follows (in millions):
December 31, 2006 | |||
Assets: |
|||
Cash and cash equivalents |
$ | 239 | |
Receivables, net |
3,262 | ||
Inventories |
3,506 | ||
Other current assets |
640 | ||
Current assets of discontinued operations |
7,647 | ||
Property, plant and equipment, net |
9,693 | ||
Goodwill |
27,038 | ||
Other intangible assets, net |
10,177 | ||
Prepaid pension assets |
1,168 | ||
Other assets |
729 | ||
Long-term assets of discontinued operations |
48,805 | ||
Liabilities: |
|||
Short-term borrowings |
1,715 | ||
Current portion of long-term debt |
1,418 | ||
Accounts payable |
2,602 | ||
Accrued liabilities |
3,980 | ||
Income taxes |
151 | ||
Current liabilities of discontinued operations |
9,866 | ||
Long-term debt |
7,081 | ||
Deferred income taxes |
3,930 | ||
Accrued pension costs |
1,022 | ||
Accrued postretirement health care costs |
3,014 | ||
Minority interest |
3,109 | ||
Other liabilities |
1,473 | ||
Long-term liabilities of discontinued operations |
19,629 | ||
Net Assets |
$ | 26,957 | |
Note 8. Stock Plans:
In connection with the Kraft spin-off, Altria Group, Inc. employee stock options were modified through the issuance of Kraft employee stock options and the adjustment of the stock option exercise prices for the Altria Group, Inc. awards. For each employee stock option outstanding the aggregate intrinsic value of the option immediately after the spin-off was not greater than the aggregate intrinsic value of the option immediately before the spin-off. Due to the fact that the Black-Scholes fair values of the awards immediately before and immediately after the spin-off were equivalent, as measured in accordance with the provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R), no incremental compensation expense was recorded as a result of the modification of the Altria Group, Inc. awards.
-19-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
In January 2007, Altria Group, Inc. issued 1.7 million rights to receive shares of stock to eligible U.S.-based and non-U.S. employees. Restrictions on these rights lapse in the first quarter of 2010. The market value per right was $87.36 on the date of grant. Recipients of these Altria Group, Inc. stock rights did not receive restricted stock or stock rights of Kraft upon the Kraft spin-off. Rather, they received approximately 0.6 million additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
During the nine months ended September 30, 2007, 2.1 million shares of restricted stock and rights to receive shares of stock vested. The total fair value of restricted stock and rights vested during the nine months ended September 30, 2007 was $183 million. The grant date fair value per share of these awards was $55.46 (prior to any adjustment for the Kraft spin-off).
Note 9. Earnings Per Share:
Basic and diluted EPS from continuing and discontinued operations were calculated using the following:
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, | |||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||
(in millions) | ||||||||||||
Earnings from continuing operations |
$ | 6,973 | $ | 6,923 | $ | 2,633 | $ | 2,214 | ||||
Earnings from discontinued operations |
625 | 2,140 | 661 | |||||||||
Net earnings |
$ | 7,598 | $ | 9,063 | $ | 2,633 | $ | 2,875 | ||||
Weighted average shares for basic EPS |
2,100 | 2,086 | 2,103 | 2,090 | ||||||||
Plus incremental shares from assumed |
||||||||||||
Restricted stock and stock rights |
2 | 3 | 2 | 3 | ||||||||
Stock options |
13 | 15 | 12 | 14 | ||||||||
Weighted average shares for diluted EPS |
2,115 | 2,104 | 2,117 | 2,107 | ||||||||
For the nine months and three months ended September 30, 2007, there were no antidilutive stock options. For the nine months and three months ended September 30, 2006, the number of stock options excluded from the calculation of weighted average shares for diluted EPS because their effects were antidilutive was immaterial.
Note 10. Segment Reporting:
The products of ALGs subsidiaries include cigarettes and other tobacco products sold in the United States by PM USA and outside of the United States by PMI. PMIs operations are organized and managed by geographic region. Another subsidiary of ALG, PMCC, maintains a portfolio of leveraged and direct finance leases.
As discussed in Note 1. Basis of Presentation and Kraft Spin-Off, Altria Group, Inc. revised its reportable segments. Beginning with the second quarter of 2007, Altria Group, Inc.s reportable segments are U.S. tobacco; European Union; Eastern Europe, Middle East and Africa; Asia; Latin America; and Financial Services.
-20-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Altria Group, Inc.s management reviews operating companies income to evaluate segment performance and allocate resources. Operating companies income for the segments excludes general corporate expenses and amortization of intangibles. Interest and other debt expense, net (consumer products), and provision for income taxes are centrally managed at the ALG level and, accordingly, such items are not presented by segment since they are excluded from the measure of segment profitability reviewed by Altria Group, Inc.s management.
Segment data were as follows:
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, |
|||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
(in millions) | ||||||||||||||||
Net revenues: |
||||||||||||||||
U.S. tobacco |
$ | 13,998 | $ | 13,938 | $ | 4,944 | $ | 4,830 | ||||||||
European Union |
20,253 | 18,248 | 6,832 | 6,458 | ||||||||||||
Eastern Europe, Middle East and Africa |
9,205 | 7,716 | 3,312 | 2,607 | ||||||||||||
Asia |
8,351 | 7,667 | 2,814 | 2,586 | ||||||||||||
Latin America |
3,639 | 3,183 | 1,274 | 1,052 | ||||||||||||
Total International tobacco |
41,448 | 36,814 | 14,232 | 12,703 | ||||||||||||
Financial Services |
126 | 272 | 31 | 109 | ||||||||||||
Net revenues |
$ | 55,572 | $ | 51,024 | $ | 19,207 | $ | 17,642 | ||||||||
Earnings from continuing operations before income taxes, and equity earnings and minority interest, net: |
||||||||||||||||
Operating companies income: |
||||||||||||||||
U.S. tobacco |
$ | 3,429 | $ | 3,687 | $ | 1,295 | $ | 1,270 | ||||||||
European Union |
3,256 | 2,735 | 1,151 | 955 | ||||||||||||
Eastern Europe, Middle East and Africa |
1,911 | 1,639 | 710 | 582 | ||||||||||||
Asia |
1,412 | 1,456 | 514 | 449 | ||||||||||||
Latin America |
333 | 395 | 143 | 133 | ||||||||||||
Total International tobacco |
6,912 | 6,225 | 2,518 | 2,119 | ||||||||||||
Financial Services |
332 | 138 | 33 | 101 | ||||||||||||
Amortization of intangibles |
(18 | ) | (17 | ) | (6 | ) | (6 | ) | ||||||||
General corporate expenses |
(456 | ) | (390 | ) | (135 | ) | (128 | ) | ||||||||
Operating income |
10,199 | 9,643 | 3,705 | 3,356 | ||||||||||||
Interest and other debt expense, net |
(187 | ) | (325 | ) | (11 | ) | (59 | ) | ||||||||
Earnings from continuing operations before income taxes, and equity earnings and minority interest, net |
$ | 10,012 | $ | 9,318 | $ | 3,694 | $ | 3,297 | ||||||||
Items affecting the comparability of results from continuing operations were as follows:
| Asset Impairment and Exit Costs See Note 2. Asset Impairment and Exit Costs, for a breakdown of asset impairment and exit costs by segment. |
-21-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
| Recoveries/Provision from/for Airline Industry Exposure During the nine months and three months ended September 30, 2007, PMCC recorded pre-tax gains of $214 million and $7 million, respectively, on the sale of its ownership interests and bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down. During the second quarter of 2006, PMCC increased its allowance for losses by $103 million, due to continuing issues within the airline industry. |
| Italian Antitrust Charge During the first quarter of 2006, PMI recorded a $61 million charge related to an Italian antitrust action. This charge was included in the operating companies income of the European Union segment. |
Note 11. Contingencies:
Legal proceedings covering a wide range of matters are pending or threatened in various United States and foreign jurisdictions against ALG, its subsidiaries and affiliates, including PM USA and PMI, as well as their respective indemnitees. Various types of claims are raised in these proceedings, including product liability, consumer protection, antitrust, tax, contraband shipments, patent infringement, employment matters, claims for contribution and claims of competitors and distributors.
Overview of Tobacco-Related Litigation
Types and Number of Cases
Claims related to tobacco products generally fall within the following categories: (i) smoking and health cases alleging personal injury brought on behalf of individual plaintiffs, (ii) smoking and health cases primarily alleging personal injury or seeking court-supervised programs for ongoing medical monitoring and purporting to be brought on behalf of a class of individual plaintiffs, including cases in which the aggregated claims of a number of individual plaintiffs are to be tried in a single proceeding, (iii) health care cost recovery cases brought by governmental (both domestic and foreign) and non-governmental plaintiffs seeking reimbursement for health care expenditures allegedly caused by cigarette smoking and/or disgorgement of profits, (iv) class action suits alleging that the uses of the terms Lights and Ultra Lights constitute deceptive and unfair trade practices, common law fraud, or violations of the Racketeer Influenced and Corrupt Organizations Act (RICO), and (v) other tobacco-related litigation described below. Damages claimed in some of the tobacco-related litigation range into the billions of dollars. Plaintiffs theories of recovery and the defenses raised in pending smoking and health, health care cost recovery and Lights/Ultra Lights cases are discussed below.
The table below lists the number of certain tobacco-related cases pending in the United States against PM USA and, in some instances, ALG or PMI, as of November 1, 2007, December 31, 2006 and December 31, 2005, and a page-reference to further discussions of each type of case.
-22-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Type of Case |
Number of Cases 2007 |
Number of Cases Pending as of December 31, 2006 |
Number of Cases Pending as of December 31, 2005 |
Page References | ||||
Individual Smoking and Health Cases (1) |
123 | 196 | 228 | 33 | ||||
Smoking and Health Class Actions and Aggregated Claims Litigation (2) |
10 | 10 | 9 | 33-34 | ||||
Health Care Cost Recovery Actions | 3 | 5 | 4 | 34-39 | ||||
Lights/Ultra Lights Class Actions | 17 | 20 | 24 | 39-42 | ||||
Tobacco Price Cases | 2 | 2 | 2 | 42 | ||||
Cigarette Contraband Cases | 0 | 0 | 1 | 43 |
(1) | Does not include 2,622 cases brought by flight attendants seeking compensatory damages for personal injuries allegedly caused by exposure to environmental tobacco smoke (ETS). The flight attendants allege that they are members of an ETS smoking and health class action, which was settled in 1997. The terms of the court-approved settlement in that case allow class members to file individual lawsuits seeking compensatory damages, but prohibit them from seeking punitive damages. Also, does not include nine individual smoking and health cases brought against certain retailers that are indemnitees of PM USA. Additionally, does not include 189 individual smoking and health cases brought by or on behalf of 993 plaintiffs in Florida following the decertification of the Engle case discussed below. |
(2) | Includes as one case the aggregated claims of 923 individuals (of which 536 individuals have claims against PM USA) that are proposed to be tried in a single proceeding in West Virginia. The West Virginia Supreme Court of Appeals has ruled that the United States Constitution does not preclude a trial in two phases in this case. Issues related to defendants conduct, plaintiffs entitlement to punitive damages and a punitive damages multiplier, if any, would be determined in the first phase. The second phase would consist of individual trials to determine liability, if any, and compensatory damages. Defendants have renewed their motion for review of the trial plan with the West Virginia Supreme Court of Appeals. |
There are also a number of other tobacco-related actions pending outside the United States against PMI and its affiliates and subsidiaries, including an estimated 134 individual smoking and health cases as of November 1, 2007 (Argentina (58), Australia (2), Brazil (54), Chile (9), Costa Rica (1), Greece (1), Italy (4), the Philippines (1), Poland (3) and Scotland (1)), compared with approximately 133 such cases on December 31, 2006, and approximately 132 such cases on December 31, 2005. In addition, in Italy, 2,023 cases are pending in the Italian equivalent of small claims court where damages are limited to 2,000 per case, and three cases are pending in Finland and one in Israel against defendants that are indemnitees of a subsidiary of PMI.
-23-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
In addition, as of November 1, 2007, there were three smoking and health putative class actions pending outside the United States against PMI or its affiliates in Brazil (2) and Israel (1) compared with two such cases on December 31, 2006, and two such cases on December 31, 2005. Seven health care cost recovery actions are pending in Nigeria (4), Israel (1), Canada (1) and Spain (1), against PMI or its affiliates, and two Lights/Ultra Lights class actions are pending in Israel. PM USA is also a named defendant in the smoking and health putative class action in Israel, a Lights class action in Israel and health care cost recovery actions in Israel and Canada.
Also, as of November 1, 2007, there were nine public civil actions pending outside the Untied States against PMI or its affiliates in Argentina (1), Brazil (3), Colombia (4), and Turkey (1) compared with three such actions on December 31, 2006, and one such action on December 31, 2005. Public civil actions are claims filed either by an individual, or a public or private entity, seeking to protect a variety of collective or individual rights. Plaintiffs in these cases seek various forms of relief including injunctive relief such as banning cigarettes, descriptors, smoking in certain places and advertising, as well as implementing communication campaigns and reimbursement of medical expenses incurred by public or private institutions.
Pending and Upcoming Trials
On October 31, 2007, the jury in the Whiteley case found that plaintiffs are not entitled to punitive damages against PM USA. A trial in a flight attendant case began on October 29, 2007. In addition, as of November 1, 2007, 7 individual smoking and health cases against PM USA are scheduled for trial through the end of 2008. Cases against other tobacco companies are also scheduled for trial through the end of 2008. Trial dates are subject to change.
Recent Trial Results
Since January 1999, verdicts have been returned in 45 smoking and health, Lights/Ultra Lights and health care cost recovery cases in which PM USA was a defendant. Verdicts in favor of PM USA and other defendants were returned in 28 of the 45 cases. These 28 cases were tried in California (4), Florida (9), Mississippi (1), Missouri (2), New Hampshire (1), New Jersey (1), New York (3), Ohio (2), Pennsylvania (1), Rhode Island (1), Tennessee (2), and West Virginia (1). Plaintiffs appeals or post-trial motions challenging the verdicts are pending in California, the District of Columbia and Florida. A motion for a new trial has been granted in one of the cases in Florida. In addition, in December 2002, a court dismissed an individual smoking and health case in California at the end of trial.
In July 2005, a jury in Tennessee returned a verdict in favor of PM USA in a case in which plaintiffs had challenged PM USAs retail promotional and merchandising programs under the Robinson-Patman Act.
Of the 17 cases in which verdicts were returned in favor of plaintiffs, eight have reached final resolution. A verdict against defendants in a health care cost recovery case has been reversed and all claims were dismissed with prejudice. In addition, a verdict against defendants in a purported Lights class action in Illinois has been reversed and the case has been dismissed with prejudice. After exhausting all appeals, PM USA has paid six judgments totaling $71,826,707, and interest totaling $33,806,665.
The chart below lists the verdicts and post-trial developments in the nine pending cases, as well as the Illinois Lights class action, that have gone to trial since January 1999 in which verdicts were returned in favor of plaintiffs.
-24-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Date |
Location of |
Type of Case |
Verdict |
Post-Trial Developments | ||||
May 2007 |
California/ Whiteley |
Individual Smoking and Health |
Approximately $2.5 million in compensatory damages against PM USA and the other defendant in the case, as well as $250,000 in punitive damages against the other defendant in the case. | In July 2007, the trial court granted plaintiffs motion for a limited retrial against PM USA on the question of whether plaintiffs are entitled to punitive damages against PM USA, and if so, the amount. On October 31, 2007, the jury found that plaintiffs are not entitled to punitive damages against PM USA. | ||||
August 2006 |
District of Columbia/ United States of America |
Health Care Cost Recovery |
Finding that defendants, including ALG and PM USA, violated the civil provisions of the Racketeer Influenced and Corrupt Organizations Act (RICO). No monetary damages assessed, but court made specific findings and issued injunctions. See Federal Governments Lawsuit, below. | Defendants filed notices of appeal to the United States Court of Appeals in September 2006 and the Department of Justice filed its notice of appeal in October. In October 2006, a three-judge panel of the Court of Appeals stayed implementation of the trial courts remedies order pending its review of the decision. In March 2007, the trial court denied in part and granted in part defendants post-trial motion for clarification of portions of the courts remedial order. Briefing of the parties consolidated appeal is scheduled to conclude in May 2008. See Federal Governments Lawsuit, below. | ||||
March 2005 |
New York/ Rose |
Individual Smoking and Health |
$3.42 million in compensatory damages against two defendants, including PM USA, and $17.1 million in punitive damages against PM USA. | PM USAs appeal is pending. |
-25-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Date |
Location of |
Type of Case |
Verdict |
Post-Trial Developments | ||||
May 2004 |
Louisiana/ Scott |
Smoking and Health Class Action |
Approximately $590 million against all defendants, including PM USA, jointly and severally, to fund a 10- year smoking cessation program. | In June 2004, the state trial court entered judgment in the amount of the verdict of $590 million, plus prejudgment interest accruing from the date the suit commenced. As of February 15, 2007, the amount of prejudgment interest was approximately $444 million. PM USAs share of the verdict and prejudgment interest has not been allocated. Defendants, including PM USA, appealed. In February 2007, the Louisiana Court of Appeal upheld the class certification and finding of liability, but reduced the judgment by $312 million and vacated the award of prejudgment interest. The Court of Appeal also remanded the case to the trial court with instructions to further reduce the remaining $279 million judgment to eliminate amounts awarded to any individual who began smoking after the Louisiana Product Liability Act became effective on September 1, 1988. In March 2007, the Louisiana Court of Appeal rejected defendants motion for rehearing and clarification. Plaintiffs and defendants have filed petitions for writ of certiorari with the Louisiana Supreme Court. See Scott Class Action below. |
-26-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Date |
Location of |
Type of Case |
Verdict |
Post-Trial Developments | ||||
March 2003 |
Illinois/ Price |
Lights/Ultra Lights Class Action |
$7.1005 billion in compensatory damages and $3 billion in punitive damages against PM USA. | In December 2005, the Illinois Supreme Court reversed the trial courts judgment in favor of the plaintiffs and remanded the case to the trial court with instructions to dismiss the case against PM USA. In May 2006, the Illinois Supreme Court rejected the plaintiffs motion for rehearing. In November 2006, the United States Supreme Court denied plaintiffs petition for writ of certiorari and in December 2006, the trial court dismissed the case with prejudice. In May 2007, the trial court granted plaintiffs motion to certify certain questions to the Illinois Fifth District Appellate Court, and plaintiffs petitioned the Fifth District to review the certified questions. In May 2007, PM USA filed applications for a supervisory order and writ of mandamus with the Illinois Supreme Court seeking an order compelling the lower courts to deny plaintiffs motion to vacate and/or withhold final judgment. The Illinois appellate court stayed the plaintiffs appeal until the related matters pending before the Illinois Supreme Court are resolved. In August 2007, the Illinois Supreme Court granted PM USAs motion for supervisory order, and the trial court dismissed plaintiffs motion to vacate or withhold final judgment. | ||||
October 2002 |
California/ Bullock |
Individual Smoking and Health |
$850,000 in compensatory damages and $28 billion in punitive damages against PM USA. | In December 2002, the trial court reduced the punitive damages award to $28 million. In April 2006, the California Court of Appeal affirmed the $28 million punitive damage award. See discussion (1) below. |
-27-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Date |
Location of |
Type of Case |
Verdict |
Post-Trial Developments | ||||
June 2002 |
Florida/ Lukacs |
Individual Smoking and Health |
$37.5 million in compensatory damages against all defendants, including PM USA. | In March 2003, the trial court reduced the damages award to $24.86 million. PM USAs share of the damages award is approximately $6 million. The court has not yet entered the judgment on the jury verdict. In January 2007, defendants petitioned the trial court to set aside the jurys verdict and dismiss plaintiffs punitive damages claim. On August 1, 2007, the trial court deferred ruling on plaintiffs motion for entry of judgment until after the United States Supreme Courts review of Engle is complete and after further submissions by the parties. If a judgment is entered in this case, PM USA intends to appeal. | ||||
March 2002 |
Oregon/ Schwarz |
Individual Smoking and Health |
$168,500 in compensatory damages and $150 million in punitive damages against PM USA. | In May 2002, the trial court reduced the punitive damages award to $100 million. In May 2006, the Oregon Court of Appeals affirmed the compensatory damages verdict, reversed the award of punitive damages and remanded the case to the trial court for a second trial to determine the amount of punitive damages, if any. In June 2006, plaintiff petitioned the Oregon Supreme Court to review the portion of the Court of Appeals decision reversing and remanding the case for a new trial on punitive damages. In October 2006, the Oregon Supreme Court announced that it would hold this petition in abeyance until the United States Supreme Court decided the Williams case discussed below. In February 2007, the United States Supreme Court vacated the punitive damages judgment in Williams and remanded the case to the Oregon Supreme Court for proceedings consistent with its decision. The parties have submitted their briefs to the Oregon Supreme Court setting forth their respective views on how the Williams decision impacts the plaintiffs pending petition for review. |
-28-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Date |
Location of |
Type of Case |
Verdict |
Post-Trial Developments | ||||
July 2000 |
Florida/ Engle |
Smoking and Health Class Action |
$145 billion in punitive damages against all defendants, including $74 billion against PM USA. | In July 2006, the Florida Supreme Court ordered that the punitive damages award be vacated, that the class approved by the trial court be decertified, that certain Phase I trial court findings be allowed to stand as against the defendants in individual actions that individual former class members may bring within one year of the issuance of the mandate, compensatory damage awards totaling approximately $6.9 million to two individual class members be reinstated and that a third former class members claim was barred by the statute of limitations. In December 2006, the Florida Supreme Court denied all motions by the parties for rehearing but issued a revised opinion. In January 2007, the Florida Supreme Court issued the mandate from its revised December opinion and defendants filed a motion with the Florida Third District Court of Appeal requesting the courts review of legal errors previously raised but not ruled upon. This motion was denied in February 2007. In May 2007, defendants motion for a partial stay of the mandate pending the completion of appellate review was denied by the Third District Court of Appeal. In May 2007, defendants filed a petition for writ of certiorari with the United States Supreme Court. On October 1, 2007, the United States Supreme Court denied defendants petition. See Engle Class Action below. On October 26, 2007, defendants filed a motion for rehearing of the United States Supreme Courts denial of their petition for certiorari. As of November 1, 2007, 189 individual smoking and health cases have been |
-29-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Date |
Location of |
Type of Case |
Verdict |
Post-Trial Developments | ||||
brought by or on behalf of 993 plaintiffs in Florida following the Florida Supreme Courts decertification decision. | ||||||||
March 1999 | Oregon/ Williams |
Individual Smoking and Health |
$800,000 in compensatory damages, $21,500 in medical expenses and $79.5 million in punitive damages against PM USA. | See discussion (2) below. |
(1) | Bullock: In August 2006, the California Supreme Court denied plaintiffs petition to overturn the trial courts reduction of the punitive damage award and granted PM USAs petition for review challenging the punitive damage award. The court granted review of the case on a grant and hold basis under which further action by the court is deferred pending the United States Supreme Courts decision on punitive damages in the Williams case described below. In February 2007, the United States Supreme Court vacated the punitive damages judgment in Williams and remanded the case to the Oregon Supreme Court for proceedings consistent with its decision. Parties to the appeal in Bullock requested that the court establish a briefing schedule on the merits of the pending appeal. In May 2007, the California Supreme Court transferred the case to the Second District of the California Court of Appeal with directions that the court vacate its 2006 decision and reconsider the case in light of the United States Supreme Courts decision in Williams. The California Court of Appeal has indicated that it will hear oral arguments on this issue in November 2007. |
(2) | Williams: The trial court reduced the punitive damages award to $32 million, and PM USA and plaintiff appealed. In June 2002, the Oregon Court of Appeals reinstated the $79.5 million punitive damages award. Following the Oregon Supreme Courts refusal to hear PM USAs appeal, PM USA recorded a provision of $32 million in connection with this case and petitioned the United States Supreme Court for further review. In October 2003, the United States Supreme Court set aside the Oregon appellate courts ruling and directed the Oregon court to reconsider the case in light of the 2003 State Farm decision by the United States Supreme Court, which limited punitive damages. In June 2004, the Oregon Court of Appeals reinstated the $79.5 million punitive damages award. In February 2006, the Oregon Supreme Court affirmed the Court of Appeals decision. Following this decision, PM USA recorded an additional provision of approximately $20 million in interest charges related to this case. The United States Supreme Court granted PM USAs petition for writ of certiorari in May 2006. In February 2007, the United States Supreme Court vacated the $79.5 million punitive damages award, holding that the United States Constitution prohibits basing punitive damages awards on harm to non-parties. The Court also found that states must assure that appropriate procedures are in place so that juries are provided with proper legal guidance as to the constitutional limitations on awards of punitive damages. Accordingly, the Court remanded the case to the Oregon Supreme Court for further proceedings consistent with this decision. On September 11, 2007, the Oregon Supreme Court heard oral arguments on the impact of the United States Supreme Courts decision on this case. |
In addition to the cases discussed above, in October 2003, a three-judge appellate panel in Brazil reversed a lower courts dismissal of an individual smoking and health case and ordered PMIs Brazilian affiliate to pay plaintiff approximately $256,000 and other unspecified damages. PMIs Brazilian affiliate appealed. In
-30-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
December 2004, the three-judge panels decision was vacated by an en banc panel of the appellate court, which upheld the trial courts dismissal of the case. The case is currently on appeal to the Superior Court.
With respect to certain adverse verdicts currently on appeal, excluding amounts relating to the Engle case, as of September 30, 2007, PM USA has posted various forms of security totaling approximately $193 million, the majority of which have been collateralized with cash deposits, to obtain stays of judgments pending appeals. The cash deposits are included in other assets on the consolidated balance sheets.
Engle Class Action
In July 2000, in the second phase of the Engle smoking and health class action in Florida, a jury returned a verdict assessing punitive damages totaling approximately $145 billion against various defendants, including $74 billion against PM USA. Following entry of judgment, PM USA posted a bond in the amount of $100 million and appealed.
In May 2001, the trial court approved a stipulation providing that execution of the punitive damages component of the Engle judgment will remain stayed against PM USA and the other participating defendants through the completion of all judicial review. As a result of the stipulation, PM USA placed $500 million into a separate interest-bearing escrow account that, regardless of the outcome of the judicial review, will be paid to the court and the court will determine how to allocate or distribute it consistent with Florida Rules of Civil Procedure. In July 2001, PM USA also placed $1.2 billion into an interest-bearing escrow account, which will be returned to PM USA should it prevail in the judicial review. (The $1.2 billion escrow account is included in the September 30, 2007 and December 31, 2006 consolidated balance sheets as other assets. Interest income on the $1.2 billion escrow account is paid to PM USA quarterly and is being recorded as earned, in interest and other debt expense, net, in the consolidated statements of earnings.) In connection with the stipulation, PM USA recorded a $500 million pre-tax charge in its consolidated statement of earnings for the quarter ended March 31, 2001. In May 2003, the Florida Third District Court of Appeal reversed the judgment entered by the trial court and instructed the trial court to order the decertification of the class. Plaintiffs petitioned the Florida Supreme Court for further review.
In July 2006, the Florida Supreme Court ordered that the punitive damages award be vacated, that the class approved by the trial court be decertified, and that members of the decertified class could file individual actions against defendants within one year of issuance of the mandate. The court further declared the following Phase I findings are entitled to res judicata effect in such individual actions brought within one year of the issuance of the mandate: (i) that smoking causes various diseases; (ii) that nicotine in cigarettes is addictive; (iii) that defendants cigarettes were defective and unreasonably dangerous; (iv) that defendants concealed or omitted material information not otherwise known or available knowing that the material was false or misleading or failed to disclose a material fact concerning the health effects or addictive nature of smoking; (v) that all defendants agreed to misrepresent information regarding the health effects or addictive nature of cigarettes with the intention of causing the public to rely on this information to their detriment; (vi) that defendants agreed to conceal or omit information regarding the health effects of cigarettes or their addictive nature with the intention that smokers would rely on the information to their detriment; (vii) that all defendants sold or supplied cigarettes that were defective; and (viii) that all defendants were negligent. The court also reinstated compensatory damage awards totaling approximately $6.9 million to two individual plaintiffs and found that a third plaintiffs claim was barred by the statute of limitations.
In August 2006, PM USA sought rehearing from the Florida Supreme Court on parts of its July 2006 opinion, including the ruling (described above) that certain jury findings have res judicata effect in subsequent individual trials timely brought by Engle class members. The rehearing motion also asked, among other things, that legal errors that were raised but not expressly ruled upon in the Third District Court of Appeal or in the Florida Supreme Court now be addressed. Plaintiffs also filed a motion for rehearing in August 2006 seeking
-31-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
clarification of the applicability of the statute of limitations to non-members of the decertified class. In December 2006, the Florida Supreme Court refused to revise its July 2006 ruling, except that it revised the set of Phase I findings entitled to res judicata effect by excluding finding (v) listed above (relating to agreement to misrepresent information), and added the finding that defendants sold or supplied cigarettes that, at the time of sale or supply, did not conform to the representations of fact made by defendants. On January 11, 2007, the Florida Supreme Court issued the mandate from its revised opinion. Defendants then filed a motion with the Florida Third District Court of Appeal requesting that the court address legal errors that were previously raised by defendants but have not yet been addressed either by the Third District or by the Florida Supreme Court. In February 2007, the Third District Court of Appeal denied defendants motion. In May 2007, defendants motion for a partial stay of the mandate pending the completion of appellate review was denied by the District Court of Appeal. In May 2007, defendants filed a petition for writ of certiorari with the United States Supreme Court. On October 1, 2007, the United States Supreme Court denied defendants petition. On October 26, 2007, defendants filed a motion for rehearing of the United States Supreme Courts denial of defendants petition for certiorari.
It is currently unknown how many members of the decertified class will file individual claims by January 10, 2008, as required by the Florida Supreme Courts decision. Since the Florida Supreme Court ruling, 189 cases have been served upon PM USA or other defendants asserting individual claims on or on behalf of 993 plaintiffs based upon the ruling. Some of these cases have been removed from various Florida state courts to the federal district courts in Florida, while others were filed in federal court. In July 2007, PM USA and other defendants requested that the multi-district litigation panel order the transfer of all such cases pending in the federal courts, as well as any other Engle progeny cases that may be filed, to the Middle District of Florida for pretrial coordination. The panel is scheduled to hear this application in November 2007. In October 2007, attorneys for plaintiffs filed a motion to consolidate all pending and future cases filed in the state trial court in Hillsborough County.
Scott Class Action
In July 2003, following the first phase of the trial in the Scott class action, in which plaintiffs sought creation of a fund to pay for medical monitoring and smoking cessation programs, a Louisiana jury returned a verdict in favor of defendants, including PM USA, in connection with plaintiffs medical monitoring claims, but also found that plaintiffs could benefit from smoking cessation assistance. The jury also found that cigarettes as designed are not defective but that the defendants failed to disclose all they knew about smoking and diseases and marketed their products to minors. In May 2004, in the second phase of the trial, the jury awarded plaintiffs approximately $590 million against all defendants jointly and severally, to fund a 10-year smoking cessation program.
In June 2004, the court entered judgment, which awarded plaintiffs the approximately $590 million jury award plus prejudgment interest accruing from the date the suit commenced. As of February 15, 2007, the amount of prejudgment interest was approximately $444 million. PM USAs share of the jury award and prejudgment interest has not been allocated. Defendants, including PM USA, appealed. Pursuant to a stipulation of the parties, the trial court entered an order setting the amount of the bond at $50 million for all defendants in accordance with an article of the Louisiana Code of Civil Procedure, and a Louisiana statute (the bond cap law) fixing the amount of security in civil cases involving a signatory to the MSA (as defined below). Under the terms of the stipulation, plaintiffs reserve the right to contest, at a later date, the sufficiency or amount of the bond on any grounds including the applicability or constitutionality of the bond cap law. In September 2004, defendants collectively posted a bond in the amount of $50 million.
In February 2007, the Louisiana Court of Appeal issued a ruling on defendants appeal that, among other things: affirmed class certification but limited the scope of the class; struck certain of the categories of damages that comprised the judgment, reducing the amount of the award by approximately $312 million; vacated the award
-32-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
of prejudgment interest, which totaled approximately $444 million as of February 15, 2007; and ruled that the only class members who are eligible to participate in the smoking cessation program are those who began smoking before, and whose claims accrued by, September 1, 1988. As a result, the Louisiana Court of Appeal remanded for proceedings consistent with its opinion, including further reduction of the amount of the award based on the size of the new class. In March 2007, the Louisiana Court of Appeal rejected defendants motion for rehearing and clarification. Plaintiffs and defendants have filed petitions for writ of certiorari with the Louisiana Supreme Court.
Smoking and Health Litigation
Overview
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, nuisance, 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 and state anti-racketeering statutes. Plaintiffs in the smoking and health actions seek various forms of relief, including compensatory and punitive damages, treble/multiple damages and other statutory damages and penalties, creation of medical monitoring and smoking cessation funds, disgorgement of profits, and injunctive and equitable relief. Defenses raised in these cases include lack of proximate cause, assumption of the risk, comparative fault and/or contributory negligence, statutes of limitations and preemption by the Federal Cigarette Labeling and Advertising Act.
Smoking and Health Class Actions
Since the dismissal in May 1996 of a purported nationwide class action brought on behalf of allegedly addicted smokers, plaintiffs have filed numerous putative smoking and health class action suits in various state and federal courts. In general, these cases purport to be brought on behalf of residents of a particular state or states (although a few cases purport to be nationwide in scope) and raise addiction claims and, in many cases, claims of physical injury as well.
Class certification has been denied or reversed by courts in 57 smoking and health class actions involving PM USA in Arkansas (1), the District of Columbia (2), Florida (2), Illinois (2), Iowa (1), Kansas (1), Louisiana (1), Maryland (1), Michigan (1), Minnesota (1), Nevada (29), New Jersey (6), New York (2), Ohio (1), Oklahoma (1), Pennsylvania (1), Puerto Rico (1), South Carolina (1), Texas (1) and Wisconsin (1). A class remains certified in the Scott class action discussed above.
In addition to the cases brought in the United States, three smoking and health class actions have been brought against tobacco industry participants, including certain PMI subsidiaries in Brazil (2) and Israel (1). In one class action in Brazil, a consumer organization is seeking damages for smokers and former smokers, and injunctive relief. The trial court found in favor of the plaintiff in February 2004. The court awarded R$1,000 (currently approximately U.S. $500) per smoker per full year of smoking for moral damages plus interest at the rate of 1% per month, as of the date of the ruling. Actual damages are to be assessed in a second phase of the case. The size of the class is currently unknown. Defendants appealed the decision to the Sao Paulo Court of Appeals and the case, including the judgment, is currently stayed pending appeal. In addition, the defendants filed a constitutional appeal to the Federal Supreme Court on the basis that the consumer association does not have standing to bring the lawsuit. Both appeals are pending.
There are currently pending two purported class actions against PM USA brought in New York (Caronia, filed in January 2006 in the United States District Court for the Eastern District of New York) and Massachusetts (Donovan, filed in March 2007 in the United States District Court for the District of Massachusetts) on behalf of each states respective residents who: are age 50 or older; have smoked the Marlboro brand for 20 pack-years
-33-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
or more; and have neither been diagnosed with lung cancer nor are under examination by a physician for suspected lung cancer. Plaintiffs in these cases seek to impose liability under various product-based causes of action and the creation of a court-supervised program providing members of the purported class Low Dose CT Scanning in order to identify and diagnose lung cancer. Neither claim seeks punitive damages. Plaintiffs motion for class certification is pending in Caronia.
Health Care Cost Recovery Litigation
Overview
In health care cost recovery litigation, domestic and foreign governmental entities and non-governmental plaintiffs seek reimbursement of health care cost expenditures allegedly caused by tobacco products and, in some cases, of future expenditures and damages as well. Relief sought by some but not all plaintiffs includes punitive damages, 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, additional disclosure of nicotine yields, and payment of attorney and expert witness fees.
The claims asserted include the claim that cigarette manufacturers were unjustly enriched by plaintiffs payment of health care costs allegedly attributable to smoking, as well as claims of indemnity, 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 anti-racketeering statutes.
Defenses raised include lack of proximate cause, remoteness of injury, 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 standing and injury, federal preemption, lack of statutory authority to bring suit, and statutes of limitations. In addition, defendants argue that they should be entitled to set off any alleged damages to the extent the plaintiffs benefit 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.
Although there have been some decisions to the contrary, most judicial decisions have dismissed all or most health care cost recovery claims against cigarette manufacturers. Nine federal circuit courts of appeals and six state appellate courts, relying primarily on grounds that plaintiffs claims were too remote, have ordered or affirmed dismissals of health care cost recovery actions. The United States Supreme Court has refused to consider plaintiffs appeals from the cases decided by five circuit courts of appeals.
In March 1999, in the first health care cost recovery case to go to trial, an Ohio jury returned a verdict in favor of defendants on all counts. In addition, a $17.8 million verdict against defendants (including $6.8 million against PM USA) was reversed in a health care cost recovery case in New York, and all claims were dismissed with prejudice in February 2005 (Blue Cross/Blue Shield). The trial in the health care cost recovery case brought by the City of St. Louis, Missouri and approximately 50 Missouri hospitals, in which PM USA and ALG are defendants, is scheduled to begin in February 2010.
Individuals and associations have also sued in purported class actions or as private attorneys general under the Medicare As Secondary Payer statute to recover from defendants Medicare expenditures allegedly incurred for
-34-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
the treatment of smoking-related diseases. Cases brought in New York (Mason), Florida (Glover) and Massachusetts (United Seniors Association) have been dismissed by federal courts, and plaintiffs appealed in United Seniors Association. In August 2007, the United States Court of Appeals for the First Circuit affirmed the district courts dismissal in United Seniors Association.
In addition to the cases brought in the United States, health care cost recovery actions have also been brought against tobacco industry participants, including PM USA, PMI and certain PMI subsidiaries in Israel (1), the Marshall Islands (1 dismissed), Canada (1), France (1 dismissed), Spain (1) and Nigeria (4) and other entities have stated that they are considering filing such actions. In September 2005, in the case in Canada, the Canadian Supreme Court ruled that legislation passed in British Columbia permitting the lawsuit is constitutional, and, as a result, the case which had previously been dismissed by the trial court was permitted to proceed. PM USA, PMI and other defendants challenge to the British Columbia courts exercise of jurisdiction was rejected by the Court of Appeals of British Columbia and, in April 2007, the Supreme Court of Canada denied review of that decision. Several other provinces in Canada have enacted similar legislation or are in the process of enacting similar legislation.
Settlements of Health Care Cost Recovery Litigation
In November 1998, PM USA and certain other United States tobacco product manufacturers entered into the Master Settlement Agreement (the MSA) with 46 states, the District of Columbia, 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 USA 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). The State Settlement Agreements require that the original participating manufacturers make substantial annual payments in the following amounts (excluding future annual payments, if any, under the National Tobacco Grower Settlement Trust discussed below), subject to adjustments for several factors, including inflation, market share and industry volume: 2007, $8.4 billion and thereafter, $9.4 billion each year. In addition, the original participating manufacturers are required to pay settling plaintiffs attorneys fees, subject to an annual cap of $500 million.
The State Settlement Agreements also include provisions relating to advertising and marketing restrictions, public disclosure of certain industry documents, limitations on challenges to certain tobacco control and underage use laws, restrictions on lobbying activities and other provisions.
Possible Adjustments in MSA Payments for 2003, 2004 and 2005
Pursuant to the provisions of the MSA, domestic tobacco product manufacturers, including PM USA, who are original signatories to the MSA (OPMs), are participating in proceedings that may result in downward adjustments to the amounts paid by the OPMs and the other MSA participating manufacturers to the states and territories that are parties to the MSA for the years 2003, 2004, and 2005. The proceedings are based on the collective loss of market share for 2003, 2004 and 2005, respectively, by all manufacturers who are subject to the payment obligations and marketing restrictions of the MSA to non-participating manufacturers (NPMs) who are not subject to such obligations and restrictions.
In these proceedings, an independent economic consulting firm jointly selected by the MSA parties is required to determine whether the disadvantages of the MSA were a significant factor contributing to the collective loss of market share for the year in question. If the firm determines that the disadvantages of the MSA were such a significant factor, each state may avoid a downward adjustment to its share of the participating manufacturers annual payments for that year by establishing that it diligently enforced a qualifying escrow statute during the entirety of that year. Any potential downward adjustment would then be reallocated to those states that do not establish such diligent enforcement. PM USA believes that the MSAs arbitration clause
-35-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
requires a state to submit its claim to have diligently enforced a qualifying escrow statute to binding arbitration before a panel of three former federal judges in the manner provided for in the MSA. A number of states have taken the position that this claim should be decided in state court on a state-by-state basis.
In March of 2006, an independent economic consulting firm determined that the disadvantages of the MSA were a significant factor contributing to the participating manufacturers collective loss of market share for the year 2003. In February 2007, this same firm determined that the disadvantages of the MSA were a significant factor contributing to the participating manufacturers collective loss of market share for the year 2004. As of October 2007, PM USA is also participating in another such proceeding before the same economic consulting firm to determine whether the disadvantages of the MSA were a significant factor contributing to the participating manufacturers collective loss of market share for the year 2005. The economic consulting firm is expected to render its final determination on the significant factor issue for 2005 sometime in February 2008. Following the economic consulting firms determination with respect to 2003, thirty-eight states filed declaratory judgment actions in state courts seeking a declaration that the state diligently enforced its escrow statute during 2003. The OPMs and other MSA-participating manufacturers have responded to these actions by filing motions to compel arbitration in accordance with the terms of the MSA, including filing motions to compel arbitration in eleven MSA states and territories that have not filed declaratory judgment actions. Courts in over 45 states have ruled that the question of whether a state diligently enforced its escrow statute during 2003 is subject to arbitration and only one state court ruling to the contrary currently stands, and it remains subject to appeal. Many of these rulings, including the one ruling against arbitration, remain subject to appeal or further review. Additionally, Ohio filed a declaratory judgment action in state court with respect to the 2004 diligent enforcement issue. The action has been stayed pending the decision about the 2003 payments.
The availability and the precise amount of any NPM Adjustment for 2003 and 2004 will not be finally determined until 2008 or thereafter. The availability and the precise amount of any NPM Adjustment for 2005 will not be finally determined until late 2008 or thereafter. There is no certainty that the OPMs and other MSA-participating manufacturers will ultimately receive any adjustment as a result of these proceedings. If the OPMs do receive such an adjustment through these proceedings, the adjustment would be allocated among the OPMs pursuant to the MSAs provisions, and PM USAs share would likely be applied as a credit against a future MSA payment.
National Grower Settlement Trust
As part of the MSA, the settling defendants committed to work cooperatively with the tobacco-growing states to address concerns about the potential adverse economic impact of the MSA on tobacco growers and quota holders. To that end, in 1999, four of the major domestic tobacco product manufacturers, including PM USA, established the National Tobacco Grower Settlement Trust (NTGST), a trust fund to provide aid to tobacco growers and quota holders. The trust was to be funded by these four manufacturers over 12 years with payments, prior to application of various adjustments, scheduled to total $5.15 billion. Provisions of the NTGST allowed for offsets to the extent that industry-funded payments were made for the benefit of growers or quota holders as part of a legislated end to the federal tobacco quota and price support program.
In October 2004, the Fair and Equitable Tobacco Reform Act of 2004 (FETRA) was signed into law. FETRA provides for the elimination of the federal tobacco quota and price support program through an industry-funded buy-out of tobacco growers and quota holders. The cost of the buy-out, which is estimated at approximately $9.5 billion, is being paid over 10 years by manufacturers and importers of each kind of tobacco product. The cost is being allocated based on the relative market shares of manufacturers and importers of each kind of tobacco product. The quota buy-out payments offset already scheduled payments to the NTGST. FETRA also obligated manufacturers and importers of tobacco products to cover any losses (up to $500 million) that the government incurred on the disposition of tobacco pool stock accumulated under the previous tobacco price support program. PM USA has paid $138 million for its share of the tobacco pool stock losses. ALG does not
-36-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
currently anticipate that the quota buy-out will have a material adverse impact on its consolidated results in 2007 and beyond.
Other MSA-Related Litigation
In June 2004, a putative class of California smokers filed a complaint against PM USA and the MSAs other Original Participating Manufacturers (OPMs) seeking damages from the OPMs for post-MSA price increases and an injunction against their continued compliance with the MSAs terms. The complaint alleges that the MSA and related legislation protect the OPMs from competition in a manner that violates federal and state antitrust and consumer protection laws. The complaint also names the California Attorney General as a defendant and seeks to enjoin him from enforcing Californias Escrow Statute. In March 2005, the United States District Court for the Northern District of California granted defendants motion to dismiss the case. On September 26, 2007, the United States Court of Appeals for the Ninth Circuit affirmed the dismissal.
Without naming PM USA or any other private party as a defendant, manufacturers that have elected not to sign the MSA (Non-Participating Manufacturers or NPMs) and/or their distributors or customers have filed several other legal challenges to the MSA and related legislation. New York state officials are defendants in a lawsuit pending in the United States District Court for the Southern District of New York in which cigarette importers allege that the MSA and/or related legislation violates federal antitrust laws and the Commerce Clause of the United States Constitution. In a separate proceeding pending in the same court, plaintiffs assert the same theories against not only New York officials but also the Attorneys General for thirty other states. The United States Court of Appeals for the Second Circuit has held that the allegations in both actions, if proven, establish a basis for relief on antitrust and Commerce Clause grounds and that the trial courts in New York have personal jurisdiction sufficient to enjoin other states officials from enforcing their MSA-related legislation. On remand in those two actions, one trial judge preliminarily enjoined New York from enforcing its allocable share amendment to the MSAs Model Escrow Statute against the plaintiffs, while another trial judge refused to do so after concluding that the plaintiffs were unlikely to prove their allegations. Summary judgment motions are pending in one of those cases.
In another action, the United States Court of Appeals for the Fifth Circuit reversed a trial courts dismissal of challenges to MSA-related legislation in Louisiana under the First and Fourteenth Amendments to the United States Constitution. The case will now proceed to motions for summary judgment and, if necessary, a trial. Summary judgment proceedings in another challenge to Louisianas participation in the MSA and its MSA-related legislation may begin in mid-2008. Yet another proceeding has been initiated before an international arbitration tribunal under the provisions of the North American Free Trade Agreement. Appeals from trial court decisions holding that plaintiffs have failed either to make allegations establishing a claim for relief or to submit evidence supporting those allegations are currently, or will soon be, pending before the United States Court of Appeals for the Eighth and Tenth Circuits. The United States Court of Appeals for the Sixth Circuit has affirmed the dismissal of two similar challenges.
Federal Governments Lawsuit
In 1999, the United States government filed a lawsuit in the United States District Court for the District of Columbia against various cigarette manufacturers, including PM USA, and others, including ALG, asserting claims under three federal statutes, the Medical Care Recovery Act (MCRA), the Medicare Secondary Payer (MSP) provisions of the Social Security Act and the civil provisions of RICO. Trial of the case ended in June 2005. The lawsuit sought to recover an unspecified amount of health care costs for tobacco-related illnesses allegedly caused by defendants fraudulent and tortious conduct and paid for by the government under various federal health care programs, including Medicare, military and veterans health benefits programs, and the Federal Employees Health Benefits Program. The complaint alleged that such costs total more than $20 billion annually. It also sought what it alleged to be equitable and declaratory relief, including disgorgement of profits
-37-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
which arose from defendants allegedly tortious conduct, an injunction prohibiting certain actions by the defendants, and a declaration that the defendants are liable for the federal governments future costs of providing health care resulting from defendants alleged past tortious and wrongful conduct. In September 2000, the trial court dismissed the governments MCRA and MSP claims, but permitted discovery to proceed on the governments claims for relief under the civil provisions of RICO.
The government alleged that disgorgement by defendants of approximately $280 billion is an appropriate remedy. In May 2004, the trial court issued an order denying defendants motion for partial summary judgment limiting the disgorgement remedy. In February 2005, a panel of the United States Court of Appeals for the District of Columbia Circuit held that disgorgement is not a remedy available to the government under the civil provisions of RICO and entered summary judgment in favor of defendants with respect to the disgorgement claim. In April 2005, the Court of Appeals denied the governments motion for rehearing. In July 2005, the government petitioned the United States Supreme Court for further review of the Court of Appeals ruling that disgorgement is not an available remedy, and in October 2005, the Supreme Court denied the petition.
In June 2005, the government filed with the trial court its proposed final judgment seeking remedies of approximately $14 billion, including $10 billion over a five-year period to fund a national smoking cessation program and $4 billion over a ten-year period to fund a public education and counter-marketing campaign. Further, the governments proposed remedy would have required defendants to pay additional monies to these programs if targeted reductions in the smoking rate of those under 21 are not achieved according to a prescribed timetable. The governments proposed remedies also included a series of measures and restrictions applicable to cigarette business operations including, but not limited to, restrictions on advertising and marketing, potential measures with respect to certain price promotional activities and research and development, disclosure requirements for certain confidential data and implementation of a monitoring system with potential broad powers over cigarette operations.
In August 2006, the federal trial court entered judgment in favor of the government. The court held that certain defendants, including ALG and PM USA, violated RICO and engaged in 7 of the 8 sub-schemes to defraud that the government had alleged. Specifically, the court found that:
| defendants falsely denied, distorted and minimized the significant adverse health consequences of smoking; |
| defendants hid from the public that cigarette smoking and nicotine are addictive; |
| defendants falsely denied that they control the level of nicotine delivered to create and sustain addiction; |
| defendants falsely marketed and promoted low tar/light cigarettes as less harmful than full-flavor cigarettes; |
| defendants falsely denied that they intentionally marketed to youth; |
| defendants publicly and falsely denied that ETS is hazardous to non-smokers; and |
| defendants suppressed scientific research. |
The court did not impose monetary penalties on the defendants, but ordered the following relief: (i) an injunction against committing any act of racketeering relating to the manufacturing, marketing, promotion, health consequences or sale of cigarettes in the United States; (ii) an injunction against participating directly or indirectly in the management or control of the Council for Tobacco Research, the Tobacco Institute, or the
-38-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Center for Indoor Air Research, or any successor or affiliated entities of each; (iii) an injunction against making, or causing to be made in any way, any material false, misleading, or deceptive statement or representation or engaging in any public relations or marketing endeavor that is disseminated to the United States public and that misrepresents or suppresses information concerning cigarettes; (iv) an injunction against conveying any express or implied health message through use of descriptors on cigarette packaging or in cigarette advertising or promotional material, including lights, ultra lights and low tar, which the court found could cause consumers to believe a cigarette brand is less hazardous than another brand; (v) the issuance of corrective statements in various media regarding the adverse health effects of smoking, the addictiveness of smoking and nicotine, the lack of any significant health benefit from smoking low tar or light cigarettes, defendants manipulation of cigarette design to ensure optimum nicotine delivery and the adverse health effects of exposure to environmental tobacco smoke; (vi) the disclosure on defendants public document websites and in the Minnesota document repository of all documents produced to the government in the lawsuit or produced in any future court or administrative action concerning smoking and health until 2021, with certain additional requirements as to documents withheld from production under a claim of privilege or confidentiality; (vii) the disclosure of disaggregated marketing data to the government in the same form and on the same schedule as defendants now follow in disclosing such data to the Federal Trade Commission, for a period of ten years; (viii) certain restrictions on the sale or transfer by defendants of any cigarette brands, brand names, formulas or cigarette businesses within the United States; and (ix) payment of the governments costs in bringing the action.
In September 2006, defendants filed notices of appeal to the United States Court of Appeals for the District of Columbia Circuit. In September 2006, the trial court denied defendants motion to stay the judgment pending defendants appeals, and defendants then filed an emergency motion with the Court of Appeals to stay enforcement of the judgment pending their appeals. In October 2006, the government filed a notice of appeal to the Court of Appeals in which it appeals the denial of certain remedies, including the disgorgement of profits and the cessation remedies it had sought. In October 2006, a three-judge panel of the United States Court of Appeals granted defendants motion and stayed the trial courts judgment pending its review of the decision. Certain defendants, including PM USA and ALG, have filed a motion to clarify the trial courts August 2006 Final Judgment and Remedial Order. In March 2007, the trial court denied in part and granted in part defendants post-trial motion for clarification of portions of the courts remedial order. As noted above, the trial courts judgment and remedial order remain stayed pending the appeal to the Court of Appeals. In May 2007, the United States Court of Appeals for the District of Columbia scheduled briefing of the parties consolidated appeal to begin in August 2007 and conclude in May 2008.
Lights/Ultra Lights Cases
Overview
Plaintiffs in these class actions (some of which have not been certified as such), allege, among other things, that the uses of the terms Lights and/or Ultra Lights constitute deceptive and unfair trade practices, common law fraud, or RICO violations, and seek injunctive and equitable relief, including restitution and, in certain cases, punitive damages. These class actions have been brought against PM USA and, in certain instances, ALG and PMI or its subsidiaries, on behalf of individuals who purchased and consumed various brands of cigarettes, including Marlboro Lights, Marlboro Ultra Lights, Virginia Slims Lights and Superslims, Merit Lights and Cambridge Lights. Defenses raised in these cases include lack of misrepresentation, lack of causation, injury, and damages, the statute of limitations, express preemption by the Federal Cigarette Labeling and Advertising Act and implied preemption by the policies and directives of the Federal Trade Commission, non-liability under state statutory provisions exempting conduct that complies with federal regulatory directives, and the First Amendment. Seventeen cases are pending in Arkansas (2), Delaware (1), Florida (1), Illinois (1), Maine (1), Massachusetts (1), Minnesota (1), Missouri (1), New Hampshire (1), New Jersey (1), New Mexico (1), New York (1), Oregon (1), Tennessee (1), and West Virginia (2). In addition, there are two cases pending in Israel. Other entities have stated that they are considering filing such actions against ALG, PMI, and PM USA.
-39-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
To date, 10 courts in 11 cases have refused to certify class actions, reversed prior class certification decisions or have entered judgment in favor of PM USA. Trial courts in Arizona, Kansas, New Mexico, Oregon and Washington have refused to certify a class, an appellate court in Florida has overturned class certification by a trial court, the Ohio Supreme Court has overturned class certifications in two cases, the United States Court of Appeals for the Fifth Circuit has dismissed a purported Lights class action brought in Louisiana federal court (Sullivan) on the grounds that plaintiffs claims were preempted by the Federal Cigarette Labeling and Advertising Act, a federal trial court in Maine has dismissed a purported class action on federal preemption grounds (Good), plaintiffs voluntarily dismissed an action in a federal trial court in Michigan after the court dismissed claims asserted under the Michigan Unfair Trade and Consumer Protection Act, and the Supreme Court of Illinois has overturned a judgment in favor of a plaintiff class in the Price case, which is discussed below. The United States Court of Appeals for the First Circuit vacated the district courts grant of PM USAs motion for summary judgment in the Good case on federal preemption grounds and remanded the case to district court. The district court has stayed proceedings pending the ruling of the United States Supreme Court on defendants anticipated petition for a writ of certiorari, which was filed on October 26, 2007. An intermediate appellate court in Oregon and the Supreme Court in Washington have denied plaintiffs motions for interlocutory review of the trial courts refusals to certify a class. Plaintiffs in the Oregon case failed to appeal by the deadline for doing so and the trial court subsequently entered judgment against plaintiffs on the ground of express preemption under the Federal Cigarette Labeling and Advertising Act. Plaintiffs in the case in Washington voluntarily dismissed the case with prejudice. Plaintiffs in the New Mexico case renewed their motion for class certification. Plaintiffs in the Florida case have petitioned the Florida Supreme Court for further review, and the Supreme Court has ordered briefing on why its Engle opinion should not control the decision in that case.
Trial courts have certified classes against PM USA in Massachusetts (Aspinall), Minnesota (Curtis), Missouri (Craft) and New York (Schwab). PM USA has appealed or otherwise challenged these class certification orders, and the appeals in Aspinall and Schwab are pending. In addition, the United States Supreme Court has reversed the trial and appellate courts rulings denying plaintiffs motion to remand the case to state trial court in a purported Lights class action brought in Arkansas (Watson). Developments in these cases include:
| Watson: In June 2007, the United States Supreme Court reversed the lower court rulings that denied plaintiffs motion to have the case heard in a state, as opposed to federal, trial court. The Supreme Court rejected defendants contention that the case must be tried in federal court under the federal officer statute. The case has been remanded to the state trial court in Arkansas. |
| Aspinall: In August 2004, the Massachusetts Supreme Judicial Court affirmed the class certification order. In April 2006, plaintiffs filed a motion to redefine the class to include all persons who after November 25, 1994 purchased packs or cartons of Marlboro Lights cigarettes in Massachusetts that displayed the legend Lower Tar & Nicotine (the original class definition did not include a reference to lower tar and nicotine). In August 2006, the trial court denied PM USAs motion for summary judgment based on the state consumer protection statutory exemption and federal preemption. On motion of the parties, the trial court has subsequently reported its decision to deny summary judgment to the appeals court for review and the trial court proceedings are stayed pending completion of the appellate review. Motions for direct appellate review with the Massachusetts Supreme Judicial Court were granted in April 2007. |
| Curtis: In April 2005, the Minnesota Supreme Court denied PM USAs petition for interlocutory review of the trial courts class certification order. In September 2005, PM USA removed Curtis to federal court based on the Eighth Circuits decision in Watson, which upheld the removal of a Lights case to federal court based on the federal officer jurisdiction of the Federal Trade Commission. In February 2006, the federal court denied plaintiffs motion to remand the case to state court. The case was stayed pending the outcome of Dahl v. R. J. Reynolds Tobacco Co., which was argued before the United States Court of Appeals for the Eighth Circuit in December 2006. In February 2007, the United States Court of Appeals for the Eighth Circuit issued its ruling in Dahl, and reversed the federal district courts denial of plaintiffs motion to remand that case to the state trial court. On October 17, 2007, the district court remanded the Curtis case to state court. |
-40-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
| Craft: In August 2005, a Missouri Court of Appeals affirmed the class certification order. In September 2005, PM USA removed Craft to federal court based on the Eighth Circuits decision in Watson. In March 2006, the federal trial court granted plaintiffs motion and remanded the case to the Missouri state trial court. In May 2006, the Missouri Supreme Court declined to review the trial courts class certification decision. Trial has been set for January 2009. |
| Schwab: In September 2005, the trial court granted in part defendants motion for partial summary judgment dismissing plaintiffs claims for equitable relief and denied a number of plaintiffs motions for summary judgment. In November 2005, the trial court ruled that the plaintiffs would be permitted to calculate damages on an aggregate basis and use fluid recovery theories to allocate them among class members. In September 2006, the trial court denied defendants summary judgment motions and granted plaintiffs motion for certification of a nationwide class of all United States residents that purchased cigarettes in the United States that were labeled light or lights from the first date defendants began selling such cigarettes until the date trial commences. The court also declined to certify the order for interlocutory appeal, declined to stay the case and ordered jury selection to begin in January 2007, with trial scheduled to begin immediately after the jury is impaneled. In October 2006, a single judge of the United States Court of Appeals for the Second Circuit granted PM USAs petition for a temporary stay of pre-trial and trial proceedings pending disposition of the petitions for stay and interlocutory review by a three-judge panel of the Court of Appeals. In November 2006, the Second Circuit granted interlocutory review of the trial courts class certification order and stayed the case before the trial court pending the appeal. Oral argument was heard on July 10, 2007. |
In addition to these cases, in December 2005, in the Miner case which was pending at that time in the United States District Court for the Western District of Arkansas, plaintiffs moved for certification of a class composed of individuals who purchased Marlboro Lights or Cambridge Lights brands in Arkansas, California, Colorado, and Michigan. PM USAs motion for summary judgment based on preemption and the Arkansas statutory exemption is pending. Following the filing of this motion, plaintiffs moved to voluntarily dismiss Miner without prejudice, which PM USA opposed. The court then stayed the case pending the United States Supreme Courts decision on a petition for writ of certiorari in the Watson case discussed above. In July 2007, the case was remanded to a state trial court in Arkansas. In August 2007, plaintiffs renewed their motion for class certification. In October 2007, the court denied PM USAs motion to dismiss on procedural grounds and the court entered a case management order. In addition, plaintiffs motions for class certification are pending in cases in New Jersey and Tennessee.
The Price Case
Trial in the Price case commenced in state court in Illinois in January 2003, and in March 2003, the judge found in favor of the plaintiff class and awarded approximately $7.1 billion in compensatory damages and $3 billion in punitive damages against PM USA. In April 2003, the judge reduced the amount of the appeal bond that PM USA must provide and ordered PM USA to place a pre-existing 7.0%, $6 billion long-term note from ALG to PM USA in an escrow account with an Illinois financial institution. (Since this note is the result of an intercompany financing arrangement, it does not appear on the consolidated balance sheets of ALG.) The judges order also required PM USA to make cash deposits with the clerk of the Madison County Circuit Court in the following amounts: beginning October 1, 2003, an amount equal to the interest earned by PM USA on the
-41-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
ALG note ($210 million every six months), an additional $800 million in four equal quarterly installments between September 2003 and June 2004 and the payments of principal on the note, which are due in April 2008, 2009 and 2010. Plaintiffs appealed the judges order reducing the bond. In July 2003, the Illinois Fifth District Court of Appeals ruled that the trial court had exceeded its authority in reducing the bond. In September 2003, the Illinois Supreme Court upheld the reduced bond set by the trial court and announced it would hear PM USAs appeal on the merits without the need for intermediate appellate court review. In December 2005, the Illinois Supreme Court reversed the trial courts judgment in favor of the plaintiffs and remanded the case to the trial court with instructions that the case be dismissed. In May 2006, the Illinois Supreme Court denied plaintiffs motion for rehearing. In June 2006, the Illinois Supreme Court ordered the return to PM USA of approximately $2.2 billion being held in escrow to secure the appeal bond in the case and terminated PM USAs obligations to pay administrative fees to the Madison County Clerk. In November 2006, the United States Supreme Court denied plaintiffs petition for writ of certiorari and, in December 2006, the Circuit Court of Madison County entered final judgment in favor of PM USA and dismissed the case with prejudice. In December 2006, the pre-existing 7.0%, $6 billion long-term note from ALG to PM USA that was in escrow pending the outcome of plaintiffs petition for writ of certiorari to the United States Supreme Court was returned to PM USA. Plaintiffs filed a motion to vacate or withdraw the Price decision based upon the United States Supreme Courts grant of the petition for writ of certiorari in the Watson case discussed above. In May 2007, the trial court granted plaintiffs motion to certify certain questions to the Illinois Fifth District Appellate Court, and plaintiffs petitioned the Fifth District to review the certified questions. In May 2007, PM USA filed applications for writ of prohibition and writ of mandamus with the Illinois Supreme Court seeking an order compelling the lower courts to deny plaintiffs motion to vacate and/or withhold final judgment. In June 2007, the appellate court granted PM USAs motion to stay plaintiffs appeal pending resolution of related matters before the Illinois Supreme Court. In August 2007, the Illinois Supreme Court granted PM USAs motion for supervisory order and the trial court dismissed plaintiffs motion to vacate or withhold final judgment.
Certain Other Tobacco-Related Litigation
Tobacco Price Cases: As of November 1, 2007, two cases were pending in Kansas and New Mexico in which plaintiffs allege that defendants, including PM USA and PMI, conspired to fix cigarette prices in violation of antitrust laws. ALG and PMI are defendants in the case in Kansas. Plaintiffs motions for class certification have been granted in both cases. In February 2005, the New Mexico Court of Appeals affirmed the class certification decision. In June 2006, defendants motion for summary judgment was granted in the New Mexico case. Plaintiffs in the New Mexico case have appealed.
Wholesale Leaders Cases: In June 2003, certain wholesale distributors of cigarettes filed suit in Tennessee against PM USA seeking to enjoin the PM USA 2003 Wholesale Leaders (WL) program that became available to wholesalers in June 2003. The complaint alleges that the WL program constitutes unlawful price discrimination and is an attempt to monopolize. In addition to an injunction, plaintiffs seek unspecified monetary damages, attorneys fees, costs and interest. The states of Tennessee and Mississippi intervened as plaintiffs in this litigation. In August 2003, the trial court issued a preliminary injunction, subject to plaintiffs posting a bond in the amount of $1 million, enjoining PM USA from implementing certain discount terms with respect to the sixteen wholesale distributor plaintiffs, and PM USA appealed. In September 2003, the United States Court of Appeals for the Sixth Circuit granted PM USAs motion to stay the injunction pending PM USAs expedited appeal. In January 2004, Tennessee filed a motion to dismiss its complaint, and its complaint was dismissed without prejudice in March 2004. In August 2005, the trial court granted PM USAs motion for summary judgment, dismissed the case, and dissolved the preliminary injunction. Plaintiffs appealed to the United States Court of Appeals for the Sixth Circuit. In February 2007, the Sixth Circuit affirmed the trial courts grant of PM USAs motion for summary judgment. Plaintiffs filed a petition for writ of certiorari with the United States Supreme Court seeking review of the Sixth Circuits decision, which was denied on October 1, 2007.
-42-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Cigarette Contraband Cases: In May 2000 and August 2001, various departments of Colombia and the European Community and 10 Member States filed suits in the United States against ALG and certain of its subsidiaries, including PM USA and PMI, and other cigarette manufacturers and their affiliates, alleging that defendants sold to distributors cigarettes that would be illegally imported into various jurisdictions. In February 2002, the federal district court granted defendants motions to dismiss the actions. In January 2004, the United States Court of Appeals for the Second Circuit affirmed the dismissals of the cases based on the common law Revenue Rule, which bars a foreign government from bringing civil claims in U.S. courts for the recovery of lost taxes. It is possible that future litigation related to cigarette contraband issues may be brought. In this regard, ALG believes that Canadian authorities are contemplating a legal proceeding based on an investigation of ALG entities relating to allegations of contraband shipments of cigarettes into Canada in the early to mid-1990s.
Cases Under the California Business and Professions Code: In June 1997 and July 1998, two suits (Brown and Daniels) were filed in California state court alleging that domestic cigarette manufacturers, including PM USA and others, have violated California Business and Professions Code Sections 17200 and 17500 regarding unfair, unlawful and fraudulent business practices. Class certification was granted in both cases as to plaintiffs claims that class members are entitled to reimbursement of the costs of cigarettes purchased during the class periods and injunctive relief. In September 2002, the court granted defendants motion for summary judgment as to all claims in one of the cases (Daniels), and plaintiffs appealed. In October 2004, the California Fourth District Court of Appeal affirmed the trial courts ruling, and also denied plaintiffs motion for rehearing. In February 2005, the California Supreme Court agreed to hear plaintiffs appeal. In August 2007, the California Supreme Court affirmed the dismissal of the Daniels class action on federal preemption grounds. In September 2004, the trial court in the other case granted defendants motion for summary judgment as to plaintiffs claims attacking defendants cigarette advertising and promotion and denied defendants motion for summary judgment on plaintiffs claims based on allegedly false affirmative statements. Plaintiffs motion for rehearing was denied. In March 2005, the court granted defendants motion to decertify the class based on a recent change in California law, which, in two July 2006 opinions, the California Supreme Court ruled applicable to pending cases. Plaintiffs motion for reconsideration of the order that decertified the class was denied, and plaintiffs have appealed. In September 2006, an intermediate appellate court affirmed the trial courts order decertifying the class in Brown. In November 2006, the California Supreme Court accepted review of the appellate courts decision.
In May 2004, a lawsuit (Gurevitch) was filed in California state court on behalf of a purported class of all California residents who purchased the Merit brand of cigarettes since July 2000 to the present alleging that defendants, including PM USA, violated Californias Business and Professions Code Sections 17200 and 17500 regarding unfair, unlawful and fraudulent business practices, including false and misleading advertising. The complaint also alleges violations of Californias Consumer Legal Remedies Act. Plaintiffs seek injunctive relief, disgorgement, restitution, and attorneys fees. In July 2005, defendants motion to dismiss was granted; however, plaintiffs motion for leave to amend the complaint was also granted, and plaintiffs filed an amended complaint in September 2005. In October 2005, the court stayed this action pending the California Supreme Courts rulings on two cases not involving PM USA. In July 2006, the California Supreme Court issued rulings in the two cases and held that a recent change in California law known as Proposition 64, which limits the ability to bring a lawsuit to only those plaintiffs who have suffered injury in fact and lost money or property as a result of defendants alleged statutory violations, properly applies to pending cases. In September 2006, the stay was lifted and defendants filed their demurrer to plaintiffs amended complaint. In March 2007, the court, without ruling on the demurrer, again stayed the action pending rulings from the California Supreme Court in another case involving Proposition 64 that is relevant to PM USAs demurrer.
-43-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Certain Other Actions
IRS Challenges to PMCC Leases: The IRS concluded its examination of ALGs consolidated tax returns for the years 1996 through 1999, and issued a final Revenue Agents Report (RAR) on March 15, 2006. The RAR disallowed benefits pertaining to certain PMCC leveraged lease transactions for the years 1996 through 1999. Altria Group, Inc. has agreed with all conclusions of the RAR, with the exception of the disallowance of benefits pertaining to several PMCC leveraged lease transactions for the years 1996 through 1999. PMCC will continue to assert its position regarding these leveraged lease transactions and contest approximately $150 million of tax and net interest assessed and paid with regard to them. The IRS may in the future challenge and disallow more of PMCCs leveraged leases based on Revenue Rulings, an IRS Notice and subsequent case law addressing specific types of leveraged leases (lease-in/lease-out (LILO) and sale-in/lease-out (SILO) transactions). PMCC believes that the position and supporting case law described in the RAR, Revenue Rulings and the IRS Notice are incorrectly applied to PMCCs transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRSs position. PMCC and ALG intend to vigorously defend against any challenges based on that position through litigation. In this regard, on October 16, 2006, PMCC filed a complaint in the U.S. District Court for the Southern District of New York to claim refunds for a portion of these tax payments and associated interest. However, should PMCCs position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and significantly lower its earnings to reflect the recalculation of the income from the affected leveraged leases, which could have a material effect on the earnings and cash flows of Altria Group, Inc. in a particular fiscal quarter or fiscal year. PMCC considered this matter in its adoption of FASB Interpretation No. 48 and FASB Staff Position No. FAS 13-2.
It is possible that there could be adverse developments in pending cases. An unfavorable outcome or settlement of pending tobacco related litigation could encourage the commencement of additional litigation. Although PM USA has historically been able to obtain required bonds or relief from bonding requirements in order to prevent plaintiffs from seeking to collect judgments while adverse verdicts have been appealed, there remains a risk that such relief may not be obtainable in all cases. This risk has been substantially reduced given that 42 states now limit the dollar amount of bonds or require no bond at all.
ALG and its subsidiaries record provisions in the consolidated financial statements for pending litigation when they determine that an unfavorable outcome is probable and the amount of the loss can be reasonably estimated. Except as discussed elsewhere in this Note 11, Contingencies: (i) management has not concluded that it is probable that a loss has been incurred in any of the pending tobacco-related cases; (ii) management is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome of any of the pending tobacco-related cases; and (iii) accordingly, management has not provided any amounts in the consolidated financial statements for unfavorable outcomes, if any.
It is possible that PM USAs or Altria Group, Inc.s consolidated results of operations, cash flows or financial position could be materially affected in a particular fiscal quarter or fiscal year by an unfavorable outcome or settlement of certain pending litigation. Nevertheless, although litigation is subject to uncertainty, management believes the litigation environment has substantially improved. ALG 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 the litigation pending against it, as well as valid bases for appeal of adverse verdicts against it. All such cases are, and will continue to be, vigorously defended. However, ALG and its subsidiaries may enter into settlement discussions in particular cases if they believe it is in the best interests of ALGs stockholders to do so.
-44-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Third-Party Guarantees
At September 30, 2007, Altria Group, Inc.s third-party guarantees, which are primarily related to excise taxes and divestiture activities, were $69 million, of which $64 million have no specified expiration dates. The remainder expire through 2011, with none expiring through September 30, 2008. Altria Group, Inc. is required to perform under these guarantees in the event that a third party fails to make contractual payments or achieve performance measures. Altria Group, Inc. has a liability of $22 million on its condensed consolidated balance sheet at September 30, 2007, relating to these guarantees. In the ordinary course of business, certain subsidiaries of ALG have agreed to indemnify a limited number of third parties in the event of future litigation.
Note 12. Income Taxes:
Altria Group, Inc. accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under SFAS No. 109, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Significant judgment is required in determining income tax provisions and in evaluating tax positions.
In the third quarter of 2007, Altria Group, Inc. recorded net tax benefits of $55 million related to the reversal of tax reserves and associated interest resulting from an expiration of the statute of limitations and $42 million related to the reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany.
Altria Group, Inc.s U.S. subsidiaries join in the filing of a U.S. federal consolidated income tax return. The U.S. federal statute of limitations remains open for the year 2000 and onward with years 2000 to 2003 currently under examination by the Internal Revenue Service (IRS). Foreign and U.S. state jurisdictions have statutes of limitations generally ranging from 3 to 5 years. Years still open to examination by foreign tax authorities in major jurisdictions include Germany (2002 onward), Indonesia (2000 onward), Russia (2005 onward), and Switzerland (2005 onward). Altria Group, Inc. is currently under examination in various U.S. state and foreign jurisdictions.
On January 1, 2007, Altria Group, Inc. adopted the provisions of FIN 48. The Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. As a result of the January 1, 2007 adoption of FIN 48, Altria Group, Inc. lowered its liability for unrecognized tax benefits by $1,021 million. This resulted in an increase to stockholders equity of $857 million ($835 million, net of minority interest), a reduction of Krafts goodwill of $85 million and a reduction of federal deferred tax benefits of $79 million.
-45-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
Unrecognized tax benefits and Altria Group, Inc.s consolidated liability for contingent income taxes, interest and penalties were as follows:
January 1, 2007 |
September 30, 2007 |
|||||||
(in millions) | ||||||||
Unrecognized tax benefits - Altria Group, Inc. |
$ | 434 | $ | 377 | ||||
Unrecognized tax benefits - Kraft |
619 | 270 | ||||||
Unrecognized tax benefits |
1,053 | 647 | ||||||
Accrued interest and penalties |
292 | 257 | ||||||
Tax credits and other indirect benefits |
(104 | ) | (124 | ) | ||||
Liability for tax contingencies |
$ | 1,241 | $ | 780 | ||||
The amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate at January 1, 2007 was $848 million, with the remaining $205 million affecting deferred taxes. The amount of unrecognized tax benefits that, if recognized, would impact the effective tax rate at September 30, 2007 was $265 million, along with $112 million affecting deferred taxes and the remainder of $270 million affecting the receivable from Kraft discussed below.
Altria Group, Inc.s unrecognized tax benefits decreased to $647 million as of September 30, 2007, principally due to the spin-off of Kraft, expiration of statutes of limitations and audit closures in U.S. state and foreign jurisdictions. Under the Tax Sharing Agreement between Altria Group, Inc. and Kraft, Kraft is responsible for its own pre-spin-off tax obligations. However, due to regulations governing the U.S. federal consolidated tax return, Altria Group, Inc. remains severally liable for Krafts pre-spin-off federal taxes. As a result, Altria Group, Inc. continues to include $270 million of Krafts unrecognized tax benefits in its liability for uncertain tax positions, and a corresponding receivable from Kraft of $270 million is included in other assets.
Altria Group, Inc. recognizes accrued interest and penalties associated with uncertain tax positions as part of the tax provision. As of January 1, 2007, Altria Group, Inc. had $292 million of accrued interest and penalties of which approximately $125 million related to Kraft. The accrued interest and penalties decreased to $257 million at September 30, 2007, principally as a result of the Kraft spin-off, expiration of statutes of limitations and audit closures in U.S. state and foreign jurisdictions. This amount includes $82 million of Kraft federal interest for which Kraft is responsible under the Tax Sharing Agreement. A corresponding receivable from Kraft is included in other assets.
It is reasonably possible that within the next 12 months certain U.S. state and foreign examinations will be resolved, which could result in a decrease in unrecognized tax benefits and interest and penalties of up to $90 million and $30 million, respectively.
Altria Group, Inc. adopted the provisions of FASB Staff Position No. FAS 13-2, Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction, effective January 1, 2007. This Staff Position requires the revenue recognition calculation to be reevaluated if there is a revision to the projected timing of income tax cash flows generated by a leveraged lease. The adoption of this Staff Position by Altria Group, Inc. resulted in a reduction to stockholders equity of $124 million as of January 1, 2007.
The IRS concluded its examination of Altria Group, Inc.s consolidated tax returns for the years 1996 through 1999, and issued a final Revenue Agents Report (RAR) on March 15, 2006. Altria Group, Inc. agreed with the RAR, with the exception of certain leasing matters discussed below. Consequently, in March 2006, Altria Group, Inc. recorded non-cash tax benefits of $1.0 billion, which principally represented the reversal of tax reserves following the issuance of and agreement with the RAR. Altria Group, Inc. reimbursed $337 million in
-46-
Altria Group, Inc. and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
cash to Kraft for its portion of the $1.0 billion in tax benefits, as well as pre-tax interest of $46 million. The amounts related to Kraft were reclassified to income from discontinued operations. The tax reversal resulted in an increase to earnings from continuing operations of $631 million for the nine months ended September 30, 2006.
Altria Group, Inc. has agreed with all conclusions of the RAR, with the exception of the disallowance of benefits pertaining to several PMCC leveraged lease transactions for the years 1996 through 1999. PMCC will continue to assert its position regarding these leveraged lease transactions and contest approximately $150 million of tax and net interest assessed and paid with regard to them. The IRS may in the future challenge and disallow more of PMCCs leveraged leases based on Revenue Rulings, an IRS Notice and subsequent case law addressing specific types of leveraged leases (lease-in/lease-out (LILO) and sale-in/lease-out (SILO) transactions). PMCC believes that the position and supporting case law described in the RAR, Revenue Rulings and the IRS Notice are incorrectly applied to PMCCs transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRSs position. PMCC and ALG intend to vigorously defend against any challenges based on that position through litigation. In this regard, on October 16, 2006, PMCC filed a complaint in the U.S. District Court for the Southern District of New York to claim refunds for a portion of these tax payments and associated interest. However, should PMCCs position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and significantly lower its earnings to reflect the recalculation of the income from the affected leveraged leases, which could have a material effect on the earnings and cash flows of Altria Group, Inc. in a particular fiscal quarter or fiscal year. PMCC considered this matter in its adoption of FIN 48 and FASB Staff Position No. FAS 13-2.
Note 13. New Accounting Standard:
In September 2006, the FASB issued SFAS No. 157 Fair Value Measurements, which will be effective for financial statements issued for fiscal years beginning after November 15, 2007. This statement defines fair value, establishes a framework for measuring fair value and expands disclosures about fair value measurements. Altria Group, Inc. anticipates that the adoption of this statement will not have a material impact on its financial statements.
Note 14. Subsequent Event:
On November 1, 2007, Altria Group, Inc. announced that it entered into an agreement to acquire 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, for $2.9 billion in cash. The net cost of the acquisition, after deducting approximately $700 million in present value tax benefits arising from the terms of the transaction, is $2.2 billion. The transaction is expected to be completed by the end of 2007, subject to the necessary regulatory approvals.
-47-
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |
Description of the Company
Throughout Managements Discussion and Analysis of Financial Condition and Results of Operations, the term Altria Group, Inc. refers to the consolidated financial position, results of operations and cash flows of the Altria family of companies and the term ALG refers solely to the parent company. ALGs wholly-owned subsidiaries, Philip Morris USA Inc. (PM USA) and Philip Morris International Inc. (PMI), are engaged in the manufacture and sale of cigarettes and other tobacco products. The operations of PMI are organized and managed by geographic region. Philip Morris Capital Corporation (PMCC), another wholly-owned subsidiary, maintains a portfolio of leveraged and direct finance leases. In addition, ALG held a 28.6% economic and voting interest in SABMiller plc (SABMiller) at September 30, 2007. ALGs access to the operating cash flows of its subsidiaries consists of cash received from the payment of dividends and interest, and the repayment of amounts borrowed from ALG by its subsidiaries.
On August 29, 2007, the Board of Directors of Altria Group, Inc. announced its intention to pursue the spin-off of PMI to Altria Group, Inc.s stockholders. The Board of Directors anticipates that it will be in a position to finalize its decision and announce the precise timing of the spin-off at its regularly scheduled meeting on January 30, 2008. In addition to a final determination by the Board of Directors, the spin-off of PMI will be subject to the receipt of a favorable ruling from the U.S. Internal Revenue Service, the receipt of an opinion of tax counsel, the effectiveness of a registration statement with the U.S. Securities and Exchange Commission (SEC), as well as the execution of several inter-company agreements and the finalization of other matters. On September 27, 2007, PMI filed with the SEC a preliminary registration statement on Form 10 in preparation for its potential spin-off from Altria Group, Inc. In addition, Altria Group, Inc. submitted a private letter ruling request to the U.S. Internal Revenue Service.
Altria Group, Inc. has announced its intention to close its New York headquarters should the spin-off of PMI occur and to sell its headquarters building. The closure of this facility would result in future severance charges while its sale is anticipated to result in a gain.
Kraft Spin-Off
On March 30, 2007 (the Distribution Date), Altria Group, Inc. distributed all of its remaining interest (88.9%) in Kraft Foods Inc. (Kraft) on a pro rata basis to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 (the Record Date) in a tax-free distribution. The distribution ratio was 0.692024 of a share of Kraft for each share of Altria Group, Inc. common stock outstanding. Altria Group, Inc. stockholders received cash in lieu of fractional shares of Kraft. Following the distribution, Altria Group, Inc. does not own any shares of Kraft. During the second quarter of 2007, Altria Group, Inc. adjusted its quarterly dividend to $0.69 per share, so that its stockholders who retained their Altria Group, Inc. and Kraft shares would receive, in the aggregate, the same dividend rate as before the distribution. In August 2007, Altria Group, Inc. increased its quarterly dividend to $0.75 per share.
Holders of Altria Group, Inc. stock options were treated similarly to public stockholders and accordingly, had their stock awards split into two instruments. Holders of Altria Group, Inc. stock options received the following stock options, which, immediately after the spin-off, had an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:
| a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Distribution Date and (b) the distribution ratio of 0.692024 mentioned above; and |
-48-
| an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price. |
The new Kraft option has an exercise price equal to the Kraft market price at the time of the distribution ($31.66) multiplied by the Option Conversion Ratio, which represents the exercise price of the original Altria Group, Inc. option divided by the Altria Group, Inc. market price immediately before the distribution ($87.81). The reduced exercise price of the adjusted Altria Group, Inc. option is determined by multiplying the Altria Group, Inc. market price immediately following the distribution ($65.90) by the Option Conversion Ratio.
Holders of Altria Group, Inc. restricted stock or stock rights awarded prior to January 31, 2007, retained their existing award and received restricted stock or stock rights of Kraft Class A common stock. The amount of Kraft restricted stock or stock rights awarded to such holders was calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and stock rights will vest at the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. stock rights awarded on January 31, 2007, did not receive restricted stock or stock rights of Kraft. Rather, they received additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
To the extent that employees of the remaining Altria Group, Inc. received Kraft stock options, Altria Group, Inc. reimbursed Kraft in cash for the Black-Scholes fair value of the stock options received. To the extent that Kraft employees held Altria Group, Inc. stock options, Kraft reimbursed Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. stock rights received Kraft stock rights, Altria Group, Inc. paid to Kraft the fair value of the Kraft stock rights less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at the Distribution Date, the net amount of these reimbursements resulted in a payment of $179 million from Kraft to Altria Group, Inc. in April 2007. The reimbursement from Kraft is reflected as an increase to the additional paid-in capital of Altria Group, Inc. on the September 30, 2007 condensed consolidated balance sheet.
Kraft was previously included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies were recorded as liabilities on the balance sheet of ALG. As part of the intercompany account settlement discussed below, ALG reimbursed Kraft in cash for these liabilities, which as of March 30, 2007, were approximately $305 million, plus pre-tax interest of $63 million ($41 million after taxes). ALG also reimbursed Kraft in cash for the federal income tax consequences of the adoption of Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income Taxes an interpretation of FASB Statement No. 109 (FIN 48) (approximately $70 million plus pre-tax interest of $14 million, $9 million after taxes). See Note 12. Income Taxes for a discussion of the FIN 48 adoption and the Tax Sharing Agreement between Altria Group, Inc. and Kraft.
A subsidiary of ALG previously provided Kraft with certain services at cost plus a 5% management fee. After the Distribution Date, Kraft undertook these activities, and any remaining limited services provided to Kraft will cease in 2007. All intercompany accounts were settled in cash within 30 days of the Distribution Date. The settlement of the intercompany accounts (including the amounts discussed above related to stock awards and tax contingencies) resulted in a net payment from Kraft to ALG of $85 million in April 2007.
The distribution resulted in a net decrease to Altria Group, Inc.s stockholders equity of $27.4 billion on the Distribution Date.
Altria Group, Inc. has reflected the results of Kraft prior to the Distribution Date as discontinued operations on the condensed consolidated statements of earnings and the condensed consolidated statements of cash flows. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the condensed consolidated balance sheet at December 31, 2006.
-49-
Other
Beginning with the second quarter of 2007, Altria Group, Inc. revised its reportable segments to reflect PMIs operations by geographic region. Altria Group, Inc.s revised segments are U.S. tobacco; European Union; Eastern Europe, Middle East and Africa; Asia; Latin America; and Financial Services. Accordingly, prior period segment results have been revised.
Executive Summary
The following executive summary is intended to provide significant highlights of the Discussion and Analysis that follows.
Consolidated Operating Results for the Nine Months Ended September 30, 2007 The changes in Altria Group, Inc.s earnings from continuing operations and diluted earnings per share (EPS) from continuing operations for the nine months ended September 30, 2007, from the nine months ended September 30, 2006, were due primarily to the following (in millions, except per share data):
Earnings from Continuing Operations |
Diluted EPS from Continuing Operations |
|||||||
For the nine months ended September 30, 2006 |
$ | 6,923 | $ | 3.29 | ||||
2006 Italian antitrust charge |
61 | 0.03 | ||||||
2006 Asset impairment and exit costs |
80 | 0.04 | ||||||
2006 Interest on tax reserve transfers to Kraft |
29 | 0.01 | ||||||
2006 Tax items |
(631 | ) | (0.30 | ) | ||||
2006 Provision for airline industry exposure |
66 | 0.03 | ||||||
Subtotal 2006 items |
(395 | ) | (0.19 | ) | ||||
2007 Asset impairment, exit and implementation costs |
(367 | ) | (0.17 | ) | ||||
2007 Recoveries from airline industry exposure |
137 | 0.06 | ||||||
2007 Interest on tax reserve transfers to Kraft |
(50 | ) | (0.02 | ) | ||||
2007 Tax items |
97 | 0.05 | ||||||
Subtotal 2007 items |
(183 | ) | (0.08 | ) | ||||
Currency |
212 | 0.10 | ||||||
Change in tax rate |
63 | 0.03 | ||||||
Higher shares outstanding |
| (0.02 | ) | |||||
Operations |
353 | 0.17 | ||||||
For the nine months ended September 30, 2007 |
$ | 6,973 | $ | 3.30 | ||||
Adjusted for the 2006 and 2007 items listed above, diluted EPS for the nine months ended September 30, 2007 of $3.38 increased 9.0% from $3.10 in 2006 and earnings from continuing operations for the nine months ended September 30, 2007 of $7,156 million increased 9.6% from $6,528 million in 2006.
See discussion of events affecting the comparability of statement of earnings amounts in the Consolidated Operating Results section of the following Discussion and Analysis.
Asset Impairment, Exit and Implementation Costs In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMIs decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. From 2007 through 2011, PM USA expects to incur total pre-tax asset impairment, exit and implementation charges of
-50-
approximately $670 million for the program, including $340 million incurred through September 30, 2007 ($218 million after taxes). During the first nine months of 2007 and 2006, PMI recorded pre-tax asset impairment and exit costs of $153 million ($111 million after taxes) and $88 million ($57 million after taxes), respectively. In addition, during the first nine months of 2007 and 2006, pre-tax asset impairment and exit costs of $64 million ($38 million after taxes) and $35 million ($23 million after taxes), respectively, were recorded for general corporate purposes. For further details, see Note 2 to the Condensed Consolidated Financial Statements and the Tobacco Business Environment section of the following Discussion and Analysis.
Italian Antitrust Charge During the first quarter of 2006, PMI recorded a $61 million charge related to an Italian antitrust action.
Recoveries/Provision from/for Airline Industry Exposure During the nine months ended September 30, 2007, PMCC recorded a pre-tax gain of $214 million ($137 million after taxes) on the sale of its ownership interests and bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down. During the second quarter of 2006, PMCC increased its allowance for losses by $103 million ($66 million after taxes), due to continuing issues within the airline industry.
Currency The favorable currency impact is due primarily to the weakness of the U.S. dollar versus the euro, Russian ruble and the Turkish lira, partially offset by the strength of the U.S. dollar versus the Japanese yen.
Income Taxes Altria Group, Inc.s income tax rate increased 5.0 percentage points to 32.3%. The 2007 tax rate includes favorable tax adjustments of $97 million, due primarily to the reversal of tax reserves no longer required and a reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany. The 2006 tax rate includes $631 million of non-cash tax benefits, principally representing the reversal of tax reserves after the U.S. Internal Revenue Service (IRS) concluded its examination of Altria Group, Inc.s consolidated tax returns for the years 1996 through 1999 in the first quarter of 2006.
Interest on Tax Reserve Transfers to Kraft As further discussed in Note 1. Basis of Presentation and Kraft Spin-Off, and Note 12. Income Taxes, the interest on tax reserves transferred to Kraft is related to the spin-off and the adoption of FIN 48 in 2007 and the conclusion of an IRS audit in 2006.
Shares Outstanding Higher shares outstanding during the nine months ended September 30, 2007, primarily reflects exercises of employee stock options (which become outstanding when exercised) and the incremental share impact of stock options outstanding.
Continuing Operations The increase in earnings from continuing operations was due primarily to the following:
| Higher Eastern Europe, Middle East and Africa income, reflecting higher pricing and higher volume/mix, partially offset by higher marketing, administration and research costs; |
| Higher European Union income, reflecting higher pricing and lower marketing, administration and research costs, partially offset by lower volume/mix; and |
| Higher U.S. tobacco income, reflecting lower marketing, administration and research costs, and lower wholesale promotional allowance rates, partially offset by lower volume and higher ongoing resolution costs; |
partially offset by:
| Lower financial services income (after excluding the impact of the recoveries/provision from/for airline industry exposure), reflecting lower gains from asset management activity and lower lease revenues. |
-51-
Consolidated Operating Results for the Three Months Ended September 30, 2007 The changes in Altria Group, Inc.s earnings from continuing operations and diluted EPS from continuing operations for the three months ended September 30, 2007, from the three months ended September 30, 2006, were due primarily to the following (in millions, except per share data):
Earnings from Continuing Operations |
Diluted EPS from Continuing Operations |
|||||||
For the three months ended September 30, 2006 |
$ | 2,214 | $ | 1.05 | ||||
2006 Asset impairment and exit costs |
43 | 0.02 | ||||||
2007 Asset impairment, exit and implementation costs |
(26 | ) | (0.02 | ) | ||||
2007 Recoveries from airline industry exposure |
4 | |||||||
2007 Tax items |
97 | 0.05 | ||||||
Subtotal 2007 items |
75 | 0.03 | ||||||
Currency |
91 | 0.04 | ||||||
Change in tax rate |
50 | 0.02 | ||||||
Operations |
160 | 0.08 | ||||||
For the three months ended September 30, 2007 |
$ | 2,633 | $ | 1.24 | ||||
Adjusted for the 2006 and 2007 items listed above, diluted EPS for the quarter ended September 30, 2007 of $1.21 increased 13.1% from $1.07 in 2006 and earnings from continuing operations for the quarter ended September 30, 2007 of $2,558 million increased 13.3% from $2,257 million in 2006.
See discussion of events affecting the comparability of statement of earnings amounts in the Consolidated Operating Results section of the following Discussion and Analysis.
Asset Impairment, Exit and Implementation Costs During the third quarter of 2007, PM USA recorded pre-tax asset impairment, exit and implementation charges of $22 million ($13 million after taxes) related to the announced closure of its Cabarrus, North Carolina manufacturing facility. During the third quarter of 2007 and 2006, PMI recorded pre-tax asset impairment and exit costs of $15 million ($11 million after taxes) and $65 million ($41 million after taxes), respectively. In addition, during the third quarter of 2007 and 2006, pre-tax asset impairment and exit costs of $3 million ($2 million after taxes) were recorded for general corporate purposes. For further details, see Note 2 to the Condensed Consolidated Financial Statements and the Tobacco Business Environment section of the following Discussion and Analysis.
Recoveries from Airline Industry Exposure During the third quarter of 2007, PMCC recorded a pre-tax gain of $7 million ($4 million after taxes) on the sale of bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down.
Currency The favorable currency impact is due primarily to the weakness of the U.S. dollar versus the euro, Turkish lira and Russian ruble, partially offset by the strength of the U.S. dollar versus the Japanese yen.
Income Taxes Altria Group, Inc.s income tax rate decreased 3.9 percentage points to 30.2%. The 2007 tax rate includes favorable tax adjustments of $97 million, due primarily to the reversal of tax reserves no longer required and a reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany.
Continuing Operations The increase in earnings from continuing operations was due primarily to the following:
-52-
| Higher Eastern Europe, Middle East and Africa income, reflecting higher pricing and higher volume/mix, partially offset by higher marketing, administration and research costs; |
| Higher Asia income, reflecting higher pricing and lower marketing, administration and research costs, partially offset by unfavorable volume/mix; |
| Higher European Union income, reflecting higher pricing and lower marketing, administration and research costs, partially offset by lower volume/mix; and |
| Higher U.S. tobacco income, reflecting lower wholesale promotional allowance rates, and lower marketing, administration and research costs, partially offset by higher ongoing resolution costs and lower volume; |
partially offset by:
| Lower financial services income (after excluding the impact of the recoveries from airline industry exposure), reflecting lower gains from asset management activity and lower lease revenues. |
For further details, see the Consolidated Operating Results and Operating Results by Business Segment sections of the following Discussion and Analysis.
2007 Forecasted Results On October 17, 2007, Altria Group, Inc. raised its forecast for reported 2007 full-year diluted earnings per share from continuing operations to a range of $4.20 to $4.25 versus its previously announced range of $4.05 to $4.10, reflecting a lower tax rate ($0.08 per share), favorable currency ($0.04 per share) and improved results at PMI ($0.03 per share). The revised forecast includes charges of $0.17 per share, which are $0.07 per share lower due mainly to the above-mentioned favorable tax items, versus $0.24 per share in charges in the previous forecast. Both the revised and previous forecasts include $0.06 per share for cash recoveries at PMCC, which were recorded in the first half of 2007. The forecast excludes Kraft, which is accounted for as a discontinued operation in 2007, reflecting the distribution of Kraft shares. The forecast also excludes the impact of the increased ownership interest in PMIs Mexican tobacco business and the recently announced acquisition of John Middleton, Inc. The factors described in the Cautionary Factors That May Affect Future Results section of the following Discussion and Analysis represent continuing risks to this forecast.
-53-
Discussion and Analysis
Consolidated Operating Results
See pages 82-86 for a discussion of Cautionary Factors That May Affect Future Results.
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, |
|||||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||||
(in millions) | ||||||||||||||||
Net revenues: |
||||||||||||||||
U.S. tobacco |
$ | 13,998 | $ | 13,938 | $ | 4,944 | $ | 4,830 | ||||||||
European Union |
20,253 | 18,248 | 6,832 | 6,458 | ||||||||||||
Eastern Europe, Middle East and Africa |
9,205 | 7,716 | 3,312 | 2,607 | ||||||||||||
Asia |
8,351 | 7,667 | 2,814 | 2,586 | ||||||||||||
Latin America |
3,639 | 3,183 | 1,274 | 1,052 | ||||||||||||
Total International tobacco |
41,448 | 36,814 | 14,232 | 12,703 | ||||||||||||
Financial Services |
126 | 272 | 31 | 109 | ||||||||||||
Net revenues |
$ | 55,572 | $ | 51,024 | $ | 19,207 | $ | 17,642 | ||||||||
Operating income: |
||||||||||||||||
Operating companies income: |
||||||||||||||||
U.S. tobacco |
$ | 3,429 | $ | 3,687 | $ | 1,295 | $ | 1,270 | ||||||||
European Union |
3,256 | 2,735 | 1,151 | 955 | ||||||||||||
Eastern Europe, Middle East and Africa |
1,911 | 1,639 | 710 | 582 | ||||||||||||
Asia |
1,412 | 1,456 | 514 | 449 | ||||||||||||
Latin America |
333 | 395 | 143 | 133 | ||||||||||||
Total International tobacco |
6,912 | 6,225 | 2,518 | 2,119 | ||||||||||||
Financial Services |
332 | 138 | 33 | 101 | ||||||||||||
Amortization of intangibles |
(18 | ) | (17 | ) | (6 | ) | (6 | ) | ||||||||
General corporate expenses |
(456 | ) | (390 | ) | (135 | ) | (128 | ) | ||||||||
Operating income |
$ | 10,199 | $ | 9,643 | $ | 3,705 | $ | 3,356 | ||||||||
As discussed in Note 10. Segment Reporting, management reviews operating companies income, which is defined as operating income before general corporate expenses and amortization of intangibles, to evaluate segment performance and allocate resources. Management believes it is appropriate to disclose this measure to help investors analyze the business performance and trends of the various business segments.
The following events that occurred during the nine months ended September 30, 2007 and 2006, affected the comparability of statement of earnings amounts.
| Income Taxes The IRS concluded its examination of Altria Group, Inc.s consolidated tax returns for the years 1996 through 1999, and issued a final Revenue Agents Report (RAR) on March 15, 2006. Consequently, in March 2006, Altria Group, Inc. recorded non-cash tax benefits of approximately $1.0 billion, which principally represented the reversal of tax reserves following the issuance of and agreement with the RAR. Altria Group, Inc. reimbursed $337 million in cash to Kraft for its portion of the $1.0 billion in tax benefits, as well as pre-tax interest of $46 million. The amounts related to Kraft were reclassified to |
-54-
income from discontinued operations. The tax reversal resulted in an increase to earnings from continuing operations of $631 million for the first quarter of 2006. During 2007, Altria Group, Inc.s tax rate includes favorable tax adjustments of $97 million, due primarily to the reversal of tax reserves no longer required and a reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany.
| Italian Antitrust Charge During the first quarter of 2006, PMI recorded a $61 million charge related to an Italian antitrust action. This charge was included in the operating companies income of the European Union segment. |
| Asset Impairment and Exit Costs For the nine months and three months ended September 30, 2007 and 2006, pre-tax asset impairment and exit costs consisted of the following: |
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, | |||||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||||
(in millions) | ||||||||||||||
Separation program |
U.S. tobacco | $ | 293 | $ | | $ | 10 | $ | | |||||
Separation program |
European Union | 101 | 78 | 13 | 56 | |||||||||
Separation program |
Eastern Europe, |
12 | ||||||||||||
Separation program |
Asia | 22 | 7 | 2 | 6 | |||||||||
Separation program |
Latin America | 18 | ||||||||||||
Separation program |
General corporate | 17 | 33 | 3 | ||||||||||
Total separation programs |
463 | 118 | 25 | 65 | ||||||||||
Asset impairment |
U.S. tobacco | 35 | ||||||||||||
Asset impairment |
European Union | 3 | 3 | |||||||||||
Asset impairment |
General corporate | 2 | ||||||||||||
Total asset impairments |
35 | 5 | 3 | |||||||||||
Spin-off fees |
General corporate | 47 | 3 | |||||||||||
Asset impairment and exit costs |
$ | 545 | $ | 123 | $ | 28 | $ | 68 | ||||||
Manufacturing Optimization Program
In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMIs decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. PMI is expected to shift sourcing of approximately 57 billion cigarettes from U.S. manufacturing to PMI facilities in Europe by the third quarter of 2008 and PM USA will close its Cabarrus manufacturing facility by the end of 2010.
As a result of this program, from 2007 through 2011, PM USA expects to incur total pre-tax charges of approximately $670 million, comprised of accelerated depreciation of $143 million (including the above mentioned asset impairment charge of $35 million recorded for the nine months ended September 30, 2007), employee separation costs of $353 million and other charges of $174 million, primarily related to the relocation of employees and equipment, net of estimated gains on sales of land and buildings. Approximately $440 million, or 66% of the total pre-tax charges, will result in cash expenditures. PM USA
-55-
recorded an initial pre-tax asset impairment and exit cost charge for the program of $318 million or $0.10 per diluted share in the second quarter of 2007 related primarily to employee separation programs. During the third quarter of 2007, PM USA recorded pre-tax asset impairment and exit cost charges for the program of $10 million related to employee separation programs. In addition, during the third quarter of 2007, PM USA incurred $12 million of pre-tax implementation costs associated with the program. These costs were primarily related to accelerated depreciation and were reflected as cost of sales on the condensed consolidated statements of earnings. Additional charges of approximately $35 million are expected during the remainder of 2007.
Philip Morris International Asset Impairment and Exit Costs
During 2005, 2006 and 2007, PMI announced plans for the streamlining of various administrative functions and operations. These plans resulted in the announced closure or partial closure of 9 production facilities through September 30, 2007. As a result of these announcements, PMI recorded pre-tax charges of $153 million and $15 million during the nine months and three months ended September 30, 2007, respectively, and $88 million and $65 million during the nine months and three months ended September 30, 2006, respectively. These pre-tax charges primarily related to severance costs. Additional pre-tax charges of approximately $47 million are expected during the remainder of 2007. The 2006 third quarter charges included $51 million of costs related to PMIs Munich factory closure.
Cash payments related to exit costs at PMI were $89 million and $16 million for the nine months and three months ended September 30, 2007, respectively. Future cash payments for exit costs incurred to date are expected to be approximately $170 million.
The streamlining of these various functions and operations is expected to result in the elimination of approximately 2,400 positions. As of September 30, 2007, approximately 1,800 of these positions have been eliminated.
Corporate Asset Impairment and Exit Costs
General corporate charges primarily related to investment banking fees associated with the Kraft spin-off in 2007 and charges related to the streamlining of various corporate functions in 2007 and 2006.
| Recoveries/Provision from/for Airline Industry Exposure During the nine months and three months ended September 30, 2007, PMCC recorded pre-tax gains of $214 million and $7 million, respectively, on the sale of its ownership interests and bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down. During the second quarter of 2006, PMCC increased its allowance for losses by $103 million, due to continuing issues within the airline industry. |
| Discontinued Operations As more fully discussed in Note 1. Basis of Presentation and Kraft Spin-Off, and Note 7. Divestitures, on March 30, 2007, Altria Group, Inc. distributed all of its remaining interest in Kraft on a pro-rata basis to Altria Group, Inc. stockholders in a tax-free distribution. Altria Group, Inc. has reflected the results of Kraft prior to the distribution date as discontinued operations on the condensed consolidated statements of earnings and the condensed consolidated statements of cash flows. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the condensed consolidated balance sheet at December 31, 2006. |
Consolidated Results of Operations for the Nine Months Ended September 30, 2007
The following discussion compares consolidated operating results for the nine months ended September 30, 2007, with the nine months ended September 30, 2006.
-56-
Net revenues, which include excise taxes billed to customers, increased $4.5 billion (8.9%). Excluding excise taxes, net revenues increased $1.4 billion (5.3%), due primarily to the favorable impact of currency and higher revenues from the Eastern Europe, Middle East and Africa segment, the U.S. tobacco segment, the Latin America segment and the European Union segment, and the impact of the 2007 acquisition in Pakistan, partially offset by lower revenues from the financial services segment.
Operating income increased $556 million (5.8%), due primarily to higher operating results from the Eastern Europe, Middle East and Africa segment, the European Union segment and the U.S. tobacco segment; an increase at PMCC due to cash recoveries in 2007 from assets which had previously been written down versus a provision in 2006 for its airline industry exposure; the favorable impact of currency; and the 2006 Italian antitrust charge. These items were partially offset by higher charges for asset impairment, exit and implementation costs.
Currency movements increased net revenues by $2,369 million ($806 million, after excluding the impact of currency movements on excise taxes) and operating income by $321 million. These increases were due primarily to the weakness versus prior year of the U.S. dollar against the euro, Russian ruble and the Turkish lira, partially offset by the strength of the U.S. dollar against the Japanese yen.
Interest and other debt expense, net, of $187 million decreased $138 million, due primarily to lower debt levels, partially offset by higher interest on tax reserve transfers to Kraft.
Altria Group, Inc.s income tax rate increased 5.0 percentage points to 32.3%. The 2007 tax rate includes favorable tax adjustments of $97 million, due primarily to the reversal of tax reserves no longer required and a reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany. The 2006 tax rate includes $631 million of non-cash tax benefits, principally representing the reversal of tax reserves after the U.S. IRS concluded its examination of Altria Group, Inc.s consolidated tax returns for the years 1996 through 1999 in the first quarter of 2006.
Equity earnings and minority interest, net, was $195 million for the nine months ended September 30, 2007, compared with $145 million for the nine months ended September 30, 2006. The change primarily reflected higher equity earnings from SABMiller.
Earnings from continuing operations of $7.0 billion increased $50 million (0.7%), due primarily to higher operating income and lower interest and other debt expense, net, mostly offset by the reversal of tax reserves in 2006. Diluted EPS from continuing operations of $3.30 increased by 0.3%. Basic EPS from continuing operations of $3.32 was equal to the prior year.
Earnings from discontinued operations, net of income taxes and minority interest (which represent the results of Kraft prior to the spin-off), decreased $1.5 billion (70.8%).
Net earnings of $7.6 billion decreased $1.5 billion (16.2%). Diluted and basic EPS from net earnings of $3.59 and $3.62, respectively, decreased by 16.7% and 16.6%, respectively.
Consolidated Results of Operations for the Three Months Ended September 30, 2007
The following discussion compares consolidated operating results for the three months ended September 30, 2007, with the three months ended September 30, 2006.
Net revenues, which include excise taxes billed to customers, increased $1.6 billion (8.9%). Excluding excise taxes, net revenues increased $551 million (5.9%), due primarily to the favorable impact of currency, higher revenues from the U.S. tobacco segment and the Eastern Europe, Middle East and Africa segment, and the impact of the 2007 acquisition in Pakistan.
-57-
Operating income increased $349 million (10.4%), due primarily to higher operating results from the Eastern Europe, Middle East and Africa segment, the Asia segment, the European Union segment and the U.S. tobacco segment, and the favorable impact of currency, partially offset by lower operating results from the financial services segment.
Currency movements increased net revenues by $861 million ($258 million, after excluding the impact of currency movements on excise taxes) and operating income by $138 million. These increases were due primarily to the weakness versus prior year of the U.S. dollar against the euro, Turkish lira and Russian ruble, partially offset by the strength of the U.S. dollar against the Japanese yen.
Interest and other debt expense, net, of $11 million decreased $48 million, due primarily to lower debt levels.
Altria Group, Inc.s income tax rate decreased 3.9 percentage points to 30.2%. The 2007 tax rate includes favorable tax adjustments of $97 million, due primarily to the reversal of tax reserves no longer required and a reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany.
Earnings from continuing operations of $2.6 billion increased $419 million (18.9%), due primarily to higher operating income and the favorable tax adjustments in 2007. Diluted and basic EPS from continuing operations of $1.24 and $1.25, respectively, increased by 18.1% and 17.9%, respectively.
Earnings from discontinued operations, net of income taxes and minority interest (which represent the results of Kraft prior to the spin-off), were $661 million for the third quarter of 2006.
Net earnings of $2.6 billion decreased $242 million (8.4%). Diluted and basic EPS from net earnings of $1.24 and $1.25, respectively, decreased by 8.8% and 9.4%, respectively.
Operating Results by Business Segment
Tobacco
Business Environment
Taxes, Legislation, Regulation and Other Matters Regarding Tobacco and Smoking
The tobacco industry, both in the United States and abroad, faces a number of challenges that may adversely affect the business, volume, results of operations, cash flows and financial position of PM USA, PMI and ALG. These challenges, which are discussed below and in the Cautionary Factors That May Affect Future Results section, include:
| pending and threatened litigation and bonding requirements as discussed in Note 11. Contingencies (Note 11); |
| competitive disadvantages related to price increases in the United States attributable to the settlement of certain tobacco litigation; |
| actual and proposed excise tax increases worldwide as well as changes in tax structures in foreign markets; |
| the sale of counterfeit cigarettes by third parties; |
| the sale of cigarettes by third parties over the Internet and by other means designed to avoid the collection of applicable taxes; |
| price gaps and changes in price gaps between premium and lowest price brands; |
-58-
| diversion into one market of products intended for sale in another; |
| the outcome of proceedings and investigations, and the potential assertion of claims, relating to contraband shipments of cigarettes; |
| governmental investigations; |
| actual and proposed requirements regarding the use and disclosure of cigarette ingredients and other proprietary information; |
| actual and proposed restrictions on imports in certain jurisdictions outside the United States; |
| actual and proposed restrictions affecting tobacco manufacturing, marketing, advertising and sales; |
| possible tobacco regulation and legislation in the United States that could put PMI at a competitive disadvantage; |
| governmental and private bans and restrictions on smoking; |
| the diminishing prevalence of smoking and increased efforts by tobacco control advocates to further restrict smoking; |
| governmental requirements setting ignition propensity standards for cigarettes; and |
| actual and proposed tobacco legislation and regulation both inside and outside the United States. |
In the ordinary course of business, PM USA and PMI are subject to many influences that can impact the timing of sales to customers, including the timing of holidays and other annual or special events, the timing of promotions, customer incentive programs and customer inventory programs, as well as the actual or speculated timing of pricing actions and tax-driven price increases.
Excise Taxes: Cigarettes are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in cigarette-related taxes or fees have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the Member States of the European Union (the EU) and in other foreign jurisdictions. Legislation has been passed by the United States Congress that would increase the federal excise tax on cigarettes by $0.61 a pack. The President has stated his intention to veto this legislation. It is not possible to predict whether such legislation will become law. In addition, in certain jurisdictions, PMIs products are subject to tax structures that discriminate against premium priced products and manufactured cigarettes and to inconsistent rulings and interpretations on complex methodologies to determine excise and other tax burdens.
Tax increases and discriminatory tax structures are expected to continue to have an adverse impact on sales of cigarettes by PM USA and PMI, due to lower consumption levels and to a shift in consumer purchases from the premium to the non-premium or discount segments or to other low-priced or low-taxed tobacco products or to counterfeit and contraband products.
Minimum Retail Selling Price Laws: Several EU Member States have enacted laws establishing a minimum retail selling price for cigarettes and, in some cases, other tobacco products. The European Commission has commenced infringement proceedings against these Member States, claiming that minimum retail selling price systems infringe EU law. In March 2007, the European Commission announced that it was bringing an action against France in the European Court of Justice on the ground that Frances minimum retail selling price system infringes EU law. On July 2, 2007, the European Commission announced that it has formally called upon Austria, Ireland and Italy to amend their legislation setting minimum retail selling prices for cigarettes. The
-59-
announcement further stated that if these Member States do not respond satisfactorily to this request within two months of the announcement, the Commission may refer the matters to the European Court of Justice. If the European Commissions actions are successful, they could adversely impact excise tax levels and/or price gaps in those markets.
Tar and Nicotine Test Methods and Brand Descriptors: A number of governments and public health organizations throughout the world have determined that the existing standardized machine-based methods for measuring tar and nicotine yields do not provide useful information about tar and nicotine deliveries and that such results are misleading to smokers. For example, in the 2001 publication of Monograph 13, the U.S. National Cancer Institute (NCI) concluded that measurements based on the Federal Trade Commission (FTC) standardized method do not offer smokers meaningful information on the amount of tar and nicotine they will receive from a cigarette or on the relative amounts of tar and nicotine exposure likely to be received from smoking different brands of cigarettes. Thereafter, the FTC issued a press release indicating that it would be working with the NCI to determine what changes should be made to its testing method to correct the limitations identified in Monograph 13. In 2002, PM USA petitioned the FTC to promulgate new rules governing the use of existing standardized machine-based methodologies for measuring tar and nicotine yields and descriptors. That petition remains pending. In addition, the World Health Organization (WHO) has concluded that these standardized measurements are seriously flawed and that measurements based upon the current standardized methodology are misleading and should not be displayed. The International Organization for Standardization (ISO) established a working group, chaired by the WHO, to propose a new measurement method that would more accurately reflect human smoking behavior.
PM USA and PMI have supported the concept of supplementing the ISO test method with a more intensive method, which PM USA and PMI believe would better illustrate the wide variability in the delivery of tar, nicotine and carbon monoxide, depending on how an individual smokes a cigarette. The working group has issued a final report proposing two alternative smoking methods. Currently, ISO is in the process of deciding whether to begin further development of the two methods or to wait for additional guidance from the Conference of the Parties. The working group has issued a final report proposing two alternative smoking methods. Currently, ISO is in the process of deciding whether to begin further development of the two methods or to wait for additional guidance from the Conference of the Parties, the governing body of the FCTC as described below.
In light of public health concerns about the limitations of current machine measurement methodologies, governments and public health organizations have increasingly challenged the use of descriptors such as light, mild, and low tar that are based on measurements produced by those methods. For example, the Scientific Advisory Committee of the WHO concluded that descriptors such as light, ultra-light, mild and low tar are misleading terms and should be banned. In 2003, the WHO proposed the Framework Convention on Tobacco Control (FCTC), a treaty that requires signatory nations to adopt and implement measures to ensure that descriptive terms do not create the false impression that a particular tobacco product is less harmful than other tobacco products. Such terms may include low tar, light, ultra-light, or mild. Many countries prohibit or are in the process of prohibiting descriptors such as lights. In most countries where descriptors are banned, tar, nicotine and carbon monoxide yields are still required to be printed on packs of cigarettes. PMI advocates that where descriptors are banned, governments should also prohibit the printing of tar, nicotine and carbon monoxide yields on packs of cigarettes. See Note 11, which describes pending litigation concerning the use of brand descriptors. As discussed in Note 11, in August 2006, a federal trial court entered judgment in favor of the United States government in its lawsuit against various cigarette manufacturers and others, including PM USA and ALG, and enjoined the defendants from using brand descriptors, such as lights, ultra-lights and low tar. In October 2006, the Court of Appeals stayed enforcement of the judgment pending its review of the trial courts decision.
Food and Drug Administration (FDA) Regulations: In February 2007, bipartisan legislation was introduced in the United States Senate and House of Representatives that, if enacted, would grant the FDA broad authority to regulate the design, manufacture and marketing of tobacco products and disclosures of related information. This legislation would also grant the FDA the authority to address counterfeit and contraband tobacco products
-60-
and would impose fees to pay for the cost of regulation and other matters. ALG and PM USA support this legislation. On August 1, 2007, the Senate Health, Education, Labor and Pensions Committee approved a revised version of this legislation. Whether Congress will grant the FDA broad authority over tobacco products, and the precise nature of that authority if granted, cannot be predicted.
Tobacco Quota Buy-Out: In October 2004, the Fair and Equitable Tobacco Reform Act of 2004 (FETRA) was signed into law. FETRA provides for the elimination of the federal tobacco quota and price support program through an industry-funded buy-out of tobacco growers and quota holders. The cost of the buy-out is approximately $9.5 billion and is being paid over 10 years by manufacturers and importers of each kind of tobacco product. The cost is being allocated based on the relative market shares of manufacturers and importers of each kind of tobacco product. The quota buy-out payments will offset already scheduled payments to the National Tobacco Grower Settlement Trust (the NTGST), a trust fund established in 1999 by four of the major domestic tobacco product manufacturers to provide aid to tobacco growers and quota holders. Manufacturers and importers of tobacco products are also obligated to cover any losses (up to $500 million) that the government may incur on the disposition of tobacco pool stock accumulated under the previous tobacco price support program. PM USA has paid $138 million for its share of the tobacco pool stock losses. For a discussion of the NTGST, see Note 11. Altria Group, Inc. does not anticipate that the quota buy-out will have a material adverse impact on its consolidated results in 2007 and beyond.
The WHOs Framework Convention on Tobacco Control (FCTC): The FCTC entered into force on February 27, 2005. As of August 2007, 148 countries, as well as the European Community, have become parties to the FCTC. The FCTC is the first international public health treaty and its objective is to establish a global agenda for tobacco regulation with the purpose of reducing initiation of tobacco use and encouraging cessation. The treaty recommends (and in certain instances, requires) signatory nations to enact legislation that would, among other things:
| establish specific actions to prevent youth smoking; |
| restrict and/or eliminate all tobacco product advertising, marketing, promotions and sponsorships; |
| initiate public education campaigns to inform the public about the health consequences of smoking and the benefits of quitting; |
| implement regulations imposing product testing, disclosure and performance standards; |
| impose package warning requirements; |
| adopt measures that would eliminate cigarette smuggling and counterfeit cigarettes; |
| restrict smoking in public places; |
| implement fiscal policies (tax and price increases); |
| adopt and implement measures that ensure that descriptive terms do not create the false impression that one brand of cigarettes is safer than another; |
| phase out duty-free tobacco sales; and |
| encourage litigation against tobacco product manufacturers. |
In addition, some of the proposals currently under consideration by the Conference of the Parties, the governing body of the FCTC, could have the potential to substantially restrict the ability of PM USA and PMI to manufacture and market their products. It is not possible to predict the outcome of regulations under consideration.
Ingredient Disclosure Laws: Jurisdictions inside and outside the United States have enacted or proposed legislation or regulations that would require cigarette manufacturers to disclose to the government and, in some instances, publicly the ingredients used in the manufacture of cigarettes and, in certain cases, to provide toxicological information. In some jurisdictions, governments have prohibited the use of certain ingredients, and proposals have been discussed to further prohibit or limit the use of ingredients. Under an EU tobacco product directive, tobacco companies are now required to disclose ingredients and toxicological information to each Member State. In implementing the EU tobacco product directive, the Netherlands has issued a decree that would require tobacco companies to disclose the ingredients used in each brand of cigarettes, including quantities used. PMI and other tobacco companies filed an action to contest this decree on the grounds of lack
-61-
of protection of proprietary information. In December 2005, the District Court of the Hague agreed with the tobacco companies that certain information required to be disclosed under the decree constitutes proprietary trade secrets. However, the court also held that the companies interests in protecting their trade secrets must be balanced against the publics right to information about the ingredients in tobacco products. The court therefore upheld the decree and instructed the government to weigh the publics interests against the companies interests, in implementing the ingredient disclosure requirements in the decree. In March 2006, PMI, the government and others appealed these decisions. Concurrently, while pursuing this appeal, PMI is discussing with the relevant authorities the appropriate implementation of the EU tobacco product directive in the Netherlands and throughout the EU.
Restrictions and Bans on the Use of Ingredients: Some governments have prohibited the use of certain ingredients and propose further prohibitions or limits. For example, the Conference of the Parties is considering guidelines providing detailed product regulation requirements that are likely to include standards for the use of tobacco product ingredients, including flavorings. PM USA and PMI support regulations requiring all manufacturers to determine that the use of ingredients does not increase the inherent toxicity in cigarette smoke.
Bans and Restrictions on Advertising, Marketing, Promotions and Sponsorships: For many years, countries have imposed partial or total bans on tobacco advertising, marketing and promotion. The FCTC calls for a comprehensive ban on advertising, promotion and sponsorship and requires governments that have no constitutional constraints to ban all forms of advertising. Where constitutional constraints exist, the FCTC requires governments to restrict or ban radio, television, print media, other media, including the internet, and sponsorships of international events within 5 years. The FCTC also requires disclosure of expenditures on advertising, promotion and sponsorship that are not prohibited. Some public health groups have called for bans of product displays and for generic packaging. PM USA and PMI oppose complete bans on advertising, but support limitations on marketing, provided that the limitations are within constitutional constraints and manufacturers are able to communicate appropriately with adult smokers.
Health Warning Requirements: Many countries require substantial health warnings on cigarette packs. In the EU, for example, health warnings cover 30% of the front and 40% of the back of cigarette packs. The FCTC requires health warnings that cover, at a minimum, 30% of the front and back of the pack. However, the treaty recommends warnings covering 50% of the front and back of the pack. PM USA and PMI support health warning requirements and defer to the governments on the content of the warnings. In countries where health warnings are not required, PMI places them on packaging voluntarily in the official language or languages of the country. For example, PMI is voluntarily placing health warnings in many African countries in official local languages and occupying 30% of the front and back of the pack. PM USA and PMI do not support warning sizes that deprive them of the ability to use their distinctive trademarks and pack designs which differentiate their products from those of their competitors.
Health Effects of Smoking and Exposure to Environmental Tobacco Smoke (ETS): Reports with respect to the health risks of cigarette smoking have been publicized for many years, including most recently in a June 2006 United States Surgeon General report on ETS entitled The Health Consequences of Involuntary Exposure to Tobacco Smoke. Many countries have restricted smoking in public places. The pace and scope of public smoking bans has increased significantly, particularly in the EU, where Italy, Ireland, the UK, France, Finland and Sweden have banned virtually all indoor public smoking. Other countries around the world have adopted or are likely to adopt substantial public smoking restrictions. Some public health groups have called for, and some municipalities have adopted or proposed, bans on smoking in outdoor places, and some tobacco control groups have advocated banning smoking in cars with minors in them. The FCTC requires parties to the treaty to adopt restrictions on public smoking, and the Conference of Parties has proposed guidelines on regulations which are based on the premise that any exposure to ETS is harmful and call for total bans in all indoor public places, defines indoor broadly, and rejects any exemptions based on type of venue (e.g., nightclubs). On private place smoking, such as cars and homes, the guidelines call for increased education on the risk of exposure to ETS.
It is not possible to predict the results of ongoing scientific research or the types of future scientific research into the health risks of tobacco exposure. Although most regulation of ETS exposure to date has been done at
-62-
the local level through bans in public establishments, the State of California is in the process of regulating ETS exposure in the ambient air at the state level. In January 2006, the California Air Resources Board (CARB) listed ETS as a toxic air contaminant under state law. CARB is now required to consider the adoption of appropriate control measures utilizing best available control technology in order to reduce public exposure to ETS in outdoor air to the lowest level achievable. In addition, in June 2006, the California Office of Environmental Health Hazard Assessment (OEHHA) listed ETS as a contaminant known to the State of California to cause reproductive toxicity. Consequently, under California Proposition 65, businesses employing 10 or more persons must post warning signs in certain areas stating that ETS is known to the State of California to be a reproductive toxicant.
It is the policy of PM USA and PMI to support a single, consistent public health message on the health effects of cigarette smoking in the development of diseases in smokers, smoking and addiction, and on exposure to ETS. It is also their policy to defer to the judgment of public health authorities as to the content of warnings in advertisements and on product packaging regarding the health effects of smoking, addiction and exposure to ETS.
PM USA and PMI each have established websites that include, among other things, the views of public health authorities on smoking, disease causation in smokers, addiction and ETS. These sites reflect PM USAs and PMIs agreement with the medical and scientific consensus that cigarette smoking is addictive, and causes lung cancer, heart disease, emphysema and other serious diseases in smokers. The websites advise smokers, and those considering smoking, to rely on the messages of public health authorities in making all smoking-related decisions. The website addresses are www.philipmorrisusa.com and www.philipmorrisinternational.com. The information on PM USAs and PMIs websites is not, and shall not be deemed to be, a part of this document or incorporated into any filings ALG makes with the Securities and Exchange Commission.
Testing and Reporting of Other Smoke Constituents: In addition to tar, nicotine and carbon monoxide, public health authorities have classified between 45 and 70 other smoke constituents as potential causes of tobacco-related diseases. Several countries require manufacturers to provide by-brand yields of these constituents. The FCTC requires signatory nations to adopt and implement guidelines for testing and measuring the contents and emissions of tobacco products. PM USA and PMI measure most of these constituents for their product research and development purposes, and support such regulation. However, the capacity to conduct by-brand testing on a global basis does not exist today, and the cost of by-brand annual testing would be significant.
Ceilings on Tar, Nicotine, Carbon Monoxide and Other Smoke Constituents: A number of countries and the EU have established maximum yields of tar, nicotine and/or carbon monoxide, as measured by the ISO standard test method. As discussed above, public health authorities have questioned whether reducing machine-measured tar, nicotine and carbon monoxide yields results in meaningful reductions in risk. Further, some public health groups have questioned the appropriateness of imposing nicotine ceilings per cigarette.
To date, no country has adopted ceilings for other smoke constituents. However, in June 2007, the panel advising the Conference of the Parties issued a report that recommends limiting specific smoke constituents. The advisory panel stated that ceilings do not have to be based on proof of benefit, but only on a showing that the substance be known to be harmful and that processes exist for its diminution or removal. The advisory panel proposed ceilings on tobacco specific nitrosamines, or TSNA, smoke constituents unique to tobacco, based on data showing that there is a wide variation in TSNA yields across brands. The advisory panel stated that the levels of the TSNAs are higher in air-cured/processed Burley tobacco than in flue-cured bright tobacco and that levels of TSNAs are much lower in markets where the predominant brands are Virginia cigarettes, such as Australia and Canada, as opposed to markets, such as the EU, where American blended cigarettes are predominantly sold. The recommended ceilings are the lower of the median values for a sample of international brands or the median for the brands for the country implementing the regulation. It is not possible to predict whether or when this recommendation will be endorsed by the Conference of the Parties and implemented by governments.
-63-
Reduced Cigarette Ignition Propensity Legislation: Legislation or regulation requiring cigarettes to meet reduced ignition propensity standards is being considered in many states, at the federal and local levels and in jurisdictions outside the United States. New York State implemented ignition propensity standards in June 2004. To date, the same standards have been enacted by twenty-one other states, effective as follows: Vermont (May 2006), California (January 2007), Oregon (April 2007), New Hampshire (October 2007), Illinois (January 2008), Maine (January 2008), Massachusetts (January 2008), Kentucky (April 2008), Montana (May 2008), Alaska (August 2008), New Jersey (June 2008), Maryland (July 2008), Utah (July 2008), Connecticut (July 2008), Rhode Island (August 2008), Delaware (January 2009), Iowa (January 2009), Minnesota (January 2009), Texas (January 2009), Louisiana (August 2009) and North Carolina (January 2010). Similar legislation has been enacted in Canada and is being considered in several other countries, notably Australia and several Member States of the EU. The European Commission expects to propose ignition propensity standards in the fall of 2007. PM USA supports the enactment of federal legislation mandating a uniform and technically feasible national standard for reduced ignition propensity cigarettes that would preempt state standards and apply to all cigarettes sold in the United States. Similarly, PMI believes that reduced ignition propensity standards should be uniform, technically feasible, and applied to all manufacturers.
Illicit Trade: Regulatory measures and related governmental actions to prevent the illicit manufacture and trade of tobacco products are being considered by a number of jurisdictions. Article 15 of the FCTC requires parties to the treaty to take steps to eliminate all forms of illicit trade, including counterfeiting, and states that national, regional and global agreements on this issue are essential components of tobacco control. The Conference of the Parties has announced that it is working on a protocol on illicit trade to be negotiated in 2008 and proposed in 2009. According to a draft template, topics that the protocol will address include:
| licensing schemes for participants in the tobacco business, measures to eliminate money laundering and the development of an international system that enables the tracking and tracing of tobacco products; |
| the implementation of laws governing record keeping and internet sales of tobacco products; |
| the criminalization of participation in illicit trade in various forms; |
| obligations for tobacco manufacturers to control their supply chain with penalties for those that fail to do so; |
| programs to increase the capacity of law enforcement bodies; and |
| programs to increase cooperation and technical assistance with respect to investigation and prosecutions and the sharing of information. |
PM USA and PMI support strict regulations and enforcement measures to prevent all forms of illicit trade in tobacco products. They agree that manufacturers should implement monitoring systems of their sales and distribution practices, and that where appropriately confirmed, manufacturers should stop supplying vendors who have knowingly engaged in illicit trade. For example, PM USA is engaged in a number of initiatives to help prevent contraband trade in cigarettes, including: enforcement of PM USA wholesale and retail trade policies on trade in contraband cigarettes and Internet/remote sales; engagement with and support of law enforcement and regulatory agencies; litigation to protect the Companys trademarks; and support for federal and state legislation. PM USAs legislative initiatives to address contraband trade in cigarettes are designed to better control and protect the legitimate channels of distribution, impose more stringent penalties for the violation of laws and provide additional tools for law enforcement.
PMI Cooperation Agreements to Combat Illicit Trade of Cigarettes: PMI has entered into agreements with several governments to combat the illicit trade of cigarettes and may continue to do so. In July 2004, PMI entered into an agreement with the European Commission (acting on behalf of the European Community) and 10 Member States of the EU that provides for broad cooperation with European law enforcement agencies on
-64-
anti-contraband and anti-counterfeit efforts. To date, 26 of the 27 Member States have signed the agreement. The agreement resolves all disputes between the European Community and the Member States that signed the agreement, on the one hand, and PMI and certain affiliates, on the other hand, relating to these issues. Under the terms of the agreement, PMI will make 13 payments over 12 years. In the second quarter of 2004, PMI recorded a pre-tax charge of $250 million for the initial payment. The agreement calls for payments of approximately $150 million on the first anniversary of the agreement (this payment was made in July 2005), approximately $100 million on the second anniversary (this payment was made in July 2006), and approximately $75 million each year thereafter for 10 years, each of which is to be adjusted based on certain variables, including PMIs market share in the EU in the year preceding payment. PMI will record these payments as an expense in cost of sales when product is shipped. PMI is also responsible to pay the excise taxes, VAT and customs duties on qualifying product seizures of up to 90 million cigarettes and is subject to payments of five times the applicable taxes and duties if product seizures exceed 90 million cigarettes in a given year. To date, PMIs payments related to product seizures have been immaterial.
State Settlement Agreements: As discussed in Note 11, during 1997 and 1998, PM USA and other major domestic tobacco product manufacturers entered into agreements with states and various United States jurisdictions settling asserted and unasserted health care cost recovery and other claims. These settlements require PM USA to make substantial annual payments. The settlements also place numerous restrictions on PM USAs business operations, including prohibitions and restrictions on the advertising and marketing of cigarettes. Among these are prohibitions of outdoor and transit brand advertising; payments for product placement; and free sampling (except in adult-only facilities). Restrictions are also placed on the use of brand name sponsorships and brand name non-tobacco products. The State Settlement Agreements also place prohibitions on targeting youth and the use of cartoon characters. In addition, the State Settlement Agreements require companies to affirm corporate principles directed at reducing underage use of cigarettes; impose requirements regarding lobbying activities; mandate public disclosure of certain industry documents; limit the industrys ability to challenge certain tobacco control and underage use laws; and provide for the dissolution of certain tobacco-related organizations and place restrictions on the establishment of any replacement organizations.
Other Legislation or Governmental Initiatives: Legislative and regulatory initiatives affecting the tobacco industry have been adopted or are being considered in a number of countries and jurisdictions. In 2001, the EU adopted a directive on tobacco product regulation requiring EU Member States to implement regulations that reduce maximum permitted levels of tar, nicotine and carbon monoxide yields; require manufacturers to disclose ingredients and toxicological data; and require cigarette packs to carry health warnings covering no less than 30% of the front panel and no less than 40% of the back panel. The directive also gives Member States the option of introducing graphic warnings as of 2005; requires tar, nicotine and carbon monoxide data to cover at least 10% of the side panel; and prohibits the use of texts, names, trademarks and figurative or other signs suggesting that a particular tobacco product is less harmful than others. All 27 EU Member States have implemented the directive.
The European Commission has issued guidelines for optional graphic warnings on cigarette packaging that Member States may apply as of 2005. Graphic warning requirements have also been proposed or adopted in a number of other jurisdictions. In 2003, the EU adopted a directive prohibiting radio, press and Internet tobacco marketing and advertising, which has now been implemented in most EU Member States. Tobacco control legislation addressing the manufacture, marketing and sale of tobacco products has been proposed or adopted in numerous other jurisdictions.
In the United States in recent years, various members of federal and state governments have introduced legislation that would subject cigarettes to various regulations; restrict or eliminate the use of descriptors such as lights or ultra lights; establish educational campaigns relating to tobacco consumption or tobacco control programs, or provide additional funding for governmental tobacco control activities; further restrict the advertising of cigarettes; require additional warnings, including graphic warnings, on packages and in advertising; eliminate or reduce the tax deductibility of tobacco advertising; provide that the Federal Cigarette Labeling and Advertising Act and the Smoking Education Act not be used as a defense against liability under
-65-
state statutory or common law; and allow state and local governments to restrict the sale and distribution of cigarettes. In addition, legislation and regulation inside the United States could put PMI at a disadvantage vis a vis its international competitors.
It is not possible to predict what, if any, additional legislation, regulation or other governmental action will be enacted or implemented relating to the manufacturing, advertising, sale or use of cigarettes, or the tobacco industry generally. It is possible, however, that legislation, regulation or other governmental action could be enacted or implemented in the United States and in other countries and jurisdictions that might materially affect the business, volume, results of operations and cash flows of PM USA or PMI and ultimately their parent, ALG.
Governmental Investigations: From time to time, ALG and its subsidiaries are subject to governmental investigations on a range of matters. In this regard, ALG believes that Canadian authorities are contemplating a legal proceeding based on an investigation of ALG entities relating to allegations of contraband shipments of cigarettes into Canada in the early to mid-1990s. ALG and its subsidiaries cannot predict the outcome of this investigation or whether additional investigations may be commenced.
Manufacturing Optimization Program
In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMIs decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. PMI is expected to shift sourcing of approximately 57 billion cigarettes from U.S. manufacturing to PMI facilities in Europe by the third quarter of 2008 and PM USA will close its Cabarrus, North Carolina manufacturing facility by the end of 2010.
As a result of this program, from 2007 through 2011, PM USA expects to incur total pre-tax charges of approximately $670 million, comprised of accelerated depreciation of $143 million, employee separation costs of $353 million and other charges of $174 million, primarily related to the relocation of employees and equipment, net of estimated gains on sales of land and buildings. Approximately $440 million, or 66% of the total pre-tax charges, will result in cash expenditures. PM USA recorded an initial pre-tax asset impairment and exit cost charge for the program of $318 million or $0.10 per diluted share in the second quarter of 2007 related primarily to employee separation programs. During the third quarter of 2007, PM USA recorded pre-tax asset impairment and exit cost charges for the program of $10 million related to employee separation programs. In addition, during the third quarter of 2007, PM USA incurred $12 million of pre-tax implementation costs associated with the program. These costs were primarily related to accelerated depreciation and were reflected as cost of sales on the condensed consolidated statements of earnings. Additional charges of approximately $35 million are expected during the remainder of 2007. In addition, the program will entail capital expenditures of approximately $230 million at PM USA and $50 million at PMI.
The program is expected to generate pre-tax cost savings beginning in 2008, with total estimated annual cost savings of approximately $335 million by 2011, of which $179 million will be realized by PMI and $156 million by PM USA.
Philip Morris International Asset Impairment and Exit Costs
During 2005, 2006 and 2007, PMI announced plans for the streamlining of various administrative functions and operations. These plans resulted in the announced closure or partial closure of 9 production facilities through September 30, 2007. As a result of these announcements, PMI recorded pre-tax charges of $153 million and $15 million during the nine months and three months ended September 30, 2007, respectively, and $88 million and $65 million during the nine months and three months ended September 30, 2006, respectively. These pre-tax charges primarily related to severance costs. Additional pre-tax charges of approximately $47 million are expected during the remainder of 2007. The 2006 third quarter charges included $51 million of costs related to PMIs Munich factory closure.
-66-
Cash payments related to exit costs at PMI were $89 million and $16 million for the nine months and three months ended September 30, 2007, respectively. Future cash payments for exit costs incurred to date are expected to be approximately $170 million.
The streamlining of these various functions and operations is expected to result in the elimination of approximately 2,400 positions. As of September 30, 2007, approximately 1,800 of these positions have been eliminated. These actions generated pre-tax cost savings beginning in 2005, with cumulative estimated annual cost savings of approximately $210 million expected by the end of 2007, of which $130 million are incremental savings in 2007.
Acquisitions
On November 1, 2007, Altria Group, Inc. announced that it entered into an agreement to acquire 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, for $2.9 billion in cash. The net cost of the acquisition, after deducting approximately $700 million in present value tax benefits arising from the terms of the transaction, is $2.2 billion. The transaction is expected to be completed by the end of 2007, subject to the necessary regulatory approvals. The acquisition, which will be financed with existing cash, is expected to be modestly accretive to Altrias 2008 earnings.
On July 18, 2007, PMI announced that it had reached an agreement in principle to acquire an additional 30% stake in its Mexican tobacco business from its joint venture partner, Grupo Carso, S.A.B. de C.V. (Grupo Carso). PMI currently holds a 50% stake in its Mexican tobacco business and this transaction would bring PMIs stake to 80%. Grupo Carso would retain a 20% stake in the business. The transaction has a value of approximately $1.1 billion and was completed on November 1, 2007. The transaction is expected to increase Altrias annualized net earnings by approximately $0.03 per share in 2008.
During the first quarter of 2007, PMI acquired an additional 50.2% stake in a Pakistan cigarette manufacturer, Lakson Tobacco Company Limited (Lakson Tobacco), and completed a mandatory tender offer for the remaining shares, which increased PMIs total ownership interest in Lakson Tobacco from 40% to approximately 98%, for $388 million. The effect of this acquisition was not material to Altria Group, Inc.s consolidated financial position, results of operations or operating cash flows in any of the periods presented.
Operating Results Nine Months Ended September 30, 2007
The following discussion compares tobacco operating results for the nine months ended September 30, 2007, with the nine months ended September 30, 2006.
For the Nine Months Ended September 30, | ||||||||||||
Net Revenues | Operating Companies Income | |||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||
(in millions) | ||||||||||||
U.S. tobacco |
$ | 13,998 | $ | 13,938 | $ | 3,429 | $ | 3,687 | ||||
European Union |
20,253 | 18,248 | 3,256 | 2,735 | ||||||||
Eastern Europe, Middle East and Africa |
9,205 | 7,716 | 1,911 | 1,639 | ||||||||
Asia |
8,351 | 7,667 | 1,412 | 1,456 | ||||||||
Latin America |
3,639 | 3,183 | 333 | 395 | ||||||||
Total tobacco |
$ | 55,446 | $ | 50,752 | $ | 10,341 | $ | 9,912 | ||||
U.S. tobacco. PM USAs net revenues, which include excise taxes billed to customers, increased $60 million (0.4%). Excluding excise taxes, net revenues increased $158 million (1.4%) to $11.4 billion, due primarily to
-67-
lower wholesale promotional allowance rates and higher list prices ($683 million), partially offset by lower volume ($533 million).
Operating companies income decreased $258 million (7.0%), due primarily to lower volume ($358 million) and the 2007 pre-tax charges for asset impairment, exit and implementation costs related to the announced closing of the Cabarrus, North Carolina cigarette manufacturing facility ($340 million), partially offset by lower marketing, administration and research costs ($278 million) and lower wholesale promotional allowance rates, net of higher ongoing resolution costs ($171 million).
PM USAs shipment volume was 133.3 billion units, a decrease of 3.5% or 4.8 billion units, reflecting an overall decline in industry volume. In the premium segment, PM USAs shipment volume decreased 3.1%. Marlboro shipment volume decreased 2.9 billion units (2.6%) to 110.1 billion units. In the discount segment, PM USAs shipment volume also decreased, with Basic shipment volume down 8.0% to 10.1 billion units.
The following table summarizes PM USAs cigarette volume performance by brand for the nine months ended September 30, 2007 and 2006:
For the Nine Months Ended September 30, | ||||
2007 | 2006 | |||
(in billion units) | ||||
Marlboro |
110.1 | 113.0 | ||
Parliament |
4.4 | 4.5 | ||
Virginia Slims |
5.4 | 5.7 | ||
Basic |
10.1 | 11.0 | ||
Focus on Four Brands |
130.0 | 134.2 | ||
Other |
3.3 | 3.9 | ||
Total PM USA |
133.3 | 138.1 | ||
The following table summarizes PM USAs retail share performance, based on data from the IRI/Capstone Total Retail Panel, which is a tracking service that uses a sample of stores to project market share performance in retail stores selling cigarettes. This panel was not designed to capture sales through other channels, including Internet and direct mail:
For the Nine Months Ended September 30, |
||||||
2007 | 2006 | |||||
Marlboro |
41.0 | % | 40.6 | % | ||
Parliament |
1.9 | 1.8 | ||||
Virginia Slims |
2.2 | 2.3 | ||||
Basic |
4.1 | 4.2 | ||||
Focus on Four Brands |
49.2 | 48.9 | ||||
Other |
1.3 | 1.5 | ||||
Total PM USA |
50.5 | % | 50.4 | % | ||
Effective December 18, 2006, PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $1.00 per carton, from $5.00 to $4.00, and increased the price of its other brands by $1.00 per carton. Effective February 12, 2007, PM USA increased the price of its other brands by $9.95 per thousand cigarettes or $1.99 per carton. Effective September 10, 2007, PM USA reduced its wholesale promotional allowances on Marlboro, Parliament and Basic by $0.50 per carton, from $4.00 to $3.50, and Virginia Slims by $2.00 per carton, from $4.00 to $2.00. In addition, PM USA raised the price on its other brands by $2.50 per thousand cigarettes or $0.50 per carton effective September 10, 2007.
-68-
PM USA cannot predict future long-term changes or rates of change in U.S. tobacco industry volume, the relative sizes of the premium and discount segments or its shipment or retail market share; however, it believes that its results may be materially adversely affected by the items discussed under the caption Tobacco Business Environment.
European Union. Net revenues, which include excise taxes billed to customers, increased $2.0 billion (11.0%). Excluding excise taxes, net revenues increased $643 million (10.5%) to $6.7 billion, due primarily to favorable currency ($534 million) and price increases ($294 million), partially offset by lower volume/mix ($185 million).
Operating companies income increased $521 million (19.0%), due primarily to favorable currency ($294 million), price increases ($294 million), lower marketing, administration and research costs ($78 million) and the Italian antitrust charge in 2006 ($61 million), partially offset by lower volume/mix ($165 million), higher pre-tax charges for asset impairment and exit costs ($20 million) and higher fixed manufacturing costs ($17 million).
In the European Union, PMIs cigarette volume decreased 0.9%, due to declines in the Czech Republic, France, Germany and Poland, partially offset by gains in the Baltic States, Hungary, Italy and Spain. PMIs cigarette market share in the European Union remained at 39.4%, with increases in Austria, the Baltic States, Denmark, Finland, France, Hungary, Italy, the Netherlands, Portugal and Sweden, offset by declines in Belgium, the Czech Republic, Germany, Poland, the Slovak Republic, Switzerland and the United Kingdom.
In Italy, the total cigarette market was down 0.9%. PMIs cigarette shipment volume increased 0.9% and market share in Italy increased 0.8 share points to 54.5%, driven by Chesterfield, Diana, Merit and Philip Morris.
In Germany, PMIs cigarette volume declined 5.5%. The total cigarette market in Germany declined 2.7%, following the October 2006 tax-driven price increase. PMIs cigarette market share declined 1.0 share point to 36.1%, reflecting a 38.4% volume decline in the vending channel. The vending channel accounted for 14.5% of total industry volume for the nine months ended September 30, 2007, a decline from 22.9% in the comparative period last year reflecting a reduction in the number of vending machines due to new regulations that require electronic age verification. PMIs share of the vending channel at 49.8% is greater than its overall market share, and as a consequence, PMI has been adversely impacted by this development. PMI expects the volume share of the vending channel to gradually improve. Marlboro share was down 3.1 share points to 25.4%, due primarily to the increase of the low-price segment and shrinkage in the vending channel. L&M continued to grow strongly, adding 2.5 share points to reach 4.7%.
In Spain, the total cigarette market declined 0.4%. PMIs shipment volume increased 1.7%, due mainly to the favorable timing of shipments. PMIs market share declined 0.2 share points to 32.0%, primarily reflecting declines in Marlboro, following a price increase.
In France, shipment volume decreased 3.6%, due primarily to a lower market following the August 2007 excise tax-driven price increase. Market share increased 0.3 share points to 42.9%, driven by the Philip Morris brand.
In Poland, the total cigarette market declined 2.2% due to consumer price sensitivity following significant tax-driven price increases. PMIs shipment volume was down 4.2% and market share decreased 0.5 share points to 39.5%, driven mainly by the continuing decline of PMIs low price brands and brands in the declining low-price 70mm segment.
Eastern Europe, Middle East and Africa. Net revenues, which include excise taxes billed to customers, increased $1.5 billion (19.3%). Excluding excise taxes, net revenues increased $545 million (12.7%) to $4.8 billion, due primarily to favorable currency ($210 million), price increases ($196 million) and higher volume/mix ($139 million).
-69-
Operating companies income increased $272 million (16.6%), due primarily to price increases and lower costs ($202 million), higher volume/mix ($95 million) and favorable currency ($65 million), partially offset by higher marketing, administration and research costs ($63 million), higher fixed manufacturing costs ($15 million) and pre-tax charges for asset impairment and exit costs in 2007 ($12 million).
In Eastern Europe, Middle East and Africa, volume increased 0.7%, driven by gains in Algeria, Bulgaria, Egypt and Ukraine, partially offset by declines in Russia and Turkey.
In Russia, shipments were down 3.3%, due largely to L&M and local low-price brands. This decline was partially offset by higher shipments and market share of higher-margin international brands, Marlboro, Parliament and Chesterfield.
In Turkey, shipments declined 3.3% and market share declined 2.2 share points to 40.5%, due to the February 2007 tax-driven retail price increase. Volume declines in low-priced L&M and Bond Street were partially offset by growth in Lark and Parliament.
In Ukraine, shipments grew 4.7% and share rose 0.6 share points to 33.6%, driven by continued consumer up-trading to premium brands, particularly Marlboro and Chesterfield.
In Egypt, improved economic conditions and increased tourism continued to fuel the growth of the total cigarette industry and premium brands. PMIs shipments rose 24.1% and share advanced 2.0 share points to 12.2%, driven by L&M and Merit.
In Algeria, shipments increased, driven by an improved distribution network and the timing of shipments.
In Bulgaria, shipments increased, driven by PMIs market entry in July 2006 as well as higher sales of Marlboro following price repositioning, and portfolio expansion following the lifting of import duties in January 2007.
Asia. Net revenues, which include excise taxes billed to customers, increased $684 million (8.9%). Excluding excise taxes, net revenues increased $94 million (2.2%) to $4.3 billion, due primarily to price increases ($108 million), the Lakson Tobacco acquisition ($80 million) and favorable currency ($45 million), partially offset by lower volume/mix ($139 million).
Operating companies income decreased $44 million (3.0%), due primarily to lower volume/mix ($122 million), unfavorable currency ($36 million), higher marketing, administration and research costs ($25 million, including $30 million for a distributor termination in Indonesia) and higher pre-tax charges for asset impairment and exit costs ($15 million), partially offset by price increases ($108 million), lower fixed manufacturing costs ($34 million) and the Lakson Tobacco acquisition ($9 million).
In Asia, volume increased 8.5%, reflecting the acquisition in Pakistan. Excluding this acquisition, volume in Asia was down 2.6%, due primarily to lower volume in Japan and the Philippines, partially offset by gains in Korea and Indonesia.
In Japan, the total market declined 5.4%, driven by the July 1, 2006 tax-driven price increase. Market share in Japan decreased 0.2 share point to 24.4%. PMIs shipments in Japan were down 9.3%.
In Korea, shipments increased 17.7%, due primarily to the performance of Parliament and Marlboro, driven by new line extensions, including Marlboro Filter Plus and Parliament 0.3mg. Market share in Korea increased 1.2 share points to 9.7% with Marlboro market share up 0.9 share points to 4.2%.
In Indonesia, the total market increased 2.2% due mainly to the growth of the low price segment. Consequently, PMI shipment volume rose 1.6%. Market share decreased 0.1 share point to 28.0%.
-70-
Latin America. Net revenues, which include excise taxes billed to customers, increased $456 million (14.3%). Excluding excise taxes, net revenues increased $150 million (11.8%) to $1.4 billion, due primarily to price increases ($80 million), the acquisition of the Dominican Republic cigarette business ($39 million), favorable currency ($17 million) and favorable volume/mix ($14 million).
Operating companies income decreased $62 million (15.7%), due primarily to the divestiture of the Dominican Republic beer business ($45 million), higher marketing, administration and research costs ($30 million), pre-tax charges for asset impairment and exit costs in 2007 ($18 million) and lower volume/mix, partially offset by price increases, net of higher costs ($48 million).
In Latin America, volume decreased 1.3%, driven by declines in Colombia, the Dominican Republic and Mexico, partially offset by gains in Argentina.
In Argentina, the total market was up 1.2%, while PMI shipments grew 5.7% and share was up 2.9 share points, due mainly to the Philip Morris brand.
In the Dominican Republic, shipment volume declined 23.5%, reflecting a lower total market following price increases in January and February 2007 to partially compensate for a very significant excise tax increase imposed on cigarettes in January 2007. Market share declined 0.8 share points to 77.4%, due primarily to Marlboro.
In Mexico, PMI shipments declined 4.0%, reflecting increased trade purchases in the fourth quarter of 2006 ahead of the January 2007 tax increase, and the market decline due to lower consumption following the January 2007 tax-driven price increase. However, market share rose 1.2 share points to 64.0%, driven by Marlboro, Benson & Hedges and Delicados.
Operating Results Three Months Ended September 30, 2007
The following discussion compares tobacco operating results for the three months ended September 30, 2007, with the three months ended September 30, 2006.
For the Three Months Ended September 30, | ||||||||||||
Net Revenues | Operating Companies Income | |||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||
(in millions) | ||||||||||||
U.S. tobacco |
$ | 4,944 | $ | 4,830 | $ | 1,295 | $ | 1,270 | ||||
European Union |
6,832 | 6,458 | 1,151 | 955 | ||||||||
Eastern Europe, Middle East and Africa |
3,312 | 2,607 | 710 | 582 | ||||||||
Asia |
2,814 | 2,586 | 514 | 449 | ||||||||
Latin America |
1,274 | 1,052 | 143 | 133 | ||||||||
Total tobacco |
$ | 19,176 | $ | 17,533 | $ | 3,813 | $ | 3,389 | ||||
U.S. tobacco. PM USAs net revenues, which include excise taxes billed to customers, increased $114 million (2.4%). Excluding excise taxes, net revenues increased $125 million (3.2%) to $4.0 billion, due primarily to lower wholesale promotional allowance rates ($167 million), partially offset by lower volume ($46 million).
Operating companies income increased $25 million (2.0%), due primarily to lower marketing, administration and research costs ($85 million), partially offset by lower volume ($31 million), the 2007 pre-tax charges for asset impairment, exit and implementation costs related to the announced closing of the Cabarrus, North Carolina cigarette manufacturing facility ($22 million) and higher ongoing resolution costs, net of lower wholesale promotional allowance rates ($10 million).
-71-
PM USAs shipment volume was 47.1 billion units, a decrease of 1.0% or 0.5 billion units, but was estimated to be down approximately 3% when adjusted for changes in trade inventories and calendar differences. During the third quarter of 2007, PM USA estimates that total cigarette industry volume declined between 3% and 4%, and for the full year 2007 PM USA is maintaining its prior estimate of a 3% to 4% decline in total cigarette industry volume. In the premium segment, PM USAs shipment volume decreased 0.5%; however, Marlboro shipment volume increased 0.1 billion units (0.2%) to 39.1 billion units. In the discount segment, PM USAs shipment volume also decreased, with Basic shipment volume down 8.4% to 3.5 billion units.
The following table summarizes PM USAs cigarette volume performance by brand for the three months ended September 30, 2007 and 2006:
For the Three Months Ended September 30, | ||||
2007 | 2006 | |||
(in billion units) | ||||
Marlboro |
39.1 | 39.0 | ||
Parliament |
1.5 | 1.5 | ||
Virginia Slims |
1.9 | 2.0 | ||
Basic |
3.5 | 3.8 | ||
Focus on Four Brands |
46.0 | 46.3 | ||
Other |
1.1 | 1.3 | ||
Total PM USA |
47.1 | 47.6 | ||
The following table summarizes PM USAs retail share performance, based on data from the IRI/Capstone Total Retail Panel, which is a tracking service that uses a sample of stores to project market share performance in retail stores selling cigarettes. This panel was not designed to capture sales through other channels, including Internet and direct mail:
For the Three Months Ended September 30, |
||||||
2007 | 2006 | |||||
Marlboro |
41.1 | % | 40.6 | % | ||
Parliament |
1.9 | 1.8 | ||||
Virginia Slims |
2.2 | 2.3 | ||||
Basic |
4.0 | 4.2 | ||||
Focus on Four Brands |
49.2 | 48.9 | ||||
Other |
1.4 | 1.5 | ||||
Total PM USA |
50.6 | % | 50.4 | % | ||
European Union. Net revenues, which include excise taxes billed to customers, increased $374 million (5.8%). Excluding excise taxes, net revenues increased $144 million (6.7%) to $2.3 billion, due primarily to favorable currency ($144 million) and price increases ($116 million), partially offset by lower volume/mix ($116 million).
Operating companies income increased $196 million (20.5%), due primarily to price increases ($116 million), favorable currency ($100 million), lower pre-tax charges for asset impairment and exit costs ($46 million) and lower marketing, administration and research costs ($22 million), partially offset by lower volume/mix ($91 million).
In the European Union, PMIs cigarette volume decreased 4.8%, due mainly to declines in the Czech Republic, France, Germany and Poland. PMIs cigarette market share in the European Union declined 0.6 share points to 39.1%. The total market declined 3.8%, due largely to the impact of tax-driven price increases, particularly in the Czech Republic, Germany, Poland and the United Kingdom.
-72-
In the Czech Republic, the total cigarette market was down 9.2%, due to the timing of trade purchases. PMIs shipment volume declined 22.6% and market share of 49.3% was down 8.5 share points. PMI implemented tax-driven price increases in the second quarter, while most competitive brands, particularly at the low end, followed in the third quarter. This placed PMIs brands at a temporary price disadvantage and was the main cause of the significant market share loss. PMI expects to recover a large part of this loss in the fourth quarter of 2007.
In France, the total market declined 3.9%, due to the impact of higher pricing. PMIs market share of 42.0% declined 0.5 share points and shipments decreased 5.5%.
In Germany, the cigarette market declined 5.7%, due to a tax-driven price increase in the fourth quarter of 2006. PMIs cigarette shipments in Germany were down 9.0% and its cigarette market share declined 1.3 share points to 35.2%, driven by consumer downtrading to the low price segment and an increase in a key competitors trade inventory. Marlboro share declined 3.1 share points to 24.1%, due to the decline of the vending segment and the previously mentioned trade inventory increase. L&M share grew 2.4 share points to reach 5.3%.
In Italy, the total cigarette market was down 0.9%. PMIs cigarette shipment volume increased 0.6% and its market share in Italy increased 0.6 share points to 54.7%, driven by Merit, Chesterfield and Philip Morris.
In Poland, PMIs cigarette shipment volume declined 16.1%. Consumer price sensitivity following significant tax-driven price increases resulted in a total market decline of 10.5% and PMIs market share was down 2.6 share points to 38.0%, due primarily to declines of its low price brands, as well as its local 70mm brands. However, PMIs profitability increased significantly due to higher pricing.
In Spain, PMIs cigarette shipments increased 1.8%. The total cigarette market in Spain declined 0.6%, while PMIs market share of 32.7% rose 0.4 share points, driven by Chesterfield and L&M.
Eastern Europe, Middle East and Africa. Net revenues, which include excise taxes billed to customers, increased $705 million (27.0%). Excluding excise taxes, net revenues increased $213 million (14.3%) to $1.7 billion, due primarily to favorable currency ($99 million), price increases ($81 million), and higher volume/mix ($33 million).
Operating companies income increased $128 million (22.0%), due primarily to price increases ($81 million), favorable currency ($44 million) and higher volume/mix ($32 million), partially offset by higher marketing, administration and research costs ($19 million).
In Eastern Europe, Middle East and Africa, volume increased 0.3%, driven by gains in Algeria, Bulgaria, Egypt, Lebanon and Ukraine, mostly offset by the unfavorable timing of shipments in Kuwait and lower volume in Russia, Serbia and worldwide duty-free.
In Egypt, shipment volume increased 21.1%. The total market rose 6.4% in Egypt, while PMIs market share grew 2.6 share points to 14.2%, due to the continued strength of L&M.
In Russia, shipment volume was down 1.0%, due to unfavorable distributor inventory movements following consolidation to a single distributor. Market share rose 0.2 share points to 26.6%, as share gains for Marlboro, Parliament and Virginia Slims were mostly offset by a share decline for L&M.
In Serbia, PMIs shipments were down 10.6%, due to the continued decline of local brands, and market share was down 2.0 share points to 52.1%. However, PMIs market share increased for its international brands, driven by Marlboro and Bond Street. Market share for Marlboro rose slightly and its share of the premium segment increased.
In Ukraine, shipment volume grew 3.5% and share increased 0.6 share points to 34.0%, driven by consumer uptrading to Marlboro, Parliament and Chesterfield.
-73-
In Algeria, shipments increased, driven by an improved distribution network and the timing of shipments.
In Bulgaria, shipments increased, driven by PMIs market entry in July 2006 as well as higher sales of Marlboro following price repositioning, and portfolio expansion following the lifting of import duties in January 2007.
Asia. Net revenues, which include excise taxes billed to customers, increased $228 million (8.8%). Excluding excise taxes, net revenues increased $75 million (5.5%) to $1.4 billion, due primarily to favorable pricing ($56 million) and the Lakson Tobacco acquisition ($32 million), partially offset by lower volume/mix ($10 million).
Operating companies income increased $65 million (14.5%), due primarily to favorable pricing and lower costs ($73 million) and lower marketing, administration and research costs ($18 million), partially offset by lower volume/mix ($23 million) and unfavorable currency ($9 million).
In Asia, volume increased 9.6%, due to acquisition volume in Pakistan and gains in Korea, partially offset by volume declines in Indonesia, Malaysia and Thailand. Excluding acquired volume, shipment volume in Asia declined 1.3%.
In Indonesia, the total cigarette market was essentially flat. PMIs market share was down 0.6 share points to 28.0%, reflecting the decline of A Mild and Dji Sam Soe due to a temporary stick-price disadvantage versus low price competition, partially offset by the growth of Marlboro, which gained 0.5 share points to 4.3%. PMI shipment volume declined 1.9%, although Marlboro shipments rose 20.7%, driven by improved marketing and distribution and the July 2007 Marlboro kretek launch.
In Japan, the total cigarette market was up 16.4%, due to a favorable comparison with the third quarter of 2006, which was depressed by trade inventory depletions following the July 2006 excise tax-driven price increase. Consequently, PMIs in-market sales were up 13.4%, but market share declined 0.6 share points to 24.3%, due mainly to Lark. Marlboro share of 10.1% was essentially flat. Cigarette shipment volume was flat, as higher in-market sales were offset by unfavorable inventory movements.
In Korea, the total market was down 3.2%, while PMIs shipments rose 10.0% and market share increased 1.3 share points to 9.9%. Parliament and Marlboro continued to gain share, driven by recent new line extensions, including Marlboro Filter Plus.
Latin America. Net revenues, which include excise taxes billed to customers, increased $222 million (21.1%). Excluding excise taxes, net revenues increased $72 million (17.2%) to $490 million, due primarily to price increases ($27 million), favorable currency ($18 million), the acquisition of the Dominican Republic cigarette business ($16 million) and favorable volume/mix ($11 million).
Operating companies income increased $10 million (7.5%), due primarily to price increases, net of higher costs ($12 million) and lower marketing, administration and research costs ($8 million), partially offset by the divestiture of the Dominican Republic beer business ($14 million).
In Latin America, volume declined 1.5%, due mainly to declines in Brazil and Colombia, partially offset by growth in Argentina.
In Argentina, the total cigarette market grew 1.7%. PMIs shipment volume grew 5.0% and market share increased 2.2 share points to 69.7%, due mainly to Marlboro and the Philip Morris brand.
In Brazil, the total market declined 0.9% and PMIs market share declined 0.2 share points to 12.0%. However, Marlboro share grew 0.2 share points to 5.9%. PMIs shipments were down 2.8%.
-74-
In Colombia, PMI shipment volume declined 17.6%, due primarily to distributor inventory distortions. However, PMI expects volume to recover in the fourth quarter of 2007.
In Mexico, the total cigarette market declined 1.9%, due to lower consumption following the January 2007 tax-driven price increase. PMI market share was up 1.6 share points to 65.5%, due primarily to Marlboro and Benson & Hedges.
Financial Services
Business Environment
In 2003, PMCC shifted its strategic focus and is no longer making new investments but is instead focused on managing its existing portfolio of finance assets in order to maximize gains and generate cash flow from asset sales and related activities. Accordingly, PMCCs operating companies income will fluctuate over time as investments mature or are sold. During the first nine months of 2007 and 2006, PMCC received proceeds from asset sales, maturities and bankruptcy recoveries of $363 million and $339 million, respectively, and recorded gains of $268 million and $127 million, respectively, in operating companies income. During the third quarter of 2007 and 2006, PMCC received proceeds from asset sales, maturities and bankruptcy recoveries of $23 million and $137 million, respectively, and recorded gains of $22 million and $61 million, respectively, in operating companies income.
Included in the proceeds for 2007 were partial recoveries of amounts previously provided for in the allowance for losses related to aircraft exposure, which resulted in additional operating companies income of $214 million and $7 million for the nine months and three months ended September 30, 2007, respectively.
PMCC leases one 750 megawatt (MW) natural gas-fired power plant (located in Pasadena, Texas) to an indirect subsidiary of Calpine Corporation (Calpine). Calpine, which has guaranteed the lease, is currently operating under bankruptcy protection. The subsidiary was not included as part of the bankruptcy filing of Calpine. PMCC does not record income on leases when the lessee or its guarantor is in bankruptcy. At September 30, 2007, PMCCs finance asset balance for this lessee was $60 million. Based on PMCCs assessment of the prospect for recovery on the Pasadena plant, a portion of the outstanding finance asset balance has been provided for in the allowance for losses.
During the third quarter of 2007, Calpine foreclosed on PMCCs interest in two 265 MW natural gas-fired power plants (located in Tiverton, Rhode Island, and Rumford, Maine), which were part of the bankruptcy filing. These leases were rejected and written off during 2006. The foreclosure resulted in the acceleration of approximately $50 million in deferred taxes.
At September 30, 2007, PMCCs allowance for losses was $223 million. During the nine months ended September 30, 2007, PMCCs allowance for losses decreased by $257 million related to the partial recovery and write-off of certain aircraft leveraged lease investments. During the second quarter of 2006, PMCC increased its allowance for losses by $103 million due to continuing issues within the airline industry.
As discussed further in Note 12. Income Taxes, the IRS has disallowed benefits pertaining to several PMCC leverage lease transactions for the years 1996 through 1999.
-75-
Operating Results
2007 | 2006 | |||||
(in millions) | ||||||
Net revenues: |
||||||
Nine months ended September 30, |
$ | 126 | $ | 272 | ||
Three months ended September 30, |
$ | 31 | $ | 109 | ||
Operating companies income: |
||||||
Nine months ended September 30, |
$ | 332 | $ | 138 | ||
Three months ended September 30, |
$ | 33 | $ | 101 | ||
PMCCs net revenues for the nine months ended September 30, 2007, decreased $146 million (53.7%) from the comparable period in 2006, due primarily to lower gains from asset management activity and lower lease revenues due to lower investment balances. Net revenues for the three months ended September 30, 2007, decreased $78 million (71.6%) from the comparable period in 2006, due primarily to lower gains from asset management activity and lower lease revenues.
PMCCs operating companies income for the nine months ended September 30, 2007 increased $194 million (100.0+%) from the comparable period in 2006, due primarily to cash recoveries in 2007 on aircraft leases previously written down versus an increase to the loss provision in 2006, partially offset by lower revenues. PMCCs operating companies income for the three months ended September 30, 2007, decreased $68 million (67.3%) from the comparable period in 2006, due primarily to lower revenues.
Financial Review
Net Cash Provided by Operating Activities, Continuing Operations
During the first nine months of 2007, net cash provided by operating activities on a continuing operations basis was $8.1 billion compared with $8.3 billion during the comparable 2006 period. The decrease in cash provided by operating activities was due primarily to the return in 2006 of approximately $2 billion of escrow bond deposits related to the Price U.S. tobacco case, mostly offset by higher earnings from continuing operations (after excluding the non-cash reversal of income tax reserves in 2006) and lower pension plan contributions.
Net Cash Used in Investing Activities, Continuing Operations
One element of PMIs growth strategy is to strengthen its brand portfolio and/or expand its geographic reach through active programs of selective acquisitions. PM USA from time to time considers acquisitions as part of its adjacency strategy.
During the first nine months of 2007, net cash used in investing activities on a continuing operations basis was $921 million, compared with $357 million during the first nine months of 2006. The increase in cash used was due primarily to PMIs purchase of an additional stake of a cigarette manufacturer in Pakistan in the first quarter of 2007.
Net Cash Used in Financing Activities, Continuing Operations
During the first nine months of 2007, net cash used in financing activities on a continuing operations basis was $4.8 billion, compared with $9.0 billion during the first nine months of 2006. The decrease in cash used in financing activities was due primarily to higher repayment of debt in 2006.
-76-
Debt and Liquidity
Credit Ratings At September 30, 2007, ALGs debt ratings by major credit rating agencies were as follows:
Short-term | Long-term | Outlook | ||||
Moodys |
P-2 | Baa1 | Stable | |||
Standard & Poors |
A-2 | BBB | Stable | |||
Fitch |
F-2 | BBB+ | Stable |
ALGs credit quality, measured by 5 year credit default swaps, has improved over the past year with levels which approximate that of Single-A rated issuers.
Moodys expects that, should PMI be spun-off from Altria Group, Inc. in early 2008, PMIs long-term and short-term ratings could be as high as A2 and Prime-1, respectively. Standard & Poors believes that the potential corporate credit rating for PMI could be as high as A+ based solely on its business risk assessment.
Credit Lines ALG and PMI maintain separate revolving credit facilities. ALG intends to use its revolving credit facilities to support the issuance of commercial paper.
The purchase price of the Sampoerna acquisition was primarily financed through a euro 4.5 billion bank credit facility arranged for PMI and its subsidiaries in May 2005, consisting of a euro 2.5 billion three-year term loan facility (which, through repayments has been reduced to euro 1.5 billion) and a euro 2.0 billion five-year revolving credit facility. These facilities, which are not guaranteed by ALG, require PMI to maintain an earnings before interest, taxes, depreciation and amortization (EBITDA) to interest ratio of not less than 3.5 to 1.0. At September 30, 2007, PMIs ratio calculated in accordance with the agreements was 40.9 to 1.0.
In March 2007, ALG negotiated a new 364-day revolving credit facility in the amount of $1.0 billion, which expires on March 27, 2008, and replaces ALGs 364-day facility which matured on March 30, 2007. In addition, ALG maintains a multi-year credit facility in the amount of $4.0 billion, which expires in April 2010. The ALG facilities require the maintenance of an earnings to fixed charges ratio, as defined by the agreements, of not less than 2.5 to 1.0. At September 30, 2007, the ratio calculated in accordance with the agreements was 20.0 to 1.0.
ALG and PMI expect to continue to meet their respective covenants. These facilities do not include any credit rating triggers or any provisions that could require the posting of collateral. The multi-year facilities enable the respective companies to reclassify short-term debt on a long-term basis.
-77-
At September 30, 2007, credit lines for ALG and PMI, and the related activity, were as follows (in billions of dollars):
ALG | September 30, 2007 | |||||||||||
Type | Credit Lines |
Amount Drawn |
Commercial Paper Outstanding |
Lines Available | ||||||||
364-day |
$ | 1.0 | $ | | $ | | $ | 1.0 | ||||
Multi-year |
4.0 | 4.0 | ||||||||||
$ | 5.0 | $ | | $ | | $ | 5.0 | |||||
PMI | September 30, 2007 | |||||||||||
Type | Credit Lines |
Amount Drawn |
Lines Available |
|||||||||
3-year term loan |
$ | 2.1 | $ | 2.1 | $ | | ||||||
5-year revolving credit |
2.7 | 0.4 | 2.3 | |||||||||
$ | 4.8 | $ | 2.5 | $ | 2.3 | |||||||
In addition to the above, certain international subsidiaries of PMI maintain credit lines to meet their respective working capital needs. These credit lines, which amounted to approximately $2.2 billion are for the sole use of these international businesses. Borrowings on these lines amounted to approximately $0.5 billion and $0.4 billion at September 30, 2007 and December 31, 2006, respectively.
Debt Altria Group, Inc.s total debt (consumer products and financial services) was $8.0 billion and $8.5 billion at September 30, 2007 and December 31, 2006, respectively. Total consumer products debt was $7.5 billion and $7.4 billion at September 30, 2007 and December 31, 2006, respectively. Total consumer products debt includes PMI third-party debt of $3.4 billion and $2.8 billion at September 30, 2007 and December 31, 2006, respectively. At September 30, 2007 and December 31, 2006 (after giving effect to the Kraft spin-off), Altria Group, Inc.s ratio of consumer products debt to total equity was 0.44 and 0.58, respectively. The ratio of total debt to total equity was 0.47 and 0.67 at September 30, 2007 and December 31, 2006 (after giving effect to the Kraft spin-off), respectively.
ALG does not guarantee the debt of PMI.
Guarantees As discussed in Note 11, at September 30, 2007, Altria Group, Inc.s third-party guarantees, which are primarily related to excise taxes and divestiture activities, were $69 million, of which $64 million have no specified expiration dates. The remainder expire through 2011, with none expiring through September 30, 2008. Altria Group, Inc. is required to perform under these guarantees in the event that a third party fails to make contractual payments or achieve performance measures. Altria Group, Inc. has a liability of $22 million on its condensed consolidated balance sheet at September 30, 2007, relating to these guarantees. In the ordinary course of business, certain subsidiaries of ALG have agreed to indemnify a limited number of third parties in the event of future litigation. At September 30, 2007, subsidiaries of ALG were also contingently liable for $2.9 billion of guarantees related to their own performance, consisting of the following:
| $2.6 billion of guarantees of excise tax and import duties related primarily to international shipments of tobacco products. In these agreements, financial institutions provide guarantees of tax payments to the respective governments. PMI then issues guarantees to the respective financial institutions for the payment |
-78-
of the taxes. These are revolving facilities that are integral to the shipment of tobacco products in international markets, and the underlying taxes payable are recorded on Altria Group, Inc.s condensed consolidated balance sheet.
| $0.3 billion of other guarantees related to the tobacco businesses. |
Although Altria Group, Inc.s guarantees of its own performance are frequently short-term in nature, they are expected to be replaced, upon expiration, with similar guarantees of similar amounts. These items have not had, and are not expected to have, a significant impact on Altria Group, Inc.s liquidity.
Payments Under State Settlement and Other Tobacco Agreements As discussed previously and in Note 11, PM USA has entered into State Settlement Agreements with the states and territories of the United States and also entered into a trust agreement to provide certain aid to U.S. tobacco growers and quota holders, but PM USAs obligations under this trust have now been eliminated by the obligations imposed on PM USA by FETRA. During 2004, PMI entered into a cooperation agreement with the European Community. Each of these agreements calls for payments that are based on variable factors, such as cigarette volume, market shares and inflation. PM USA and PMI account for the cost of these agreements as a component of cost of sales as product is shipped.
As a result of these agreements and the enactment of FETRA, PM USA and PMI recorded the following amounts in cost of sales (in millions):
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, | |||||||||||
2007 | 2006 | 2007 | 2006 | |||||||||
PM USA |
$ | 4,137 | $ | 3,774 | $ | 1,462 | $ | 1,306 | ||||
PMI |
68 | 75 | 23 | 21 | ||||||||
Total |
$ | 4,205 | $ | 3,849 | $ | 1,485 | $ | 1,327 | ||||
Based on current agreements and current estimates of volume and market share, the estimated amounts that PM USA and PMI may charge to cost of sales under these agreements will be approximately as follows (in billions):
PM USA | PMI | Total | ||||
2007 |
$5.4 | $0.1 | $5.5 | |||
2008 |
5.5 | 0.1 | 5.6 | |||
2009 |
5.5 | 0.1 | 5.6 | |||
2010 |
5.5 | 0.1 | 5.6 | |||
2011 |
5.5 | 0.1 | 5.6 | |||
2012 to 2016 |
5.6 annually | 0.1 annually | 5.7 annually | |||
Thereafter |
5.7 annually | 5.7 annually |
The estimated amounts charged to cost of sales in each of the years above would generally be paid in the following year. As previously stated, the payments due under the terms of these agreements are subject to adjustment for several factors, including cigarette volume, inflation and certain contingent events and, in general, are allocated based on each manufacturers market share. The amounts shown in the table above are estimates, and actual amounts will differ as underlying assumptions differ from actual future results. See Note 11. Contingencies for a discussion of proceedings that may result in a downward adjustment of amounts paid under State Settlement Agreements for the years 2003 and 2004.
Litigation Escrow Deposits As discussed in Note 11, in connection with obtaining a stay of execution in the Engle class action, PM USA placed $1.2 billion into an interest-bearing escrow account. The $1.2 billion escrow account and a deposit of $100 million related to the bonding requirement are included in the September 30, 2007 and December 31, 2006 condensed consolidated balance sheets as other assets. As discussed in Note 11, in July 2006, the Florida Supreme Court issued its ruling in the Engle case. The escrow and deposit
-79-
amounts will be returned to PM USA subject to and upon the completion of final review of the judgment. Interest income on the $1.2 billion escrow account is paid to PM USA quarterly and is being recorded as earned in interest and other debt expense, net, in the condensed consolidated statements of earnings.
Also, as discussed in Note 11, in June 2006 under the order of the Illinois Supreme Court, cash deposits of approximately $2.2 billion related to the Price case were returned to PM USA, and PM USAs obligations to deposit further cash payments were terminated.
With respect to certain adverse verdicts and judicial decisions currently on appeal, other than the Engle case discussed above, as of September 30, 2007, PM USA has posted various forms of security totaling approximately $193 million, the majority of which have been collateralized with cash deposits, to obtain stays of judgments pending appeals. These cash deposits are included in other assets on the condensed consolidated balance sheets.
Although litigation is subject to uncertainty and could result in material adverse consequences for the financial condition, cash flows or results of operations of PM USA or Altria Group, Inc. in a particular fiscal quarter or fiscal year, management believes the litigation environment has substantially improved and expects cash flow from operations, together with existing credit facilities, to provide sufficient liquidity to meet the ongoing needs of the business.
Leases PMCCs investment in leases is included in the line item finance assets, net, on the condensed consolidated balance sheets as of September 30, 2007 and December 31, 2006. At September 30, 2007, PMCCs net finance receivable of $6.2 billion in leveraged leases, which is included in the line item on Altria Group, Inc.s condensed consolidated balance sheet of finance assets, net, consists of rents receivable ($20.9 billion) and the residual value of assets under lease ($1.6 billion), reduced by third-party nonrecourse debt ($13.8 billion) and unearned income ($2.5 billion). The repayment of the nonrecourse debt is collateralized by lease payments receivable and the leased property, and is nonrecourse to the general assets of PMCC. As required by accounting principles generally accepted in the United States of America (U.S. GAAP), the third-party nonrecourse debt has been offset against the related rents receivable and has been presented on a net basis within the line item finance assets, net, in Altria Group, Inc.s condensed consolidated balance sheets. Finance assets, net, at September 30, 2007, also include net finance receivables for direct finance leases ($0.4 billion) and an allowance for losses ($0.2 billion).
Equity and Dividends
As discussed in Note 1. Basis of Presentation and Kraft Spin-Off, on March 30, 2007, Altria Group, Inc. spun-off all of its remaining interest (88.9%) in Kraft on a pro rata basis to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 in a tax-free distribution. The distribution resulted in a net decrease to Altria Group, Inc.s stockholders equity of $27.4 billion on March 30, 2007.
As discussed in Note 8. Stock Plans, in January 2007, Altria Group, Inc. issued 1.7 million rights to receive shares of stock to eligible U.S.-based and non-U.S. employees. Restrictions on these rights lapse in the first quarter of 2010. The market value per right was $87.36 on the date of grant. Recipients of these Altria Group, Inc. stock rights did not receive restricted stock or stock rights of Kraft upon the Kraft spin-off. Rather, they received 0.6 million additional stock rights of Altria Group, Inc. to preserve the intrinsic value of the original award.
Dividends paid in the first nine months of 2007 and 2006 were $5.1 billion and $5.0 billion, respectively, an increase of 1.1%, primarily reflecting a greater number of shares outstanding in 2007 and a higher dividend rate on Altria Group, Inc. stock.
During the second quarter of 2007, Altria Group, Inc. adjusted its quarterly dividend rate to $0.69 per share so that its stockholders who retained their Altria Group, Inc. and Kraft shares would receive in the aggregate the same dividend rate as before the distribution.
-80-
During the third quarter of 2007, Altria Group, Inc.s Board of Directors approved an 8.7% increase in the quarterly dividend rate to $0.75 per share. As a result, the present annualized dividend rate is $3.00 per share.
Market Risk
ALGs subsidiaries operate globally, with manufacturing and sales facilities in various locations around the world. ALG and its subsidiaries utilize certain financial instruments to manage foreign currency exposures. Derivative financial instruments are used by ALG and its subsidiaries, principally to reduce exposures to market risks resulting from fluctuations in foreign exchange rates by creating offsetting exposures. Altria Group, Inc. is not a party to leveraged derivatives and, by policy, does not use derivative financial instruments for speculative purposes.
A substantial portion of Altria Group, Inc.s derivative financial instruments are effective as hedges. Hedging activity affected accumulated other comprehensive earnings (losses), net of income taxes, as follows:
For the Nine Months Ended September 30, |
For the Three Months Ended September 30, |
||||||||||||||
2007 | 2006 | 2007 | 2006 | ||||||||||||
(in millions) | |||||||||||||||
Gain at beginning of period |
$ | 13 | $ | 24 | $ | 8 | $ | 17 | |||||||
Derivative (gains) losses transferred to earnings |
(38 | ) | (51 | ) | 3 | (33 | ) | ||||||||
Change in fair value |
45 | 6 | 11 | (5 | ) | ||||||||||
Kraft spin-off |
2 | ||||||||||||||
Gain (loss) as of September 30 |
$ | 22 | $ | (21 | ) | $ | 22 | $ | (21 | ) | |||||
The fair value of all derivative financial instruments has been calculated based on market quotes.
Foreign exchange rates. Altria Group, Inc. uses forward foreign exchange contracts, foreign currency swaps and foreign currency options to mitigate its exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. The primary currencies to which Altria Group, Inc. is exposed include the Japanese yen, Swiss franc and the euro. At September 30, 2007 and December 31, 2006, Altria Group, Inc. had contracts with aggregate notional amounts of $4.9 billion and $3.2 billion, respectively.
In addition, Altria Group, Inc. uses foreign currency swaps to mitigate its exposure to changes in exchange rates related to foreign currency denominated debt. These swaps typically convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity, and are accounted for as cash flow hedges. The unrealized gain (loss) relating to foreign currency swap agreements that do not qualify for hedge accounting treatment under U.S. GAAP was insignificant as of September 30, 2007 and December 31, 2006. At September 30, 2007 and December 31, 2006, the notional amounts of foreign currency swap agreements aggregated $1.4 billion.
Altria Group, Inc. also designates certain foreign currency denominated debt as net investment hedges of foreign operations. During the nine months ended September 30, 2007 and 2006, these hedges of net investments resulted in gains, net of income taxes of $2 million, and losses, net of income taxes, of $134 million, respectively, and were reported as a component of accumulated other comprehensive earnings (losses) within currency translation adjustments.
New Accounting Standard
See Note 13 to the Condensed Consolidated Financial Statements for a discussion of a new accounting standard.
-81-
Contingencies
See Note 11 to the Condensed Consolidated Financial Statements for a discussion of contingencies.
Cautionary Factors That May Affect Future Results
Forward-Looking and Cautionary Statements
We* may from time to time make written or oral forward-looking statements, including statements contained in filings with the SEC, in reports to stockholders and in press releases and investor webcasts. You can identify these forward-looking statements by use of words such as strategy, expects, continues, plans, anticipates, believes, will, estimates, intends, projects, goals, targets and other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts.
We cannot guarantee that any forward-looking statement will be realized, although we believe we have been prudent in our plans and assumptions. Achievement of future results is subject to risks, uncertainties and inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements and whether to invest in or remain invested in Altria Group, Inc.s securities. In connection with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, we are identifying important factors that, individually or in the aggregate, could cause actual results and outcomes to differ materially from those contained in any forward-looking statements made by us; any such statement is qualified by reference to the following cautionary statements. We elaborate on these and other risks we face throughout this document, particularly in the Business Environment sections preceding our discussion of operating results of our subsidiaries businesses. You should understand that it is not possible to predict or identify all risk factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. We do not undertake to update any forward-looking statement that we may make from time to time.
Tobacco-Related Litigation. There is substantial litigation related to tobacco products in the United States and certain foreign jurisdictions. Damages claimed in some of the tobacco-related litigation are significant, and in certain cases, range into the billions of dollars. We anticipate that new cases will continue to be filed. It is possible that there could be adverse developments in pending cases. An unfavorable outcome or settlement of pending tobacco-related litigation could encourage the commencement of additional litigation. Although PM USA has historically been able to obtain required bonds or relief from bonding requirements in order to prevent plaintiffs from seeking to collect judgments while adverse verdicts have been appealed, there remains a risk that such relief may not be obtainable in all cases. This risk has been substantially reduced given that 42 states now limit the dollar amount of bonds or require no bond at all.
It is possible that the consolidated results of operations, cash flows or financial position of PM USA, PMI or Altria Group, Inc. could be materially affected in a particular fiscal quarter or fiscal year by an unfavorable outcome or settlement of certain pending litigation. Nevertheless, although litigation is subject to uncertainty, management believes the litigation environment has substantially improved. ALG 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 the litigation pending against it, as well as valid bases for appeal of adverse verdicts against it. All such cases are, and will continue to be, vigorously defended. However, ALG and its subsidiaries may enter into settlement discussions in particular cases if they believe it is in the best interests of ALGs stockholders to do so. Please see Note 11 for a discussion of pending tobacco-related litigation.
* | This section uses the terms we, our and us when it is not necessary to distinguish among ALG and its various operating subsidiaries or when any distinction is clear from the context. |
-82-
Corporate Restructuring. On August 29, 2007, the Board of Directors of ALG announced its intention to pursue the spin-off of PMI to ALG shareholders, and anticipates that it will be in a position to finalize its decision and announce the precise timing of the spin-off at its regularly scheduled meeting on January 30, 2008. If the spin-off is authorized, it is possible that an action may be brought seeking to enjoin the spin-off. Any such injunction would have to be based on a finding that Altria is insolvent or would be insolvent after giving effect to the spin-off or intends to delay, hinder or defraud creditors. In the event the spin-off is challenged, ALG will defend such action vigorously, including by prosecuting any necessary appeals. Although litigation is subject to uncertainty, management believes that Altria should ultimately prevail against such action.
Tobacco Control Action in the Public and Private Sectors. Our tobacco subsidiaries face significant governmental action, including efforts aimed at reducing the incidence of smoking, restricting marketing and advertising, imposing regulations on warnings and disclosure of ingredients and seeking to hold us responsible for the adverse health effects associated with both smoking and exposure to environmental tobacco smoke. Governmental actions, combined with the diminishing social acceptance of smoking and private actions to restrict smoking, have resulted in reduced industry volume, and we expect that such actions will continue to reduce consumption levels. Significant regulatory developments will take place over the next few years in most of PMIs markets, driven principally by the World Health Organizations Framework Convention for Tobacco Control, or FCTC. The FCTC is the first international public health treaty, and its objective is to establish a global agenda for tobacco regulation with the purpose of reducing initiation of tobacco use and encouraging cessation. In addition, the FCTC has led to increased efforts by tobacco control advocates and public health organizations to reduce the palatability and appeal of tobacco products to adult smokers. Regulatory initiatives that have been proposed, introduced or enacted include:
| the levying of substantial and increasing tax and duty charges; |
| restrictions or bans on advertising, marketing and sponsorship; |
| the display of larger health warnings, graphic health warnings and other labeling requirements; |
| restrictions on packaging design, including the use of colors and generic packaging; |
| restrictions or bans on the display of tobacco product packaging at the point of sale, and restrictions or bans on cigarette vending machines; |
| requirements regarding testing, disclosure and performance standards for tar, nicotine, carbon monoxide and other smoke constituents levels; |
| requirements regarding testing, disclosure and use of tobacco product ingredients; |
| increased restrictions on smoking in public and work places and, in some instances, in private places and outdoors; |
| elimination of duty free allowances for travelers; and |
| encouraging litigation against tobacco companies. |
Partly because of some or a combination of these measures, unit sales of tobacco products in certain markets, principally Western Europe and Japan, have been in general decline and PMI expects this trend to continue. PMIs operating income could be significantly affected by any significant decrease in demand for its products, any significant increase in the cost of complying with new regulatory requirements and requirements that lead to a commoditization of tobacco products.
-83-
Excise Taxes. Cigarettes are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in cigarette-related taxes or fees have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the Member States of the European Union (the EU) and in other foreign jurisdictions. Legislation has been passed by the United States Congress that would increase the federal excise tax on cigarettes by $0.61 a pack. The President has stated his intention to veto this legislation. It is not possible to predict whether such legislation will become law. In addition, in certain jurisdictions, PMIs products are subject to tax structures that discriminate against premium priced products and manufactured cigarettes and to inconsistent rulings and interpretations on complex methodologies to determine excise and other tax burdens.
Tax increases and discriminatory tax structures are expected to continue to have an adverse impact on sales of cigarettes by PM USA and PMI, due to lower consumption levels and to a shift in consumer purchases from the premium to the non-premium or discount segments or to other low-priced or low-taxed tobacco products or to counterfeit and contraband products.
Minimum Retail Selling Price Laws. Several EU Member States have enacted laws establishing a minimum retail selling price for cigarettes and, in some cases, other tobacco products. The European Commission has commenced infringement proceedings against these Member States, claiming that minimum retail selling price systems infringe EU law. If the European Commissions actions are successful, they could adversely impact excise tax levels and/or price gaps in those markets.
Increased Competition in the United States Tobacco Market. Settlements of certain tobacco litigation in the United States have resulted in substantial cigarette price increases. PM USA faces competition from lowest priced brands sold by certain United States and foreign manufacturers that have cost advantages because they are not parties to these settlements. These manufacturers may fail to comply with related state escrow legislation or may avoid escrow deposit obligations on the majority of their sales by concentrating on certain states where escrow deposits are not required or are required on fewer than all such manufacturers cigarettes sold in such states. Additional competition has resulted from diversion into the United States market of cigarettes intended for sale outside the United States, the sale of counterfeit cigarettes by third parties, the sale of cigarettes by third parties over the Internet and by other means designed to avoid collection of applicable taxes, and increased imports of foreign lowest priced brands.
International Competition. PMI competes primarily on the basis of product quality, brand recognition, brand loyalty, service, marketing, advertising and price. PMI is subject to highly competitive conditions in all aspects of its business. The competitive environment and PMIs competitive position can be significantly influenced by weak economic conditions, erosion of consumer confidence, competitors introduction of low priced products or innovative products, higher cigarette taxes, higher absolute prices and larger gaps between price categories, and products regulation that diminishes the ability to differentiate tobacco products. Competitors include three large international tobacco companies and several regional and local tobacco companies and, in some instances, government-owned tobacco monopolies, principally in the PRC, Egypt, Thailand, Taiwan and Algeria. Industry consolidation and privatizations of governmental monopolies have led to an overall increase in competitive pressures. Some competitors have different profit and volume objectives and some international competitors are less susceptible to changes in currency exchange rates.
Counterfeit Cigarettes in International Markets. Large quantities of counterfeit cigarettes are sold in the international market. PMI believes that Marlboro is the most heavily counterfeited international cigarette brand, although PMI cannot quantify the amount of revenue it loses as a result of this activity. In addition, PMIs revenues are reduced by contraband and legal cross-border transactions.
Governmental Investigations. From time to time, ALG and its tobacco subsidiaries are subject to governmental investigations on a range of matters. Ongoing investigations include allegations of contraband shipments of cigarettes and allegations of unlawful pricing activities within certain international markets. We cannot predict the outcome of those investigations or whether additional investigations may be commenced, and it is possible
-84-
that our tobacco subsidiaries business could be materially affected by an unfavorable outcome of pending or future investigations.
New Tobacco Product Technologies. Our tobacco subsidiaries continue to seek ways to develop and to commercialize new product technologies that may reduce the risk of tobacco use while continuing to offer adult consumers products that meet their taste expectations. Potential solutions being researched include attempting to reduce constituents in tobacco smoke identified by public health authorities as harmful and seeking to produce products that reduce or eliminate exposure to tobacco smoke. Our tobacco subsidiaries may not succeed in these efforts. If they do not succeed, but one or more of their competitors do, our tobacco subsidiaries may be at a competitive disadvantage. Further, we cannot predict whether regulators will permit the marketing of products with claims of reduced risk to consumers, which could significantly undermine the commercial viability of any products that might be developed.
Adjacency Strategy. PM USA and PMI have adjacency growth strategies involving potential moves into complementary tobacco or tobacco-related products or processes. We cannot guarantee that these strategies, or any products introduced in connection with these strategies, will be successful.
Foreign Currency. PMI conducts its business in local currency and, for purposes of financial reporting, its results are translated into U.S. dollars based on average exchange rates prevailing during a reporting period. During times of a strengthening U.S. dollar, our reported net revenues and operating income will be reduced because the local currency will translate into fewer U.S. dollars. During periods of economic crises internationally, foreign currencies may be devalued significantly against the U.S. dollar, reducing PMIs margins. Actions to recover margins may result in lower volume and a weaker competitive position for PMI.
Tobacco Availability and Quality. Government mandated prices, production control programs, shifts in crops driven by economic conditions and adverse weather patterns may increase or decrease the cost or reduce the quality of tobacco and other agricultural products used to manufacture our products. As with other agriculture commodities, the price of tobacco leaf and cloves can be influenced by imbalances in supply and demand and crop quality can be influenced by variations in weather patterns. Tobacco production in certain countries is subject to a variety of controls, including governmental mandated prices and production control programs. Changes in the patterns of demand for agricultural products could cause farmers to plant less tobacco. Any significant change in tobacco leaf and clove prices, quality and quantity could affect our tobacco subsidiaries profitability and business.
Attracting and Retaining Talent. Our ability to implement our strategy of attracting and retaining the best global talent may be impaired by the decreasing social acceptance of cigarette smoking. The tobacco industry competes for talent with the consumer products and other companies that enjoy greater societal acceptance. As a result, our tobacco subsidiaries may be unable to attract and retain the best global talent.
Competition and Economic Downturns. Each of our tobacco subsidiaries is subject to intense competition, changes in consumer preferences and local economic conditions. To be successful, they must continue to:
| promote brand equity successfully; |
| anticipate and respond to new consumer trends; |
| develop new products and markets and to broaden brand portfolios in order to compete effectively with lower priced products; |
| improve productivity; and |
| be able to protect or enhance margins through price increases. |
-85-
The willingness of consumers to purchase premium cigarette brands depends in part on local economic conditions. In periods of economic uncertainty, consumers tend to purchase more private label and other economy brands, and the volume of our consumer products subsidiaries could suffer accordingly.
Our finance subsidiary, PMCC, holds investments in finance leases, principally in transportation (including aircraft), power generation and manufacturing equipment and facilities. Its lessees are also subject to intense competition and economic conditions. If counterparties to PMCCs leases fail to manage through difficult economic and competitive conditions, PMCC may have to increase its allowance for losses, which would adversely affect our profitability.
Strengthening Brand Portfolios Through Acquisitions. One element of PMIs growth strategy is to strengthen its brand portfolio and/or expand its geographic reach through active programs of selective acquisitions. PM USA from time to time considers acquisitions as part of its adjacency strategy. Acquisition opportunities are limited, and acquisitions present risks of failing to achieve efficient and effective integration, strategic objectives and anticipated revenue improvements and cost savings. There can be no assurance that we will be able to continue to acquire attractive businesses on favorable terms or that all future acquisitions will be quickly accretive to earnings.
Asset Impairment. We periodically calculate the fair value of our goodwill and intangible assets to test for impairment. This calculation may be affected by the market conditions noted above, as well as interest rates and general economic conditions. If an impairment is determined to exist, we will incur impairment losses, which will reduce our earnings.
IRS Challenges to PMCC Leases. The IRS concluded its examination of Altria Group, Inc.s consolidated tax returns for the years 1996 through 1999, and issued a final Revenue Agents Report (RAR) on March 15, 2006. The RAR disallowed benefits pertaining to certain PMCC leveraged lease transactions for the years 1996 through 1999. Altria Group, Inc. has agreed with all conclusions of the RAR, with the exception of the disallowance of benefits pertaining to several PMCC leveraged lease transactions for the years 1996 through 1999. PMCC will continue to assert its position regarding these leveraged lease transactions and contest approximately $150 million of tax and net interest assessed and paid with regard to them. The IRS may in the future challenge and disallow more of PMCCs leveraged leases based on Revenue Rulings, an IRS Notice and subsequent case law addressing specific types of leveraged leases (lease-in/lease-out (LILO) and sale-in/lease-out (SILO) transactions). PMCC believes that the position and supporting case law described in the RAR, Revenue Rulings and the IRS Notice are incorrectly applied to PMCCs transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRSs position. PMCC and ALG intend to vigorously defend against any challenges based on that position through litigation. In this regard, on October 16, 2006, PMCC filed a complaint in the U.S. District Court for the Southern District of New York to claim refunds for a portion of these tax payments and associated interest. However, should PMCCs position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and significantly lower its earnings to reflect the recalculation of the income from the affected leveraged leases, which could have a material effect on the earnings and cash flows of Altria Group, Inc. in a particular fiscal quarter or fiscal year. PMCC considered this matter in its adoption of FIN 48 and FASB Staff Position No. FAS 13-2.
-86-
Item 4. Controls and Procedures.
Altria Group, Inc. carried out an evaluation, with the participation of Altria Group, Inc.s management, including ALGs Chief Executive Officer and Chief Financial Officer, of the effectiveness of Altria Group, Inc.s disclosure controls and procedures (as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934, as amended) as of the end of the period covered by this report. Based upon that evaluation, ALGs Chief Executive Officer and Chief Financial Officer concluded that Altria Group, Inc.s disclosure controls and procedures are effective. There have been no changes in Altria Group, Inc.s internal control over financial reporting during the most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, Altria Group, Inc.s internal control over financial reporting.
-87-
See Note 11. Contingencies, of the Notes to the Condensed Consolidated Financial Statements included in Part I, Item 1 of this report for a discussion of legal proceedings pending against Altria Group, Inc. and its subsidiaries. See also Exhibits 99.1 and 99.2 to this report.
Information regarding Risk Factors appears in MD&A Cautionary Factors That May Affect Future Results, in Part I Item 2 of this Form 10-Q and in Part I Item 1A. Risk Factors of our Report on Form 10-K for the year ended December 31, 2006. Other than as set forth in Part I Item 2 of this Form 10-Q, there have been no material changes from the risk factors previously disclosed in our Report on Form 10-K, with the exception of the following additions:
Corporate Restructuring. On August 29, 2007, the Board of Directors of ALG announced its intention to pursue the spin-off of PMI to ALG shareholders, and anticipates that it will be in a position to finalize its decision and announce the precise timing of the spin-off at its regularly scheduled meeting on January 30, 2008. If the spin-off is authorized, it is possible that an action may be brought seeking to enjoin the spin-off. Any such injunction would have to be based on a finding that Altria is insolvent or would be insolvent after giving effect to the spin-off or intends to delay, hinder or defraud creditors. In the event the spin-off is challenged, ALG will defend such action vigorously, including by prosecuting any necessary appeals. Although litigation is subject to uncertainty, management believes that Altria should ultimately prevail against such action.
Tobacco Control Action in the Public and Private Sectors. Our tobacco subsidiaries face significant governmental action, including efforts aimed at reducing the incidence of smoking, restricting marketing and advertising, imposing regulations on warnings and disclosure of ingredients and seeking to hold us responsible for the adverse health effects associated with both smoking and exposure to environmental tobacco smoke. Governmental actions, combined with the diminishing social acceptance of smoking and private actions to restrict smoking, have resulted in reduced industry volume, and we expect that such actions will continue to reduce consumption levels. Significant regulatory developments will take place over the next few years in most of PMIs markets, driven principally by the World Health Organizations Framework Convention for Tobacco Control, or FCTC. The FCTC is the first international public health treaty, and its objective is to establish a global agenda for tobacco regulation with the purpose of reducing initiation of tobacco use and encouraging cessation. In addition, the FCTC has led to increased efforts by tobacco control advocates and public health organizations to reduce the palatability and appeal of tobacco products to adult smokers. Regulatory initiatives that have been proposed, introduced or enacted include:
| the levying of substantial and increasing tax and duty charges; |
| restrictions or bans on advertising, marketing and sponsorship; |
| the display of larger health warnings, graphic health warnings and other labeling requirements; |
| restrictions on packaging design, including the use of colors and generic packaging; |
| restrictions or bans on the display of tobacco product packaging at the point of sale, and restrictions or bans on cigarette vending machines; |
| requirements regarding testing, disclosure and performance standards for tar, nicotine, carbon monoxide and other smoke constituents levels; |
-88-
| requirements regarding testing, disclosure and use of tobacco product ingredients; |
|