Management's Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

Discussion and Analysis > Financial Review

• Net Cash Provided by Operating Activities: During 2005, net cash provided by operating activities was $11.1 billion, compared with $10.9 billion during 2004. The increase in cash provided by operating activities was due primarily to higher earnings from continuing operations and lower escrow bond deposits related to the Price domestic tobacco case, partially offset by a higher use of cash to fund working capital and increased pension plan contributions.
  
  During 2004, net cash provided by operating activities was $10.9 billion, compared with $10.8 billion during 2003. The increase of $74 million was due primarily to higher net earnings in 2004, partially offset by higher escrow deposits for the Price domestic tobacco case and lower cash from the financial services business.
• Net Cash Used in Investing Activities: One element of the growth strategy of ALG’s subsidiaries is to strengthen their brand portfolios through active programs of selective acquisitions and divestitures. These subsidiaries are constantly investigating potential acquisition candidates and from time to time Kraft sells businesses that are outside its core categories or that do not meet its growth or profitability targets. The impact of future acquisitions or divestitures could have a material impact on Altria Group, Inc.’s consolidated cash flows, and future sales of businesses could in some cases result in losses on sale. 
  
  During 2005, 2004 and 2003, net cash used in investing activities was $4.9 billion, $1.4 billion and $2.4 billion, respectively. The increase in 2005 primarily reflects the purchase of 98% of the outstanding shares of Sampoerna in 2005, partially offset by proceeds from the sales of businesses (primarily Kraft’s sugar confectionery business) in 2005. The decrease in 2004 primarily reflects lower amounts used for the purchase of businesses. The discontinuation of finance asset investments, as well as the increased proceeds from finance asset sales also contributed to a lower level of cash used in investing activities.
  
  Capital expenditures for 2005 increased 15.3% to $2.2 billion. Approximately 44% related to tobacco operations and approximately 53% related to food operations; the expenditures were primarily for modernization and consolidation of manufacturing facilities, and expansion of certain production capacity. In 2006, capital expenditures are expected to be approximately 20% above 2005 expenditures and are expected to be funded by operating cash flows.
• Net Cash Used in Financing Activities: During 2005, net cash used in financing activities was $5.1 billion, compared with $8.0 billion in 2004 and $5.5 billion in 2003. The decrease of $2.9 billion from 2004 was due primarily to increased borrowings in 2005, which were primarily related to the acquisition of Sampoerna, partially offset by higher dividends paid on Altria Group, Inc. common stock and an increase in share repurchases at Kraft. The increase of $2.5 billion over 2003 was due primarily to the repayment of debt in 2004, as compared with 2003 when ALG and Kraft borrowed against their revolving credit facilities, while their access to commercial paper markets was temporarily eliminated following a $10.1 billion judgment against PM USA.

• Debt and Liquidity:
  
  Credit Ratings: Following a $10.1 billion judgment on March 21, 2003, against PM USA in the Price litigation, which is discussed in Note 19, the three major credit rating agencies took a series of ratings actions resulting in the lowering of ALG’s short-term and long-term debt ratings. During 2003, Moody’s lowered ALG’s short-term debt rating from “P-1” to “P-3” and its long-term debt rating from “A2” to “Baa2.” Standard & Poor’s lowered ALG’s short-term debt rating from “A-1” to “A-2” and its long-term debt rating from “A-” to “BBB.” Fitch Rating Services lowered ALG’s short-term debt rating from “F-1” to “F-2” and its long-term debt rating from “A” to “BBB.”
  
  While Kraft is not a party to, and has no exposure to, this litigation, its credit ratings were also lowered, but to a lesser degree. As a result of the rating agencies’ actions, borrowing costs for ALG and Kraft have increased. None of ALG’s or Kraft’s debt agreements require accelerated repayment as a result of a decrease in credit ratings. The credit rating downgrades by Moody’s, Standard & Poor’s, and Fitch Rating Services had no impact on any of ALG’s or Kraft’s other existing third-party contracts.
  
  Credit Lines: ALG and Kraft each maintain separate revolving credit facilities that they have historically used to support the issuance of commercial paper. However, as a result of the rating agencies’ actions discussed above, ALG’s and Kraft’s access to the commercial paper market was temporarily eliminated in 2003. Subsequently, in April 2003, ALG and Kraft began to borrow against existing credit facilities to repay maturing commercial paper and to fund normal working capital needs. By the end of May 2003, Kraft regained its access to the commercial paper market. ALG’s access to the commercial paper market has improved since it regained limited access in November 2003, but not to the levels achieved prior to the ratings downgrades.
  
  As discussed in Note 5. Acquisitions, 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 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 December 31, 2005, PMI exceeded this ratio by a significant amount and is expected to continue to exceed it.
  
  In April 2005, ALG negotiated a 364-day revolving credit facility in the amount of $1.0 billion and a new multi-year credit facility in the amount of $4.0 billion, which expires in April 2010. In addition, ALG terminated its existing $5.0 billion multi-year credit facility, which was due to expire in July 2006. The new ALG facilities require the maintenance of an earnings to fixed charges ratio, as defined by the agreements, of 2.5 to 1.0. At December 31, 2005, the ratio calculated in accordance with the agreements was 10.0 to 1.0.
  
  In April 2005, Kraft negotiated a new multi-year revolving credit facility to replace both its $2.5 billion 364-day facility that was due to expire in July 2005 and its $2.0 billion multi-year facility that was due to expire in July 2006. The new Kraft facility, which is for the sole use of Kraft, in the amount of $4.5 billion, expires in April 2010 and requires the maintenance of a minimum net worth of $20.0 billion. At December 31, 2005, Kraft’s net worth was $29.6 billion.
  
  ALG, PMI and Kraft 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.
  
  At December 31, 2005, $2.4 billion of short-term borrowings that PMI expects to remain outstanding at December 31, 2006 were reclassified as long-term debt.

• At December 31, 2005, credit lines for ALG, Kraft and PMI, and the related activity were as follows:
  
  
                                                                                 
  
  In addition to the above, certain international subsidiaries of ALG and Kraft maintain credit lines to meet their respective working capital needs. These credit lines, which amounted to approximately $2.2 billion for ALG subsidiaries (other than Kraft) and approximately $1.3 billion for Kraft subsidiaries, are for the sole use of these international businesses. Borrowings on these lines amounted to approximately $1.0 billion at December 31, 2005.
  
  Debt: Altria Group, Inc.’s total debt (consumer products and financial services) was $23.9 billion and $23.0 billion at December 31, 2005 and 2004, respectively. Total consumer products debt was $21.9 billion and $20.8 billion at December 31, 2005 and 2004, respectively. Total consumer products debt includes third-party debt in Kraft’s consolidated balance sheet of $10.5 billion and $12.3 billion, at December 31, 2005 and 2004, respectively, and PMI third-party debt of $4.9 billion and $0.7 billion at December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, Altria Group, Inc.’s ratio of consumer products debt to total equity was 0.61 and 0.68, respectively. The ratio of total debt to total equity was 0.67 and 0.75 at December 31, 2005 and 2004, respectively. Fixed-rate debt constituted approximately 75% and 90% of total consumer products debt at December 31, 2005 and 2004, respectively. The weighted average interest rate on total consumer products debt, including the impact of swap agreements, was approximately 5.4% at December 31, 2005 and 2004.
  
  In November 2004, Kraft issued $750 million of 5-year notes bearing interest at 4.125%. The net proceeds of the offering were used by Kraft to refinance maturing debt. Kraft has a Form S-3 shelf registration statement on file with the SEC, under which Kraft may sell debt securities and/or warrants to purchase debt securities in one or more offerings. At December 31, 2005, Kraft had $3.5 billion of capacity remaining under its shelf registration.
  
  At December 31, 2005, ALG had approximately $2.8 billion of capacity remaining under its existing shelf registration statement.
  
  ALG does not guarantee the debt of Kraft or PMI.
  
  Taxes: The IRS is examining the consolidated tax returns for Altria Group, Inc., which includes PMCC, for years 1996 through 1999. Recently, the IRS has proposed to disallow certain transactions, and may in the future challenge and disallow several more, of PMCC’s leveraged leases based on recent Revenue Rulings and a recent IRS Notice addressing specific types of leveraged leases (lease-in/lease-out transactions, qualified technological equipment transactions, and sale-in/lease-out transactions). Altria Group, Inc. is expecting an assessment regarding these transactions for the years 1996 to 1999. PMCC believes that the position and supporting case law described in the Revenue Rulings and the IRS Notice as well as those asserted in the proposed adjustments, are incorrectly applied to PMCC’s transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRS’s position. PMCC and ALG intend to vigorously defend against any challenges based on that position through administrative appeals and litigation, if necessary, and ALG believes that, given the strength of PMCC’s position, it should ultimately prevail. However, litigation is subject to many uncertainties and an adverse outcome could have a material adverse effect on Altria Group, Inc.’s consolidated results of operations, cash flows or financial position.