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

(Continued)

Discussion and Analysis > Operating Results by Business Segment > Tobacco > Operating Results

2005 compared with 2004

The following discussion compares tobacco operating results for 2005 with 2004.

• Domestic tobacco: PM USA’s net revenues, which include excise taxes billed to customers, increased $623 million (3.6%). Excluding excise taxes, net revenues increased $658 million (4.8%), due primarily to lower wholesale promotional allowance rates ($837 million), partially offset by lower volume ($189 million).
  
  Operating companies income increased $176 million (4.0%), due primarily to the previously discussed lower wholesale promotional allowance rates, net of expenses related to the quota buy-out legislation and ongoing resolution costs (aggregating $419 million), the reversal of a 2004 accrual related to tobacco quota buy-out legislation ($115 million), and lower charges for the domestic tobacco headquarters relocation ($27 million), partially offset by a charge for PM USA’s portion of the losses incurred by the federal government on disposition of its pool tobacco stock ($138 million), lower volume ($137 million) and higher marketing, administration and research costs ($133 million, due primarily to a pre-tax provision of $56 million for the Boeken individual smoking case, and an increase in research and development expenses).
  
  Marketing, administration and research costs include PM USA’s cost of administering and litigating product liability claims. Litigation defense costs are influenced by a number of factors, as more fully discussed in Note 19. Principal among these factors are the number and types of cases filed, the number of cases tried annually, the results of trials and appeals, the development of the law controlling relevant legal issues, and litigation strategy and tactics. For the years ended December 31, 2005, 2004 and 2003, product liability defense costs were $258 million, $268 million and $307 million, respectively. The factors that have influenced past product liability defense costs are expected to continue to influence future costs. While PM USA does not expect that product liability defense costs will increase significantly in the future, it is possible that adverse developments among the factors discussed above could have a material adverse effect on PM USA’s operating companies income.
  
  PM USA’s shipment volume was 185.5 billion units, a decrease of 0.8%, but was estimated to be essentially flat when adjusted for the timing of promotional shipments and trade inventory changes, and two less shipping days versus 2004. In the premium segment, PM USA’s shipment volume decreased 0.6%. Marlboro shipment volume increased 0.1 billion units (0.1%) to 150.5 billion units. In the discount segment, PM USA’s shipment volume decreased 3.2%, while Basic shipment volume was down 2.7% to 15.2 billion units.
  
  The following table summarizes PM USA’s retail share performance, based on data from the IRI/Capstone Total Retail Panel, which was developed to measure market share in retail stores selling cigarettes, but was not designed to capture Internet or direct mail sales:
  
  
                                                               

• PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $0.50 per carton, from $5.50 to $5.00, effective December 19, 2005. In addition, effective December 27, 2005, PM USA increased the price of its other brands by $2.50 per thousand cigarettes or $0.50 per carton.
  
  PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $1.00 per carton, from $6.50 to $5.50, effective December 12, 2004. In addition, effective January 16, 2005, PM USA increased the price of its other brands by $5.00 per thousand cigarettes or $1.00 per carton.
  
  In April 2005, PM USA announced the construction of a research and technology center in Richmond, Virginia, which is estimated to cost $350 million. When completed in 2007, the facility will nearly double PM USA’s research space and will house more than 500 scientists, engineers and support staff.
  
  PM USA cannot predict future changes or rates of change in domestic 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 price increases related to increased excise taxes and tobacco litigation settlements, as well as by the other items discussed under the caption Tobacco—Business Environment.
• International tobacco: International tobacco net revenues, which include excise taxes billed to customers, increased $5.8 billion (14.5%). Excluding excise taxes, net revenues increased $2.4 billion (13.8%), due primarily to price increases ($1.0 billion), the impact of acquisitions ($796 million) and favorable currency ($576 million).
  
  Operating companies income increased $1.3 billion (19.2%), due primarily to price increases ($1.0 billion, including the benefit from the return of the Marlboro license in Japan), favorable currency ($331 million), the 2004 charge related to the international tobacco E.C. agreement ($250 million) and the impact of acquisitions ($341 million, which includes Sampoerna equity income earned from March to May of 2005), partially offset by higher marketing, administration and research costs ($246 million, due primarily to higher marketing, and research and development expenses), unfavorable volume/mix ($198 million, reflecting favorable volume but unfavorable mix), expenses related to the international tobacco E.C. agreement ($61 million), higher fixed manufacturing costs ($63 million) and higher pre-tax charges for asset impairment and exit costs ($46 million).
  
  During the third quarter of 2005, PMI refined its organizational structure to bring greater focus to the enlarged European Union and the Asia region. Accordingly, in place of Western Europe and Central Europe regions, PMI now reports results for a European Union region, which includes the original European Union countries and the Baltic States, Cyprus, Czech Republic, Hungary, Malta, Norway, Poland, Slovak Republic and Switzerland. Other regions remain essentially unchanged. The region commentary throughout PMI’s section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects the revised organizational structure, with prior-year results restated for comparability.
  
  PMI’s cigarette volume of 804.5 billion units increased 43.1 billion units (5.7%), due primarily to acquisition volumes in Indonesia and Colombia, and higher volume in Italy as a result of the one-time inventory sale to PMI’s new distributor. Excluding the volume related to acquisitions and the one-time inventory sale to the new distributor in Italy, shipments increased 0.3%. PMI’s total tobacco volume, which includes 7.1 billion cigarette equivalent units of other tobacco products, grew 6.1% overall, and 0.8% excluding acquisitions and the one-time inventory sale to the new distributor in Italy.
  
  In the European Union, PMI’s cigarette volume decreased 2.7%, due primarily to declines in Germany, Portugal, Switzerland and Spain, partially offset by the 2005 inventory sale in Italy and higher shipments in France. Excluding the inventory sale in Italy, PMI’s volume decreased 3.8% in the European Union.

• In Germany, PMI’s cigarette volume declined 15.9% and market share was down 0.2 share points to 36.6%, reflecting tax-driven price increases in March and December 2004, which accelerated down-trading to low-priced tobacco portions that currently are subject to favorable excise tax treatment compared with cigarettes. PMI captured a 16.9% share of the German tobacco portions segment, driven by Marlboro, Next, and f6 tobacco portions. During the fourth quarter of 2005, the European Court of Justice issued a mandate that requires the German government to equalize the tax burden between cigarettes and tobacco portions. As a result of this ruling, tobacco portions in Germany will be taxed at the same rate as cigarettes for products manufactured as of April 1, 2006. Nevertheless, lower-priced tobacco portions are expected to remain available at retail for some time due to anticipated high stock levels.
  
  In Spain, PMI’s shipment volume decreased 2.2%, reflecting increased consumer down-trading to the deep-discount segment. As a result of growing price gaps, PMI’s market share in Spain declined 1.1 share points to 34.5%, with a pronounced product mix deterioration. On January 21, 2006, the Spanish government raised excise taxes on cigarettes, which would have resulted in even larger price gaps if the tax increase had been passed on to consumers. Accordingly, PMI reduced its cigarette prices on January 26, 2006 to restore the competitiveness of its brands. PMI expects that the price reduction will significantly reduce its income in Spain in 2006. Late in February the Spanish government again raised the level of excise taxes, but also established a minimum excise tax, following which PMI raised its prices back to prior levels. While the introduction of a minimum excise tax effectively raises the floor price of the cheapest brands, it still permits these brands to maintain sizeable price gaps. Accordingly, PMI must await further developments before being able to make a more accurate assessment of its 2006 volume and income projections from the Spanish market.
  
  In Italy, the total cigarette market declined 6.1% in 2005, largely reflecting tax-driven pricing and the impact of indoor smoking restrictions in public places. PMI’s shipment volume in Italy increased 2.7%, mainly reflecting the one-time inventory sale to its new distributor. Excluding the one-time inventory sale, cigarette shipment volume in Italy declined 3.2%. However, market share in Italy increased 1.1 share points to 52.6%, driven by Diana.
  
  In France, shipment volume increased 2.5% and market share increased 1.9 share points to 41.7%, reflecting the strong performance of Marlboro and the Philip Morris brands.
  
  In Eastern Europe, Middle East and Africa, volume increased 6.4%, due to gains in Egypt, Russia, North Africa, Turkey and Ukraine. Higher shipments in Ukraine and Egypt reflect improved economic conditions. In Turkey, shipment volume increased 8.6% and market share increased 4.4 points to 41.4%, fueled by the growth of Marlboro, Parliament, Lark and Bond Street.
  
  In Asia, volume increased 21.3%, due primarily to the acquisition in Indonesia, the strong performance of Marlboro in the Philippines and L&M growth in Thailand, partially offset by lower volumes in Korea and Japan. Excluding the acquisition in Indonesia, volume in Asia was essentially flat.
  
  In Latin America, volume increased 5.5%, due primarily to the acquisition in Colombia, and higher shipments in Mexico, partially offset by declines in Argentina and Brazil. Excluding the acquisition in Colombia, volume in Latin America declined 3.8%.
  
  PMI achieved market share gains in a number of important markets, including Egypt, France, Italy, Japan, Korea, Mexico, the Netherlands, the Philippines, Russia, Thailand, Turkey, Ukraine and the United Kingdom. In addition, in Indonesia, Sampoerna’s share in 2005 was significantly higher than the prior year.
  
  Volume for Marlboro cigarettes grew 2.0%, due primarily to gains in Eastern Europe, the Middle East and Africa, higher inventories in Japan following the return of the Marlboro license in May 2005, and the one-time inventory sale in Italy, partially offset by lower volumes in Germany and worldwide duty-free. Excluding the one-time gains in Italy and Japan, Marlboro cigarette volume was essentially flat. Marlboro market share increased in many important markets, including Egypt, France, Japan, Mexico, Portugal, Russia, Turkey, Ukraine and the United Kingdom.
  
  As discussed in Note 5. Acquisitions, during 2005, PMI acquired 98% of the outstanding shares of Sampoerna, an Indonesian tobacco company, and a 98.2% stake in Coltabaco, the largest tobacco company in Colombia.
  
  During 2004, PMI purchased a tobacco business in Finland for a cost of approximately $42 million. During 2004, PMI also increased its ownership interest in a tobacco business in Serbia from 74.2% to 85.2%.
  
  PMI’s license agreement with Japan Tobacco Inc. for the manufacture and sale of Marlboro cigarettes in Japan was not renewed when the agreement expired in April 2005. PMI has undertaken the manufacture and merchandising of Marlboro and has expanded its field force and vending machine infrastructure in Japan.
  
  In December 2005, the China National Tobacco Corporation (“CNTC”) and PMI reached agreement on the licensed production in China of Marlboro and the establishment of an international joint venture between China National Tobacco Import and Export Group Corporation (“CNTIEGC”), a wholly owned subsidiary of CNTC, and PMI. PMI and CNTIEGC will each hold 50% of the shares of the joint venture company, which will be based in Lausanne, Switzerland. Following its establishment, the joint venture company will offer consumers a comprehensive portfolio of Chinese heritage brands globally, expand the export of tobacco products and tobacco materials from China, and explore other business development opportunities. It is expected that the production and sale of Marlboro cigarettes under license in China and the sale of Chinese style brands in selected international markets through the joint venture company will commence in the first half of 2006. The agreements will not result in a material impact on PMI’s financial results.