Food

Kraft Foods (Kraft) faced significant challenges in 2003, and its results were disappointing. Operating income decreased 1.7% to $6.0 billion, primarily as a result of higher commodity and benefit costs, and increased investment spending. Volume increased 0.7%, as growth of 1.6% from ongoing businesses was partially offset by divestitures.

Roger Deromedi, who had been Co-Chief Executive Officer of Kraft overseeing its international food business, became Kraft’s CEO in December 2003 and is focused single-mindedly on getting the business back on track. I have great confidence in the ability of Roger and his team to address Kraft’s challenges. They are taking the actions needed to restore growth, and anticipate reinvesting $500 to $600 million in the business in 2004 to narrow price gaps and enhance brand equity. But there are no quick fixes, and Kraft acknowledges that 2004 will be a difficult year.

In January 2004, Kraft outlined a new Sustainable Growth Plan to strengthen performance and achieve its long-term growth objectives. The plan includes a restructuring program that is expected to cost up to $1.2 billion, pre-tax, and generate approximately $400 million in annual savings by 2006. Kraft has reset its long-term performance targets, with revenue growth of around 3% on volume growth of 2% to 3%, both including tack-on acquisitions and excluding the impact of divestitures. While the charges associated with the restructuring program will lower Kraft’s earnings per share in 2004, we are confident these actions will position Kraft to deliver sustainable earnings-per-share growth in the 6% to 9% range over the long term.

Despite recent challenges, Kraft continues to innovate and has good potential for growth based on its strong position in some of the food industry’s key categories, including convenient meals, ready-to-drink beverages and snacks. It is transforming its portfolio to reflect changing consumer and customer trends, with integrated solutions addressing health and wellness concerns. I believe that Kraft has the right strategies and fundamental strength in its business to return it to sustained volume and profit growth.

Improving Litigation Environment

I would like to explain in some detail why the favorable litigation developments in the U.S. during 2003 were so significant. First, however, it is important to provide some perspective. PM USA has a long history of successfully managing its litigation, in part by obtaining pre-trial dismissals of tobacco cases. Since the beginning of 2001, more than 400 individual smoking cases have been dismissed prior to trial. During the same time period, 36 class actions and over 70 health care reimbursement cases have also been dismissed. The vast majority of pending cases are inactive, with fewer cases set for trial in the coming 12 months than at any time in the past five years.

PM USA successfully defended the last three cases tried in California, and in 2003 obtained dismissals of more than 30 other California cases, seven of which had been set for trial in 2003. These are particularly meaningful developments, given the previous difficulties faced by the industry in this state.

We also are encouraged that, despite certification by several trial courts, as I write this letter no appellate court has upheld certification of a “Lights” class action. In the Aspinall “Lights” class action case in Massachusetts, the class was decertified on appeal and now is under review by the Massachusetts Supreme Judicial Court, and the class in the Hines “Lights” class action case in Florida was similarly decertified by an intermediate appellate court. In January, the trial judge in the Curtis “Lights” case refused to certify the case as a class action in Minnesota, and the Fischer “Lights” case was dismissed in California. Although “Lights” cases remain certified in Missouri, Illinois and Ohio, PM USA is challenging those certifications.

Last year, there were landmark rulings at both the state and federal levels. In May 2003, a Florida appeals court overturned the $145 billion verdict in the Engle case and decertified that class action—a decision it reaffirmed in September. During September, the Illinois Supreme Court granted direct review of the judgment in the Price case, thereby shortcutting the normal appellate process and expediting what we hope will be a favorable decision later this year. It also reinstated an onerous, but manageable, bond requirement for PM USA.

The Price case highlighted the fact that not all states have bond caps, thus limiting a defendant’s ability to exercise its right to an appeal in the face of an unmanageable bond. Together with other businesses, PM USA has made it a priority to advocate bond cap legislation in state legislatures. In 2001, only five states had appeal bond caps and five states plus Puerto Rico did not require a bond. As of year-end 2003, 30 states and Puerto Rico, representing nearly two thirds of the U.S. population, had appeal bond caps in place or did not require one. There has been remarkable success on this issue in a very short period of time, and we are hopeful that there will be additional progress in 2004.

Another important case last year was the U.S. Supreme Court decision in Campbell v. State Farm, which speaks clearly on the issue of excessive punitive damages. Among its rulings, the court concluded that in calculating punitive damages, courts should rarely, if ever, apply more than a “single-digit” ratio of punitive to compensatory damages. The State Farm decision has already had positive ramifications for some cases in which excessive punitive damages had been awarded against PM USA, and we expect similar results in future cases.

The Department of Justice case is scheduled for trial in September. A civil RICO claim remains, after the two other claims for reimbursement of health care costs were dismissed shortly after the lawsuit was filed. PM USA has filed motions for summary judgment seeking dismissal of the remaining RICO claim, and we expect a decision sometime during the first half of 2004. We continue to believe that the remaining claim lacks merit.

Taken together, these trends are a clear indication that the domestic litigation environment has improved significantly, and recent events are likely to have a positive effect on the legal environment in 2004 and beyond.