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

(Continued)

Discussion and Analysis Operating Results by Business Segment Tobacco Operating Results

		Net Revenues									Operating Companies Income
	(in millions)		2003				2002		2001			2003			2002		2001
	Domestic
	tobacco		$17,001				$18,877		$19,902			$ 3,889			$ 5,011		$ 5,264
	International
	tobacco		33,389				28,672		26,517			6,286			5,666		5,406
	Total tobacco		$50,390				$47,549		$46,419			$10,175			$10,677		$10,670

2003 compared with 2002

The following discussion compares tobacco operating results for 2003 with 2002.

Domestic tobacco: PM USA’s net revenues, which include excise taxes billed to customers, decreased $1.9 billion (9.9%). Excluding excise taxes, net revenues decreased $1.8 billion (11.9%), due primarily to price promotions to narrow price gaps ($1.5 billion) and lower volume ($335 million).

Operating companies income decreased $1.1 billion (22.4%), due primarily to price promotions to narrow price gaps, net of lower costs under the State Settlement Agreements (aggregating $620 million), lower volume ($186 million), higher marketing, administration and research costs, and the 2003 pre-tax charges for a legal settlement ($202 million) and headquarters relocation ($69 million).

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 18. 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, 2003, 2002 and 2001, product liability defense costs were $307 million, $358 million and $387 million, respectively, reflecting an overall improvement in the above factors since January 1, 2001. 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 187.2 billion units, a decrease of 2.3%. In the premium segment, PM USA’s shipment volume decreased 1.1%, while Marlboro shipment volume decreased 636 million units (0.4%) to 147.9 billion units. In the discount segment, PM USA’s shipment volume decreased 12.9%, while Basic shipment volume was down 11.6% to 15.8 billion units. While PM USA’s shipment volume comparisons to 2002 continued to be affected by factors such as a weak economic environment and sharp increases in state excise taxes, PM USA’s sequential retail share has improved.

Effective with the first quarter of 2003, PM USA began reporting retail share results based on a retail tracking service, with data beginning in the fourth quarter of 2002. This service, IRI/Capstone Total Retail Panel, was developed to provide a more comprehensive measure of market share in retail stores selling cigarettes. It is not designed to capture Internet or direct mail sales. The following table summarizes sequential retail share performance for PM USA’s key brands from the fourth quarter of 2002 through the fourth quarter of 2003, and the full year 2003, based on data from the IRI/Capstone Total Retail Panel:

	For the Three Months Ended					For the Year Ended
	December 31,	March 31,	June 30,	September 30,	December 31,	December 31,
	2002	2003	2003	2003	2003	2003
Marlboro	37.4%	37.5%	37.8%	38.1%	38.5%	38.0%
Parliament	1.3	1.5	1.7	1.8	1.7	1.7
Virginia Slims	2.5	2.5	2.4	2.4	2.4	2.4
Basic	4.3	4.3	4.2	4.2	4.2	4.2
Focus Brands	45.5	45.8	46.1	46.5	46.8	46.3
Other	2.6	2.5	2.4	2.3	2.3	2.4
Total PM USA	48.1%	48.3%	48.5%	48.8%	49.1%	48.7%

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 in PM USA’s shipments or retail share; however, it believes that PM USA’s 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 $4.7 billion (16.5%). Excluding excise taxes, net revenues increased $1.3 billion (8.7%), due primarily to favorable currency ($1.1 billion), price increases ($212 million), the impact of acquisitions in Serbia and Greece, and higher volume.

Operating companies income increased $620 million (10.9%), due primarily to favorable currency ($469 million), price increases ($212 million) and the pre-tax charges for asset impairment and exit costs in 2002 ($58 million), partially offset by higher marketing, administration and research costs, and unfavorable volume/mix, reflecting lower volume in the higher margin markets of France, Germany and Italy.

PMI’s volume of 735.8 billion units increased 12.7 billion units (1.8%). In Western Europe, volume declined, due primarily to decreases in France, Germany and Italy, partially offset by increases in Spain and Austria. Shipment volume decreased in France, although market share was higher, reflecting contraction of the entire market following tax-driven price increases in January 2002, January 2003 and October 2003. In Germany, volume declined, reflecting a lower total market and consumer down-trading to low-priced tobacco portions following tax-driven price increases. In Italy, volume decreased 14.3% and market share fell 7.1 share points to 54.1%, as PMI’s brands remain under pressure from low-priced competitive brands. In Central and Eastern Europe, Middle East and Africa, volume increased, due to gains in Russia, the Ukraine, Romania and Turkey, and acquisitions in Greece and Serbia, partially offset by declines in Hungary and Poland, due to intense price competition, and declines in Lithuania and the Slovak Republic, due to lower markets as a result of tax-driven price increases. In Asia, volume declined slightly as decreases in the Philippines and Indonesia were partially offset by increases in Japan, Korea, Taiwan and Thailand. In Latin America, volume increased, driven by gains in Argentina and Mexico.

PMI achieved market share gains in a number of important markets including Argentina, Austria, France, Germany, Greece, Japan, Poland, Russia, Singapore, the Slovak Republic, Spain, Turkey, the Ukraine and the United Kingdom.

Volume for Marlboro declined 1.9%, due primarily to tax-driven price increases in France and Germany, intense price competition in Italy, consumer down-trading in Turkey and difficult economic conditions and price competition in Egypt and Indonesia, partially offset by higher volume in Argentina, Austria, Brazil, the Czech Republic, Japan, Romania, Russia, Serbia, the Slovak Republic, Spain and the Ukraine.

During 2003, PMI purchased approximately 74.2% of a tobacco business in Serbia for a cost of approximately $486 million and purchased 99% of a tobacco business in Greece for approximately $387 million. PMI also increased its ownership interest in its affiliate in Ecuador from less than 50% to approximately 98% for a cost of $70 million. In addition, during the third quarter of 2003, PMI announced that its license agreement with Japan Tobacco Inc. for the manufacture and sale of Marlboro cigarettes in Japan will not be renewed when the current term of the agreement expires in April 2005.