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Remarks by David R. Beran Executive Vice President Finance, Planning and Information Philip Morris USA Inc. at Prudential Back-to-School Consumer ConferencePrudential Back-to-School Consumer ConferenceNEW YORKSeptember 07, 2005
Before I begin, let me say that my remarks today contain projections of future results. I direct your attention to the Forward Looking and Cautionary Statements section at the end of today’s news release for a review of the various factors that could cause actual results to differ from projections. A copy of my remarks will be posted later today to the Altria Website.
Today I’m going to update you on the progress we’ve made this year in our cigarette business and how we’re going about growing revenue and income, and then I’m going to speak more generally about our efforts to develop new revenue and income sources for the future.
Let me start with some context setting regarding the cigarette industry. The U.S. cigarette industry remains very large and profitable. Approximately 45 million adults in America smoke cigarettes. U.S. consumers spend an estimated $69 billion annually on cigarettes, more than they spend on carbonated soft drinks or snacks. We estimate that industry before-tax profits exceeded $7 billion last year, of which Philip Morris USA (PM USA) earned $4.4 billion. PM USA as a stand-alone company would rank in the Fortune 50 in net income.
However, when PM USA evaluates its potential each year to grow income versus the previous year it faces two significant challenges. The first is declining industry volume. Industry volume has declined 34% over the last 20 years, which equates to an average annual rate of about 1% to 2%, a trend that we expect to continue this year.
The second is inflation, which has been averaging about 2% to 3% a year and increases our manufacturing, marketing and administrative costs just as it does for other industries.
However, unique to PM USA, and the other tobacco companies that have signed the tobacco settlement agreements, are the inflationary adjustments built into these agreements. For PM USA, this inflationary adjustment is a minimum of 3% each year on a payment to the States that approximates our annual pre-tax income. So, when we consider the impact of these inflationary factors, and historical volume declines, PM USA starts each year needing to generate 3% to 5% income growth at a minimum just to stay even with the previous year’s result.
It is against this backdrop that PM USA goes about growing its cigarette income.
Our cigarette enterprise can expand its income in several ways, primarily through increased pricing, changing the mix of products that we sell, and share growth. We can also grow income by carefully managing our costs to offset inflation or by eliminating infrastructure as volume declines. I’ll talk about each of these elements in a little more detail.
Pricing can be a direct means to revenue and income expansion, but the availability of pricing is a function of the competitive marketplace at any point in time. For antitrust reasons, I can’t comment on specific pricing plans or provide opinions about the state of the market relative to pricing, other than to say that we pay attention to marketplace dynamics. As shown by our conduct in the past, we give appropriate consideration to revenue and income expansion from pricing, but we are also willing to thoughtfully reduce margins when the marketplace makes it necessary to protect brand franchises for the longer term. For example, the marketplace required margin reductions in 1993 and 2003, and we reacted accordingly.
The second way to grow revenue and income is by improving the mix of products that we sell. For the first half of 2005, PM USA’s premium volume mix improved 0.2 percentage point to 91.6% versus 2004.
We focus virtually all of our efforts on building premium brand franchises like Marlboro, Parliament and Virginia Slims. Even our discount brand, Basic, has high margins relative to the rest of the segment. This strategy has allowed us to grow brand share and income from mix rather than simply build share with discounted products that cause margin and income erosion.
The third way to expand revenue and income is by growing our market share. PM USA has achieved significant share growth over the years by providing adult consumers with a preferred value equation comprised of product, packaging, positioning, promotion and price.
The second quarter of 2005 was no exception, as PM USA’s retail share increased 0.2 share point to 50.0% versus the second quarter of 2004. This growth was driven by Marlboro, which was up 0.4 share point to 40.0% in the second quarter, a record share for the brand. Marlboro has grown its retail share for 10 consecutive quarters.
A key to Marlboro’s success has been PM USA’s effective management of the brand’s price gap with the lowest-priced brands in the market. Marlboro’ s net price gap versus the lowest-priced brand in convenience stores has remained in the mid-40% range.
This year marks the brand’s 50th anniversary and we have used this occasion to remind adult smokers of the brand’s core values and its modern relevance. Beginning in November 2004 and continuing through November 2005, this celebration is being marked by a number of exciting events designed to reinforce Marlboro’s flavor positioning and reward adult Marlboro smokers.
For its 50th anniversary, Marlboro has used direct mail, retail point-of-sale advertising and the pack itself to invite adult smokers to join in the celebration. Throughout the anniversary year, adult smokers have had the opportunity to purchase special 50th anniversary packs and to enter sweepstakes to win prizes like 50 acres in Marlboro Country, 50 2005 Ford Mustang GT convertibles or one of 50 custom vacation trips. We have a few more 50-related surprises planned before the anniversary year is complete to allow Marlboro’ s customers to celebrate with the brand.
Unrelated to the 50th anniversary, in the first quarter, we introduced Marlboro UltraSmooth, testing three different versions of this product in test markets in Atlanta, Tampa and Salt Lake City. Marlboro UltraSmooth products contain new carbon filters which let the flavor through for a new, filtered smooth taste. In these test markets, we are evaluating consumer acceptance of taste with varying applications of filter technologies.
Among our other focus brands, Parliament’s share was up 0.1 share point in the second quarter to 1.7% versus a year ago. In recent weeks, we began test marketing Parliament Blue, a new offering from Parliament in contemporary packaging.
Virginia Slims’ share was flat in the second quarter at 2.3%, behind a strong equity program that allows the brand to carry a premium price versus its primary competitors.
Marlboro, Parliament and Virginia Slims helped the industry’s premium segment grow 0.3 share point in the second quarter versus the prior year to 73.7%, up 2.2 percentage points from the fourth quarter of 2002. PM USA maintained its share of the premium category at 62.0% in the second quarter versus the year-ago period.
The overall discount segment declined 0.3 share point as major manufacturers’ branded discount declined and deep discount, comprised of major manufacturers’ private label and all other manufacturers’ discount brands, gained 0.1 share point versus the year-ago period.
Basic’s share increased 0.1 share point versus a year ago to 4.3% even as the overall discount segment declined.
While PM USA has successfully improved our premium mix and grown retail share, we continue to face significant challenges, including excessive excise tax increases and a continued competitive marketplace.
Since the dramatic increases in 2002, overall state excise tax increases have moderated, though we continue to see large increases enacted in a number of individual states. Twelve states representing approximately 24% of industry volume have increased their cigarette excise taxes or imposed a new user fee this year and a handful of others remain under active consideration. The weighted average state excise tax is currently about $0.86 per pack, up $0.08 from the end of 2004.
We have, however, seen some positive results from our efforts to mitigate some of the unintended consequences created by high excise taxes. For example, PM USA continues to take steps on its own and with others to combat illegal sales of cigarettes over the Internet. In March 2005, a federal judge awarded PM USA $173 million in damages for trademark infringement by Switzerland-based Internet retailer Otamedia. While our ability to collect this judgment remains uncertain, the company is exploring all available legal options for enforcement.
We have also seen increased enforcement efforts on the part of federal and state officials. In late 2004, authorities seized 300,000 cartons of cigarettes -- 60 million cigarettes -- at John F. Kennedy International Airport in New York. We believe that many, if not most, of these cigarettes were manufactured for international markets and illegally shipped into the U.S. by Otamedia. Several states have sent state excise or use tax bills to consumers who purchased cigarettes over the Internet. Major credit card companies and a major package delivery company have agreed to take steps to prohibit the use of their services for illegal Internet cigarette sales. We believe that all of these efforts have contributed to a decline in illegal sales over the Internet in the last few months.
We also believe that the availability of counterfeit cigarettes is declining. We have seen a reduction in the incidence of counterfeit product in the national retail purchases conducted by our brand integrity department.
Figures from U.S. Customs also reflect a decline in the amount of counterfeit cigarettes seized. In 2002 and 2003, counterfeit cigarettes, as valued by Customs, were number one on the list of products seized for intellectual property rights violations. So far this year, cigarettes have fallen to fifth place, as seizures have dropped compared to the same period last year, as valued by Customs.
In addition, after increasing for several years, import volume began to decline in 2004 and has continued that trend in the first half of 2005.
While we will continue to face certain challenges, the business environment has improved for PM USA in several aspects over the last few years, and reductions in illegal Internet and counterfeit sales have helped PM USA recover some volume.
This volume recovery, along with our share growth, contributed to a stable volume performance in the second quarter of 2005. PM USA’s shipments were up 1.4% versus the prior year, but were essentially flat when adjusted for the timing of promotional shipments and the timing of trade purchases in advance of the July 4th holiday.
As I mentioned earlier, another focus area that enables PM USA to grow its income is effective cost management. We have several primary areas that make up our cost structure: settlement payments, manufacturing, marketing and sales, general and administrative overhead, corporate responsibility and research-and-development. PM USA has a well-established and disciplined program of cost management that drives its cost reduction initiatives in several of these areas, generating savings that can be used for investments in the future and to enhance income.
There are a few costs that, while predictable, cannot be reduced by PM USA. For example, as I discussed earlier, settlement payments are determined by our agreements with the states and assessment payments for the quota buyout are governed by federal law enacted last year. Our spending increases in these areas from 1998 to 2004 exceeded the average annual rate of inflation.
We have also made strategic investments in our business, increasing our spending on corporate responsibility and research-and-development over the last several years at a rate that exceeds inflation. We evaluate our spending in these areas regularly to ensure that we are spending money as effectively as possible.
In other areas, we have systematically worked to reduce our infrastructure and increase efficiencies. For instance, in manufacturing we have implemented a number of productivity initiatives, including automation and strategic supplier relationships that are projected to save millions of dollars annually. We are investing more than $200 million over three years to modernize and improve the efficiency of our Cabarrus County, North Carolina plant, including the installation of the latest generation of high-speed cigarette manufacturing equipment.
In marketing and sales, PM USA constantly evaluates its marketing and promotional activities and makes adjustments when appropriate. In the last few years, as a result of the marketing restrictions in the tobacco settlement agreement and our own voluntary efforts, we have significantly reduced our mass marketing and focused on efforts to directly reach adult smokers. We have made some improvements related to our adult consumer database, allowing adult smokers who want to receive coupons and special offers from our brands to sign up and have their age and identity verified on-line at www.smokersignup.com, a responsible and more cost-effective way to grow our database. We have also improved our segmentation tools to help ensure that we are sending the right offer to the right adult consumer, thus eliminating waste.
From an administrative standpoint, we have substantially completed the relocation of our corporate headquarters to Richmond, Virginia. From 2005 onward, PM USA will realize an annual cost savings of approximately $80 million associated with the relocation, an amount that exceeds our original forecast. We are also outsourcing our data center activities, generating additional cost savings over the next several years.
These actions have helped keep our cost increases in manufacturing, marketing and sales below the average annual inflation rate. In addition, when you exclude our investment in corporate responsibility, general and administrative cost increases are also below inflation.
Overall, we have continued to reduce our infrastructure and headcount as our volume has declined. From 1998 to 2004, PM USA reduced its total headcount by 19% as its volume declined 18% during the same time period.
Critical to the success of our revenue and income enhancing initiatives is the way we manage the footprint we make on society when we carry them out. Success in the long-term comes from understanding our footprint on society and meeting society’s expectations relative to it.
Over the last few years, we have taken steps to help prevent youth smoking, to communicate openly about the health effects of our products and to provide information and resources to help smokers who have decided to quit be more successful. All these programs are based on learnings from society.
At the center of these efforts is our Website, www.philipmorrisusa.com, where people can find information about the health effects of our products with links to public health authorities, resources to help parents talk to their kids about not smoking, and our QuitAssistTM resource to connect smokers who have decided to quit to a wealth of expert quitting information. We have used a variety of communication vehicles to raise awareness of these resources, including television and magazine advertising, retail point-of-sale materials, onserts on our cigarette packs and direct mail.
In summary, our efforts this year have resulted in a solid financial performance. Our operating companies income was up 4.0% to $1.3 billion in the second quarter, primarily driven by higher volume and lower wholesale promotional allowance rates, partially offset by expenses related to the quota buyout legislation and higher spending for research and development. Our first half results were also solid, with income up 5.4% to $2.3 billion.
For the full year 2005, PM USA continues to project moderate growth in retail share and operating companies income growth in the low to mid-single digits, excluding any judgment that may have to be paid related to the Boeken case in California.
I’d like to turn now to our efforts to develop our business for the future. Before I continue, I’ll let you know that I do not plan to elaborate on this topic beyond my prepared remarks, due to the competitively sensitive nature of our future plans.
As we look toward the future, we continue to be guided by our mission and values. Our goal is to be the most responsible, effective and respected developer, manufacturer and marketer of consumer products, especially products intended for adults. Our core business is manufacturing and marketing the best quality tobacco products to adults who use them.
Within this context, we have examined a number of potential models to grow our business beyond cigarettes. We have chosen an adjacency growth strategy, looking at potential moves into complementary tobacco or tobacco-related products or processes that would allow PM USA to use its existing core infrastructure elements. The concept of adjacency growth has been discussed by Bain & Company’s Chris Zook in his book, “Beyond the Core” and has been used by other consumer package goods companies over time.
An adjacency growth strategy has three distinctive elements:
* It builds on a strong core business. * It pushes out the boundaries of the core business in a way that limits risk. * It can lead to a sequence of related adjacency moves over time that can generate substantial growth.
When I talk about our core business, I’m referring to the essence of what makes PM USA successful and what drives and sustains profits.
PM USA’s core is Marlboro. Marlboro is larger than the next 10 brands combined and contributes 80 percent of PM USA’s revenues and profits.
We support our core with key infrastructure elements that are fundamental to how PM USA makes money and sustains its competitive position. The interaction of these elements in a cohesive system is critical to our success.
Our key infrastructure elements are focused on being responsible, attracting and retaining high quality talent, providing affordable pleasure, maintaining high-quality/premium priced products, ensuring availability of our products at convenient retail locations, offering products with superior flavor, conveying lifestyle images that connect with adult smokers, and developing and maintaining personal relationships with adult smokers.
We currently use this key infrastructure to support other brands like Parliament, Virginia Slims and Basic — one step removed from our core of Marlboro. As we look to continue to grow from our core, we could use this infrastructure to provide similar tobacco or tobacco-related products to the same consumers. Beyond that, we could offer new tobacco or tobacco-related product concepts to the same consumers. Therefore, adjacency is a methodical approach to growth that builds on what we know.
To develop this strategy, we will have to make significant investments in product development, consumer research and other areas, and have already taken steps to do so. For example, in June, PM USA broke ground on a new $300 million research and technology center in Richmond, Virginia. For many years, PM USA has dedicated significant resources toward scientific research, new product development and commercialization which might help address the harm caused by smoking. The research and technology center will enhance this commitment. This new center will allow us to develop new technologies that improve the products we currently manufacture, and may lead to innovative new products.
The center will be the newest addition to the Virginia BioTech Research Park. The park is already home to dozens of bioscience companies and more than 1,300 researchers, scientists and engineers. When completed in 2007, the center will nearly double PM USA’s research space.
To sum up, despite a highly competitive marketplace and a challenging external environment, PM USA is delivering solid business results. Our performance is driven by the retail share growth of strong brands, led by Marlboro and supported by our other focus brands. We remain focused on effective cost management and cost reduction and are using the savings that result from these efforts to enhance income and invest in the future. Our initiatives to align with society are on track and remain at the heart of everything we do, because they are essential to our long-term success. And, finally, we are contributing substantial returns based on solid business fundamentals to our shareholder Altria.
Thank you. # # # 
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