Remarks by Michael E. Szymanczyk, Chairman and CEO, Philip Morris USA Inc. at Prudential Consumer Conference

Prudential Consumer Conference

Thank you and good morning everyone.  With me today is Steve Rissman, associate general counsel for Altria.  Following my presentation, Steve will join me to answer your questions.

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 on the Altria website.

Today, I am going to start by reviewing our recent business performance.  I will then talk about our efforts to develop new sources of revenue and income, and end by addressing the strategies we have in place to manage the inevitable challenges we face in our cigarette business.

We will start our business review by looking at shipments.  For the first half of the year, Philip Morris USA shipments were down 1.7% versus last year.  When you consider the impact of changes in trade inventories, an extra shipping day and the July 4th holiday, we estimate that shipments were down about 1% in the first half.

In the second quarter, our retail share performance was strong, as was the performance of the premium segment of the industry, which was up 0.9 share points versus last year.  Since our focus is on strong premium brands, we saw improvements in our premium volume mix, share of the premium segment and our overall share.  Philip Morris USA’s premium volume mix increased 0.4 percentage points to 92% and our share of the premium segment increased by 0.1 share point to 62.1%.  Our company’s total share increased 0.5 share points versus year-ago to 50.5%, driven by two premium brands: Marlboro and Parliament. 

Last year at this conference, we talked about the events we had planned around Marlboro’s 50th anniversary to reinforce the brand’s flavor positioning and reward adult Marlboro smokers.  These efforts were successful and Marlboro’s share increased 0.5 share points in 2005 to 40%.  Throughout its history, Marlboro’s brand image has remained consistent even while the brand has introduced new product offerings and launched new marketing efforts to remain relevant to adult smokers.  Its growth over the years has been largely driven by Marlboro Red and Marlboro Lights, supported by a range of other products that round out the brand family.

And while images of Marlboro Country are no longer part of the mass marketing landscape on billboards or in magazines, the brand continues to communicate directly with adult smokers through direct mail, at retail stores and by providing unique experiences that reinforce the brand’s image and flavor heritage.

For example, thousands of smokers 21 years of age and older will be invited this year to experience Marlboro Country first-hand through a trip to Crazy Mountain Ranch in Montana.  Adult smokers and their guests can go horseback riding, whitewater rafting and off-roading by day and enjoy cook-outs under the stars at night in one of the most beautiful areas of the country.

For those interested in a faster pace, we offer the opportunity for a select group of adult smokers to get behind the wheel at Marlboro Racing School, where they learn to drive three different race cars on three different tracks.  A larger group will experience the next best thing through Marlboro Hot Laps, an opportunity to ride shotgun with a pro driver in three different race cars.

And, finally, we invite tens of thousands of adult smokers to come out to their local race track as guests of the brand to watch Marlboro Team Penske compete in the Indy Racing League.  Fans who attended the Indianapolis 500 got to watch Team Penske’s Sam Hornish, Jr. win that race with an exciting pass in the final seconds.  And this Sunday, adult smokers in the Chicago area will be cheering on both Sam Hornish and Helio Castroneves as they both head into the final race of the year in contention to finish at the top of the IRL’s point standings. 

All of these efforts have helped contribute to continued share gains for Marlboro.  The brand continued its momentum in the second quarter of 2006, increasing its retail share by 0.6 share points to 40.6% versus a year ago. 

Also contributing to Marlboro’s success is the performance of Marlboro Menthol.  The menthol segment has been growing for several years and Marlboro Menthol has shared in this growth.  Marlboro Menthol’s share is up 1.2 share points over the last three years while the menthol segment has increased by one share point.  During this time, Marlboro has grown its share of the menthol segment from 12% to 16.1% and is now the number two menthol brand behind Newport.  This year, Marlboro Menthol has benefited from enhanced packaging and retail merchandising.

With Marlboro Menthol and other offerings, Marlboro has remained true to its heritage and its flavor proposition while offering a portfolio of products that meet the tastes of adult smokers. 

Turning to our other focus brands, Parliament was also a contributor to the company’s share growth, growing 0.2 share points in the second quarter versus last year to a 1.9% share.  Share for Virginia Slims, our other premium focus brand, was flat at 2.3 percent.

Within the discount segment, major manufacturers’ branded discount declined 0.4 share points while deep discount, comprised of major manufacturers’ private label and all other manufacturers’ discount brands, declined 0.5 share points.

In this declining segment, Basic’s share was down 0.1 share points to 4.2% while the brand’s retail share of the discount segment increased 0.3 share points to 16.6%.

So to conclude our review of our core business, Philip Morris USA’s underlying operating income in the first half of the year increased 5% to $2.4 billion dollars.  We continue to forecast moderate retail share growth and operating companies income growth in the mid-single digits for full-year 2006.

We have achieved these business results while continuing to further our goal to address society’s concerns about our products.  While some may view our efforts in this area as being distinct from our financial performance, I view understanding and addressing society’s expectations of our company as an essential element of our financial success.  While any good consumer products company should respond to society, the nature of our product and the harm it causes give rise to a unique set of challenges for us.  Operating our business in a manner consistent with what society expects of a responsible cigarette manufacturer is crucial if we wish to maintain our license to operate. 

We have tried to play an active role in addressing many of the issues that arise from the business of manufacturing cigarettes.  For example, Philip Morris USA is working hard to engage with others who have a vested interest in preventing youth smoking, providing resources to help smokers who have decided to quit be more successful, and reducing the harm associated with our products.

For example, our Youth Smoking Prevention department has worked with an advisory board of respected psychologists, psychiatrists and public health professionals to create resources to help parents talk to their kids about not smoking. To date, we have distributed more than 70 million copies of these brochures.  We have provided grants to schools and community organizations to help them implement life skills education programs, after-school and sports activities and mentoring relationships.  We have also worked for many years with our retail partners to help them prevent illegal sales to minors in their stores. 

Philip Morris USA has also introduced programs to help smokers who decide to quit be more successful.  While this may seem counterintuitive to some, we are focused on ensuring that consumers who interact with our company have a great experience, including when they decide to quit smoking.  The evidence indicates that many of our consumers will, at some point, decide to stop using our products.  We want to be there to help them succeed when they make that decision.

Since the launch of our QuitAssist initiative, we have distributed more than 3.9 million quitting resource guides, received more than 1.5 million visits to our website, and directed more than 650,000 people to quitting information provided by groups that include the National Cancer Institute, the Centers for Disease Control and the American Cancer Society.  A recent survey indicated that our QuitAssist website is the most frequently visited cessation website in the United States.

Another important area of focus for Philip Morris USA has been developing products that have the potential to reduce smokers’ exposure to harmful compounds and, ultimately, to reduce the harm caused by smoking.  Over the years, we have made significant investments in research and product development that we hope will lead to the commercialization of products with the potential to achieve these goals.  We will also continue to be an advocate of Food and Drug Administration regulation of tobacco products, in part because we believe that the federal government should establish standards for products that could potentially reduce the harm caused by smoking and define the appropriate ways to communicate about these products. 

While I believe we are making good progress in our cigarette business, I recognize that our ability to grow revenue in the future is limited by several factors, including declining industry volume, a very competitive environment and the adverse impact of state excise tax increases.  I will talk more about the challenges we face in a few minutes, but before I do that I want to talk about some of the opportunities ahead for Philip Morris USA. 

The fact that we are in a declining industry and have limits on our ability to grow cigarette revenue means that, as we look to the future, we need to find new ways to grow by expanding beyond our core business to other tobacco and tobacco-related adjacent categories, a topic we discussed at this conference last year. 

Given our unmatched brand portfolio and infrastructure, we believe we can expand beyond cigarettes in two ways.  The first is through internal or organic development and the second is through acquisition.  Both approaches represent promising and potentially complementary opportunities for Philip Morris USA.

While acquisitions would provide us with immediate entry into existing categories and a solid base on which to grow, we recognize that finding appropriate acquisition candidates that meet our very strict economic return and other acquisition criteria is not an easy task.

Internal development provides us with the opportunity to both develop new categories by bringing innovative products to market and to penetrate existing categories with products that enjoy a clear edge over existing consumer offerings.  Our primary focus will be on products that directly appeal to adult smokers, a group we know well and communicate with everyday.  There are far more cigarette smokers in this country than users of other tobacco products.  For example, there are 44 million adult cigarette smokers and this compares to approximately 6 million moist snuff users.  

Rest assured that we are determined to develop new growth strategies that accommodate both approaches and that we recognize that only careful assessment of each opportunity will determine the approach, or approaches, ultimately taken.

We took our first step beyond cigarettes when we launched a test market of Taboka and Taboka Green, a menthol version, in July in Indianapolis.  Taboka is a new brand, a new product and a new category for Philip Morris USA and a new way for adult smokers to enjoy tobacco. 

To help you better understand this product, I will provide you a little context.  It is helpful to look at the experience in Sweden, where smokeless tobacco can be sold and smokers found certain smokeless tobacco products to be acceptable alternatives to cigarettes.  In Sweden, cigarette smokers turned to snus, a smokeless tobacco product that is spitless and sold mainly in pouch form.  Snus volumes have grown at an annual rate of 6.6% since 1998 in Sweden and more Swedish males currently use snus than cigarettes.

We know that some adult smokers in the United States are interested in smokeless tobacco alternatives.  Today’s alternatives, like moist snuff, satisfy some adult smokers.  However, most adult smokers do not find these alternatives to be acceptable.  Some of the concerns they raise relate to their aversion to spitting, the appearance of the product, its texture and taste, and its packaging.  We set out to address these concerns by designing a smokeless product that would appeal specifically to adult smokers in the United States and provide them with an acceptable alternative to existing smokeless products.  Half of the adult smokers we talked to in our studies expressed interest in the Taboka concept.  Over half of the adult smokers who tried Taboka in our studies expressed interest in purchasing the product.

So what is Taboka?  It’s a smoke-free, spit-free tobacco product that comes in a pouch that we call a Tobaccopak that is tucked in the cheek.  The Tobaccopak contains pasteurized tobacco and features a flavor strip.  It lasts about twice as long as a cigarette and can be enjoyed almost anywhere, anytime.

Our packaging is also designed to appeal to adult smokers with an innovative and sleek SlidePak with its unique slide feature.  In our test market, each pack contains 12 pouches, or Tobaccopaks, and each carton contains five packs.  Inside, the Tobaccopaks are hermetically sealed in foil to keep the flavor fresh.  Unlike snus, Taboka does not require refrigeration.

In the test market, we are reaching out to adult smokers to create awareness, educate them about the product attributes and how to use it, and generate product trial through retail communications, brochures on Taboka and on our cigarette packs, and via direct mail.  Taboka is merchandised on the cigarette rack with a sliding merchandising unit that resembles the SlidePak, slides from side to side, and also holds inventory. 

To reflect our entrance into this new category, we are offering retailers in the test market new signage to promote responsible retailing of all tobacco products, not just cigarettes. 

We are also using the pack itself to provide consumers with the federally required warnings and other smokeless tobacco health information, instructions on how to use the product, product ingredients, and other reminders about responsible use and handling of the product.  We also provide consumers with a range of ways to contact Philip Morris USA to get more information about the product.  At Philipmorrisusa.com, consumers can find more information about Taboka, health issues, preventing youth tobacco use and our responsible marketing practices.

While we will not provide detailed information about our test market for competitive reasons and because it is too early, I can tell you that we are pleased with the strong distribution we have achieved in more than 2,000 retail stores across Indianapolis and the initial response to Taboka from adult consumers who have tried it in the marketplace.

Taboka is our first product in an adjacent category and we expect to bring other new products to market in the future. 

To enhance our abilities to develop innovative new products and to develop new technologies that improve the products we currently manufacture, we are building a new Center for Research and Technology in downtown Richmond, Virginia.  We broke ground on this new research center in June 2005 and construction is on schedule for completion in mid-2007.  In the meantime, we have already begun to add new capabilities to our research and development group by starting to hire the diverse group of scientists that will work in the new building.

I would like to conclude my remarks today with a brief reminder of the strategies we have in place to successfully manage some of the challenges we face, namely litigation and the potential for counterfeit and other illegal sales.

In recent years, we have witnessed clearly positive developments related to the litigation environment.  This favorable momentum has continued with some very significant decisions in recent months.

On June 19, the Illinois Supreme Court, with consent from both parties, ordered the return to Philip Morris USA of the approximately $2.15 billion in cash securing the appeal bond in the Price “Lights” case.  A $6 billion note, which also secured the 2003 judgment, will be returned to the company if the U.S. Supreme Court declines to hear the plaintiffs’ appeal.  Philip Morris USA’s obligations to deposit payments on the note and to pay administrative fees to the Madison County, Illinois clerk also were terminated by the court’s order on June 19.

On July 6, the Florida Supreme Court decertified the Engle class and reversed the state court jury’s award of $145 billion in punitive damages because, as a matter of law, the award was improper and excessive.  The Florida Supreme Court also decided that, although the liability of the defendants had not been established, certain facts decided by the Engle trial jury are considered to be resolved in any future cases filed by individual former class members.  The company has asked the Florida Supreme Court to, among other things, revisit and change that portion of its decision.

In the Department of Justice case, Philip Morris USA and our parent company, Altria, will seek review of Judge Kessler’s ruling that the companies and other cigarette manufacturers violated civil provisions of the RICO Act.  The court refused to order the companies to pay $10 billion for a smoking cessation program or $4 billion for a “counter-marketing” youth advertising program sought by the government.  The court did order the companies to remove descriptors such as “light” or “ultra-light” from cigarette packages and publish statements concerning smoking and health issues, among other things.

Philip Morris USA and Altria believe much of the court’s decision and order are not supported by the law or the evidence presented at trial, and appear to be Constitutionally impermissible or infringe on Congress’ sole right to provide for the regulation of tobacco products.  Moreover, the conclusion that Philip Morris USA and Altria are reasonably likely to engage in future wrongdoing is flawed in light of the profound and permanent changes in the way Philip Morris USA markets cigarettes today.

Altria and Philip Morris USA have asked the district court for a stay of its order pending an appeal to the U.S. Circuit Court of Appeals for the District of Columbia.

We believe the overall litigation environment has improved, marked by a reduction in the number of smoking and health cases pending against our company, with both total and individual cases declining since 2003.  While challenges and risks remain, we continue to believe that we have strong defenses available to us in each of these matters and that we will continue to manage them successfully. 

A threat that we face is the potential for new growth in counterfeit products, other illegal sales and the deep discount segment, which includes non-participating manufacturers that are not subject to the financial payment obligations and marketing restrictions of the Master Settlement Agreement.  In the past, the growth in these areas has been driven by large price increases resulting from state excise tax increases and higher settlement payments.  State revenues generated by cigarettes sales grew by 69% from 1998 to 2005, due to increases in both settlement payments and higher excise taxes.

As a manufacturer, we give careful thought to the potential impact of any price increase.  Philip Morris USA, for example, has carefully managed its price gap versus the cheapest brand in the store to help keep adult smokers from switching away from our brands to competitive brands.

The states, however, do not share the same competitive concerns and their decisions in past years have led to unintended increases in illegal activity as alternative distribution systems have arisen and adult smokers have turned to the Internet, other sources of lower-tax or no-tax product, and, in some cases, to counterfeit product smuggled from overseas.

We will face these challenges again as a tax increase in Texas and tax threats in California and other states have the potential to increase illegal activity. 

With these threats on the horizon, it is worth reflecting on what has changed since we last saw an increase in illegal activity in 2002.  Since then, steps have been taken by the federal and state governments and our company to mitigate these activities.  We formed a brand integrity department that works to protect our trademarks through engagement with our trade partners, support of legislative and law enforcement efforts, product security efforts and through counterfeit litigation.  Federal and state law enforcement agencies have taken steps to fight counterfeit cigarettes and other forms of tax evasion.  As a result of these efforts, we have seen sharp declines in both counterfeit and Internet sales in recent years, though these issues require constant monitoring.  As we look to 2007, we will remain vigilant and continue to work aggressively to reduce the incidence of these problems and protect the integrity of the legitimate trade channels in which our products are sold. 

As discussed earlier, the deep discount segment of the industry declined in the second quarter of this year and has remained relatively stable over the last several years.  This is due in part to the enactment of legislation in many states that has closed loopholes in their escrow statutes and has given them additional enforcement tools.  We will continue to encourage states to aggressively enforce these laws.

So to conclude, Philip Morris USA has delivered a solid business performance so far this year and has seen positive developments in the Engle and Price cases.  It has also launched its first product outside of the cigarette category and we believe that we have the right strategies, tools and people to effectively manage the inevitable challenges that we will confront in the future.

We are optimistic about our ability to grow our business by continuing to strengthen our core brands and by complementing this growth with new revenue and income sources for the future.  Thank you.

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