10-Q 1 0001.txt FORM 10-Q SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2000 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to Commission file number 1-8940 Philip Morris Companies Inc. -------------------------------------------------------------------------------- (Exact name of registrant as specified in its charter) Virginia 13-3260245 -------------------------------------------------------------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 120 Park Avenue, New York, New York 10017 -------------------------------------------------------------------------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (917) 663-5000 -------------------------------------------------------------------------------- Former name, former address and former fiscal year, if changed since last report Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes |X| No |_| At July 31, 2000, there were 2,252,065,182 shares outstanding of the registrant's common stock, par value $0.33 1/3 per share. PHILIP MORRIS COMPANIES INC. TABLE OF CONTENTS Page No. PART I - FINANCIAL INFORMATION Item 1. Financial Statements (Unaudited). Condensed Consolidated Balance Sheets at June 30, 2000 and December 31, 1999 3 - 4 Condensed Consolidated Statements of Earnings for the Six Months Ended June 30, 2000 and 1999 5 Three Months Ended June 30, 2000 and 1999 6 Condensed Consolidated Statements of Stockholders' Equity for the Year Ended December 31, 1999 and the Six Months Ended June 30, 2000 7 Condensed Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2000 and 1999 8 - 9 Notes to Condensed Consolidated Financial Statements 10 - 26 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. 27 - 49 PART II - OTHER INFORMATION Item 1. Legal Proceedings. 50 Item 6. Exhibits and Reports on Form 8-K. 50 Signature 51 -2- PART I - FINANCIAL INFORMATION Item 1. Financial Statements. Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Balance Sheets (in millions of dollars) (Unaudited) June 30, December 31, 2000 1999 -------- ------------ ASSETS Consumer products Cash and cash equivalents $ 4,224 $ 5,100 Receivables, net 4,710 4,313 Inventories: Leaf tobacco 3,759 4,294 Other raw materials 1,730 1,794 Finished product 2,624 2,940 ------- ------- 8,113 9,028 Other current assets 1,922 2,454 ------- ------- Total current assets 18,969 20,895 Property, plant and equipment, at cost 21,876 21,599 Less accumulated depreciation 9,521 9,328 ------- ------- 12,355 12,271 Goodwill and other intangible assets (less accumulated amortization of $6,059 and $5,840) 16,686 16,879 Other assets 3,761 3,625 ------- ------- Total consumer products assets 51,771 53,670 Financial services Finance assets, net 7,820 7,527 Other assets 195 184 ------- ------- Total financial services assets 8,015 7,711 ------- ------- TOTAL ASSETS $59,786 $61,381 ======= ======= See notes to condensed consolidated financial statements. Continued -3- Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Balance Sheets (Continued) (in millions of dollars, except per share data) (Unaudited) June 30, December 31, 2000 1999 -------- ------------ LIABILITIES Consumer products Short-term borrowings $ 231 $ 641 Current portion of long-term debt 1,070 1,601 Accounts payable 2,426 3,351 Accrued marketing 2,984 2,756 Accrued taxes, except income taxes 1,662 1,519 Accrued settlement charges 2,784 2,320 Other accrued liabilities 3,131 3,577 Income taxes 1,305 1,124 Dividends payable 1,090 1,128 -------- -------- Total current liabilities 16,683 18,017 Long-term debt 10,339 11,280 Deferred income taxes 1,374 1,214 Accrued postretirement health care costs 2,681 2,606 Other liabilities 6,683 6,853 -------- -------- Total consumer products liabilities 37,760 39,970 Financial services Short-term borrowings 723 Long-term debt 916 946 Deferred income taxes 4,559 4,466 Other liabilities 750 694 -------- -------- Total financial services liabilities 6,948 6,106 -------- -------- Total liabilities 44,708 46,076 Contingencies (Note 5) STOCKHOLDERS' EQUITY Common stock, par value $0.33 1/3 per share (2,805,961,317 shares issued) 935 935 Earnings reinvested in the business 31,468 29,556 Accumulated other comprehensive losses (including currency translation of $2,510 and $2,056) (2,562) (2,108) -------- -------- 29,841 28,383 Less cost of repurchased stock (544,095,975 and 467,441,576 shares) (14,763) (13,078) -------- -------- Total stockholders' equity 15,078 15,305 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 59,786 $ 61,381 ======== ======== See notes to condensed consolidated financial statements. -4- Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Statements of Earnings (in millions of dollars, except per share data) (Unaudited) For the Six Months Ended June 30, ------------------------ 2000 1999 ------- ------- Operating revenues $40,884 $39,307 Cost of sales 14,820 14,747 Excise taxes on products 8,871 8,606 ------- ------- Gross profit 17,193 15,954 Marketing, administration and research costs 9,670 8,924 Amortization of goodwill 293 292 ------- ------- Operating income 7,230 6,738 Interest and other debt expense, net 378 428 ------- ------- Earnings before income taxes 6,852 6,310 Provision for income taxes 2,672 2,493 ------- ------- Net earnings $ 4,180 $ 3,817 ======= ======= Per share data: Basic earnings per share $ 1.82 $ 1.58 ======= ======= Diluted earnings per share $ 1.82 $ 1.57 ======= ======= Dividends declared $ 0.96 $ 0.88 ======= ======= See notes to condensed consolidated financial statements. -5- Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Statements of Earnings (in millions of dollars, except per share data) (Unaudited) For the Three Months Ended June 30, -------------------------- 2000 1999 ------- ------- Operating revenues $20,844 $19,810 Cost of sales 7,517 7,487 Excise taxes on products 4,421 4,243 ------- ------- Gross profit 8,906 8,080 Marketing, administration and research costs 5,007 4,358 Amortization of goodwill 147 145 ------- ------- Operating income 3,752 3,577 Interest and other debt expense, net 193 222 ------- ------- Earnings before income taxes 3,559 3,355 Provision for income taxes 1,388 1,325 ------- ------- Net earnings $ 2,171 $ 2,030 ======= ======= Per share data: Basic earnings per share $ 0.96 $ 0.84 ======= ======= Diluted earnings per share $ 0.95 $ 0.84 ======= ======= Dividends declared $ 0.48 $ 0.44 ======= ======= See notes to condensed consolidated financial statements. -6- Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Statements of Stockholders' Equity for the Year Ended December 31, 1999 and the Six Months Ended June 30, 2000 (in millions of dollars, except per share data) (Unaudited)
Accumulated Other Comprehensive Losses Earnings ---------------------------------- Total Reinvested Currency Cost of Stock- Common in the Translation Repurchased holders' Stock Business Adjustments Other Total Stock Equity ------ ---------- ----------- ------- -------- ----------- -------- Balances, January 1, 1999 $ 935 $26,261 $(1,081) $ (25) $(1,106) $(9,893) $16,197 Comprehensive earnings: Net earnings 7,675 7,675 Other comprehensive losses, net of income taxes: Currency translation adjustments (975) (975) (975) Additional minimum pension liability (27) (27) (27) -------- Total other comprehensive losses (1,002) -------- Total comprehensive earnings 6,673 -------- Exercise of stock options and issuance of other stock awards 13 115 128 Cash dividends declared ($1.84 per share) (4,393) (4,393) Stock repurchased (3,300) (3,300) ----- ------- ------- ------- ------- -------- ------- Balances, December 31, 1999 935 29,556 (2,056) (52) (2,108) (13,078) 15,305 Comprehensive earnings: Net earnings 4,180 4,180 Other comprehensive losses, net of income taxes: Currency translation adjustments (454) (454) (454) ------- Total other comprehensive losses (454) ------- Total comprehensive earnings 3,726 ------- Exercise of stock options and issuance of other stock awards (77) 136 59 Cash dividends declared ($0.96 per share) (2,191) (2,191) Stock repurchased (1,821) (1,821) ----- ------- ------- ------- ------- -------- ------- Balances, June 30, 2000 $ 935 $31,468 $(2,510) $ (52) $(2,562) $(14,763) $15,078 ===== ======= ======= ======= ======= ======== =======
Total comprehensive earnings, which represents net earnings partially offset by currency translation adjustments, were $1,911 million and $1,902 million, respectively, for the quarters ended June 30, 2000 and 1999, and $3,214 million for the first six months of 1999. See notes to condensed consolidated financial statements. -7- Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (in millions of dollars) (Unaudited) For the Six Months Ended June 30, ------------------------ 2000 1999 ------- ------- CASH PROVIDED BY (USED IN) OPERATING ACTIVITIES Net earnings - Consumer products $ 4,100 $ 3,749 - Financial services 80 68 ------- ------- Net earnings 4,180 3,817 Adjustments to reconcile net earnings to operating cash flows: Consumer products Depreciation and amortization 861 824 Deferred income tax provision 674 27 Gains on sales of businesses (35) (20) Cash effects of changes, net of the effects from acquired and divested companies: Receivables, net (523) (383) Inventories 762 53 Accounts payable (881) (638) Income taxes 219 235 Accrued liabilities and other current assets 458 1,566 Other (79) (173) Financial services Deferred income tax provision 93 66 Other 120 77 ------- ------- Net cash provided by operating activities 5,849 5,451 ------- ------- CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES Consumer products Capital expenditures (700) (724) Purchases of businesses, net of acquired cash (358) (385) Proceeds from sales of businesses 51 29 Other 8 (111) Financial services Investments in finance assets (394) (196) Proceeds from finance assets 18 38 ------- ------- Net cash used in investing activities (1,375) (1,349) ------- ------- See notes to condensed consolidated financial statements. Continued -8- Philip Morris Companies Inc. and Subsidiaries Condensed Consolidated Statements of Cash Flows (Continued) (in millions of dollars) (Unaudited) For the Six Months Ended June 30, ------------------------ 2000 1999 ------- ------- CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES Consumer products Net repayment of short-term borrowings $ (475) $ (9) Long-term debt proceeds 66 1,275 Long-term debt repaid (1,379) (1,339) Financial services Net issuance of short-term borrowings 723 Repurchase of common stock (1,807) (1,475) Dividends paid (2,229) (2,137) Issuance of common stock 29 69 Other (83) (54) ------- ------- Net cash used in financing activities (5,155) (3,670) ------- ------- Effect of exchange rate changes on cash and cash equivalents (195) (105) ------- ------- Cash and cash equivalents: (Decrease) increase (876) 327 Balance at beginning of period 5,100 4,081 ------- ------- Balance at end of period $ 4,224 $ 4,408 ======= ======= See notes to condensed consolidated financial statements. -9- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) Note 1. Accounting Policies: The interim condensed consolidated financial statements of Philip Morris Companies Inc. (the "Company") are unaudited. It is the opinion of the Company's management that all adjustments necessary for a fair statement of the interim results presented have been reflected therein. All such adjustments were of a normal recurring nature. For interim reporting purposes, certain expenses are charged to results of operations as a percentage of sales. Operating revenues and net earnings for any interim period are not necessarily indicative of results that may be expected for the entire year. These statements should be read in conjunction with the consolidated financial statements and related notes which appear in the Company's Annual Report to Stockholders and which are incorporated by reference into the Company's Annual Report on Form 10-K for the year ended December 31, 1999 (the "1999 Form 10-K"). Balance sheet accounts are segregated by two broad types of businesses. Consumer products assets and liabilities are classified as either current or non-current, whereas financial services assets and liabilities are unclassified, in accordance with respective industry practices. Note 2. Acquisitions: In June 2000, the Company announced that it entered into definitive agreements to acquire all of the outstanding shares of Nabisco Holdings Corp. ("Nabisco") for $55 per share in cash. The transaction reflects an aggregate cost of $18.9 billion, which includes the assumption of approximately $4.0 billion in net debt. The acquisition will be financed initially through a combination of short-term debt and bank borrowings. The transaction is subject to approval by the shareholders of Nabisco Group Holdings and requires customary regulatory approvals. The transaction is expected to be completed during the fourth quarter of 2000. The acquisition will be accounted for as a purchase. Subsequent to the acquisition, Nabisco will be combined with Kraft Foods, Inc. ("Kraft"). Following the combination, the Company plans to undertake an initial public offering ("IPO") of less than 20% of the newly combined food company. The IPO proceeds will be used to retire a portion of the debt incurred as a result of the acquisition of Nabisco. -10- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) Note 3. Earnings Per Share: Basic and diluted earnings per share ("EPS") were calculated using the following: For the Six Months Ended June 30, ------------------------ 2000 1999 ------- ------- (in millions) Net earnings $4,180 $3,817 ====== ====== Weighted average shares for basic EPS 2,294 2,415 Plus incremental shares from conversions: Restricted stock and stock rights 2 2 Stock options 3 11 ------ ------ Weighted average shares for diluted EPS 2,299 2,428 ====== ====== For the Three Months Ended June 30, -------------------------- 2000 1999 ------- ------- (in millions) Net earnings $2,171 $2,030 ====== ====== Weighted average shares for basic EPS 2,273 2,406 Plus incremental shares from conversions: Restricted stock and stock rights 2 2 Stock options 5 9 ------ ------ Weighted average shares for diluted EPS 2,280 2,417 ====== ====== Options on shares of common stock were excluded from the calculation of weighted average shares for diluted EPS because their effects were antidilutive, as follows: 2000 1999 ------ ------ (in millions) For the six months ended June 30, 87 15 For the three months ended June 30, 83 37 Note 4. Segment Reporting: The Company's products include cigarettes, food (consisting principally of coffee, cheese, chocolate confections, processed meat products and various packaged grocery products) and beer. A subsidiary of the Company, Philip Morris Capital Corporation, invests in leveraged and direct finance leases, other tax-oriented financing transactions and third-party financings. These products and services constitute the Company's reportable segments of domestic tobacco, international tobacco, North American food, international food, beer and financial services. -11- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) The Company's management reviews operating companies income to evaluate segment performance and allocate resources. Operating companies income for the reportable segments excludes general corporate expenses, minority interest and amortization of goodwill. Interest and other debt expense, net (consumer products) and provision for income taxes are centrally managed at the corporate level and, accordingly, such items are not presented by segment since they are excluded from the measure of segment profitability reviewed by the Company's management. Goodwill and amortization of goodwill are principally attributable to the North American food segment. Reportable segment data were as follows: For the Six Months Ended June 30, ------------------------ 2000 1999 ------- ------- (in millions) Operating revenues: Domestic tobacco $ 11,152 $ 9,195 International tobacco 13,799 14,266 North American food 9,258 9,022 International food 4,176 4,446 Beer 2,300 2,208 Financial services 199 170 -------- -------- Total operating revenues $ 40,884 $ 39,307 ======== ======== Operating companies income: Domestic tobacco $ 2,390 $ 2,069 International tobacco 2,741 2,683 North American food 1,863 1,631 International food 535 521 Beer 346 314 Financial services 127 110 -------- -------- Total operating companies income 8,002 7,328 Amortization of goodwill (293) (292) General corporate expenses (419) (235) Minority interest (60) (63) -------- -------- Total operating income 7,230 6,738 Interest and other debt expense, net (378) (428) -------- -------- Total earnings before income taxes $ 6,852 $ 6,310 ======== ======== -12- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) For the Three Months Ended June 30, -------------------------- 2000 1999 ------- ------- Operating revenues: (in millions) Domestic tobacco $ 5,706 $ 4,735 International tobacco 6,801 6,926 North American food 4,803 4,626 International food 2,171 2,204 Beer 1,256 1,222 Financial services 107 97 -------- -------- Total operating revenues $ 20,844 $ 19,810 ======== ======== Operating companies income: Domestic tobacco $ 1,274 $ 1,151 International tobacco 1,310 1,252 North American food 996 946 International food 289 275 Beer 193 178 Financial services 69 60 -------- -------- Total operating companies income 4,131 3,862 Amortization of goodwill (147) (145) General corporate expenses (204) (111) Minority interest (28) (29) -------- -------- Total operating income 3,752 3,577 Interest and other debt expense, net (193) (222) -------- -------- Total earnings before income taxes $ 3,559 $ 3,355 ======== ======== General corporate expenses of $419 million for the first half of 2000 and $204 million for the second quarter of 2000 increased $184 million (78.3%) and $93 million (83.8%), respectively, over the comparable periods of 1999. These increases were due primarily to increased spending for the Company's corporate image campaign. During the first quarter of 1999, Philip Morris Incorporated ("PM Inc."), the Company's domestic tobacco subsidiary, announced plans to phase out cigarette production capacity at its Louisville, Kentucky manufacturing plant by August 2000 (the "Louisville Closure"). The Louisville Closure, which occurred in stages, has been completed. As a result, PM Inc. recorded pre-tax charges for the first six months and the second quarter of 1999 of $175 million and $45 million, respectively. These charges, which are in marketing, administration and research costs in the respective consolidated statements of earnings, included enhanced severance, pension and postretirement benefits for approximately 1,500 hourly and salaried employees. Severance benefits, which were either paid in a lump sum or as income protection payments over a period of time, commenced upon termination of employment. Payments of enhanced pension and postretirement benefits are being made over the remaining lives of the former employees in accordance with the terms of the related benefit plans. All operating costs of the manufacturing plant, including increased depreciation, were charged to expense as incurred during the closing period. During the first quarter of 1999, Kraft announced that it was offering voluntary retirement incentive or separation programs to certain eligible hourly and salaried employees in the United States (the "Kraft Separation Programs"). Employees electing to terminate employment under the terms of the Kraft Separation Programs were entitled to enhanced retirement or severance benefits. Approximately 1,100 hourly and salaried employees accepted the benefits offered by these programs and elected to retire or terminate. As a result, Kraft -13- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) recorded a pre-tax charge of $157 million for the first six months of 1999. This charge was included in marketing, administration and research costs in the consolidated statement of earnings for the North American food segment. Payments of pension and postretirement benefits are made in accordance with the terms of the applicable benefit plans. Severance benefits, which are paid over a period of time, commenced upon dates of termination that ranged from April 1999 to March 2000. Salary and related benefit costs of employees prior to the retirement or termination date were expensed as incurred. Note 5. Contingencies: Legal proceedings covering a wide range of matters are pending or threatened in various United States and foreign jurisdictions against the Company, its subsidiaries and affiliates, including PM Inc., and Philip Morris International Inc. ("PMI"), the Company's international tobacco subsidiary, and their respective indemnitees. Various types of claims are raised in these proceedings, including product liability, consumer protection, antitrust, tax, patent infringement, employment matters, claims for contribution and claims of competitors and distributors. Overview of Tobacco-Related Litigation Types and Number of Cases Pending claims related to tobacco products generally fall within the following categories: (i) smoking and health cases alleging personal injury brought on behalf of individual plaintiffs, (ii) smoking and health cases primarily alleging personal injury and purporting to be brought on behalf of a class of individual plaintiffs, (iii) health care cost recovery cases brought by governmental (both domestic and foreign) and non-governmental plaintiffs seeking reimbursement for health care expenditures allegedly caused by cigarette smoking and/or disgorgement of profits, and (iv) other tobacco-related litigation, including suits by former asbestos manufacturers seeking contribution or reimbursement for amounts expended in connection with the defense and payment of asbestos claims that were allegedly caused in whole or in part by cigarette smoking. Damages claimed in some of the smoking and health class actions, health care cost recovery cases and other tobacco-related litigation range into the billions of dollars. A jury in a Florida smoking and health class action recently returned a punitive damages award of approximately $74 billion against PM Inc. (See discussion of the Engle case below.) Plaintiffs' theories of recovery and the defenses raised in the smoking and health and health care cost recovery cases are discussed below. Exhibit 99.1 hereto lists the smoking and health class actions, health care cost recovery cases and certain other actions pending as of August 1, 2000, and discusses certain developments in such cases since April 14, 2000. As of August 1, 2000, there were approximately 390 smoking and health cases filed and served on behalf of individual plaintiffs in the United States against PM Inc. and, in some cases, the Company, compared with approximately 425 such cases on August 1, 1999, and approximately 410 such cases on August 1, 1998. Approximately nine of the individual cases involve allegations of various personal injuries allegedly related to exposure to environmental tobacco smoke ("ETS"). In addition, approximately 680 additional individual cases are pending in Florida by current and former flight attendants claiming personal injuries allegedly related to ETS. The flight attendants were members of an ETS smoking and health class action which was settled in 1997. The terms of the court-approved settlement in that case allow class members to file individual lawsuits seeking compensatory damages, but prohibit them from seeking punitive damages. As of August 1, 2000, there were approximately 35 smoking and health putative class actions pending in the United States against PM Inc. and, in some cases, the Company (including eight that involve allegations of various personal injuries related to exposure to ETS), compared with approximately 55 such cases on August 1, 1999, and approximately 55 such cases on August 1, 1998. Many of these actions purport to constitute statewide class actions and were filed after May 1996 when the United States Court of Appeals for the Fifth Circuit, in the Castano case, reversed a federal district court's certification of a purported nationwide class action on behalf of persons who were allegedly "addicted" to tobacco products. -14- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) As of August 1, 2000, there were approximately 50 health care cost recovery actions pending in the United States (excluding the cases covered by the 1998 Master Settlement Agreement discussed below), compared with approximately 80 health care cost recovery cases pending on August 1, 1999, and 140 cases on August 1, 1998. There are also a number of tobacco-related actions pending outside the United States against PMI and its affiliates and subsidiaries, including approximately 45 smoking and health cases initiated by one or more individuals (Argentina (31), Australia (1), Brazil (4), Canada (1), Germany (3), Hong Kong (1), Ireland (1), Japan (1), the Philippines (1), and Poland (1)), compared with approximately 35 such cases on May 1, 1999. In addition, there are eight smoking and health putative class actions pending outside the United States (Australia (1), Brazil (3), Canada (3), and Israel (1)), compared with nine on August 1, 1999. In addition, during the past two years, health care cost recovery actions have been brought in Israel, the Marshall Islands, British Columbia, Canada and France (by a local agency of the French social security health insurance system) and, in the United States, by Bolivia, Ecuador, Guatemala (dismissed, as discussed below), Nicaragua (dismissed, as discussed below), Province of Ontario, Canada (dismissed, as discussed below), Panama, Thailand (voluntarily dismissed), Ukraine (dismissed, as discussed below), Venezuela, State of Goias and the States of Espirito Santo, Goias, Mato Grosso do Sul, Rio de Janeiro and Sao Paulo, Brazil. Federal Government's Lawsuit In September 1999, the U.S. government filed a lawsuit in the U.S. District Court for the District of Columbia against various cigarette manufacturers and others, including the Company and PM Inc., asserting claims under three federal statutes, the Medical Care Recovery Act, the Medicare Secondary Payer provisions of the Social Security Act, and the Racketeer Influenced and Corrupt Organizations Act ("RICO"). The lawsuit seeks to recover an unspecified amount of health care costs for tobacco-related illnesses allegedly caused by defendants' fraudulent and tortious conduct and paid for by the government under various federal health care programs, including Medicare, military and veterans' health benefits programs, and the Federal Employees Health Benefits Program. The complaint alleges that such costs total more than $20 billion annually. It also seeks various types of equitable and declaratory relief, including disgorgement, an injunction prohibiting certain actions by the defendants, and a declaration that the defendants are liable for the federal government's future costs of providing health care resulting from defendants' alleged past tortious and wrongful conduct. The Company and PM Inc. have filed a motion to dismiss this lawsuit on numerous grounds, including that the statutes invoked by the government do not provide a basis for the relief sought. Oral arguments on the motion to dismiss were presented on June 2, 2000. The Company and PM Inc. believe that they have a number of valid defenses to the lawsuit and will continue to vigorously defend it. Industry Trial Results There have been several jury verdicts in tobacco-related litigation during the past three years. On July 14, 2000 the jury in the Engle smoking and health class action in Florida, returned a verdict assessing punitive damages totaling approximately $145 billion against all defendants in the case, including approximately $74 billion against PM Inc. (see "Engle Trial," below, for a more detailed discussion of this verdict and certain other developments in this case). -15- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) In July 2000, a jury in Mississippi returned a verdict in favor of another cigarette manufacturer in an individual smoking and health case. In June 2000, a jury in New York returned a verdict in favor of all defendants including, PM Inc., in another individual smoking and health case. In July 2000, plaintiffs in both cases filed post-trial motions. In March 2000, a jury in California awarded a former smoker with lung cancer $1.72 million in compensatory damages against PM Inc. and another cigarette manufacturer and $10 million in punitive damages against PM Inc. as well as an additional $10 million against the other defendant. PM Inc. is appealing the verdict and damage award in this case. In July 1999, a Louisiana jury returned a verdict in favor of defendants in an individual smoking and health case against other cigarette manufacturers. In June 1999, a Mississippi jury returned a verdict in favor of defendants, including PM Inc., in an action brought on behalf of an individual who died allegedly as a result of exposure to ETS. In May 1999, a Missouri jury returned a verdict in favor of defendant in an individual smoking and health case against another cigarette manufacturer. Also in May 1999, a Tennessee jury returned a verdict in favor of defendants, including PM Inc., in two of three individual smoking and health cases consolidated for trial. In the third case (not involving PM Inc.), the jury found liability against defendants and apportioned fault equally between plaintiff and defendants. Under Tennessee's system of modified comparative fault, because the jury found plaintiff's fault equal to that of defendants, recovery was not permitted. In March 1999, an Oregon jury awarded the estate of a deceased smoker $800,000 in actual damages, $21,500 in medical expenses and $79.5 million in punitive damages against PM Inc. In February 1999, a California jury awarded a former smoker $1.5 million in compensatory damages and $50 million in punitive damages against PM Inc. The punitive damage awards in the Oregon and California actions have been reduced to $32 million and $25 million, respectively. PM Inc. is appealing the verdicts and the damage awards in these cases. In March 1999, a jury returned a verdict in favor of defendants, including PM Inc., in a union health care cost recovery action brought on behalf of approximately 114 employer-employee trust funds in Ohio. Previously, juries had returned verdicts for defendants in three individual smoking and health cases and in one individual ETS smoking and health case. In January 1999, a Florida court set aside a jury award totaling approximately $1 million in an individual smoking and health case against another United States cigarette manufacturer and ordered a new trial in the case. In June 1998, a Florida appeals court reversed a $750,000 jury verdict awarded in August 1996 against another United States cigarette manufacturer, and the Florida Supreme Court has heard oral arguments on this ruling. In 1997, in an action brought on behalf of a deceased smoker, a court in Brazil awarded the Brazilian currency equivalent of $81,000, attorneys' fees and a monthly annuity for 35 years equal to two-thirds of the deceased smoker's last monthly salary. In March 1999, an appeals court reversed the trial court's award and dismissed the case. Neither the Company nor its affiliates were parties to that action. In December 1999, a French court, in an action brought on behalf of a deceased smoker, found that another cigarette manufacturer had a duty to warn him about risks associated with smoking prior to 1976, when the French government required warning labels on cigarette packs, and failed to do so. The court did not determine causation or liability, which shall be considered in future proceedings. Neither the Company nor its affiliates are parties to this action. -16- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) Engle Trial As discussed below, verdicts have been returned against PM Inc. and other cigarette manufacturers and defendants in the first two phases of this three-phase smoking and health class action trial underway in Florida. The class consists of all Florida residents and citizens, and their survivors, "who have suffered, presently suffer or have died from diseases and medical conditions caused by their addiction to cigarettes that contain nicotine." In July 1999, the jury returned a verdict against defendants in phase one of the trial concerning certain issues determined by the trial court to be "common" to the causes of action of the plaintiff class. Among other things, the jury found that smoking cigarettes causes 20 diseases or medical conditions, that cigarettes are addictive or dependence-producing, defective and unreasonably dangerous, that defendants made materially false statements with the intention of misleading smokers, that defendants concealed or omitted material information concerning the health effects and/or the addictive nature of smoking cigarettes, and that defendants were negligent and engaged in extreme and outrageous conduct or acted with reckless disregard with the intent to inflict emotional distress. The jury also found that defendants' conduct "rose to a level that would permit a potential award or entitlement to punitive damages." During phase two of the trial, the claims of three of the named plaintiffs were adjudicated in a consolidated trial before the same jury that returned the verdict in phase one. In April 2000, the jury determined liability against the defendants and awarded $12.7 million in compensatory damages to the three named plaintiffs, although PM Inc. has requested that the court dismiss the award to one of the plaintiffs because of the jury's findings on a statute of limitations question. That plaintiff had been awarded approximately $5.8 million of the total $12.7 million in compensatory damages. On July 14, 2000, the same jury returned a verdict assessing punitive damages on a lump sum basis for the entire class totaling approximately $145 billion against the various defendants in the case, including approximately $74 billion severally against PM Inc. Following this verdict, the jury was dismissed, notwithstanding that liability and compensatory damages for all but three class members have not yet been determined. According to the trial plan, phase three of the trial will address other class members' claims, including issues of specific causation, reliance, affirmative defenses and other individual-specific issues regarding entitlement to damages, in individual trials before separate juries. PM Inc. believes that the punitive damages award was determined improperly and that it should ultimately be set aside on any one of numerous grounds. Included among these grounds are the following: under applicable law (i) defendants are entitled to have liability and damages for each plaintiff tried by the same jury, an impossibility due to the jury's dismissal; (ii) punitive damages cannot be assessed before the jury determines entitlement to and the amount of compensatory damages for all class members; (iii) punitive damages must bear a reasonable relationship to compensatory damages, a determination that cannot be made before compensatory damages are assessed for all class members; and (iv) punitive damages can "punish" but cannot "destroy" the defendant. In March 2000, at the request of the Florida legislature, the Attorney General of Florida issued an advisory legal opinion stating that "Florida law is clear that compensatory damages must be determined prior to an award of punitive damages" in cases such as Engle. As noted above, compensatory damages for all but three of the class members have not been determined. It is unclear how the trial plan will be further implemented. The trial plan provides that the punitive damages award should be standard as to each class member and acknowledges that the actual size of the class will not be known until the last class member's case has withstood appeal, i.e., the punitive damages -17- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) amount would be divided equally among those plaintiffs who, in addition to the successful phase two plaintiffs, are ultimately successful in phase three of the trial and in any appeal. The trial plan does not address whether the defendants would be required to pay the compensatory and punitive damage awards prior to a determination of claims of all class members, a process that could take years to conclude. Plaintiffs have indicated that they intend to seek entry of a final judgment at this time. PM Inc. and the Company do not believe that Florida law and the trial plan permit entry of a judgment for compensatory or punitive damages at this time that would require the posting of a bond to stay its execution pending appeal or that any party would be entitled to execute on such a judgment in the absence of a bond. Under recent Florida legislation, in the event a judgment for punitive damages were entered, PM Inc. would be required to post an appeal bond in the maximum amount of $100 million in order to stay its execution. However, plaintiffs have stated that they believe this legislation is unconstitutional. In a worst case scenario, it is possible that a judgment for punitive damages could be entered in an amount not capable of being bonded, resulting in an execution of the judgment before it could be set aside on appeal. PM Inc. and the Company believe that such a result would be unconstitutional and would also violate Florida laws. PM Inc. and the Company will take all appropriate steps to seek to prevent this worst case scenario from occurring and believe these efforts should be successful. The Engle trial judge scheduled a hearing beginning August 28, 2000 on numerous pending phase one and two motions, including defendants' challenges of various rulings made by the judge and the jury's verdicts on compensatory and punitive damages. On July 24, 2000, defendants filed a notice to remove the case to a federal district court following the intervention application of a union health fund that raises federal issues in the case. Until the federal district court decides whether to retain jurisdiction or remand the case in whole or in part to state court, the state court may not take further action in this case. If the federal court retains jurisdiction over the case, the pending motions and all further trial proceedings would be decided in the federal court. In other developments, in August 1999, the trial judge denied a motion filed by PM Inc. and other defendants to disqualify the judge. The motion asserted, among other things, that the trial judge was required to disqualify himself because he is a former smoker who has a serious medical condition of a type that the plaintiffs claim, and the jury has found, is caused by smoking, making him financially interested in the result of the case and, under plaintiffs' theory of the case, a member of the plaintiff class. The Third District Court of Appeal denied defendants' petition to disqualify the trial judge. In January 2000, defendants filed a petition for a writ of certiorari to the United States Supreme Court requesting that it review the issue of the trial judge's disqualification and in May 2000 the writ of certiorari was denied. PM Inc. and the Company remain of the view that the Engle case should not have been certified as a class action. The certification is inconsistent with the overwhelming majority of federal and state court decisions that have held that mass smoking and health claims are inappropriate for class treatment. PM Inc. intends to challenge the class certification and the compensatory and punitive damage awards, as well as numerous other reversible errors that it believes occurred during the trial to date, at the earliest time that an appeal of these issues is appropriate under Florida law. PM Inc. and the Company believe that an appeal of these issues on the merits should prevail. Pending and Upcoming Trials Trials in two cases under the California Business Code in which PM Inc. is a defendant are scheduled to begin -18- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) in California in September 2000. As set forth in Exhibit 99.3, additional cases against PM Inc. and, in some cases, the Company as well, are scheduled for trial through the end of 2001, including four health care cost recovery actions; four asbestos contribution cases, one of which was scheduled to begin trial in July 2000 but has been stayed pending the resolution of certain interlocutory appeals; three purported smoking and health class actions; and approximately 19 other individual smoking and health cases, including a consolidated trial of individual smoking and health cases scheduled to begin in June 2001 in West Virginia. Cases against other tobacco companies are also scheduled for trial during this period. Trial dates, however, are subject to change. Litigation Settlements In November 1998, PM Inc. and certain other United States tobacco product manufacturers entered into the Master Settlement Agreement (the "MSA") with 46 states, the District of Columbia, the Commonwealth of Puerto Rico, Guam, the United States Virgin Islands, American Samoa and the Northern Marianas to settle asserted and unasserted health care cost recovery and other claims. PM Inc. and certain other United States tobacco product manufacturers had previously settled similar claims brought by Mississippi, Florida, Texas and Minnesota (together with the MSA, the "State Settlement Agreements") and an ETS smoking and health class action brought on behalf of airline flight attendants. The State Settlement Agreements and certain ancillary agreements are filed as exhibits to various of the Company's reports filed with the Securities and Exchange Commission, and such agreements and the ETS settlement are discussed in detail therein. The settlement agreements require that the domestic tobacco industry make substantial annual payments in the following amounts (excluding future annual payments contemplated by the agreement with tobacco growers discussed below), subject to adjustment for several factors, including inflation, market share and industry volume: 2000, $9.2 billion; 2001, $9.9 billion; 2002, $11.3 billion; 2003, $10.9 billion; 2004 through 2007, $8.4 billion each year; and, thereafter, $9.4 billion each year. In addition, the domestic tobacco industry is required to pay settling plaintiffs' attorneys' fees, subject to an annual cap of $500 million, as well as additional amounts as follows: 2000, $416 million; and 2001 through 2003, $250 million each year. These payment obligations are the several and not joint obligations of each settling defendant. PM Inc.'s portion of ongoing adjusted payments and legal fees is based on its share of domestic cigarette shipments in the year preceding that in which the payment is due. Accordingly, PM Inc. records its portions of ongoing settlement payments as part of cost of sales as product is shipped. -19- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) The State Settlement Agreements also include provisions, discussed below in Management's Discussion and Analysis of Financial Condition and Results of Operations, relating to advertising and marketing restrictions, public disclosure of certain industry documents, limitations on challenges to certain tobacco control and underage use laws, restrictions on lobbying activities and other provisions. As set forth in Exhibit 99.2, the MSA has been initially approved by trial courts in all settling jurisdictions. If a jurisdiction does not obtain "final judicial approval" (i.e., trial court approval and expiration of the time for review or appeal of such approval) of the MSA by December 31, 2001, then, unless the settling defendants and the relevant jurisdiction agree otherwise, the agreement will be terminated with respect to such jurisdiction. As of August 1, 2000, the MSA has received final judicial approval in 50 jurisdictions. As part of the MSA, the settling defendants committed to work cooperatively with the tobacco-growing states to address concerns about the potential adverse economic impact of the MSA on tobacco growers and quota-holders. To that end, four of the major domestic tobacco product manufacturers, including PM Inc., and the grower states, have established a trust fund to provide aid to tobacco growers and quota-holders. The trust will be funded by these four manufacturers over 12 years with payments, prior to application of various adjustments, scheduled to total $5.15 billion. Future industry payments (in 2000, $280 million; 2001, $400 million; 2002 through 2008, $500 million each year; 2009 and 2010, $295 million each year) are subject to adjustment for several factors, including inflation, United States cigarette volume and certain other contingent events, and, in general, are to be allocated based on each manufacturer's relative market share. PM Inc. records its portion of these payments as part of cost of sales as product is shipped. The State Settlement Agreements have materially adversely affected the volumes of PM Inc. and the Company; the Company believes that they may materially adversely affect the business, volume, results of operations, cash flows or financial position of PM Inc. and the Company in future periods. The degree of the adverse impact will depend, among other things, on the rates of decline in United States cigarette sales in the premium and discount segments, PM Inc.'s share of the domestic premium and discount cigarette segments, and the effect of any resulting cost advantage of manufacturers not subject to the MSA and the other State Settlement Agreements. Manufacturers representing almost all domestic shipments in 1998 have agreed to become subject to the terms of the MSA. Certain litigation, described in Exhibit 99.1, has arisen challenging the validity of the MSA and alleging violation of the antitrust laws. A description of the smoking and health litigation, health care cost recovery litigation and certain other proceedings pending against the Company and/or its subsidiaries and affiliates follows. Smoking and Health Litigation Plaintiffs' allegations of liability in smoking and health cases are based on various theories of recovery, including negligence, gross negligence, strict liability, fraud, misrepresentation, design defect, failure to warn, breach of express and implied warranties, breach of special duty, conspiracy, concert of action, violations of deceptive trade practice laws and consumer protection statutes, and claims under the federal and state RICO statutes. In certain of these cases, plaintiffs claim that cigarette smoking exacerbated the injuries caused by their exposure to asbestos. Plaintiffs in the -20- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) smoking and health actions seek various forms of relief, including compensatory and punitive damages, treble/multiple damages and other statutory damages and penalties, creation of medical monitoring and smoking cessation funds, disgorgement of profits, and injunctive and equitable relief. Defenses raised in these cases include lack of proximate cause, assumption of the risk, comparative fault and/or contributory negligence, statutes of limitations and preemption by the Federal Cigarette Labeling and Advertising Act. In May 1996, the United States Court of Appeals for the Fifth Circuit held in the Castano case that a class consisting of all "addicted" smokers nationwide did not meet the standards and requirements of the federal rules governing class actions. Since this class decertification, lawyers for plaintiffs have filed numerous putative smoking and health class action suits in various state and federal courts. In general, these cases purport to be brought on behalf of residents of a particular state or states (although a few cases purport to be nationwide in scope) and raise "addiction" claims similar to those raised in the Castano case and, in many cases, claims of physical injury as well. As of August 1, 2000, smoking and health putative class actions were pending in Alabama, Florida, Hawaii, Illinois, Indiana, Iowa, Louisiana, Missouri, Nevada, New Jersey, New Mexico, New York, North Carolina, Oklahoma, Pennsylvania, South Carolina, Tennessee, Texas, Utah and West Virginia, as well as in Australia, Brazil, Canada and Israel. Class certification has been denied or reversed by courts in 23 smoking and health class actions involving PM Inc. in Arkansas, California (2), the District of Columbia, Illinois, Kansas, Louisiana, Maryland, Michigan, Minnesota, New Jersey (6), New York (2), Ohio, Pennsylvania, Puerto Rico, Texas, and Wisconsin, while classes remain certified in two cases in Florida and Louisiana. A number of the decisions denying the plaintiffs' motions for class certification are on appeal. In May 2000, the Maryland Court of Appeals, in the Richardson case, ordered the lower court judge to decertify the class action lawsuit filed against PM Inc. and several other cigarette manufacturers. The Richardson case was filed in 1996 on behalf of all Maryland smokers who are allegedly addicted to nicotine or who suffer from alleged smoking-related injuries. In May 1999, the United States Supreme Court declined to review the decision of the United States Court of Appeals for the Third Circuit affirming a lower court's decertification of a class. As mentioned in Overview of Tobacco-Related Litigation, above, one ETS smoking and health class action was settled in 1997. Health Care Cost Recovery Litigation In certain of the pending proceedings, domestic and foreign governmental entities and non-governmental plaintiffs, including union health and welfare funds ("unions"), native American tribes, insurers and self-insurers such as Blue Cross and Blue Shield Plans, hospitals, taxpayers and others, are seeking reimbursement of health care cost expenditures allegedly caused by tobacco products and, in some cases, of future expenditures and damages as well. Certain of these cases purport to be brought on behalf of a class of plaintiffs. Other relief sought by some but not all plaintiffs includes punitive damages, treble/multiple damages and other statutory damages and penalties, injunctions prohibiting alleged marketing and sales to minors, disclosure of research, disgorgement of profits, funding of anti-smoking programs, disclosure of nicotine yields, and payment of attorney and expert witness fees. The claims asserted in these health care cost recovery actions include the equitable claim that the tobacco industry was "unjustly enriched" by plaintiffs' payment of health care costs allegedly attributable to smoking, the equitable claim of indemnity, common law claims of negligence, strict liability, breach of express and implied warranty, violation of a voluntary undertaking or special duty, fraud, negligent misrepresentation, conspiracy, public nuisance, claims under federal and state -21- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) statutes governing consumer fraud, antitrust, deceptive trade practices and false advertising, and claims under federal and state RICO statutes. Defenses raised include lack of proximate cause, remoteness of injury, failure to state a valid claim, lack of benefit, adequate remedy at law, "unclean hands" (namely, that plaintiffs cannot obtain equitable relief because they participated in, and benefited from, the sale of cigarettes), lack of antitrust standing and injury, federal preemption, lack of statutory authority to bring suit and statute of limitations. In addition, defendants argue that they should be entitled to "set off" any alleged damages to the extent the plaintiff benefits economically from the sale of cigarettes through the receipt of excise taxes or otherwise. Defendants also argue that these cases are improper because plaintiffs must proceed under principles of subrogation and assignment. Under traditional theories of recovery, a payer of medical costs (such as an insurer) can seek recovery of health care costs from a third party solely by "standing in the shoes" of the injured party. Defendants argue that plaintiffs should be required to bring any actions as subrogees of individual health care recipients and should be subject to all defenses available against the injured party. Excluding the cases covered by the MSA, as of August 1, 2000, there were approximately 50 health care cost recovery cases pending in the United States against PM Inc. and, in some cases, the Company, of which approximately 20 were filed by union trust funds. As discussed above under "Federal Government's Lawsuit," the U.S. government filed a health care cost recovery action in September 1999 against various cigarette manufacturers and others, including the Company and PM Inc., asserting claims under three federal statutes. Health care cost recovery actions have also been brought in Israel, the Marshall Islands, British Columbia, Canada and France and, in the United States, by Bolivia, Ecuador, Guatemala, Nicaragua, Province of Ontario, Canada, Panama, Thailand (voluntarily dismissed), Ukraine, Venezuela and the Brazilian States of Espirito Santo, Goias, Mato Grosso do Sul, Rio de Janeiro, and Sao Paulo. The actions brought by Bolivia, Ecuador, Guatemala, Nicaragua, Ontario, Ukraine, Venezuela and the Brazilian States of Goias and Esperito Santo were consolidated for pre-trial purposes and transferred to the United States District Court for the District of Columbia. As described below, the court has dismissed the claims of Guatemala, Nicaragua, the Province of Ontario and Ukraine. The court remanded the Venezuela, State of Goias and Ecuador cases to state court in Florida. Other foreign entities and others have stated that they are considering filing health care cost recovery actions. Five federal appeals courts have issued rulings in health care cost recovery actions that were favorable to the tobacco industry. The United States Courts of Appeals for the Second, Third, Fifth, Seventh and Ninth Circuits, relying primarily on grounds that the plaintiffs' claims were too remote, have affirmed dismissals of, or reversed trial courts that had refused to dismiss, such actions. In addition, in January 2000, the United States Supreme Court denied plaintiffs' petitions for writs of certiorari in the cases decided by the Court of Appeals for the Second, Third and Ninth Circuits, effectively refusing to consider plaintiffs' appeals. Although there have been some decisions to the contrary, to date, most lower courts that have decided motions in these cases have dismissed all or most of the claims against the industry. In December 1999, in the first ruling on a motion to dismiss a health care cost recovery case brought in the United States by a foreign governmental plaintiff, the United States District Court for the District of Columbia dismissed a lawsuit filed by Guatemala, ruling that the claimed injuries were too remote. Subsequently, in March 2000, the court also dismissed the claims of Nicaragua and Ukraine. Guatemala, Nicaragua and Ukraine each have appealed these decisions to the United States Court of Appeals for the District of Columbia Circuit. In August 2000, the United States District Court for the District of Columbia dismissed the claims of the Province of Ontario. In March 1999, in the only union case to go to trial -22- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) thus far, the jury returned a verdict in favor of defendants on all counts. Plaintiffs' motion for a new trial was denied. In December 1999, the federal district court in the District of Columbia denied defendants' motion to dismiss a suit filed by union and welfare trust funds seeking reimbursement of health care expenditures allegedly caused by tobacco products. Defendants are appealing this decision. In June 2000, the federal district court in Rhode Island dismissed a suit filed by a union, finding that the plaintiffs' claims are too remote to permit recovery. Certain Other Tobacco-Related Litigation Asbestos Contribution Cases: As of August 1, 2000, 13 suits had been filed by former asbestos manufacturers, asbestos manufacturers' personal injury settlement trusts and an insurance company against domestic tobacco manufacturers, including PM Inc. and others. Nine of these cases are pending. These cases seek, among other things, contribution or reimbursement for amounts expended in connection with the defense and payment of asbestos claims that were allegedly caused in whole or in part by cigarette smoking. Plaintiffs in most of these cases also seek punitive damages. The aggregate amounts claimed in these cases range into the billions of dollars. In November 1999, one of these cases was dismissed by the federal district court in the Eastern District of New York although the case was subsequently refiled. Trials in three of these cases are scheduled to begin in New York in January and March 2001 and in Mississippi in February 2001. Lights/Ultra Lights Cases: As of August 1, 2000, there were twelve putative class actions pending against PM Inc. and the Company, in Arizona, Florida, Illinois, Massachusetts, Missouri, New Jersey, Ohio, Pennsylvania, Tennessee, and Washington, D.C., on behalf of individuals who purchased and consumed various brands of cigarettes, including Marlboro Lights, Marlboro Ultra Lights, Virginia Slims Lights and Superslims, Merit Lights and Cambridge Lights. These cases allege, in connection with the use of the term "Lights" and/or "Ultra Lights," among other things, deceptive and unfair trade practices and unjust enrichment, and seek injunctive and equitable relief, including restitution. Retail Leaders Case: Three domestic tobacco manufacturers have filed suit against PM Inc. seeking to enjoin the PM Inc. "Retail Leaders" program that became available to retailers in October 1998. The complaint alleges that this retail merchandising program is exclusionary, creates an unreasonable restraint of trade and constitutes unlawful monopolization. In addition to an injunction, plaintiffs seek unspecified treble damages, attorneys' fees, costs and interest. In June 1999, the court issued a preliminary injunction enjoining PM Inc. from prohibiting retail outlets that participate in the program at one of the levels from installing competitive permanent signage in any section of the "industry fixture" that displays or holds packages of cigarettes manufactured by a firm other than PM Inc., or requiring those outlets to allocate a percentage of cigarette-related permanent signage to PM Inc. greater than PM Inc.'s market share. The court also enjoined PM Inc. from prohibiting retail outlets participating in the program from advertising or conducting promotional programs of cigarette manufacturers other than PM Inc. The preliminary injunction does not affect any other aspect of the Retail Leaders program. Vending Machine Case: Plaintiffs, who began their case as a purported nationwide class of cigarette vending machine operators, allege that PM Inc. has violated the Robinson-Patman Act in connection with its promotional and merchandising programs available to retail stores and not available to cigarette vending machine operators. Plaintiffs request actual damages, treble damages, injunctive relief, attorneys' fees and costs, and other unspecified relief. In June 1999, the court denied plaintiffs' motion for a preliminary injunction. Plaintiffs have withdrawn their request for class -23- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) action status. The claims of ten plaintiffs are set for trial in November 2000; the claims of remaining plaintiffs have been stayed pending disposition of those claims scheduled for trial. Cases Under the California Business and Professions Code: In July 1998, two suits were filed in California courts alleging that domestic cigarette manufacturers, including PM Inc. and others, have violated a California statute known as "Proposition 65" by not informing the public of the alleged risks of ETS to non-smokers. Plaintiffs also allege violations of California's Business and Professions Code regarding unfair and fraudulent business practices. Plaintiffs seek statutory penalties, injunctions barring the sale of cigarettes or requiring issuance of appropriate warnings, restitution, disgorgement of profits and other relief. The defendants' motions to dismiss were denied in both of these cases. In October 1999, plaintiffs' motion for a preliminary injunction was also denied. In January 2000, defendants' motion for summary judgment was granted in part, and plaintiffs' "Proposition 65" claims were dismissed. Trial on the remaining claims in these cases is scheduled to begin in September 2000. Tobacco Price Cases: As of August 1, 2000, there were approximately 45 putative class actions against the Company and other domestic tobacco manufacturers alleging that, through the MSA and other activities, the manufacturers conspired to fix cigarette prices in violation of antitrust laws. These cases are listed in Exhibit 99.1. Tobacco Growers' Case: In February 2000, a lawsuit was filed on behalf of a purported class of tobacco growers and quota-holders. The complaint, which was amended in May 2000, alleges that cigarette manufacturers, including PM Inc., violated antitrust laws by bid-rigging, conspiring to displace the tobacco quota and price support system administered by the federal government and entering into the growers' trust fund described in Litigation Settlements, above. Defendants filed a motion to dismiss the amended complaint in June 2000. Plaintiffs have indicated that they intend to seek leave to file a second amended complaint instead of filing a response to the dismissal motion. Cigarette Importation Cases: As of August 1, 2000, Ecuador and various Departments of Colombia have filed suits in the United States against the Company and certain of its subsidiaries, including PM Inc. and PMI, and other cigarette manufacturers alleging that defendants illegally imported cigarettes into the plaintiff jurisdictions in an effort to evade taxes. The claims asserted in these cases include negligence, negligent misrepresentation, unjust enrichment, violations of RICO and its state-law equivalents and conspiracy. Plaintiffs in these cases seek actual damages, treble damages and undisclosed injunctive or equitable relief. In July 2000, the European Union ("EU") announced its intention to file a civil suit in the United States against various United States cigarette manufacturers seeking to recoup tax revenues allegedly lost by members of the EU as a result of the manufacturers' alleged involvement in the illegal importation of cigarettes. The EU has declined to identify which manufacturers will be named as defendants. Certain Other Actions National Cheese Exchange Cases: Since 1996, seven putative class actions have been filed alleging that Kraft and others engaged in a conspiracy to fix and depress the prices of bulk cheese and milk through their trading activity on the National Cheese Exchange. Plaintiffs seek injunctive and equitable relief and treble damages. Two of the actions were voluntarily dismissed by plaintiffs after class certification was denied. Two other actions were dismissed in 1998 after Kraft's motions to dismiss were granted, and plaintiffs appealed those dismissals. In one of those cases, in February 2000 the court reversed the trial court's decision to dismiss the case. The remaining three cases were consolidated in state court in Wisconsin, and in November 1999, the court granted Kraft's motion for summary judgment. Plaintiffs have appealed. Italian Tax Matters: One hundred eighty-eight tax assessments alleging the nonpayment of taxes in Italy (value-added taxes for the years 1988 to 1995 and income taxes for the years 1987 to 1995) have been served upon certain affiliates of the Company. The aggregate amount of alleged unpaid taxes assessed to date is the Italian lira equivalent of $2.2 billion. In addition, the Italian lira equivalent of $3.1 billion in interest and penalties has been assessed. The Company anticipates that value-added and income tax assessments may also be received with respect to subsequent years. All of the assessments are being vigorously contested. To date, the Italian administrative tax court in Milan has overturned 162 of the assessments. The decisions to overturn 113 assessments have been appealed by the tax authorities to the regional appellate court in Milan. To date, the regional -24- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) appellate court has rejected 41 of the appeals filed by the tax authorities. The tax authorities have appealed 31 of the 41 decisions of the regional appellate court to the Italian Supreme Court. The remaining 10 decisions are expected to be appealed as well. In a separate proceeding in Naples, in October 1997, a court dismissed charges of criminal association against certain present and former officers and directors of affiliates of the Company, but permitted tax evasion and related charges to remain pending. In February 1998, the criminal court in Naples determined that jurisdiction was not proper, and the case file was transmitted to the public prosecutor in Milan. Further investigation is being conducted following which a decision will be made as to whether there should be a trial on these charges. The Company, its affiliates and the officers and directors who are subject to the proceedings believe they have complied with applicable Italian tax laws and are vigorously contesting the pending assessments and proceedings. ---------------------- It is not possible to predict the outcome of the litigation pending against the Company and its subsidiaries. Litigation is subject to many uncertainties. Unfavorable verdicts awarding compensatory and punitive damages have been returned in the Engle smoking and health class action trial. It is possible that additional cases could be decided unfavorably and that there could be further adverse developments in the Engle case. Three individual smoking and health cases in which PM Inc. is a defendant have been decided unfavorably at the trial court level and are in the process of being appealed. An unfavorable outcome or settlement of a pending smoking and health or health care cost recovery case could encourage the commencement of additional similar litigation. There have also been a number of adverse legislative, regulatory, political and other developments concerning cigarette smoking and the tobacco industry that have received widespread media attention. These developments may negatively affect the perception of potential triers of fact with respect to the tobacco industry, possibly to the detriment of certain pending litigation, and may prompt the commencement of additional similar litigation. Management is unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of pending litigation. The present legislative and litigation environment is substantially uncertain, and it is possible that the Company's business, volume, results of operations, cash flows or financial position could be materially affected by an unfavorable outcome or settlement of certain pending litigation or by the enactment of federal or state tobacco legislation. The Company and each of its subsidiaries named as a defendant believe, and each has been so advised by counsel handling the respective cases, that it has a number of valid defenses to all litigation pending against it, as well as valid bases for appeal of adverse verdicts against it. All such cases are, and will continue to be, vigorously defended. However, the Company and its subsidiaries may enter into discussions in an attempt to settle particular cases if they believe it is in the best interests of the Company's stockholders to do so. -25- Philip Morris Companies Inc. and Subsidiaries Notes to Condensed Consolidated Financial Statements (Unaudited) Note 6. Recently Issued Accounting Pronouncements: During 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," which had an initial adoption date by the Company of January 1, 2000. During 1999, the FASB postponed the adoption date of SFAS No. 133 until January 1, 2001. SFAS No. 133 requires that all derivative financial instruments be recorded on the consolidated balance sheets at their fair value. Changes in the fair value of derivatives will be recorded each period in earnings or other comprehensive earnings, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Gains and losses on derivative instruments reported in other comprehensive earnings will be reclassified as earnings in the periods in which earnings are affected by the hedged item. The Company has not yet determined the impact that adoption or subsequent application of SFAS No. 133 will have on its financial position or results of operations. During May 2000, the Emerging Issues Task Force ("EITF") issued EITF Issue No. 00-14, "Accounting for Certain Sales Incentives." EITF No. 00-14 addresses the recognition, measurement and statement of earnings classification of various sales incentives and will be effective for the fourth quarter of 2000. The Company has determined that the impact of adoption or subsequent application of EITF Issue No. 00-14 will not have a material effect on its financial position or results of operations. However, certain items previously included in marketing, administration and research costs on the consolidated statements of earnings will be recorded as a reduction of operating revenues. Upon adoption, prior period amounts will be reclassified to conform with the new requirements. -26- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Consolidated Operating Results For the Six Months Ended June 30, Operating Revenues --------------------------- (in millions) 2000 1999 -------- -------- Domestic tobacco $ 11,152 $ 9,195 International tobacco 13,799 14,266 North American food 9,258 9,022 International food 4,176 4,446 Beer 2,300 2,208 Financial services 199 170 -------- -------- Operating revenues $ 40,884 $ 39,307 ======== ======== Operating Income --------------------------- (in millions) 2000 1999 -------- -------- Domestic tobacco $ 2,390 $ 2,069 International tobacco 2,741 2,683 North American food 1,863 1,631 International food 535 521 Beer 346 314 Financial services 127 110 -------- -------- Operating companies income 8,002 7,328 Amortization of goodwill (293) (292) General corporate expenses (419) (235) Minority interest (60) (63) -------- -------- Operating income $ 7,230 $ 6,738 ======== ======== For the Three Months Ended June 30, Operating Revenues --------------------------- (in millions) 2000 1999 -------- -------- Domestic tobacco $ 5,706 $ 4,735 International tobacco 6,801 6,926 North American food 4,803 4,626 International food 2,171 2,204 Beer 1,256 1,222 Financial services 107 97 -------- -------- Operating revenues $ 20,844 $ 19,810 ======== ======== -27- For the Three Months Ended June 30, (continued) Operating Income --------------------------- (in millions) 2000 1999 -------- -------- Domestic tobacco $ 1,274 $ 1,151 International tobacco 1,310 1,252 North American food 996 946 International food 289 275 Beer 193 178 Financial services 69 60 -------- -------- Operating companies income 4,131 3,862 Amortization of goodwill (147) (145) General corporate expenses (204) (111) Minority interest (28) (29) -------- -------- Operating income $ 3,752 $ 3,577 ======== ======== Amortization of goodwill is primarily attributable to the North American food segment for all periods presented. Results of Operations for the Six Months Ended June 30, 2000 Operating revenues for the first six months of 2000 increased $1.6 billion (4.0%) over 1999, due primarily to an increase in revenues from the Company's domestic tobacco operations. Despite this increase, the operating revenue comparison for the first six months was adversely affected by approximately $225 million of incremental sales made during the fourth quarter of 1999, as the Company's customers planned for potential business failures related to the Century Date Change ("CDC"). The incremental CDC sales would have normally been made during the first quarter of 2000. Including the incremental CDC revenues in the first quarter of 2000, and excluding the revenues of several small international food businesses divested since the beginning of 1999, operating revenues for the first six months of 2000 increased $1.9 billion (4.8%) over the first six months of 1999. Operating income for the first six months of 2000 increased $492 million (7.3%) over the comparable 1999 period. The operating income comparison was affected by the following unusual items: o Louisville Factory Closure - During the first quarter of 1999, Philip Morris Incorporated ("PM Inc.") announced plans to phase out cigarette production capacity at its Louisville, Kentucky manufacturing plant by August 2000 (the "Louisville Closure"). The closure of this facility, which occurred in stages, has been completed. In connection with the closure, PM Inc. recorded pre-tax charges for the first six months of 1999 of $175 million. These charges, which are in the domestic tobacco segment's marketing, administration and research costs in the consolidated statement of earnings, included enhanced severance, pension and postretirement benefits for approximately 1,500 hourly and salaried employees. Severance benefits, which were either paid in a lump sum or as income protection payments over a period of time, commenced upon termination of employment. Payments of enhanced pension and postretirement benefits are being made over the remaining lives of the former employees in accordance with the terms of the related benefit plans. All operating costs of the manufacturing plant, including increased depreciation, were charged to expense as incurred during the closing period. -28- o Kraft Separation Programs - During the first quarter of 1999, Kraft Foods, Inc. ("Kraft") announced that it was offering voluntary retirement incentive or separation programs to certain eligible hourly and salaried employees in the United States (the "Kraft Separation Programs"). Employees electing to terminate employment under the terms of these programs were entitled to enhanced retirement or severance benefits. Approximately 1,100 hourly and salaried employees accepted the benefits offered by these programs and elected to retire or terminate. As a result, Kraft recorded a pre-tax charge of $157 million for the first six months of 1999. This charge was included in marketing, administration and research costs in the consolidated statement of earnings for the North American food segment. Payments of pension and postretirement benefits are made in accordance with the terms of the applicable benefit plans. Severance benefits, which are paid over a period of time, commenced upon dates of termination that ranged from April 1999 to March 2000. Salary and related benefit costs of employees prior to the retirement or termination date were expensed as incurred. The operating income comparison was adversely affected by approximately $100 million of operating income from the previously mentioned incremental CDC sales. Including the incremental CDC income and excluding the pre-tax charges for the Louisville Closure and the Kraft Separation Programs, as well as the results from operations divested since the beginning of 1999, operating income for the first six months of 2000 increased $264 million (3.7%) over the first six months of 1999, due primarily to higher operating results from all segments, partially offset by higher general corporate expenses. The $184 million increase in general corporate expenses over the first six months of 1999 is due primarily to higher spending on the Company's corporate image campaign. Operating companies income, which is defined as operating income before general corporate expenses, minority interest and amortization of goodwill, increased $674 million (9.2%) over the first six months of 1999, due primarily to higher operating results from all segments and the previously discussed 1999 pre-tax charges for the Louisville Closure and the Kraft Separation Programs, partially offset by the incremental CDC income. Including the impact of the incremental CDC income and excluding the 1999 pre-tax charges, as well as the results from operations divested since the beginning of 1999, operating companies income increased $446 million (5.8%). Currency movements have decreased operating revenues by $1.3 billion ($692 million, after excluding the impact of currency movements on excise taxes), and operating companies income by $176 million from the first half of 1999. Declines in operating revenues and operating companies income arising from the strength of the U.S. dollar against the Euro and certain Central and Eastern European currencies have been partially offset by the weakness of the U.S. dollar against the Japanese yen. Although the Company cannot predict future movements in currency rates, strengthening of the dollar, primarily against the Euro, if sustained during the remainder of 2000, could continue to have an unfavorable impact on operating revenues and operating companies income comparisons with 1999. Interest and other debt expense, net, decreased $50 million (11.7%) in the first six months of 2000 from the comparable 1999 period. This decrease was due primarily to lower average debt outstanding during the first six months of 2000. Diluted and basic EPS, which were each $1.82 for the first six months of 2000, increased by 15.9% and 15.2%, respectively, over the first six months of 1999. Net earnings of $4.2 billion for the first half of 2000 increased $363 million (9.5%) over the comparable period of 1999. These results reflect the charges for the previously discussed Louisville Closure and the Kraft Separation Programs, and exclude the incremental CDC income. After adjusting for the effects of these unusual items, net earnings increased 5.6% to $4.2 billion, diluted EPS increased 11.5% to $1.84 and basic EPS increased 11.4% to $1.85. -29- Results of Operations for the Three Months Ended June 30, 2000 Operating revenues for the second quarter of 2000 increased $1.0 billion (5.2%) over the comparable 1999 period, due primarily to an increase in revenues from the Company's domestic tobacco operations. Excluding the revenues of several small international food businesses divested since the beginning of 1999, underlying operating revenues for the second quarter of 2000 increased $1.1 billion (5.4%) over the second quarter of 1999. Operating income for the second quarter of 2000 increased $175 million (4.9%) over the comparable 1999 period. Second quarter 1999 operating income includes pre-tax charges of $45 million related to the Louisville Closure. Excluding these pre-tax charges, as well as the results from operations divested since the beginning of 1999, operating income for 2000 increased $133 million (3.7%) from the second quarter of 1999 due primarily to higher operating results from all segments, partially offset by higher general corporate expenses. On a reported basis, operating companies income, which is defined as operating income before general corporate expenses, minority interest and amortization of goodwill, increased $269 million (7.0%) from the second quarter of 1999. Excluding the previously mentioned pre-tax charges, as well as the results of divested operations, operating companies income increased $227 million (5.8%) from the second quarter of 1999. Currency movements have decreased operating revenues by $592 million ($330 million, after excluding the impact of currency movements on excise taxes), and operating companies income by $83 million from the second quarter of 1999. Declines in operating revenues and operating companies income arising from the strength of the U.S. dollar against the Euro and certain Central and Eastern European currencies have been partially offset by the weakness of the U.S. dollar against the Japanese yen. Although the Company cannot predict future movements in currency rates, strengthening of the dollar, primarily against the Euro, if sustained during the remainder of 2000, could continue to have an unfavorable impact on operating revenues and operating companies income comparisons with 1999. Interest and other debt expense, net, decreased $29 million (13.1%) in the second quarter of 2000 from the comparable 1999 period. This decrease was due primarily to lower average debt outstanding and lower average interest rates, partially offset by lower levels of interest income during the second quarter of 2000. Diluted and basic EPS, which were $0.95 and $0.96, respectively, for the second quarter of 2000, increased by 13.1% and 14.3%, respectively, over the second quarter of 1999. Net earnings of $2.2 billion for the second quarter of 2000 increased $141 million (6.9%) over the comparable 1999 period. These results reflect the charges for the previously discussed Louisville Closure. After adjusting for the effect of this unusual item, net earnings increased 5.5% to $2.2 billion, and diluted EPS increased 11.8% to $0.95 and basic EPS increased 12.9% to $0.96. Year 2000 To date, the Company and its subsidiaries have experienced no material disruptions to their business operations as a result of the Century Date Change. External information technology specialists have stated that CDC-related miscalculations or systems failures could occur throughout the year 2000 and into 2001. The experience of the Company and its subsidiaries thus far suggests that no material disruptions to their business operations are likely to occur. However, the Company and its subsidiaries will continue to monitor the transition to year 2000 as part of their regular management processes and will respond promptly to any problems that occur. The Company's increases in year-end inventories and trade receivables caused by preemptive contingency plans resulted in incremental cash outflows during 1999 of approximately $300 million. The cash outflows reversed in -30- the first quarter of 2000. In addition, certain operating subsidiaries of the Company had increased shipments in the fourth quarter of 1999, because customers purchased additional product in anticipation of potential CDC-related disruptions, resulting in incremental operating revenues and operating companies income in 1999 of approximately $225 million and $100 million, respectively. Accordingly, there were reductions of corresponding amounts in operating revenues and operating companies income in the first quarter of 2000. Euro On January 1, 1999, eleven of the fifteen member countries of the European Union established fixed conversion rates between their existing currencies ("legacy currencies") and one common currency--the Euro. At that time, the Euro began trading on currency exchanges and could be used in financial transactions. Beginning in January 2002, new Euro-denominated currency (bills and coins) will be issued, and legacy currencies will be withdrawn from circulation. The Company's operating subsidiaries affected by the Euro conversion have established and, where required, implemented plans to address the systems and business issues raised by the Euro currency conversion. These issues include, among others: (1) the need to adapt computer and other business systems and equipment to accommodate Euro-denominated transactions; and (2) the competitive impact of cross-border price transparency, which may make it more difficult for businesses to charge different prices for the same products on a country-by-country basis, particularly once the Euro currency is issued in 2002. The Euro conversion has not had, and the Company currently anticipates that it will not have, a material adverse impact on its financial condition or results of operations. -31- Operating Results by Business Segment Tobacco Business Environment The tobacco industry, both in the United States and abroad, has faced, and continues to face, a number of issues that may adversely affect the business, volume, results of operations, cash flows and financial position of PM Inc., Philip Morris International Inc. ("PMI") and the Company. These issues, some of which are more fully discussed below, include pending and threatened smoking and health litigation and recent jury verdicts against PM Inc., including in the Engle smoking and health class action case discussed above in Note 5. Contingencies; the filing of a civil lawsuit by the U.S. federal government against various cigarette manufacturers and others as discussed in Note 5; legislation or other governmental action seeking to ascribe to the industry responsibility and liability for the adverse health effects associated with both smoking and exposure to environmental tobacco smoke ("ETS"); price increases in the United States related to the settlement of certain tobacco litigation; actual and proposed excise tax increases; an increase in diversion into the United States market of products intended for sale outside the United States; foreign and United States governmental investigations into illegal cigarette imports; actual and proposed requirements regarding disclosure of cigarette ingredients and other proprietary information; governmental and private bans and restrictions on smoking; actual and proposed price controls and restrictions on imports in certain jurisdictions outside the United States; actual and proposed restrictions affecting tobacco manufacturing, marketing, advertising and sales outside the United States; actual and proposed legislation in Congress and the State of New York to require the establishment of fire-safety standards for cigarettes; the diminishing social acceptance of smoking and increased pressure from anti-smoking groups and unfavorable press reports; and other tobacco legislation that may be considered by the Congress, the states and other jurisdictions inside and outside the United States. Excise Taxes: Cigarettes are subject to substantial federal, state and local excise taxes in the United States and to similar taxes in most foreign markets. The United States federal excise tax on cigarettes is currently $0.34 per pack of 20 cigarettes and is scheduled to increase to $0.39 per pack on January 1, 2002. In general, excise taxes and other taxes on cigarettes have been increasing. These taxes vary considerably and, when combined with sales taxes and the current federal excise tax, may be as high as $1.87 per pack in a given locality in the United States. Congress has been considering significant increases in the federal excise tax or other payments from tobacco manufacturers, and the Clinton Administration's fiscal year 2001 budget proposal includes an additional increase of $0.25 per pack in the federal excise tax, as well as a contingent special assessment related to youth smoking rates. Increases in excise and other cigarette-related taxes have been proposed at the state and local levels and in many jurisdictions outside the United States. In the opinion of PM Inc. and PMI, increases in excise and similar taxes have had an adverse impact on sales of cigarettes. Any future increases, the extent of which cannot be predicted, -32- could result in volume declines for the cigarette industry, including PM Inc. and PMI, and might cause sales to shift from the premium segment to the discount segment. Federal Trade Commission ("FTC"): In September 1997, the FTC issued a request for public comments on its proposed revision of its "tar" and nicotine test methodology and reporting procedures established by a 1970 voluntary agreement among domestic cigarette manufacturers. In February 1998, PM Inc. and three other domestic cigarette manufacturers filed comments on the proposed revisions. In November 1998, the FTC wrote to the Department of Health and Human Services requesting its assistance in developing specific recommendations on the future of the FTC's program for testing the "tar," nicotine and carbon monoxide content of cigarettes. Food and Drug Administration ("FDA") Regulations: In August 1996, the FDA promulgated regulations asserting jurisdiction over cigarettes as "drugs" or "medical devices" under the provisions of the Food, Drug and Cosmetic Act ("FDCA"). The regulations, which included severe restrictions on the distribution, marketing and advertising of cigarettes, and would have required the industry to comply with a wide range of labeling, reporting, record-keeping, manufacturing and other requirements, were declared invalid by the United States Supreme Court in March 2000. The Company has stated that while it continues to oppose FDA regulation over cigarettes as "drugs" or "medical devices" under the provisions of the Food, Drug and Cosmetic Act, it would be prepared to support new legislation that would provide for reasonable regulation at the federal level of cigarettes as cigarettes. Currently, there are several bills pending in Congress that if enacted, would give the FDA authority to regulate tobacco products. The bills take a variety of approaches to the issue of the FDA's proposed regulation of tobacco products ranging from codification of the original FDA regulations under the "drug" and "medical device" provisions of the FDCA to the creation of provisions that would apply uniquely to tobacco products. All of the pending legislation could result in substantial Federal regulation of the design, manufacture and marketing of cigarettes. The ultimate outcome of the pending bills cannot be predicted. Ingredient Disclosure Laws: The Commonwealth of Massachusetts has enacted legislation to require cigarette manufacturers to report yearly the flavorings and other ingredients used in each brand style of cigarettes sold in the Commonwealth, and on a qualified, by-brand basis to provide "nicotine-yield ratings" for their products based on standards established by the Commonwealth. Enforcement of the ingredient disclosure provisions of the statute could result in the public disclosure of valuable proprietary information. In December 1997, a federal district court in Boston granted the tobacco company plaintiffs a preliminary injunction and enjoined the Commonwealth from enforcing the ingredient disclosure provisions of the legislation. In November 1998, the First Circuit Court of Appeals affirmed this ruling. In addition, both parties' cross-motions for summary judgment are pending before the district court. The ultimate outcome of this lawsuit cannot be predicted. Similar legislation has been enacted or proposed in other states. Some jurisdictions outside the United States have also enacted or proposed some form of ingredient disclosure legislation or regulation. Health Effects of Smoking and Exposure to ETS: Reports with respect to the health risks of cigarette smoking have been publicized for many years, and the sale, promotion and use of cigarettes continue to be subject to increasing governmental regulation. Since 1964, the Surgeon General of the United States and the Secretary of Health and Human Services have released a number of reports linking cigarette smoking with a broad range of health hazards, -33- including various types of cancer, coronary heart disease and chronic lung disease, and recommending various governmental measures to reduce the incidence of smoking. The 1988, 1990, 1992 and 1994 reports focus upon the addictive nature of cigarettes, the effects of smoking cessation, the decrease in smoking in the United States, the economic and regulatory aspects of smoking in the Western Hemisphere, and cigarette smoking by adolescents, particularly the addictive nature of cigarette smoking in adolescence. Studies with respect to the health risks of ETS to nonsmokers (including lung cancer, respiratory and coronary illnesses, and other conditions) have also received significant publicity. In 1986, the Surgeon General of the United States and the National Academy of Sciences reported that nonsmokers were at increased risk of lung cancer and respiratory illness due to ETS. In 1993, the United States Environmental Protection Agency (the "EPA") issued a report relating to certain health effects of ETS. The report included a risk assessment relating to the association between ETS and lung cancer in nonsmokers, and a determination by the EPA to classify ETS as a "Group A" carcinogen. In July 1998, a federal district court vacated those sections of the report relating to lung cancer, finding that the EPA may have reached different conclusions had it complied with certain relevant statutory requirements. The federal government has appealed the court's ruling. The ultimate outcome of this litigation cannot be predicted. In October 1997, at the request of the United States Senate Judiciary Committee, the Company provided the Committee with a document setting forth the Company's position on a number of issues. On the issues of the role played by cigarette smoking in the development of lung cancer and other diseases in smokers, and whether nicotine, as found in cigarette smoke, is addictive, the Company stated that despite the differences that may exist between its views and those of the public health community, it would, in order to ensure that there will be a single, consistent public health message on these issues, refrain from debating the issues other than as necessary to defend itself and its opinions in the courts and other forums in which it is required to do so. The Company also stated that in relation to these issues, and the health effects of exposure to ETS, the Company is prepared to defer to the judgment of public health authorities as to what health warning messages will best serve the public interest. In 1999, the Company established a Web site that includes, among other things, views of public health authorities on smoking, disease causation in smokers and addiction. Consistent with the Company's position set forth in its October 1997 submission to the United States Senate Judiciary Committee (discussed above), the Web site advises smokers and potential smokers to rely on the messages of public health authorities in making all smoking-related decisions. The site furthers the Company's efforts to implement this position. Other Legislative Initiatives: In recent years, various members of Congress have introduced legislation, some of which has been the subject of hearings or floor debate, that would subject cigarettes to various regulations under the Department of Health and Human Services or regulation under the Consumer Products Safety Act, establish anti-smoking educational campaigns or anti-smoking programs, or provide additional funding for governmental anti-smoking activities, further restrict the advertising of cigarettes, including requiring additional warnings on packages and in advertising, eliminate or reduce the tax deductibility of tobacco advertising, provide that the Federal Cigarette Labeling and Advertising Act and the Smoking Education Act not be used as a defense against liability under state statutory or common law, and allow state and local governments to restrict the sale and distribution of cigarettes. -34- Legislative initiatives adverse to the tobacco industry have also been considered in a number of jurisdictions outside the United States. In June 2000, the New York State Legislature passed legislation that, if signed by the governor, would require the State's Office of Fire Prevention and Control to promulgate rules establishing fire-safety standards for cigarettes that are manufactured or sold in New York by January 1, 2003. If enacted, the legislation would require that cigarettes manufactured or sold in New York stop burning within a time period specified by the standards or meet other performance standards set by the Office of Fire Prevention and Control. All cigarettes manufactured or sold in New York would be required to meet the established standards within one hundred and eighty days after the standards are promulgated and financial penalties would be imposed for distributing cigarettes that violate the standards. The governor of New York is expected to sign this legislation. Similar legislation has been proposed in other states and localities and at the federal level. It is not possible to predict what, if any, additional foreign or domestic governmental legislation or regulations will be adopted relating to the manufacturing, advertising, sale or use of cigarettes, or to the tobacco industry generally. However, if any or all of the foregoing were to be implemented, the business, volume, results of operations, cash flows and financial position of PM Inc., PMI and the Company could be materially adversely affected. Tobacco-Related Litigation: There is substantial litigation pending related to tobacco products in the United States and certain foreign jurisdictions, including the Engle class action case in Florida in which PM Inc. is a defendant and a civil health care cost recovery action filed by the United States Department of Justice in September 1999 against domestic tobacco manufacturers and others, including the Company and PM Inc. (See Note 5. Contingencies, above, for a discussion of such litigation.) State Settlement Agreements: As discussed in Note 5. Contingencies, during 1997 and 1998, PM Inc. and other major domestic tobacco product manufacturers entered into agreements with states and various U.S. jurisdictions settling asserted and unasserted health care cost recovery and other claims. These settlements provide for substantial annual payments. They also place numerous restrictions on the tobacco industry's conduct of its business operations, including restrictions on the advertising and marketing of cigarettes. Among these are restrictions or prohibitions on the following: targeting youth; use of cartoon characters; use of brand name sponsorships and brand name non-tobacco products; outdoor and transit brand advertising; payments for product placement; and free sampling. In addition, the settlement agreements require -35- companies to affirm corporate principles to reduce underage use of cigarettes; impose requirements regarding lobbying activities; mandate public disclosure of certain industry documents; limit the industry's ability to challenge certain tobacco control and underage use laws; and provide for the dissolution of certain tobacco-related organizations and place restrictions on the establishment of any replacement organizations. Operating Results For the Six Months Ended June 30, ---------------------------------------------- Operating Operating Revenues Companies Income -------------------- -------------------- (in millions) 2000 1999 2000 1999 ------- ------- ------- ------- Domestic tobacco $11,152 $ 9,195 $ 2,390 $ 2,069 International tobacco 13,799 14,266 2,741 2,683 ------- ------- ------- ------- Total tobacco $24,951 $23,461 $ 5,131 $ 4,752 ======= ======= ======= ======= Domestic tobacco. During the first six months of 2000, PM Inc.'s operating revenues increased $2.0 billion (21.3%) over the comparable 1999 period, due primarily to higher pricing ($1.5 billion, including $506 million related to the January 1, 2000 federal excise tax increase) and higher volume ($473 million). Operating companies income for the first six months of 2000 increased $321 million (15.5%) over the comparable 1999 period, due primarily to price increases, net of cost increases ($598 million), higher volume ($369 million) and the 1999 pre-tax charges for the Louisville Closure ($175 million), partially offset by higher marketing, administration and research costs ($768 million, primarily marketing). Excluding the impact of the 1999 pre-tax charges for the Louisville Closure, PM Inc.'s operating companies income of $2,390 million for the first six months of 2000 increased by 6.5% over the $2,244 million earned during the comparable 1999 period. Shipment volume for the domestic tobacco industry during the first six months of 2000 increased to 209.7 billion units, a 3.0% increase over the first six months of 1999. PM Inc.'s shipment volume for the first six months of 2000 was 106.5 billion units, an increase of 5.3% over the comparable 1999 period. Shipment growth for the industry and PM Inc. during the first half of 2000 was largely driven by wholesalers' decisions to rebuild their inventory levels after the January 1, 2000 federal excise tax increase. In contrast, wholesalers decreased their inventory levels during 1999, as inventory held at the end of 1999 was subject to the federal excise tax increase through a "floor tax". PM Inc. estimates that after adjusting for this factor, industry shipment volume declined approximately 2.0% from the first half of 1999, while PM Inc.'s shipment volume declined approximately 0.5%. For the first six months of 2000, PM Inc.'s shipment market share was 50.8%, an increase of 1.1 share points over the comparable period of 1999. Marlboro shipment volume increased 4.9 billion units (6.6%) over the first six months of 1999 to 79.3 billion units for a 37.8% share of the total industry, an increase of 1.3 share points over the comparable period of 1999. Contributing to this growth were introductory shipments of Marlboro Milds, which were launched nationally at retail in May. Based on shipments, the premium segment accounted for approximately 73.7% of the domestic cigarette industry volume in the first six months of 2000, an increase of 0.2 share points over the comparable period of 1999. In the premium segment, PM Inc.'s volume increased 5.3% during the first six months of 2000, compared with a 3.2% increase for the industry, resulting in a premium segment share of 60.7%, an increase of 1.2 share points over the first six months of 1999. In the discount segment, PM Inc.'s shipments increased 5.5% to 12.7 billion units in the first six months of 2000, compared with an industry increase of 2.2%, resulting in a discount segment share of 23.0%, an increase of 0.7 share points from the comparable period of 1999. Basic shipment volume for the first six months of 2000 was up 12.2% to 10.7 billion units, for a 19.4% share of the discount segment, an increase of 1.7 share points -36- from the comparable 1999 period. Basic shipment volume was influenced by the timing of promotional shipments year-over-year. According to consumer purchase data from Information Resources Inc./Capstone, PM Inc.'s share of cigarettes sold at retail grew 0.6 share points to 50.7% for the first six months of 2000. The first half of 2000 retail share for Marlboro rose 1.0 share points to 37.3%. PM Inc. cannot predict future change or rates of change in domestic tobacco industry volume, the relative sizes of the premium and discount segments or in PM Inc.'s shipments, shipment market share or retail market share; however, it believes that PM Inc.'s shipments may be materially adversely affected by price increases related to tobacco litigation settlements and, if enacted, by increased excise taxes or other tobacco legislation discussed under "Tobacco--Business Environment" above. In July 2000, PM Inc. announced a price increase of $3.00 per thousand cigarettes on its domestic premium and discount brands, principally related to increases in payments under the Master Settlement Agreement. This followed price increases of $6.50 per thousand in January 2000 and $9.00 per thousand in August 1999. Each $1.00 per thousand increase by PM Inc. equates to a $0.02 increase in the price to wholesalers of each pack of twenty cigarettes. International tobacco. During the first six months of 2000, international tobacco operating revenues, including excise taxes, decreased $467 million (3.3%) from the first six months of 1999. Excluding excise taxes, operating revenues decreased $145 million (2.0%), due primarily to unfavorable currency movements ($360 million) and the previously discussed CDC revenues ($97 million), partially offset by price increases ($265 million). Operating companies income for the first six months of 2000 increased $58 million (2.2%) over the comparable 1999 period, due primarily to price increases and favorable costs ($349 million), partially offset by unfavorable currency movements ($147 million), the shift of CDC income ($59 million) to the fourth quarter of 1999 and unfavorable volume/mix ($39 million). Adjusting for the shift in CDC income, operating companies income of $2,800 million for the first half of 2000 increased 4.4% over $2,683 million for the comparable period of 1999. PMI's volume for the first six months of 2000 of 343.7 billion units decreased 5.9 billion units (1.7%) from the first six months of 1999. Adjusting for the shift in CDC volume, (the basis of presentation for all following PMI volume disclosures), PMI's volume of 347.9 billion units for the first half of 2000 decreased 1.7 billion units (0.5%) from the comparable 1999 period, due primarily to volume declines in certain Central and Eastern European markets, as well as lower worldwide duty-free shipments, which were affected by the July 1999 cessation of intra-EU duty-free sales. However, volume grew a collective 3.9% in Western Europe and Japan, where PMI earned approximately 63% of its operating companies income. Volume advanced in a number of important markets, including Italy, France, Spain, the Benelux countries, Switzerland, Austria, Russia, Japan, Saudi Arabia, Egypt, Thailand, Korea, Malaysia, Indonesia, the Philippines and Mexico. PMI recorded market share gains in most of its major markets. Volume and share in Germany were lower as a result of the continued strong growth of trade brands and a reduction in the number of cigarettes per vending pack following industry price increases in the fourth quarter of 1999. Trade purchasing patterns in the Czech Republic and a lower total industry and market share in Poland, reflecting intense competition in the low price segment, contributed to an overall volume decline in Central Europe. Elsewhere, lower volume and share in Turkey resulted from a lower total industry following fourth quarter 1999 industry price increases. International volume for Marlboro declined 0.2%; as lower volume in certain Central and Eastern European markets and lower worldwide duty-free shipments was essentially offset by higher volumes in Japan, Asia, Western Europe, Russia and Mexico. -37- For the Three Months Ended June 30, ---------------------------------------------- Operating Operating Revenues Companies Income -------------------- -------------------- (in millions) 2000 1999 2000 1999 ------- ------- ------- ------- Domestic tobacco $ 5,706 $ 4,735 $ 1,274 $ 1,151 International tobacco 6,801 6,926 1,310 1,252 ------- ------- ------- ------- Total tobacco $12,507 $11,661 $ 2,584 $ 2,403 ======= ======= ======= ======= Domestic tobacco. During the second quarter of 2000, PM Inc.'s operating revenues increased $971 million (20.5%) over the comparable 1999 period, due primarily to higher pricing ($796 million, including $258 million related to the January 1, 2000 federal excise tax increase) and higher volume ($170 million). Operating companies income for the second quarter of 2000 increased $123 million (10.7%) from the comparable 1999 period, due primarily to price increases, net of cost increases ($411 million), higher volume ($133 million) and the 1999 pre-tax charges for the Louisville Closure ($45 million), partially offset by higher marketing, administration and research costs ($435 million, primarily marketing). Excluding the impact of the 1999 pre-tax charges for the Louisville Closure, PM Inc.'s operating companies income of $1,274 million for the second quarter of 2000 increased by 6.5% over the $1,196 million earned during the comparable 1999 period. Shipment volume for the domestic tobacco industry during the second quarter of 2000 increased to 107.5 billion units, a 1.5% increase over the second quarter of 1999. PM Inc.'s shipment volume for the second quarter of 2000 was 53.7 billion units, an increase of 3.6% over the comparable 1999 period. Second quarter 2000 shipment growth for the industry and PM Inc. was largely driven by wholesalers' decisions to continue to rebuild their inventory levels after the January 1, 2000 federal excise tax increase. In contrast, wholesalers decreased their inventory levels during the corresponding period of 1999. PM Inc. estimates that after adjusting for these inventory changes, industry shipment volume declined approximately 1.0% to 2.0% from the second quarter of 1999, while PM Inc.'s shipment volume was essentially flat. For the second quarter of 2000, PM Inc.'s shipment market share was 49.9%, an increase of 1.0 share points over the comparable period of 1999. Marlboro shipment volume increased 2.3 billion units (6.2%) over the second quarter of 1999 to 39.6 billion units for a 36.9% share of the total industry, an increase of 1.7 share points over the comparable period of 1999. Contributing to this increase were introductory shipments of Marlboro Milds, which were launched nationally at retail in May. Based on shipments, the premium segment accounted for approximately 73.5% of domestic cigarette industry volume in the second quarter of 2000, an increase of 0.4 share points over the comparable period of 1999. In the premium segment, PM Inc.'s second-quarter volume increased 4.1%, compared with a 2.0% increase for the industry, resulting in a premium segment share of 59.7%, an increase of 1.2 share points from the second quarter of 1999. In the discount segment, PM Inc.'s second quarter shipments increased 0.7% to 6.5 billion units in 2000, compared with no change in shipments for the industry, resulting in a discount segment share of 22.8%, an increase of 0.2 share points from the comparable period of 1999. Basic second quarter shipment volume increased 569 million units to 5.6 billion units, for a 19.7% share of the discount segment, an increase of 2.0 share points from the comparable 1999 period. The increase in shipment volume and the growth in market share for Basic were each influenced by the timing of promotional shipments in the second quarter of 2000 and 1999. -38- According to consumer purchase data from Information Resources Inc./Capstone, PM Inc.'s share of cigarettes sold at retail grew 0.8 share points to 51.0% for the second quarter of 2000. The second quarter 2000 retail share for Marlboro rose 1.1 share points to 37.6%. PM Inc. cannot predict future change or rates of change in domestic tobacco industry volume, the relative sizes of the premium and discount segments or in PM Inc.'s shipments, shipment market share or retail market share; however, it believes that PM Inc.'s shipments may be materially adversely affected by price increases related to tobacco litigation settlements and, if enacted, by increased excise taxes or other tobacco legislation discussed under "Tobacco--Business Environment" above. International tobacco. During the second quarter of 2000, international tobacco operating revenues, including excise taxes, decreased $125 million (1.8%) from 1999. Excluding excise taxes, operating revenues decreased $19 million (0.5%) from the second quarter of 1999, due primarily to unfavorable currency movements ($170 million), partially offset by price increases ($109 million) and favorable volume/mix ($32 million). Operating companies income for the second quarter of 2000 increased $58 million (4.6%) over the comparable 1999 period, due primarily to price increases and favorable costs ($175 million), partially offset by unfavorable currency movements ($67 million) and higher marketing, administration and research costs. PMI's volume of 172.7 billion units for the second quarter of 2000 increased 226 million units (0.1%) over the second quarter of 1999. PMI's volume grew a collective 4.5% in Western Europe and Japan, which account for approximately 62% of PMI's operating companies income. These volume gains were partially offset by volume declines in certain markets within Central and Eastern Europe, as well as by lower worldwide duty-free shipments, which were affected by the July 1999 cessation of intra-EU duty-free sales. Volume advanced in a number of important markets including Italy, France, Spain, Portugal, the Benelux countries, Sweden, Greece, Switzerland, Russia, Japan, Saudi Arabia, Egypt, Thailand, Korea, Malaysia, Indonesia and Mexico. PMI recorded market share gains in most of its major markets. Volume and share in Germany were lower as a result of the continued strong growth of trade brands and a reduction in the number of cigarettes per vending pack following fourth quarter 1999 industry price increases. Trade purchasing patterns in the Czech Republic and a lower industry and market share in Poland, reflecting intense competition in the low price segment, contributed to an overall volume decline in Central Europe. International volume for Marlboro grew 2.0%, driven by growth in Japan, Asia, Western Europe, Russia and Mexico, partly offset by lower volume in certain Central and Eastern European markets and lower worldwide duty-free shipments. Food Business Environment Kraft, the largest processor and marketer of retail packaged food in the United States, and its subsidiary, Kraft Foods International, Inc. ("KFI"), which markets coffee, confectionery and cheese and grocery products in Europe and the Asia/Pacific region, are subject to fluctuating commodity costs, currency movements and competitive challenges in various product categories and markets, including a trend toward increasing consolidation in the retail trade. Additionally, certain subsidiaries and affiliates of PMI that manufacture and sell food products in Latin America are also subject to competitive challenges in various product categories and markets. To confront these challenges, Kraft, KFI and PMI continue to take steps to build the value of premium brands with new product and marketing initiatives, to improve their food business portfolios and to reduce costs. -39- Fluctuations in commodity costs can cause retail price volatility, intensify price competition and influence consumer and trade buying patterns. The North American and international food businesses are subject to fluctuating commodity costs, particularly in dairy, coffee bean and cocoa. Dairy commodity costs in the United States on average have been below the levels seen during the first six months of 1999. Coffee bean prices were also slightly lower than the first half of 1999. However, recent coffee bean prices have been volatile due to Brazil frost risk. Cocoa prices have declined during 2000, compared with 1999. During the first quarter of 2000, Kraft completed its purchase of the outstanding common stock of Balance Bar Co., a maker of energy and nutrition snack products. In a separate transaction, Kraft also completed its acquisition of Boca Burger, Inc., a privately held manufacturer and marketer of soy-based meat alternatives. The total cost of these acquisitions was $358 million. Neither transaction is expected to have a material effect on 2000 operating revenues or operating companies income of Kraft or the Company. In June 2000, the Company announced that it entered into definitive agreements to acquire all of the outstanding shares of Nabisco Holdings Corp. ("Nabisco") for $55 per share in cash. The transaction reflects an aggregate cost of $18.9 billion, which includes the assumption of approximately $4.0 billion in net debt. The acquisition will be financed initially through a combination of short-term debt and bank borrowings. The transaction is subject to approval by the shareholders of Nabisco Group Holdings and requires customary regulatory approvals. The transaction is expected to be completed during the fourth quarter of 2000. The acquisition will be accounted for as a purchase. Subsequent to the acquisition, Nabisco will be combined with Kraft. Following the combination, the Company plans to undertake an initial public offering ("IPO") of less than 20% of the newly combined food company. The IPO proceeds will be used to retire a portion of the debt incurred as a result of the acquisition of Nabisco. During 2000 and 1999, PMI and KFI sold several small international food businesses. The operating results of businesses divested were not material to consolidated operating results in any of the periods presented. Operating Results For the Six Months Ended June 30, ---------------------------------------------- Operating Operating Revenues Companies Income -------------------- -------------------- (in millions) 2000 1999 2000 1999 ------- ------- ------- ------- North American food $ 9,258 $ 9,022 $ 1,863 $ 1,631 International food 4,176 4,446 535 521 ------- ------- ------- ------- Total food $13,434 $13,468 $ 2,398 $ 2,152 ======= ======= ======= ======= North American food. During the first six months of 2000, operating revenues increased $236 million (2.6%) from the first six months of 1999, due primarily to higher volume ($183 million), higher pricing ($81 million) and the impact of acquisitions ($67 million), partially offset by the previously mentioned shift in CDC revenues ($69 million) and unfavorable product mix ($46 million). Operating companies income for the first six months of 2000 increased $232 million (14.2%) from the comparable period of 1999, primarily reflecting favorable margins ($187 million, driven by lower manufacturing and commodity-related costs), the 1999 pre-tax charge for the Kraft Separation Programs ($157 million), and higher volume ($122 million), partially offset by higher marketing, administration and research costs ($180 million, the majority of which related to higher marketing expenses), unfavorable product mix ($37 million) and the shift in CDC income ($26 million). Excluding the impact of the pre-tax charges for the Kraft -40- Separation Programs and adjusting for the shift in CDC income, operating companies income of $1,889 million for the first half of 2000 increased 5.6% over $1,788 million in the first six months of 1999. Volume for the first six months of 2000 increased over the comparable 1999 period. Volume gains were achieved by beverages, from the strength of ready-to-drink beverages; processed meats, from lunch combinations and the first-quarter acquisition of Boca Burger; pizza and cereals, from new product introductions; cheese, from cream cheese products; and desserts and snacks, due to refrigerated ready-to-eat desserts, frozen toppings, confectionery and the first-quarter acquisition of Balance Bar. Offsetting these volume gains were volume declines in enhancers, due to barbecue sauces and seasoned coatings; in coffee, as the entire coffee category declined; and in meals, due to dinners, rice and ethnic foods. In Canada, volume was down due to a planned discontinuation of low-margin foodservice products, which more than offset gains in the retail grocery business, driven by new products. International food. Operating revenues for the first six months of 2000 decreased $270 million (6.1%) from the first six months of 1999, due primarily to unfavorable currency movements ($355 million), lower pricing ($19 million, due primarily to lower coffee prices) and the previously discussed shift in CDC revenues ($28 million), partially offset by higher volume ($168 million). Operating companies income for the first six months of 2000 increased $14 million (2.7%) from the first six months of 1999, due primarily to higher volume ($80 million) and favorable margins ($44 million, primarily related to lower commodity costs), partially offset by unfavorable currency ($30 million), higher marketing, administration and research costs ($60 million) and the shift in CDC income. Excluding the operating results of the international food businesses divested since the beginning of 1999 and adjusting for the shift in CDC revenues and income, operating revenues of $4,200 million in the first six months of 2000 decreased 3.5% from $4,352 million in 1999, and operating companies income of $547 million for the first half of 2000 increased 6.4% over $514 million for the comparable 1999 period. Coffee volume for the first six months of 2000 increased over the comparable period of 1999, as volumes were higher in most European markets. This volume growth was driven by new product launches and line extensions. In the roast and ground category, KFI brands experienced share gains in Germany and France, while soluble coffee brands gained share in the United Kingdom. Confectionery volume for the first six months of 2000 increased over the comparable period of 1999. Volume increases in the Asia Pacific region and most Western European markets more than offset volume declines in certain Eastern European markets, where weaker economic conditions continued to persist. In Latin America, higher chocolate sales in Brazil contributed to the volume growth. New product launches and line extensions also contributed to the confectionery volume growth. Volume for the first half of 2000 also increased in the cheese and grocery business, driven by lunch combinations in the United Kingdom; new product introductions for powdered soft drinks in Poland, the Czech Republic and Bulgaria; cream cheese in Italy; and cheese and powdered soft drinks in the Philippines. Also contributing to the volume gain were higher grocery shipments to the Caribbean; increased cheese sales in Puerto Rico; and higher mayonnaise and ready-to-drink beverage volumes in Mexico. Partially offsetting these increases was lower powdered soft drink volume in Argentina, due to continued intense price competition with carbonated beverages. -41- For the Three Months Ended June 30, --------------------------------------------- Operating Operating Revenues Companies Income ------------------- ------------------- (in millions) 2000 1999 2000 1999 ------ ------ ------ ------ North American food $4,803 $4,626 $ 996 $ 946 International food 2,171 2,204 289 275 ------ ------ ------ ------ Total food $6,974 $6,830 $1,285 $1,221 ====== ====== ====== ====== North American food. During the second quarter of 2000, operating revenues increased $177 million (3.8%) over the second quarter of 1999, due primarily to higher pricing ($65 million), higher volume ($55 million) and the impact of acquisitions ($53 million). Operating companies income for the second quarter of 2000 increased $50 million, (5.3%) over the second quarter of 1999, due primarily to favorable margins ($112 million, driven by lower manufacturing and commodity-related costs) and higher volume ($32 million), partially offset by higher marketing, administration and research costs ($115 million). Volume for the second quarter of 2000 increased over the comparable 1999 period. Volume gains were achieved by beverages, led by the continued success of ready-to-drink beverages; desserts and snacks led by growth in confectionery and frozen toppings, and the first-quarter acquisition of Balance Bar; frozen pizza, aided by new product introductions; processed meats, due to the continued success of lunch combinations and the first-quarter acquisition of Boca Burger; cheese, with gains in natural, cottage and cream cheese, and the national rollout of new products; and coffee, driven by the continued success of Starbucks grocery coffee and new product introductions. Offsetting these volume increases were volume declines in enhancers, as decreases in spoonable salad dressings and barbecue sauce were partially offset by a gain in pourable salad dressings; cereals due primarily to a decline in the ready-to-eat cereal category; and meals due mainly to lower shipments of dinners. In Canada, overall volume was down due to the planned discontinuation of low margin items in the foodservice business. However, the retail grocery business was up, driven by new product introductions in frozen pizza, refrigerated ready-to-eat desserts and ready-to-drink beverages. International food. Operating revenues for the second quarter of 2000 decreased $33 million (1.5%) from the second quarter of 1999, due primarily to unfavorable currency movements ($171 million), partially offset by higher volume ($133 million). Operating companies income for the second quarter of 2000 increased $14 million (5.1%) from the second quarter of 1999, due primarily to higher volume ($61 million) and favorable margins ($31 million, primarily related to lower manufacturing and commodity-related costs), partially offset by higher marketing, administration and research costs ($56 million) and unfavorable currency movements ($16 million). Excluding the operating results of the international food businesses divested since the beginning of 1999, operating revenues of $2,171 million in the second quarter of 2000 increased 0.3% from $2,165 million in 1999, and operating companies income of $289 million for the second quarter of 2000 increased 6.3% over $272 million for the comparable 1999 period. KFI's second quarter 2000 coffee volume increased over the comparable period of 1999 led by gains in key European markets, including Germany, France, Sweden and the United Kingdom. Volume growth in Germany and France benefited from new product introductions. In Germany, KFI introduced a roast and ground coffee in the mild segment; while in France, KFI introduced a resealable container for its roast and ground coffee. KFI's products gained share in a number of markets, including roast and ground brands in Germany and France, as -42- well as soluble coffees in the United Kingdom. In Central and Eastern Europe, double-digit coffee volume growth was driven by Poland, the Slovak Republic, Hungary and Lithuania. Coffee volume also grew in China. Confectionery volume for the second quarter of 2000 increased over the comparable period of 1999, with gains in all key European markets, including Germany, France, the Benelux countries, Italy, Sweden, Norway and the United Kingdom. In Asia Pacific, double-digit volume growth continued to be driven by the success of chewy candy in Indonesia. In Latin America, volume grew in Brazil due primarily to higher chocolate sales. Share growth was registered for KFI's products in several markets, including pralines and countlines in Germany; chocolate tablets in France and Norway; and chocolate products in Sweden. New product launches and line extensions contributed to the confectionery volume growth. Volume for the second quarter of 2000 also increased in the cheese and grocery business, driven by volume growth across all regions. In the United Kingdom, volume benefited from the continued success of a recently launched lunch combinations product. Volume growth was also recorded for cream cheese in Italy; powdered soft drinks in Central and Eastern Europe, due to new product introductions and geographic expansion; and cheese and powdered soft drinks in the Philippines. In Latin America, higher volume for the second quarter of 2000 was driven by higher grocery shipments to the Caribbean and higher shipments of ready-to-drink beverages, mayonnaise, cereals and cheese products in Mexico and Puerto Rico. Partially offsetting these increases was lower powdered soft drink volume in Argentina, due to continued intense price competition with carbonated beverages. During the second quarter of 2000, KFI announced the proposed sale of the French chewing gum and candy business. The sale is expected to be finalized during the second half of 2000. The operating results for this business were not material to the Company's consolidated operating results in any of the periods presented. Beer Business Environment During the first quarter of 1999, Miller Brewing Company ("Miller") purchased four trademarks from the Pabst Brewing Company ("Pabst") and the Stroh Brewery Company ("Stroh"). Miller also agreed to increase its contract manufacturing of Pabst products. Miller began brewing and shipping the newly acquired brands during the second quarter of 1999. In the third quarter of 1999, Miller assumed ownership of the former Pabst brewery in Tumwater, Washington as part of these agreements. Miller's license agreement for the rights to brew and sell Lowenbrau in the United States expired on September 30, 1999. The expiration of this agreement did not have a material impact on Miller's operating revenues or operating companies income for the first six months and second quarter of 2000 and is not expected to have a material impact on future operating revenues and operating companies income. Operating Results Six Months Ended June 30 Miller's operating revenues for the first six months of 2000 increased $92 million (4.2%) over the first six months of 1999, due primarily to higher pricing ($67 million), the previously mentioned acquired brands and contract manufacturing fees (aggregating $98 million), partially offset by lower volume ($73 million). Operating companies income for the first six months of 2000 increased $32 million (10.2%) over the first six months of 1999, due primarily to higher pricing ($47 million) and income from acquired brands and contract -43- manufacturing, partially offset by lower volume ($29 million) and higher marketing, administration and research costs. Miller's domestic shipment volume of 22.0 million barrels for the first six months of 2000 decreased 0.6% from the comparable 1999 period, due mainly to planned actions to reduce distributor inventories and the discontinuance of Lowenbrau shipments, partially offset by shipments of acquired brands. Domestic shipments of premium brands were below the comparable 1999 period, due primarily to the discontinuance of Lowenbrau shipments and lower domestic shipments of Miller Genuine Draft and Molson, partially offset by increased shipments of Miller Lite. Domestic shipments of near-premium products increased due to acquired brands, while budget products decreased on lower shipments across most brands. Wholesalers' sales to retailers in the first six months of 2000 increased 1.1% from the comparable 1999 period. Excluding the acquired brands, wholesalers' sales to retailers in the first six months of 2000 decreased 1.8% from the first six months of 1999, reflecting lower retail sales of Molson, Red Dog, Miller Genuine Draft, Milwaukee's Best and Lowenbrau, partially offset by increased sales of Miller Lite, Miller High Life, Icehouse and Foster's. Three Months Ended June 30 Miller's operating revenues for the second quarter of 2000 increased $34 million (2.8%) from the second quarter of 1999, due primarily to higher pricing ($46 million) and the previously mentioned acquired brands and contract manufacturing fees (aggregating $32 million), partially offset by lower volume ($44 million). Operating companies income for the second quarter of 2000 increased $15 million (8.4%) over the second quarter of 1999, due primarily to higher pricing and contract brewing, partially offset by lower volume and higher marketing, administration and research costs. Miller's domestic shipment volume of 11.9 million barrels for the second quarter of 2000 decreased 2.7% from the comparable 1999 period, reflecting planned actions to reduce distributor inventories, the discontinuance of Lowenbrau shipments and lower domestic shipments of Milwaukee's Best, Red Dog, Icehouse, Miller Genuine Draft and Molson, partially offset by higher shipments of Miller Lite. Domestic shipments of near-premium products were essentially even to prior year, while budget products decreased on lower shipments across most brands. Wholesalers' sales to retailers in the second quarter of 2000 decreased 3.6% from the comparable 1999 period. Excluding the acquired brands, wholesalers' sales to retailers in the second quarter of 2000 decreased 4.3% from the second quarter of 1999, reflecting lower retail sales of Miller Genuine Draft, Milwaukee's Best, Red Dog, Molson and Lowenbrau, partially offset by increased sales of Miller Lite and Foster's. Financial Services Philip Morris Capital Corporation's ("PMCC") financial services operating revenues and operating companies income for the first half of 2000 increased $29 million (17.1%) and $17 million (15.5%), respectively, over the comparable 1999 period. During the second quarter of 2000, operating revenues and operating companies income increased $10 million (10.3%) and $9 million (15.0%), respectively, over the second quarter of 1999. These increases were due primarily to new leasing and structured finance investments and gains realized on related portfolio management activities. -44- Financial Review Net Cash Provided by Operating Activities During the first six months of 2000, net cash provided by operating activities was $5.8 billion compared with $5.5 billion in the comparable 1999 period. The increase primarily reflects the Company's higher level of net earnings. Net Cash Used in Investing Activities During the first six months of 2000, net cash used in investing activities was $1.4 billion, up from $1.3 billion in 1999. The increase primarily reflects the cash used during the first six months of 2000 for additional investments in finance assets at the Company's financial services subsidiary. In June 2000, the Company announced that it entered into definitive agreements to acquire all of the outstanding shares of Nabisco. The pending transaction has an aggregate cost of approximately $18.9 billion, including the assumption of $4.0 billion in net debt. Net Cash Used in Financing Activities During the first six months of 2000, net cash of $5.2 billion was used in financing activities, as compared with $3.7 billion used in financing activities during the comparable 1999 period. This difference was primarily due to net debt repayments of $1.1 billion for the first half of 2000, compared with net debt repayments of $73 million in 1999. Higher stock repurchases and dividends paid during the first six months of 2000 also contributed to the increase. In connection with the pending acquisition of Nabisco, the Company intends to finance the purchase price of the outstanding shares of Nabisco with cash on hand and additional borrowings. Debt and Liquidity The Company's total debt (consumer products and financial services) was $13.3 billion and $14.5 billion at June 30, 2000 and December 31, 1999, respectively. Total consumer products debt was $11.6 billion and $13.5 billion at June 30, 2000 and December 31, 1999, respectively. At June 30, 2000 and December 31, 1999, the Company's ratio of consumer products debt to total equity was 0.77 and 0.88, respectively. The ratio of total debt to total equity was 0.88 and 0.95 at June 30, 2000 and December 31, 1999, respectively. The Company and its subsidiaries maintain credit facilities with a number of lending institutions, amounting to approximately $12.1 billion. These include revolving bank credit agreements totaling $10.0 billion, which may be used to support commercial paper borrowings by the Company and which are available for acquisitions and other general corporate purposes. Of these revolving bank agreements, an agreement for $8.0 billion expires in October 2002 and a second agreement for $2.0 billion will expire in September 2000. The $8.0 billion credit agreement enables the Company to reclassify short-term debt on a long-term basis. The Company may continue to refinance long-term and short-term debt from time to time. The nature and amount of the Company's long-term and short-term debt and the proportionate amount of each can be expected to vary as a result of future business requirements, market conditions and other factors. In connection with the pending acquisition of Nabisco, the Company has obtained commitments for a $9.0 billion 364-day revolving credit facility. The Company's credit ratings by Moody's at June 30, 2000 and December 31, 1999 were "P-1" in the commercial paper market and "A2" for long-term debt obligations. The Company's credit ratings by Standard -45- & Poor's ("S&P") at June 30, 2000 and December 31, 1999 were "A-1" in the commercial paper market and "A" for long-term debt obligations. As discussed in Note 5, PM Inc., along with other domestic tobacco companies, has entered into tobacco litigation settlement agreements that require the domestic tobacco industry to make substantial annual payments in the following amounts (excluding future annual payments contemplated by the agreement with tobacco growers discussed below), subject to adjustment for several factors, including inflation, market share and industry volume: 2000, $9.2 billion; 2001, $9.9 billion; 2002, $11.3 billion; 2003, $10.9 billion; 2004 through 2007, $8.4 billion each year; and thereafter, $9.4 billion each year. In addition, the domestic tobacco industry is required to pay settling plaintiffs' attorneys' fees, subject to an annual cap of $500 million, as well as additional amounts as follows: 2000, $416 million; and 2001 through 2003, $250 million each year. These payment obligations are the several and not joint obligations of each settling defendant. PM Inc.'s portion of ongoing adjusted payments and legal fees is based on its share of domestic cigarette shipments in the year preceding that in which the payment is due. Accordingly, PM Inc. records its portions of ongoing settlement payments as part of cost of sales as product is shipped. As part of the MSA, the settling defendants committed to work cooperatively with the tobacco-growing states to address concerns about the potential adverse economic impact of the MSA on tobacco growers and quota-holders. To that end, four of the major domestic tobacco product manufacturers, including PM Inc., and the grower states, have established a trust fund to provide aid to tobacco growers and quota-holders. The trust will be funded by these four manufacturers over 12 years with payments, prior to application of various adjustments, scheduled to total $5.15 billion. Future industry payments (in 2000, $280 million; 2001, $400 million; 2002 through 2008, $500 million each year; 2009 and 2010, $295 million each year) are subject to adjustment for several factors, including inflation, United States cigarette volume and certain other contingent events, and, in general, are to be allocated based on each manufacturer's relative market share. PM Inc. records its portion of these payments as part of cost of sales as product is shipped. As discussed above under "Tobacco--Business Environment," the present legislative and litigation environment is substantially uncertain and could result in material adverse consequences for the business, financial condition, cash flows or results of operations of the Company, PM Inc. and PMI. Equity and Dividends During the first six months of 2000 and 1999, the Company repurchased 81.6 million and 35.6 million shares, respectively, of its common stock at a cost of $1.8 billion and $1.4 billion, respectively. The repurchases were made under an existing $8 billion authority that expires in November 2001. At June 30, 2000, cumulative repurchases under the $8 billion authority totaled 186.0 million shares at an aggregate cost of $5.5 billion. Dividends paid in the first six months of 2000 and 1999 were $2.2 billion and $2.1 billion, respectively. During the third quarter of 1999, the Company's Board of Directors approved a 9.1% increase in the current quarterly dividend rate to $0.48 per share. As a result, the present annualized dividend rate is $1.92 per share. Cash and Cash Equivalents Cash and cash equivalents were $4.2 billion at June 30, 2000 and $5.1 billion at December 31, 1999, the decrease being largely attributable to settlement payments made under the terms of the various state settlements, the continuation of the Company's share repurchase program and a lower level of outstanding borrowings, partially offset by an increase in net cash provided by operating activities. -46- Market Risk The Company is exposed to market risk, primarily related to foreign exchange, commodity prices and interest rates. These exposures are actively monitored by management. To manage the volatility relating to these exposures, the Company enters into a variety of derivative financial instruments. The Company's objective is to reduce, where it is deemed appropriate to do so, fluctuations in earnings and cash flows associated with changes in interest rates, foreign currency rates and commodity prices. It is the Company's policy and practice to use derivative financial instruments only to the extent necessary to manage exposures. Since the Company uses currency rate-sensitive and commodity price-sensitive instruments to hedge a certain portion of its existing and anticipated transactions, the Company expects that any loss in value for the hedge instruments generally would be offset by increases in the value of the underlying transactions. The Company does not hold or issue derivative financial instruments for trading or speculative purposes. Foreign exchange rates. The Company is exposed to foreign exchange movements, primarily in European, Japanese and other Asian and Latin American currencies. Consequently, it enters into various contracts, which change in value as foreign exchange rates fluctuate, to preserve the value of commitments and anticipated transactions. The Company uses foreign currency option and forward contracts to hedge certain anticipated foreign currency cash flows. The Company also enters into short-term foreign currency swap contracts, primarily to hedge intercompany transactions denominated in foreign currencies. At June 30, 2000 and December 31, 1999, the Company had option and forward foreign exchange contracts, principally for the Japanese yen, British pound, Swiss franc and the Euro, with an aggregate notional amount of $5.8 billion and $3.8 billion, respectively, for both the purchase and/or sale of foreign currencies. The Company also seeks to protect its foreign currency net asset exposure, primarily the Swiss franc and the Euro, through the use of foreign-currency denominated debt or currency swap agreements. At June 30, 2000 and December 31, 1999, the notional amounts of currency swap agreements aggregated $2.5 billion and $2.6 billion, respectively. Commodities. The Company is exposed to price risk related to anticipated purchases of certain commodities used as raw materials by the Company's food businesses. Accordingly, the Company enters into commodity future, forward and option contracts to manage fluctuations in prices of anticipated purchases, primarily cheese, coffee, cocoa, milk, sugar, wheat and corn. At June 30, 2000 and December 31, 1999, the Company had net long commodity positions of $381 million and $163 million, respectively. Unrealized gains/losses on net commodity positions were immaterial at June 30, 2000 and December 31, 1999. Interest rates. The Company manages its exposure to interest rate risk through the proportion of fixed rate debt and variable rate debt in its total debt portfolio. To manage this mix, the Company may enter into interest rate swap agreements, in which it exchanges the periodic payments, based on a notional amount and agreed-upon fixed and variable interest rates. At December 31, 1999, the Company had an interest rate swap agreement, which converted $800 million of fixed rate debt to variable rate debt, and which matured during the first quarter of 2000. Use of the above-mentioned derivative financial instruments has not had a material impact on the Company's financial position at June 30, 2000 and December 31, 1999, or the Company's results of operations for the three and six months ended June 30, 2000 or the year ended December 31, 1999. -47- New Accounting Standards During 1998, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," which had an initial adoption date by the Company of January 1, 2000. During 1999, the FASB postponed the adoption date of SFAS No. 133 until January 1, 2001. SFAS No. 133 requires that all derivative financial instruments be recorded on the consolidated balance sheets at their fair value. Changes in the fair value of derivatives will be recorded each period in earnings or other comprehensive earnings, depending on whether a derivative is designated as part of a hedge transaction and, if it is, the type of hedge transaction. Gains and losses on derivative instruments reported in other comprehensive earnings will be reclassified as earnings in the periods in which earnings are affected by the hedged item. The Company has not yet determined the impact that adoption or subsequent application of SFAS No. 133 will have on its financial position or results of operations. During May 2000, the Emerging Issues Task Force ("EITF") issued EITF Issue No. 00-14, "Accounting for Certain Sales Incentives." EITF No. 00-14 addresses the recognition, measurement and statement of earnings classification of various sales incentives and will be effective for the fourth quarter of 2000. The Company has determined that the impact of adoption or subsequent application of EITF Issue No. 00-14 will not have a material effect on its financial position or results of operations. However, certain items previously included in marketing, administration and research costs on the consolidated statements of earnings will be recorded as a reduction of operating revenues. Upon adoption, prior period amounts will be reclassified to conform with the new requirements. Contingencies See Note 5 to the Condensed Consolidated Financial Statements for a discussion of contingencies. Forward-Looking and Cautionary Statements The Company and its representatives may from time to time make written or oral forward-looking statements, including statements contained in the Company's filings with the Securities and Exchange Commission and in its reports to stockholders. One can identify these forward-looking statements by use of words such as "expects," "plans," "believes," "will," "estimates," "intends," "projects," "goals" and other words of similar meaning. One can also identify them by the fact that they do not relate strictly to historical or current facts. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, the Company is hereby identifying important factors that could cause actual results and outcomes to differ materially from those contained in any forward-looking statement made by or on behalf of the Company; any such statement is qualified by reference to the following cautionary statements. The tobacco industry continues to be subject to health concerns relating to the use of tobacco products and exposure to ETS, legislation, including actual and potential excise tax increases, increasing marketing and regulatory restrictions, governmental regulation, privately imposed smoking restrictions, governmental and grand jury investigations, litigation, including risks associated with adverse jury and judicial determinations, courts reaching conclusions at variance with the Company's understanding of applicable law, bonding requirements and the absence of adequate appellate remedies to get timely relief from any of the foregoing, and the effects of price increases related to concluded tobacco litigation settlements and excise tax increases on consumption rates. Each of the Company's consumer products subsidiaries is subject to intense competition, -48- changes in consumer preferences, the effects of changing prices for its raw materials and local economic conditions. Their results are dependent upon their continued ability to promote brand equity successfully, to anticipate and respond to new consumer trends, to develop new products and markets and to broaden brand portfolios, in order to compete effectively with lower priced products in a consolidating environment at the retail and manufacturing levels, and to improve productivity. In addition, PMI, KFI and Kraft are subject to the effects of foreign economies and the related shifts in consumer preferences, and currency movements. Developments in any of these areas, which are more fully described above and which descriptions are incorporated into this section by reference, could cause the Company's results to differ materially from results that have been or may be projected by or on behalf of the Company. The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement that may be made from time to time by or on behalf of the Company. -49- Part II - OTHER INFORMATION Item 1. Legal Proceedings. See Note 5. Contingencies, of the Notes to the Condensed Consolidated Financial Statements included in Part I, Item 1 of this report for a discussion of legal proceedings pending against the Company and its subsidiaries. See also Exhibits 99.1, 99.2, and 99.3 to this report. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits 10.1 Agreement and Plan of Merger, dated as of June 25, 2000, among Nabisco Holdings Corp., Philip Morris Companies Inc., and Strike Acquisition Corp. 10.2 Voting and Indemnity Agreement, dated as of June 25, 2000, between Nabisco Group Holdings Corp. and Philip Morris Companies Inc. 12 Statement regarding computation of ratios of earnings to fixed charges. 27 Financial Data Schedule. 99.1 Certain Pending Litigation Matters and Recent Developments. 99.2 Status of Master Settlement Agreement. 99.3 Trial Schedule for Certain Cases. (b) Reports on Form 8-K. The Registrant filed a Current Report on Form 8-K, dated June 25, 2000, containing information on the Registrant's pending acquisition of Nabisco Holdings Corp. and plans for an Initial Public Offering ("IPO") of Kraft Foods, Inc. See Note 2. Acquisitions, of the Notes to the Condensed Consolidated Financial Statements included in Part I, Item 1 of this report for a discussion of the pending acquisition and the IPO. -50- Signature Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. PHILIP MORRIS COMPANIES INC. /s/ LOUIS C. CAMILLERI Louis C. Camilleri, Senior Vice President and Chief Financial Officer August 10, 2000 -51-