CURRENT CONDITIONS

Value Line reported that industry sales, which totaled $141.1 billion in 2000, fell sharply to $102.5 billion in 2001. Sales were estimated to reach $130.0 billion in 2002 and $165.0 billion in 2003. Net profits, which totaled $10.9 billion in 2000, fell to $9.5 billion in 2001. However, this figure was expected to reach $11.5 billion in 2002 and $12.5 billion in 2003. In 2002, Philip Morris remained the industry leader, with more than 49 percent of the market, followed by R.J. Reynolds Tobacco Co. (23 percent), BAT/Brown & Williamson (10 percent), and Liggett & Myers (2 percent). Approximately 7 percent of the market was controlled by a handful of smaller industry players.

According to data from Management Science Associates and R.J. Reynolds Tobacco Co., in 2002 manufacturers shipped more than 391 billion cigarettes in the United States, down from 406 billion in 2001 and 420 billion in 2000. Some 73 percent of this total was attributable to full-price or name-brand cigarettes. Manufacturers shipped cigarettes via a distribution chain that involved almost 40 warehouses, 770 wholesalers, and more than 280,000 retailers that marketed to an estimated 44 million U.S. smokers. On the retail front, more than 71 percent of cigarettes were sold via so-called "pack outlets," which included gas stations, convenience stores, drug stores, and liquor stores. More than 12 percent were sold at discount stores and supermarkets, and cigarette outlets accounted for almost 17 percent of retail sales.

Cigarette prices have increased significantly since the late 1990s, according to data from IRI/Capstone and R.J. Reynolds Tobacco Co. From an average of $2.69 per pack in 1999, cigarette prices increased to $2.98 in 2000, $3.23 in 2001, and $3.47 in 2002. In the wake of a sluggish economy, many states increased taxes on cigarettes in an effort to improve their budgets. In its August 2002 issue, National Petroleum News reported that in the first half of 2002 alone, nine states "enacted a cigarette/tobacco tax increase as part of their budgetary process, while as many as another 21 states have some type of tax increase still simmering." In July of 2002, New York Mayor Michael Bloomberg raised his city's tax from 8 cents per pack to $1.50 per pack. This increase made New York City's cigarette tax the nation's highest and pushed prices as high as $7.00 per pack. New York City's tax came on top of New York State's tax of $1.50 per pack-then the nation's highest state cigarette tax.

In recent years, ways to mitigate tobacco taxes-some with questionable legality-have gained attention. E-commerce has emerged as one way to beat high state taxes. When the tobacco store is based in a low-tax state or on a Native American reservation, shoppers anywhere in the country can purchase cigarettes over the Internet with little or no tax added. In high-tax states the savings could add up to more than 40 percent off local prices. However, in some states cigarette buyers are required to report their purchases from out-of-state sources and pay tax accordingly. Another cost-cutting strategy on the rise is to import cigarettes that were previously exported for foreign sale. Known as gray marketing, and often considered illegal, this practice does not circumvent all taxes but provides cigarettes at significant mark-down compared to normal domestic prices.

INDUSTRY LEADERS
Philip Morris USA, Inc. Philip Morris' ascension to the number-one position in the cigarette industry began shortly after the 1911 decree intended to dilute the staggering power of the American Tobacco Co. Although Philip Morris' initial magnitude paled in comparison to the industry's Big Four-the American Tobacco Co., R.J. Reynolds, Lorillard, and Liggett & Meyers-its rise stands as a remarkable achievement. Beginning as the U.S. operations of a British manufacturer named Philip Morris Company, the manufacturing facilities were purchased by U.S. financier George J. Whelan, who acquired several of the small manufacturing concerns left for sale after the break up of American Tobacco. Formed as a U.S. company in 1919 and renamed Philip Morris & Company Ltd., Inc., the company introduced the brand of cigarette that would eventually catapult the fledgling manufacturing concern toward the top of its market in 1925. That brand, Marlboro, did not begin its meteoric rise until the ubiquitous Marlboro Man, the rough-hewn American cowboy, first appeared on cigarette packages in 1955. In the interim, Philip Morris slowly climbed the industry's ladder through effective marketing and a strong relationship with cigarette jobbers on the East Coast, ensuring that the company's products received preferential treatment during the all-important journey from manufacturing site to retail stores.

By 1936, Philip Morris maintained a firm grip on the industry's fourth position through its widely popular English Blend cigarettes introduced three years earlier. Following World War II, several poor management decisions, including an overestimation of the nation's consumption capacity and a belated entry into the filter segment of the industry, sent the company's sales spiraling downward. By 1960, Philip Morris had fallen to sixth place in the U.S. cigarette market-last among the major U.S. manufacturers.

The introduction of the Marlboro Man in 1955, however, strengthened Philip Morris' domestic sales, while an early move into foreign markets underpinned the company's domestic resurgence. By 1973, Marlboro cigarettes were the second most popular brand in the United States, ranking only behind RJR's Winston brand. Three years later, Marlboro eclipsed Winston, and Philip Morris became the second-largest seller of tobacco in the world. As Marlboro became the nation's preferred cigarette, Philip Morris branched into the production of low-tar cigarettes with its Merit brand, then intensified its efforts toward overseas expansion. As a result of these two marketing strategies, plus the growing popularity of Marlboro cigarettes, Philip Morris surpassed RJR in 1983 to become the world's largest cigarette manufacturer. In the 1990s the company consolidated its lead, with a market share just shy of 50 percent during the late 1990s. By 2002, Philip Morris held about 49 percent of the market. That year, it recorded revenues of $18.9 billion, down almost 24 percent from the previous year.

R.J. Reynolds. Incorporated in 1879 as R.J. Reynolds Tobacco Company, RJR garnered initial success through the efforts of the company's founder, Richard Joshua Reynolds, and by virtue of its association with the American Tobacco Co. during the lucrative "trust years" in the tobacco industry. Operating as a subsidiary of American Tobacco from 1899 until the dissolution decree of 1911, Reynolds' company thrived, earning a majority of its profits through the sale of chewing and smoking tobacco under the respective Schnapps and Prince Albert brands. The company did not manufacture cigarettes until 1913-shortly after Reynolds had resumed control of the company following the U.S. Supreme Court's ruling-but once it did, the company's success came quickly with its widely popular Camel brand of cigarettes.

For the next 20 years, the company's success was primarily predicated on the popularity of Camel cigarettes, but by the late 1930s and throughout the 1940s, the company's exponential growth began to slow due to labor problems, antitrust suits, and one particular product flop, Cavalier cigarettes. By the 1950s, however, R.J. Reynolds began to effect a turnaround by selling its new filter tip brand of cigarettes, Winston, which first appeared in 1954. Two years later, the company introduced its Salem brand, the industry's first king-size filter-tipped menthol cigarette. This, combined with the continuing success of the Camel and Winston brands, elevated the company's standing in the market above all others.

When Philip Morris' Marlboro surpassed Winston in 1976, the company countered with the introduction of a "back-to-nature" brand of cigarettes called Real, but the effort failed miserably and the product was discontinued in 1980. In that same year, the company's management sought to ameliorate its position by expanding overseas, leading to an agreement with China to manufacture and sell cigarettes there, the first U.S. company to reach an accord with that country.

However, this historic move abroad was not enough to stop the company's slide to the industry's number-two position three years later, when Philip Morris ascended to the industry's number-one position. In 1985, to stave off further losses, R.J. Reynolds purchased Nabisco Brands, Inc. for $4.9 billion (the same year in which Philip Morris acquired General Foods Corporation). Three years after the Nabisco purchase, Kohlberg Kravis Roberts & Co., an investment firm, purchased RJR Nabisco for $24.88 billion in what was then the biggest leveraged buyout in U.S. history.

However, this historic move abroad was not enough to stop the company's slide to the industry's number-two position three years later, when Philip Morris ascended to the industry's number-one position. In 1985, to stave off further losses, R.J. Reynolds purchased Nabisco Brands, Inc. for $4.9 billion (the same year in which Philip Morris acquired General Foods Corporation). Three years after the Nabisco purchase, Kohlberg Kravis Roberts & Co., an investment firm, purchased RJR Nabisco for $24.88 billion in what was then the biggest leveraged buyout in U.S. history.