INDUSTRY SNAPSHOT

Battered by multibillion-dollar lawsuits and anti-smoking campaigns, the U.S. tobacco industry confronts a shrinking yet resilient market at home and widening demand abroad. In recent years, cigarette shipments fell as tax-induced price hikes and antismoking sentiment cut into demand. Although price increases have helped to prop up sales and profits, a weak economic climate coupled with cigarette tax increases were affecting the industry's profitability in the early 2000s. At this time, continued price increases were helping discount brand cigarettes to gain popularity with cost-conscious consumers.

Tobacco companies have been so besieged with lawsuits that investment reports on the industry, once flush with statistics and commentary on short-term profits, have found it necessary to delve into arguments, proceedings, and other minutia of individual cases at trial. The biggest legal initiative, brought collectively by the attorneys general of 46 states, resulted in a massive 25-year, $206-billion settlement by cigarette manufacturers. Hundreds of other lawsuits, most from private individuals, have inundated tobacco companies as well. By the end of 2002, the industry had lost five lawsuits on the West Coast since the late 1990s. In December of that year, a California Superior Court judge reduced a record $28 billion judgment against Philip Morris-which a jury awarded to a 64-year-old terminal lung cancer patient-to $28 million, calling the initial amount "legally excessive," according to Forbes. Cases such as these have allowed lawyers to collectively take in hundreds of millions of dollars a year-and they will continue to do so for decades to come.

The industry remains highly concentrated. The top three cigarette makers-Philip Morris, R.J. Reynolds, and BAT/Brown & Williamson-controlled about 82 percent of the U.S. market as of 2002. Indeed, Census Bureau reports show that in recent years, only nine cigarette companies operated in the United States. Market share evidence suggests that the larger producers, especially Philip Morris, which alone makes up half of all U.S. production, could continue to crowd out smaller producers.

ORGANIZATION AND STRUCTURE
From the industry's nascence in the mid-nineteenth century, when many cigarette manufacturers began as tobacco farmers, to the early 2000s, the number of participants has been limited. Early cigarette producers were located in proximity to the tobacco fields of the southern United States, typically operating in the same region as their competition. Nearly a century and a half later, the cigarette industry still consisted of a small, almost fraternal group of manufacturers, several of whom had been in competition with one another since the nineteenth century.

Cigarette manufacturers are still clustered in just a few southeastern states. Production of cigarettes is confined to the four-state region of North Carolina, Virginia, Georgia, and Kentucky. The bulk of these manufacturing facilities are located in North Carolina.

BACKGROUND AND DEVELOPMENT
The origins of tobacco in the United States date back to before the formation of the nation itself, and the growth and sale of this product represented one of the key agricultural crops that spurred the country's growth in the eighteenth and nineteenth centuries. The use of tobacco to produce cigarettes in any widespread fashion did not occur, however, until the dawn of the twentieth century. Other uses for tobacco precluded the popularity of cigarettes, as Americans in the early nineteenth century enjoyed plug and twist tobacco, then smoking tobacco, and finally cigars, all of which overshadowed cigarette production in terms of volume for most of the century. Even in the mid-1800s, the use of tobacco had its detractors, and cigarette smokers, many of whom were women, suffered from a somewhat ignoble image. As a social commentator in 1854 wrote in reference to New York: "Some of the ladies of this refined and fashion-forming metropolis are aping the silly ways of some pseudo-accomplished foreigners in smoking Tobacco through a weaker and more feminine article which has been most delicately denominated cigarette."

A decade later, however, the production volume of cigarettes had increased enough to become the object of special federal taxation, which, according to the Internal Revenue Law promulgated in June 1864, levied one dollar per one hundred packages not exceeding five dollars in aggregate value. The following year, 19.7 million cigarettes were produced, and manufacturers were buffeted by a series of tax hikes, first to two dollars per thousand and then to five dollars per thousand. This arrested the growth of the industry just as sales were beginning to elevate cigarette manufacturers' importance in the tobacco industry. In 1868 tax rates were cut back to $1.50 per thousand and growth resumed, marking the beginning of 20-year period that would witness the most rapid percentage growth rate in the production of cigarettes in the history of the industry.

Cigarette production reached 500 million in 1880 and eclipsed the 1 billion mark five years later. By the 1880s, there were five principal manufacturers of cigarettes: Washington Duke Sons & Co., Allen & Ginter, Kinney Tobacco Co., William S. Kimball & Co., and Goodwin & Co. Together these companies produced 2.18 billion cigarettes annually by the end of the decade, 91.7 percent of the national output of 2.41 billion. These companies, referred to as the "Tobacco Trust," essentially controlled the cigarette market, enjoying a virtually unassailable lead over other, smaller manufacturers. This monopolistic trait would characterize the industry throughout much of its existence.

The ability of these companies to secure such a wide advantage over their competition was partly due to significant technological innovations achieved during the 1880s that ended the time-consuming chore of rolling cigarettes by hand. On a good day, a skilled laborer could roll 3,000 cigarettes during a ten-hour workday-a production rate that threatened to place a ceiling on the industry's growth. But beginning in 1872, the age of mechanization in the cigarette industry was initiated. The first cigarette manufacturing machine, patented by Albert H. Hook, earned a modicum of success but did not prove to be commercially viable. By 1881, however, significant improvements had been made in a design patented by James A. Bonsack. This machine could churn out 200 to 220 cigarettes per minute, accomplishing in 15 minutes what it took an experienced production worker 10 hours to complete.

Bolstered by the ability to produce more cigarettes with lower labor costs, the five companies that occupied the industry's leading positions grew quickly by moving into untapped markets and securing their overwhelming lead in the U.S. market. In 1890 the composition of the industry's manufacturers became more homogeneous when the five leading companies, at the urging of James Duke of Washington Duke & Sons Co., merged to form the American Tobacco Co., which initially focused primarily on the production of cigarettes. Over the next 20 years, the American Tobacco Co. acquired an interest in roughly 250 companies. This cigarette giant expanded into other tobacco products, securing commanding leads in every product branch of the tobacco industry with the exception of cigars. In the manufacture of cigarettes, plug, smoking tobacco, fine cut tobacco, snuff, and little cigars, the conglomerate's production output in the first decade of the twentieth century represented no less than 76 percent of the country's total volume, giving smaller manufacturers little hope of wresting market share away from the industry's predominant leader.

If the five leading manufacturers in the 1880s justly earned the moniker "Tobacco Trust" when operating as separate companies, then their union certainly deserved the same label. The U.S. Supreme Court said as much in May 1911, when it found the American Tobacco Co. in violation of the Sherman Act. Six months after the ruling, the court issued a decree stipulating that the enormously powerful tobacco company be divided into 16 independent corporations, none of which could wield monopolistic control over any one product branch within the tobacco industry.

Post-Breakup Growth. Although certainly a significant chapter in the history of the cigarette industry, the parceling of the American Tobacco Co.'s sundry divisions and subsidiaries did not affect the cigarette industry as greatly as the cigar industry, primarily because cigarettes still did not represent a major branch of the tobacco industry. The cigarette industry was burgeoning, however, and stood on the brink of catapulting past all other branches of the tobacco industry. The first step toward this end came six years after the restructuring of the industry, when the United States entered World War I and cigarettes were issued to soldiers in the U.S. Army and Navy.

Once the habit of smoking cigarettes had extended to women, thereby doubling the potential customer base, sales began to mushroom, and the cigarette branch of the industry at last overtook all other branches. Over the ensuing 20 years, during which time many of the widely popular brands-Chesterfield, Lucky Strike, Old Gold, Camel, Raleigh, and Marlboro-emerged, the consumption of cigarettes grew rapidly. Domestic tobacco leaf consumption increased 42.5 percent between 1910 and 1930, while the production of cigarettes increased from 8.64 billion to 125.20 billion, a 1,339 percent increase. In these first two decades following the dissolution decree, there were approximately 15 to 20 manufacturers deriving the bulk of their revenue from the production of cigarettes. Only four of these manufacturers, commonly referred to as the "Big Four," held any appreciable share of the market. Indeed, these manufacturers-the restructured American Tobacco Co., R.J. Reynolds Tobacco Co., P. Lorillard Co., and Liggett & Meyers Tobacco Co.-held as firm a grip on the U.S. cigarette market as American Tobacco had before the U.S. Supreme Court's ruling; they controlled more than 95 percent of the market.

Clearly, the dissolution of American Tobacco had not produced the U.S. Supreme Court's intended effects; a monarchy had merely been replaced with an oligarchy. Smaller, independent cigarette manufacturers were able to record enviable profits during this period, largely because of the bountiful market itself, but none could challenge the Big Four in magnitude. Accordingly, as the cigarette industry continued to grow, these powerful manufacturers became more formidable, further widening the gulf separating the industry's upper echelon and the rest of the competition.

The next two decades of business brought continued success to the industry's four largest manufacturers and witnessed the rise of an additional member to the industry's elite, Philip Morris & Company Ltd., Inc. Philip Morris introduced its mainstay Marlboro brand in 1925, which reached an annual production total of approximately 500 million cigarettes. But the industry's leading brands during these years, Camel and Lucky Strike, each sold 25 billion cigarettes a year, by far outpacing Philip Morris's production volume and providing little room for the future ascension of the smaller, formerly British-based manufacturer. Instead, Philip Morris was able to climb the industry's ranking list due to a strong relationship with cigarette jobbers throughout its distribution network and by virtue of prudent management. By the end of the 1940s, after Philip Morris had already unseated Lorillard to occupy the industry's fourth place position, the "Tobacco Trust" now included five members, generating an aggregate sales total of $357.3 million.

Postwar Unease. The 1950s heralded a new era for cigarette manufacturers, one in which it became necessary to defend growing criticism of the product being sold. Since the industry's emergence, anti-cigarette and anti-tobacco factions from both the federal and consumer sector had railed against the sale and use of tobacco. Manufacturers had fared fairly well, effectively beating back the rising tide of protest against their business. While industry manufacturers had suffered run-ins with the Federal Trade Commission (FTC) concerning misleading advertising, the federal government had subsidized a large portion of the industry before World War II, which helped to allay the fears of manufacturers.

During the 1950s, however, medical reports linking health problems to smoking began to surface. In 1953 the Sloan-Kettering Cancer Institute's report showed a relation between cancer and tobacco, and manufacturers consequently found themselves fighting an entirely new and much more formidable foe-scientific evidence.

In 1964 the U.S. Surgeon General issued a landmark report linking smoking with lung cancer and heart disease. A year later, the U.S. Congress promulgated the Cigarette Advertising and Labeling Act, which stipulated that health warnings be placed on each cigarette package. In 1971 cigarette advertisements on radio and television were banned. Although these announcements and restrictions did not cause the industry to collapse, the rate of smoking in the United States began to spiral downward.

Cigarette manufacturers had already begun creating different types of cigarettes-filter tips during the 1950s, then low-tar cigarettes during the 1960s and 1970s-and marketed these products not to create more customers but to capture their competitor's customers. By the 1970s, however, Philip Morris and R.J. Reynolds had gained considerable ground on their competition, making the industry essentially a battle between the two behemoths. Philip Morris gained the upper hand in 1976 when its Marlboro brand passed R.J. Reynolds' Winston.

During the 1980s, lower-priced, discount cigarettes began to enter the market with increasing frequency. This enabled smaller cigarette manufacturers to thrive for a short time, until the industry's preeminent leaders dropped their own prices and set about capturing the lowend market. By this time, the reams of medical reports delineating the hazardous effects of smoking had firmly grabbed the attention of the American populace, transforming anti-tobacco factions into a powerful nationwide movement. Cigarette taxation doubled in 1983 and continued to rise, particularly during the late 1980s, increasing the popularity of lower-priced cigarettes. Consequently, cigarette manufacturers diversified their operations with unprecedented fervor, while casting an eye to international business opportunities.

Decade of Legal Skirmishes. As the U.S. economy recovered from recession in the early 1990s, cigarette makers were saddled with much larger problems. These difficulties had always confronted the industry, but they intensified in the early and mid-1990s.

In June 1992 the Supreme Court reversed an appeals court ruling concerning the product liability of cigarette manufacturers. Earlier, two lower courts had ruled that the family of a woman who had died of lung cancer could not sue cigarette manufacturers on the grounds they had withheld information about potential health dangers. The Court's reversal sent cigarette manufacturers' stock prices cascading downward, as industry participants braced for a rash of lawsuits.

Around the same period, cigarette manufacturers suffered diminishing influence over federal lawmakers. In the past, through the combined efforts of the tobacco lobby and elected representatives from tobacco-growing states, manufacturers had been able to slow the rate of federally imposed cigarette taxes and to mitigate federal legislation aimed at curbing cigarette use. Tobacco companies' diminished clout left them ever more vulnerable to legal attacks.

Restrictions on smoking in public areas grew increasingly common as well. This was in part a result of a 1993 Environmental Protection Agency (EPA) report that classified environmental tobacco smoke as a class-A carcinogen and alleged that 3,000 nonsmokers die annually from second-hand smoke. Many communities instituted strict rules regarding cigarette use, and even the U.S. Department of Defense issued restrictions that banned smoking in all military work spaces, including military bases. Businesses, too, banned smoking in response to state laws and public outcry.

Another threat to the cigarette industry was repeated attempts at regulatory oversight under the Clinton administration, particularly the zealous efforts of Commissioner David Kessler, head of the Food and Drug Administration (FDA). In a campaign that was part politics and part science, Kessler testified before Congress that he believed nicotine was a highly addictive drug being manipulated by tobacco companies. He argued that if tobacco functioned as a drug, it should be regulated as one too, pleading the case for FDA jurisdiction over tobacco products. Ultimately this controversial assertion was heard in 1999 before the Supreme Court, and the Court decided in March 2000 that tobacco does not fall under the FDA's purview as defined by Congress.

In the meantime, a flood of lawsuits deluged tobacco companies. Emanating from the Supreme Court's 1992 ruling, the suits were brought by individuals and groups who sought damages from cigarette manufacturers for smoking-related illnesses and by government agencies that wished to recover the costs to the public health system for treating such ailments. In total, according to one report, more than 800 individual and class-action suits were brought against tobacco companies between 1990 and mid-1998. However, only a handful made it to trial, and even fewer produced verdicts against the industry.

Government Settlements. In early 1997 the anti-tobacco forces gained new ground. They successfully split the tobacco companies' united front by pressuring the Liggett Company to settle a class-action lawsuit. Liggett's move was not entirely unexpected-with only a 2 percent share of the U.S. market, the company lacked the resources to fight an extended court battle. Liggett broke with long-established industry policy and admitted that cigarettes cause cancer and that nicotine is addictive.

By 1997 tobacco companies were in extended negotiations with state attorneys general and began to test the waters for a large national settlement that would spare the industry some or all of the seemingly endless litigation before it. In a mammoth $370-billion proposal, the companies even contemplated submitting to limited FDA regulation as well as significant measures to curb underage smoking. In return, they hoped to gain at least partial immunity from the barrage of litigation coming at them.

Some attorneys general were receptive, but the focus shifted to Congress and a plan to pass the settlement and immunity framework as federal law rather than as agreements approved separately by each state. In Washington, however, the settlement became mired in politics and competing proposals. A number of lawmakers called for a steeper payout, as much as $500 billion, and debated the merits and legality of the proposed immunity. Meanwhile, the Clinton administration, deeply divided over the matter, was slow to weigh in on what terms it would support.

In March 1998 Senate leaders tried to revive the federal tobacco settlement with a bipartisan bill negotiated by Senator John McCain. Tougher on the industry than the companies' own proposal, the bill was supported by President Clinton and a diverse mix of senators. The legislation was to include annual liability caps for punitive damages paid by tobacco companies. However, after weeks of bruising debate and a fistful of conflicting amendments put forth, in June the Republican leadership withdrew its support for the bill, and it never went before the full Senate. The House failed to produce anything even close to viable, and the federal initiative lost nearly all of its steam.

Meanwhile, state attorneys general renewed their attack, aided in some states by specially crafted laws that made it easier for them to prove their cases and collect damages. Settlement talks also restarted in June after the McCain bill died. The companies appeared more hesitant now, and some may have sensed rising political clout with Congress's failure to act. But the attorneys general, led by Washington Attorney General Christine Gregoire, pressed ahead with negotiations, attempting to unite their conflicting demands and reach a consensus the industry was likely to accept.

In November 1998 both sides finally reached an agreement. Ultimately 46 states and the country's five largest cigarette makers were party to a deal that would pay states $206 billion over 25 years, funded by new cigarette taxes. What's more, the settlement was somewhat more lenient on tobacco companies than the defunct 1997 proposal. It required less money for the states, fewer restrictions on marketing and advertising, and no stipulation that the industry be regulated by the FDA. The remaining four states, Florida, Minnesota, Mississippi, and Texas, had previously obtained settlements worth $40 billion.

Just as government litigation seemed to be winding down, however, the Clinton Justice Department in 1999 announced its intentions to sue tobacco companies on similar grounds to the state suits. Preliminary hearings on the federal suit began in 2000. Separately, in 2000 a pair of cigarette wholesalers filed suit in federal court accusing major cigarette makers of price fixing.

Rising tobacco taxes and widening antismoking policies have resulted in a diminished U.S. market for cigarettes. The industry raised cigarette prices by 45 cents in 1998 and by another 22 cents in 1999 in order to finance the state settlements. In 1999 U.S. tobacco companies shipped 419.3 billion cigarettes, a 9 percent drop from a year earlier and 13.5 percent below 1997's 485 billion. Totaling about 76 packs of cigarettes for every person in the United States, industry shipments in 1999 were valued at $52 billion. In 2000 between 45 million and 50 million U.S. adults were smokers, equal to an adult smoking rate of about 23 percent.

In 1999, Philip Morris continued to lead the industry by a huge margin. That year, it supplied 49.6 percent of all U.S. cigarette shipments. This was up slightly from the year before in part because Philip Morris acquired three minor brands from Liggett. The company's market-leading Marlboro brand alone represented 36.4 percent of shipments. R.J. Reynolds was second, with a 23.2 percent share in 1999, followed by Brown & Williamson (13.5 percent), Lorillard (9.3 percent), and Liggett (1.2 percent).

Although discount cigarettes had for years eroded market share of the premium brands, in the late 1990s premium labels regained ground. As of 1999, premium brands accounted for 73.4 percent of all domestic cigarette sales by volume, up slightly from the year before. Earlier in the decade, premium volume had sunk as low as 68.6 percent due to the popularity of discount brands, which gained favor rapidly during the 1980s. Interestingly, premium's share rebounded just as tax increases and litigation caused cigarette prices to soar.

In another surprising trend, as cigarette prices rose, according to some research, smokers tended to consume fewer but stronger cigarettes. With young smokers, this pattern can actually increase a smoker's intake of tar and nicotine.

The industry regularly develops new products, many targeted at special niches of the cigarette market. One area under active development by several companies during the late 1990s involved cigarettes made from lownitrosamine tobacco. By altering the tobacco-curing process, manufacturers are able to reduce or even eliminate nitrosamines, chemicals that some scientists have identified as a key carcinogen in tobacco products. Lownitrosamine tobacco could be used in a special line of products for health-conscious smokers or could one day become the standard in all cigarettes. Test marketing of a few products was expected to begin in 2000. The link between nitrosamines and cancer was far from certain, though, and some observers questioned the benefits of low-nitrosamine tobacco. Smoking has been linked to lung cancer, heart disease, chronic lung disease, and a wide number of other cancers and disorders.