March/April 2007

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The tobacco giant plans new product launches in its battle to retain market share.

The passages below were excerpted from a speech given by Michael E. Szymanczyk, chairman and CEO of Philip Morris USA Inc. at the Prudential Consumer Conference in Boston.

On Recent Business Performance:

For the first half of 2006, Philip Morris USA shipments were down 1.7 percent versus the previous year. When you consider the impact of changes in trade inventories, an extra shipping day and the July 4th holiday, we estimate that shipments were down about 1 percent in the first half.

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

On Marlboro’s 50th anniversary and promotional plans:

Efforts to reinforce the brand’s flavor positioning and reward adult Marlboro smokers were successful and Marlboro’s share increased 0.5 share points in 2005 to 40 percent.

While images of Marlboro Country are no longer part of the mass marketing landscape on billboards or in magazines, the brand continues to communicate directly with adult smokers through direct mail, at retail stores. and by providing unique experiences that reinforce the brand’s image and flavor heritage. For example, thousands of smokers 21 years of age and older will be invited this year to experience Marlboro Country first-hand through a trip to Crazy Mountain Ranch in Montana. Adult smokers and their guests can go horseback riding, whitewater rafting, and off-roading by day and enjoy cook-outs under the stars at night in one of the most beautiful areas of the country.

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

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

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

On the Menthol Market Segment:

The menthol segment has been growing for several years and Marlboro Menthol has shared in this growth. Marlboro Menthol’s share is up 1.2 share points over the last three years while the menthol segment has increased by one share point. During this time, Marlboro has grown its share of the menthol segment from 12 percent to 16.1 percent and is now the No. 2 menthol brand behind Newport. This year, Marlboro Menthol has benefited from enhanced packaging and retail merchandising.

On Brand Performance:

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

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

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

On Future Growth:

Our ability to grow revenue in the future is limited by several factors, including declining industry volume, a very competitive environment and the adverse impact of state excise tax increases. As we look to the future, we need to find new ways to grow by expanding beyond our core business to other tobacco and tobacco-related adjacent categories.

We believe we can expand beyond cigarettes in two ways—through internal or organic development and through acquisition. While acquisitions would provide us with immediate entry into existing categories and a solid base on which to grow, we recognize that finding appropriate acquisition candidates that meet our very strict economic return and other acquisition criteria is not an easy task.

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

On New Product Launches:

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

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

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

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

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

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

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

We are pleased with the strong distribution we have achieved in more than 2,000 retail stores across Indianapolis and the initial response to Taboka from adult consumers who have tried it in the marketplace.

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

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

On Litigation, Pricing, and Counterfeit and Other Illegal Sales:

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

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

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

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

We will face these challenges again as tax increase proposed in a number of states have the potential to increase illegal activity.

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

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

An Ounce of Prevention

Comments from Michael E. Szymanczyk on Philip Morris’s tobacco prevention activities.

“I view understanding and addressing society’s expectations of our company as an essential element of our financial success. While any good consumer products company should respond to society, the nature of our product and the harm it causes give rise to a unique set of challenges for us.

“Operating our business in a manner consistent with what society expects of a responsible cigarette manufacturer is crucial if we wish to maintain our license to operate.

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

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

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

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

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