EX-13 5 dex13.htm PAGES 16 TO 81 OF THE 2005 ANNUAL REPORT Pages 16 to 81 of the 2005 Annual Report

Exhibit 13

 

 

FINANCIAL REVIEW

 

    
   
Financial Contents     
    Management’s Discussion and Analysis of Financial Condition and Results of Operations    page 17
    Selected Financial Data — Five-Year Review    page 41
    Consolidated Balance Sheets    page 42
    Consolidated Statements of Earnings    page 44
    Consolidated Statements of Stockholders’ Equity    page 45
    Consolidated Statements of Cash Flows    page 46
    Notes to Consolidated Financial Statements    page 48
    Report of Independent Registered Public Accounting Firm    page 80
    Report of Management on Internal Control Over Financial Reporting    page 81
          

Guide to Select Disclosures

    
    For easy reference, areas that may be of interest to investors are highlighted in the index below.     
    Acquisitions — Note 5 includes a discussion of the PT HM Sampoerna Tbk acquisition    page 53
    Benefit Plans — Note 16 includes a discussion of pension plans    page 62
    Contingencies — Note 19 includes a discussion of litigation    page 67
    Finance Assets, net — Note 8 includes a discussion of leasing activities    page 53
    Segment Reporting — Note 15    page 60
    Stock Plans — Note 12 includes a discussion of stock compensation    page 57
16

 


Exhibit 13

 

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

Description of the Company

 

Throughout Management’s Discussion and Analysis of Financial Condition and Results of Operations, the term “Altria Group, Inc.” refers to the consolidated financial position, results of operations and cash flows of the Altria family of companies and the term “ALG” refers solely to the parent company. ALG’s wholly-owned subsidiaries, Philip Morris USA Inc. (“PM USA”) and Philip Morris International Inc. (“PMI”), and its majority-owned (87.2% as of December 31, 2005) subsidiary, Kraft Foods Inc. (“Kraft”), are engaged in the manufacture and sale of various consumer products, including cigarettes and other tobacco products, packaged grocery products, snacks, beverages, cheese and convenient meals. Philip Morris Capital Corporation (“PMCC”), another wholly-owned subsidiary, maintains a portfolio of leveraged and direct finance leases. In addition, ALG had a 28.7% economic and voting interest in SABMiller plc (“SABMiller”) at December 31, 2005. ALG’s access to the operating cash flows of its subsidiaries consists of cash received from the payment of dividends and interest, and the repayment of amounts borrowed from ALG by its subsidiaries.

 

As previously communicated, for significant business reasons, the Board of Directors is looking at a number of restructuring alternatives, including the possibility of separating Altria Group, Inc. into two, or potentially three, independent entities. Continuing improvements in the entire litigation environment are a prerequisite to such action by the Board of Directors, and the timing and chronology of events are uncertain.

 

In June 2005, Kraft sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings for all years presented. The assets related to the sugar confectionery business were reflected as assets of discontinued operations held for sale on the consolidated balance sheet at December 31, 2004.

 

In March 2005, a subsidiary of PMI acquired 40% of the outstanding shares of PT HM Sampoerna Tbk (“Sampoerna”), an Indonesian tobacco company. In May 2005, PMI purchased an additional 58%, for a total of 98%. The total cost of the transaction was $4.8 billion, including Sampoerna’s cash of $0.3 billion and debt of the U.S. dollar equivalent of $0.2 billion. The purchase price was primarily financed through a euro 4.5 billion bank credit facility arranged for PMI and its subsidiaries, consisting of a euro 2.5 billion three-year term loan facility and a euro 2.0 billion five-year revolving credit facility. These facilities are not guaranteed by ALG.

 

Sampoerna’s financial position and results of operations have been fully consolidated with PMI as of June 1, 2005. From March 2005 to May 2005, PMI recorded equity earnings in Sampoerna. Sampoerna contributed $315 million of operating income and $128 million of net earnings since March 2005.

 

Kraft’s operating subsidiaries generally report year-end results as of the Saturday closest to the end of each year. This resulted in fifty-three weeks of operating results for Kraft in the consolidated statement of earnings for the year ended December 31, 2005, versus fifty-two weeks for the years ended December 31, 2004 and 2003.

 

Executive Summary

 

The following executive summary is intended to provide significant highlights of the Discussion and Analysis that follows.

 

·  Consolidated Operating Results – The changes in Altria Group, Inc.’s earnings from continuing operations and diluted earnings per share (“EPS”) from continuing operations for the year ended December 31, 2005, from the year ended December 31, 2004, were due primarily to the following:

 

(in millions, except per share data)        


   Earnings
from
Continuing
Operations


    Diluted EPS
from
Continuing
Operations


 

For the year ended December 31, 2004

   $ 9,420     $ 4.57  

2004 Domestic tobacco headquarters relocation charges

     20       0.01  

2004 International tobacco E.C. agreement

     161       0.08  

2004 Asset impairment, exit and implementation costs

     446       0.21  

2004 Loss on sales of businesses

     2       -  

2004 Investment impairment

     26       0.01  

2004 Provision for airline industry exposure

     85       0.04  

2004 Tax items

     (419 )     (0.20 )

2004 Gains from investments at SABMiller

     (111 )     (0.05 )
    


 


Subtotal 2004 items

     210       0.10  

2005 Domestic tobacco headquarters relocation charges

     (2 )     -  

2005 Domestic tobacco loss on U.S. tobacco pool

     (87 )     (0.04 )

2005 Domestic tobacco quota buy-out

     72       0.03  

2005 Asset impairment, exit and implementation costs

     (426 )     (0.21 )

2005 Tax items

     521       0.25  

2005 Gains on sales of businesses, net

     60       0.03  

2005 Provision for airline industry exposure

     (129 )     (0.06 )
    


 


Subtotal 2005 items

     9       -  

Currency

     272       0.13  

Change in effective tax rate

     332       0.16  

Higher shares outstanding

             (0.07 )

Operations (including the impact of Kraft’s 53rd week)

     425       0.21  
    


 


For the year ended December 31, 2005

   $ 10,668     $ 5.10  
    


 


 

See discussion of events affecting the comparability of statement of earnings amounts in the Consolidated Operating Results section of the following Discussion and Analysis. Amounts shown above that relate to Kraft are reported net of the related minority interest impact.

 

·  Domestic Tobacco Loss on U.S. Tobacco Pool As further discussed in Note 19. Contingencies, in October 2004, the Fair and Equitable Tobacco Reform Act of 2004 (“FETRA”) was signed into law. Under the provisions of FETRA, PM USA was obligated to cover its share of potential losses that the government may incur on the disposition of pool tobacco stock accumulated under the previous tobacco price support program. In 2005, PM USA recorded a $138 million pre-tax expense for its share of the loss.

 

·  Domestic Tobacco Quota Buy-Out – The provisions of FETRA require PM USA, along with other manufacturers and importers of tobacco products, to make quarterly payments that will be used to compensate tobacco growers and quota holders affected by the legislation. Payments made by PM USA

 

17


Exhibit 13

 

 

under FETRA will offset amounts due under the provisions of the National Tobacco Grower Settlement Trust (“NTGST”), a trust formerly established to compensate tobacco growers and quota holders. Disputes arose as to the applicability of FETRA to 2004 NTGST payments. During the third quarter of 2005, a North Carolina Supreme Court ruling determined that FETRA enactment had not triggered the offset provisions during 2004 and that tobacco companies were required to make full payment to the NTGST for the full year of 2004. The ruling, along with FETRA billings from the United States Department of Agriculture (“USDA”), established that FETRA was effective beginning in 2005. Accordingly, during the third quarter of 2005, PM USA reversed a prior year pre-tax accrual for FETRA payments in the amount of $115 million.

 

·  Asset Impairment, Exit and Implementation Costs In January 2004, Kraft announced a three-year restructuring program. During the years ended December 31, 2005 and 2004, Kraft recorded pre-tax charges of $297 million ($178 million after taxes and minority interest) and $633 million ($356 million after taxes and minority interest), respectively, for the restructuring plan, including pre-tax implementation costs of $87 million and $50 million, respectively. In addition, in January 2006, Kraft announced plans to expand its restructuring efforts beyond those originally contemplated. Additional pre-tax charges are anticipated to be $2.5 billion from 2006 to 2009, reflecting additional organizational streamlining and facility closures. The entire program is expected to ultimately result in $3.7 billion in pre-tax charges, the closure of up to 40 facilities and the elimination of approximately 14,000 positions. Approximately $2.3 billion of the $3.7 billion in pre-tax charges are expected to require cash payments.

 

During 2005, Kraft incurred pre-tax asset impairment charges of $269 million ($151 million after taxes and minority interest), relating to the sale of its fruit snacks assets and the pending sales of certain assets in Canada and a small biscuit brand in the United States. In addition, during 2005, PMI and Altria Group, Inc. recorded pre-tax asset impairment and exit costs of $139 million ($97 million after taxes). For further details on the restructuring program or asset impairment, exit and implementation costs, see Note 3 to the Consolidated Financial Statements and the Food Business Environment section of the following Discussion and Analysis.

 

·  International Tobacco E.C. Agreement In July 2004, PMI entered into an agreement with the European Commission (“E.C.”) and 10 member states of the European Union that provides for broad cooperation with European law enforcement agencies on anti-contraband and anti-counterfeit efforts. Under the terms of the agreement, PMI will make 13 payments over 12 years, including an initial payment of $250 million, which was recorded as a pre-tax charge against its earnings in 2004.

 

·  Gains on Sales of Businesses, net The favorable impact is due primarily to the gain on sale of Kraft’s U.K. desserts assets in 2005.

 

·  Provision for Airline Industry Exposure – As discussed in Note 8. Finance Assets, net, during 2005, PMCC increased its allowance for losses by $200 million, reflecting its exposure to the troubled airline industry, particularly to Delta Air Lines, Inc. (“Delta”) and Northwest Airlines, Inc. (“Northwest”), both of which filed for bankruptcy protection during 2005. During 2004, in recognition of the economic downturn in the airline industry, PMCC increased its allowance for losses by $140 million.

 

·  Currency The favorable currency impact on earnings from continuing operations and diluted EPS from continuing operations is due primarily to the weakness of the U.S. dollar versus the euro, Japanese yen and Central and Eastern European currencies.

 

·  Income taxes Altria Group, Inc.’s effective tax rate decreased by 2.5 percentage points to 29.9%. The 2005 effective tax rate includes a $372 million benefit related to dividend repatriation under the American Jobs Creation Act in 2005, the reversal of $82 million of tax accruals no longer required at Kraft, as well as other benefits, including the impact of the domestic manufacturers’ deduction under the American Jobs Creation Act and lower repatriation costs. The 2004 effective tax rate includes the reversal of $355 million of tax accruals that are no longer required due to foreign tax events that were resolved during 2004, and an $81 million favorable resolution of an outstanding tax item at Kraft.

 

·  Shares Outstanding – Higher shares outstanding during 2005 primarily reflects exercises of employee stock options and the impact of stock options outstanding.

 

·  Continuing Operations – The increase in results from continuing operations was due primarily to the following:

 

    Higher international tobacco income, reflecting higher pricing, the impact of acquisitions in Indonesia and Colombia, higher income from the return of the Marlboro license in Japan and the impact of a one-time inventory sale in Italy, partially offset by unfavorable volume/mix, expenses related to the E.C. agreement and higher marketing, administration and research costs.

 

    Higher domestic tobacco income, reflecting lower wholesale promotional allowance rates, partially offset by lower volume, a pre-tax provision of $56 million for the Boeken individual smoking case, and higher research and development expenses.

 

These increases were partially offset by:

 

    Lower North American food income, reflecting higher commodity and benefit costs, and increased marketing spending, partially offset by higher pricing and favorable volume/mix (including the impact of the extra week of shipments in 2005).

 

    Lower international food income, reflecting higher commodity and developing market infrastructure costs, partially offset by higher pricing and favorable volume/mix (including the impact of the extra week of shipments in 2005).

 

    Lower financial services income, reflecting lower lease portfolio revenues and lower gains from asset sales, partially offset by lower interest expense.

 

For further details, see the Consolidated Operating Results and Operating Results by Business Segment sections of the following Discussion and Analysis.

 

·  2006 Forecasted Results – In January 2006, Altria Group, Inc. announced that it expects forecasted 2006 full-year diluted EPS from continuing operations in a range of $4.85 to $4.95. This forecast includes approximately $0.36 per share in charges associated with the Kraft restructuring program, unfavorable currency of $0.14 per share at current exchange rates, about $0.10 per share for lower tobacco income in Spain, $0.05 per share due to higher shares outstanding, and $0.04 per share as a result of a higher base

 

18


Exhibit 13

 

 

income tax rate of 33.9% versus a corresponding rate of 33.4% in 2005. It does not include any future acquisitions or divestitures, or the benefit of potential tax accrual reversals following the completion of audits in certain jurisdictions. The factors described in the Cautionary Factors That May Affect Future Results section of the following Discussion and Analysis represent continuing risks to this forecast.

 

Discussion and Analysis

 

Critical Accounting Policies and Estimates

 

Note 2 to the consolidated financial statements includes a summary of the significant accounting policies and methods used in the preparation of Altria Group, Inc.’s consolidated financial statements. In most instances, Altria Group, Inc. must use an accounting policy or method because it is the only policy or method permitted under accounting principles generally accepted in the United States of America (“U.S. GAAP”).

 

The preparation of financial statements includes the use of estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. If actual amounts are ultimately different from previous estimates, the revisions are included in Altria Group, Inc.’s consolidated results of operations for the period in which the actual amounts become known. Historically, the aggregate differences, if any, between Altria Group, Inc.’s estimates and actual amounts in any year, have not had a significant impact on its consolidated financial statements.

 

The selection and disclosure of Altria Group, Inc.’s critical accounting policies and estimates have been discussed with Altria Group, Inc.’s Audit Committee. The following is a review of the more significant assumptions and estimates, as well as the accounting policies and methods used in the preparation of Altria Group, Inc.’s consolidated financial statements:

 

·  Consolidation – The consolidated financial statements include ALG, as well as its wholly-owned and majority-owned subsidiaries. Investments in which ALG exercises significant influence (20% — 50% ownership interest), are accounted for under the equity method of accounting. Investments in which ALG has an ownership interest of less than 20%, or does not exercise significant influence, are accounted for with the cost method of accounting. All intercompany transactions and balances have been eliminated.

 

·  Revenue Recognition – As required by U.S. GAAP, Altria Group, Inc.’s consumer products businesses recognize revenues, net of sales incentives and including shipping and handling charges billed to customers, upon shipment or delivery of goods when title and risk of loss pass to customers. ALG’s tobacco subsidiaries also include excise taxes billed to customers in revenues. Shipping and handling costs are classified as part of cost of sales.

 

·  Depreciation, Amortization and Goodwill Valuation – Altria Group, Inc. depreciates property, plant and equipment and amortizes its definite life intangible assets using the straight-line method over the estimated useful lives of the assets.

 

Altria Group, Inc. is required to conduct an annual review of goodwill and intangible assets for potential impairment. Goodwill impairment testing requires a comparison between the carrying value and fair value of each reporting unit. If the carrying value exceeds the fair value, goodwill is considered impaired. The amount of impairment loss is measured as the difference between the carrying value and implied fair value of goodwill, which is determined using discounted cash flows. Impairment testing for non-amortizable intangible assets requires a comparison between the fair value and carrying value of the intangible asset. If the carrying value exceeds fair value, the intangible asset is considered impaired and is reduced to fair value. These calculations may be affected by interest rates, general economic conditions and projected growth rates. During 2005, Altria Group, Inc. completed its annual review of goodwill and intangible assets, and no charges resulted from this review. However, as part of the sale or pending sale of certain Canadian assets and two brands, Kraft recorded total non-cash pre-tax asset impairment charges of $269 million in 2005, which included impairment of goodwill and intangible assets of $13 million and $118 million, respectively, as well as $138 million of asset write-downs. The 2004 review of goodwill and intangible assets resulted in a $29 million non-cash pre-tax charge at Kraft related to an intangible asset impairment for a small confectionery business in the United States and certain brands in Mexico. A portion of this charge, $17 million, was reclassified to (loss) earnings from discontinued operations on the consolidated statement of earnings in the fourth quarter of 2004. The remaining charge was recorded as asset impairment and exit costs on the consolidated statement of earnings.

 

·  Marketing and Advertising Costs – As required by U.S. GAAP, Altria Group, Inc. records marketing costs as an expense in the year to which such costs relate. Altria Group, Inc. does not defer amounts on its year-end consolidated balance sheets with respect to marketing costs. Altria Group, Inc. expenses advertising costs in the year incurred. Consumer incentive and trade promotion activities are recorded as a reduction of revenues based on amounts estimated as being due to customers and consumers at the end of a period, based principally on historical utilization and redemption rates. Such programs include, but are not limited to, discounts, coupons, rebates, in-store display incentives and volume-based incentives. For interim reporting purposes, advertising and certain consumer incentive expenses are charged to operations as a percentage of sales, based on estimated sales and related expenses for the full year.

 

·  Contingencies – As discussed in Note 19 to the consolidated financial statements (“Note 19”), legal proceedings covering a wide range of matters are pending or threatened in various United States and foreign jurisdictions against ALG, its subsidiaries and affiliates, including PM USA and PMI, as well as their respective indemnitees. In 1998, PM USA and certain other United States tobacco product manufacturers entered into the Master Settlement Agreement (the “MSA”) with 46 states and various other governments and jurisdictions to settle asserted and unasserted health care cost recovery and other claims. PM USA 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”). PM USA’s portion of ongoing adjusted payments and legal fees is based on its relative share of the settling manufacturers’ domestic cigarette shipments, including roll-your-own cigarettes, in the year preceding that in which the payment is due. PM USA records its portion of ongoing settlement payments as part of cost of sales as product is shipped. During the years ended December 31, 2005, 2004 and 2003, PM USA recorded expenses of $5.0 billion, $4.6 billion and $4.4 billion, respectively, as part of cost of sales for the payments under the State Settlement Agreements and payments for tobacco growers and quota holders.

 

ALG and its subsidiaries record provisions in the consolidated financial statements for pending litigation when they determine that an unfavorable

 

19


Exhibit 13

 

 

outcome is probable and the amount of the loss can be reasonably estimated. Except as discussed in Note 19: (i) management has not concluded that it is probable that a loss has been incurred in any of the pending tobacco-related litigation; (ii) management is unable to make a meaningful estimate of the amount or range of loss that could result from an unfavorable outcome of pending tobacco-related litigation; and (iii) accordingly, management has not provided any amounts in the consolidated financial statements for unfavorable outcomes, if any.

 

·  Employee Benefit Plans – As discussed in Note 16. Benefit Plans (“Note 16”) of the notes to the consolidated financial statements, Altria Group, Inc. provides a range of benefits to its employees and retired employees, including pensions, postretirement health care and postemployment benefits (primarily severance). Altria Group, Inc. records annual amounts relating to these plans based on calculations specified by U.S. GAAP, which include various actuarial assumptions, such as discount rates, assumed rates of return on plan assets, compensation increases, turnover rates and health care cost trend rates. Altria Group, Inc. reviews its actuarial assumptions on an annual basis and makes modifications to the assumptions based on current rates and trends when it is deemed appropriate to do so. As permitted by U.S. GAAP, any effect of the modifications is generally amortized over future periods. Altria Group, Inc. believes that the assumptions utilized in recording its obligations under its plans, which are presented in Note 16, are reasonable based on advice from its actuaries.

 

In December 2003, the United States enacted into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003, establishing a prescription drug benefit known as “Medicare Part D,” and a federal subsidy to sponsors of retiree health care benefit plans that provide a benefit that is at least actuarially equivalent to Medicare Part D.

 

In May 2004, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. 106-2, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug, Improvement and Modernization Act of 2003” (“FSP 106-2”). FSP 106-2 requires companies to account for the effect of the subsidy on benefits attributable to past service as an actuarial experience gain and as a reduction of the service cost component of net postretirement health care costs for amounts attributable to current service, if the benefit provided is at least actuarially equivalent to Medicare Part D.

 

Altria Group, Inc. adopted FSP 106-2 in the third quarter of 2004. The impact of FSP 106-2 for 2005 and 2004 was a reduction of pre-tax net postretirement health care costs and an increase in net earnings of $67 million (including $55 million related to Kraft) and $28 million (including $24 million related to Kraft), respectively. In addition, as of July 1, 2004, Altria Group, Inc. reduced its accumulated postretirement benefit obligation for the subsidy related to benefits attributed to past service by $375 million and decreased its unrecognized actuarial losses by the same amount.

 

At December 31, 2005, for its U.S. pension and postretirement plans, Altria Group, Inc. reduced its discount rate assumption to 5.64% and modified its health care cost trend rate assumption. Altria Group, Inc. presently anticipates that these and other less significant assumption changes, coupled with the amortization of deferred gains and losses will result in an increase in 2006 pre-tax benefit expense of approximately $130 million (including $80 million related to Kraft). A fifty basis point decrease (increase) in Altria Group, Inc.’s discount rate would increase (decrease) Altria Group, Inc.’s pension and postretirement expense by approximately $123 million. Similarly, a fifty basis point decrease (increase) in the expected return on plan assets would increase (decrease) Altria Group, Inc.’s pension expense by approximately $56 million. See Note 16 for a sensitivity discussion of the assumed health care cost trend rates.

 

·  Income Taxes – Altria Group, Inc. accounts for income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. The provision for income taxes is based on domestic and international statutory income tax rates and tax planning opportunities available in the jurisdictions in which Altria Group, Inc. operates. Significant judgment is required in determining income tax provisions and in evaluating tax positions. ALG and its subsidiaries establish additional provisions for income taxes when, despite the belief that their tax positions are fully supportable, there remain certain positions that are likely to be challenged and that may not be sustained on review by tax authorities. Upon the closure of current and future tax audits in various jurisdictions, significant income tax accrual reversals could continue to occur in 2006. ALG and its subsidiaries evaluate and potentially adjust these accruals in light of changing facts and circumstances. The consolidated tax provision includes the impact of changes to accruals that are considered appropriate.

 

In October 2004, the American Jobs Creation Act (“the Jobs Act”) was signed into law. The Jobs Act includes a deduction for 85% of certain foreign earnings that are repatriated. In 2005, Altria Group, Inc. repatriated $6.0 billion of earnings under the provisions of the Jobs Act. Deferred taxes had previously been provided for a portion of the dividends remitted. The reversal of the deferred taxes more than offset the tax costs to repatriate the earnings and resulted in a net tax reduction of $372 million in the 2005 consolidated income tax provision. This reduction was included in the consolidated statement of earnings as an estimated benefit of $209 million in the second quarter and was subsequently revised to $168 million in the fourth quarter. Altria Group, Inc. recorded an additional $204 million tax benefit, which resulted from a favorable foreign tax law ruling that was received in the third quarter of 2005 related to the repatriation of earnings under the Jobs Act.

 

The Jobs Act also provides tax relief to U.S. domestic manufacturers by providing a tax deduction related to a percentage of the lesser of “qualified production activities income” or taxable income. The deduction, which was 3% in 2005, increases to 9% by 2010. In accordance with SFAS No. 109, Altria Group, Inc. will recognize these benefits in the year earned. The tax benefit in 2005 was approximately $60 million.

 

The tax provision in 2005 includes the $372 million benefit related to dividend repatriation under the Jobs Act in 2005, and the reversal of $82 million of tax accruals no longer required at Kraft, as well as other benefits, including the impact of the domestic manufacturers’ deduction under the Jobs Act and lower repatriation costs. The tax provision in 2004 includes the reversal of $355 million of tax accruals that are no longer required due to foreign tax events that were resolved during the first quarter of 2004 ($35 million) and the second quarter of 2004 ($320 million), and an $81 million favorable resolution of an outstanding tax item at Kraft, the majority of which occurred in the third quarter.

 

Altria Group, Inc. is regularly audited by federal, state and foreign tax authorities, and these audits are at various stages at any given time. Altria Group, Inc. anticipates several domestic and foreign audits will close in 2006 with expected favorable settlements. Any tax contingency reserves in excess of additional assessed liabilities will be reversed at the time the audits close.

 

20


Exhibit 13

 

 

·  Hedging – As discussed below in “Market Risk,” Altria Group, Inc. uses derivative financial instruments principally to reduce exposures to market risks resulting from fluctuations in foreign exchange rates and commodity prices by creating offsetting exposures. Altria Group, Inc. conforms with the requirements of U.S. GAAP in order to account for a substantial portion of its derivative financial instruments as hedges. As a result, gains and losses on these derivatives are deferred in accumulated other comprehensive earnings (losses) and recognized in the consolidated statement of earnings in the periods when the related hedged transaction is also recognized in operating results. If Altria Group, Inc. had elected not to use and comply with the hedge accounting provisions permitted under U.S. GAAP, gains (losses) deferred as of December 31, 2005, 2004 and 2003, would have been recorded in net earnings. Deferred gains (losses) from hedging activities included in other comprehensive earnings (losses), including the impact of currency hedges recorded as cumulative translation adjustments, were deferred gains of $393 million at December 31, 2005, and deferred losses of $358 million and $369 million at December 31, 2004 and 2003, respectively.

 

·  Impairment of Long-Lived Assets – Altria Group, Inc. reviews long-lived assets, including amortizable intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Altria Group, Inc. performs undiscounted operating cash flow analyses to determine if an impairment exists. These analyses are affected by interest rates, general economic conditions and projected growth rates. For purposes of recognition and measurement of an impairment for assets held for use, Altria Group, Inc. groups assets and liabilities at the lowest level for which cash flows are separately identifiable. If an impairment is determined to exist, any related impairment loss is calculated based on fair value. Impairment losses on assets to be disposed of, if any, are based on the estimated proceeds to be received, less costs of disposal.

 

·  Leasing – Approximately 95% of PMCC’s net revenues in 2005 related to leveraged leases. Income relating to leveraged leases is recorded initially as unearned income, which is included in the line item finance assets, net, on Altria Group, Inc.’s consolidated balance sheets, and is subsequently recorded as net revenues over the life of the related leases at a constant after-tax rate of return. The remainder of PMCC’s net revenues consist primarily of amounts related to direct finance leases, with income initially recorded as unearned and subsequently recognized in net revenues over the life of the leases at a constant pre-tax rate of return. As discussed further in Note 8. Finance Assets, net, PMCC leases certain aircraft and other assets that were affected by bankruptcy filings.

 

PMCC’s investment in leases is included in the line item finance assets, net, on the consolidated balance sheets as of December 31, 2005 and 2004. At December 31, 2005, PMCC’s net finance receivable of $7.2 billion in leveraged leases, which is included in the line item on Altria Group, Inc.’s consolidated balance sheet of finance assets, net, consists of rents receivables ($25.0 billion) and the residual value of assets under lease ($1.8 billion), reduced by third-party nonrecourse debt ($16.7 billion) and unearned income ($2.9 billion). The payment of the nonrecourse debt is collateralized by lease payments receivable and the leased property, and is nonrecourse to the general assets of PMCC. As required by U.S. GAAP, the third-party nonrecourse debt has been offset against the related rents receivable and has been presented on a net basis within the line item finance assets, net, in Altria Group, Inc.’s consolidated balance sheets. Finance assets, net, at December 31, 2005, also includes net finance receivables for direct finance leases of ($0.6 billion) and an allowance for losses ($0.6 billion).

 

Estimated residual values represent PMCC’s estimate at lease inception as to the fair value of assets under lease at the end of the lease term. The estimated residual values are reviewed annually by PMCC’s management based on a number of factors and activity in the relevant industry. If necessary, revisions to reduce the residual values are recorded. Such reviews resulted in no adjustments in 2005 or 2003, and a decrease of $25 million to PMCC’s net revenues and results of operations in 2004. To the extent that lease receivables due PMCC may be uncollectible, PMCC records an allowance for losses against its finance assets. During 2005 and 2004, PMCC increased this allowance by $200 million and $140 million, respectively, in consideration of the continuing downturn in the airline industry. PMCC’s aggregate finance asset balance related to aircraft was approximately $2.1 billion at December 31, 2005. It is possible that adverse developments in the airline and other industries may require PMCC to increase its allowance for losses in future periods.

 

Consolidated Operating Results

 

See pages 39 – 40 for a discussion of Cautionary Factors That May Affect Future Results.

 

(in millions)


   2005

    2004

    2003

 

Net Revenues

                        

Domestic tobacco

   $ 18,134     $ 17,511     $ 17,001  

International tobacco

     45,288       39,536       33,389  

North American food

     23,293       22,060       20,937  

International food

     10,820       10,108       9,561  

Financial services

     319       395       432  
    


 


 


Net revenues

   $ 97,854     $ 89,610     $ 81,320  
    


 


 


(in millions)


   2005

    2004

    2003

 

Operating Income

                        

Operating companies income:

                        

Domestic tobacco

   $ 4,581     $ 4,405     $ 3,889  

International tobacco

     7,825       6,566       6,286  

North American food

     3,831       3,870       4,658  

International food

     1,122       933       1,393  

Financial services

     31       144       313  

Amortization of intangibles

     (28 )     (17 )     (9 )

General corporate expenses

     (770 )     (721 )     (771 )
    


 


 


Operating income

   $ 16,592     $ 15,180     $ 15,759  
    


 


 


 

As discussed in Note 15. Segment Reporting, management reviews operating companies income, which is defined as operating income before general corporate expenses and amortization of intangibles, to evaluate segment performance and allocate resources. Management believes it is appropriate to disclose this measure to help investors analyze the business performance and trends of the various business segments.

 

The following events that occurred during 2005, 2004 and 2003 affected the comparability of statement of earnings amounts.

 

·  Domestic Tobacco Headquarters Relocation Charges – PM USA has substantially completed the move of its corporate headquarters from New York City to Richmond, Virginia, for which pre-tax charges of $4 million, $31 million and $69 million were recorded in the operating companies income of the domestic tobacco segment for the years ended December 31, 2005, 2004 and 2003, respectively. At December 31, 2005, a liability of $6 million remains on the consolidated balance sheet.

 

21


Exhibit 13

 

 

·  Domestic Tobacco Loss on U.S. Tobacco Pool As further discussed in Note 19. Contingencies, in October 2004, FETRA was signed into law. Under the provisions of FETRA, PM USA was obligated to cover its share of potential losses that the government may incur on the disposition of pool tobacco stock accumulated under the previous tobacco price support program. In 2005, PM USA recorded a $138 million expense for its share of the loss.

 

·  Domestic Tobacco Quota Buy-Out – The provisions of FETRA require PM USA, along with other manufacturers and importers of tobacco products, to make quarterly payments that will be used to compensate tobacco growers and quota holders affected by the legislation. Payments made by PM USA under FETRA will offset amounts due under the provisions of the NTGST, a trust formerly established to compensate tobacco growers and quota holders. Disputes arose as to the applicability of FETRA to 2004 NTGST payments. During the third quarter of 2005, a North Carolina Supreme Court ruling determined that FETRA enactment had not triggered the offset provisions during 2004 and that tobacco companies were required to make full payment to the NTGST for the full year of 2004. The ruling, along with FETRA billings from the USDA, established that FETRA was effective beginning in 2005. Accordingly during the third quarter of 2005, PM USA reversed a prior year accrual for FETRA payments in the amount of $115 million.

 

·  Domestic Tobacco Legal Settlement – During 2003, PM USA and certain other defendants reached an agreement with a class of U.S. tobacco growers and quota holders to resolve a lawsuit related to tobacco leaf purchases. During 2003, PM USA recorded pre-tax charges of $202 million for its obligations under the agreement. The pre-tax charges are included in the operating companies income of the domestic tobacco segment.

 

·  International Tobacco E.C. Agreement In July 2004, PMI entered into an agreement with the E.C. and 10 member states of the European Union that provides for broad cooperation with European law enforcement agencies on anti-contraband and anti-counterfeit efforts. The agreement resolves all disputes between the parties relating to these issues. Under the terms of the agreement, PMI will make 13 payments over 12 years, including an initial payment of $250 million, which was recorded as a pre-tax charge against its earnings in 2004. The agreement calls for additional payments of approximately $150 million on the first anniversary of the agreement (this payment was made in July 2005), approximately $100 million on the second anniversary and approximately $75 million each year thereafter for 10 years, each of which is to be adjusted based on certain variables, including PMI’s market share in the European Union in the year preceding payment. Because future additional payments are subject to these variables, PMI records charges for them as an expense in cost of sales when product is shipped.

 

·  Inventory Sale in Italy During the first quarter of 2005, PMI made a one-time inventory sale of 4.0 billion units to its new distributor in Italy, resulting in a $96 million pre-tax operating companies income benefit for the international tobacco segment. During the second quarter of 2005, the new distributor reduced its inventories by approximately 1.0 billion units, resulting in lower shipments for PMI. The net impact of these actions was a benefit to PMI’s pre-tax operating companies income of approximately $70 million for the year ended December 31, 2005.

 

·  Asset Impairment and Exit Costs – For the years ended December 31, 2005, 2004 and 2003, pre-tax asset impairment and exit costs consisted of the following:

 

(in millions)


        2005

   2004

   2003

Separation program

   Domestic tobacco    $ -    $ 1    $ 13

Separation program

   International tobacco*      55      31       

Separation program

   General corporate**      49      56      26

Restructuring program

   North American food      66      383       

Restructuring program

   International food      144      200       

Asset impairment

   International tobacco*      35      13       

Asset impairment

   North American food      269      8       

Asset impairment

   International food             12      6

Asset impairment

   General corporate**             10      41

Lease termination

   General corporate**             4       
         

  

  

Asset impairment and exit costs

        $ 618    $ 718    $ 86
         

  

  


*   During 2005, PMI recorded pre-tax charges of $90 million, primarily related to the write-off of obsolete equipment, severance benefits and impairment charges associated with the closure of a factory in the Czech Republic, and the streamlining of various operations. During 2004, PMI recorded pre-tax charges of $44 million for severance benefits and impairment charges related to the closure of its Eger, Hungary facility and a factory in Belgium, and the streamlining of its Benelux operations.

 

** In 2005, 2004 and 2003, Altria Group, Inc. recorded pre-tax charges of $49 million, $70 million and $26 million, respectively, primarily related to the streamlining of various corporate functions in each year, and the write-off of an investment in an e-business consumer products purchasing exchange in 2004. In addition, during 2004, Altria Group, Inc. sold its office facility in Rye Brook, New York. In connection with this sale, Altria Group, Inc. recorded a pre-tax charge in 2003 of $41 million to write down the facility and the related fixed assets to fair value.

 

·  (Gains)/Losses on Sales of Businesses, net – During 2005, operating companies income of the international food segment included pre-tax gains on sales of businesses of $109 million, primarily related to the sale of Kraft’s desserts assets in the U.K. During 2004, Kraft sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway, and recorded aggregate pre-tax losses of $3 million. During 2003, Kraft sold a European rice business and a branded fresh cheese business in Italy and recorded aggregate pre-tax gains of $31 million.

 

·  Provision for Airline Industry Exposure – As discussed in Note 8. Finance Assets, net, during 2005 PMCC increased its allowance for losses by $200 million, reflecting its exposure to the troubled airline industry, particularly Delta and Northwest, both of which filed for bankruptcy protection during September 2005. In addition, during 2004 and 2002, in recognition of the economic downturn in the airline industry, PMCC increased its allowance for losses by $140 million and $290 million, respectively.

 

22


Exhibit 13

 

 

·  Discontinued Operations – As more fully discussed in Note 4. Divestitures, in June 2005, Kraft sold substantially all of its sugar confectionery business. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings for all years presented.

 

2005 compared with 2004

 

The following discussion compares consolidated operating results for the year ended December 31, 2005, with the year ended December 31, 2004.

 

Net revenues, which include excise taxes billed to customers, increased $8.2 billion (9.2%). Excluding excise taxes, net revenues increased $5.0 billion (7.7%), due primarily to increases from both the tobacco and food businesses (including the impact of acquisitions at international tobacco and the extra week of shipments at Kraft), and favorable currency.

 

Operating income increased $1.4 billion (9.3%), due primarily to higher operating results from the tobacco businesses, the favorable impact of currency, the 2004 charge for the international tobacco E.C. agreement, lower asset impairment and exit costs in 2005, primarily related to the Kraft restructuring program, gains on sales of food businesses and the reversal of a 2004 accrual related to tobacco quota buy-out legislation. These items were partially offset by an increase in the provision for airline industry exposure at PMCC, a charge for PM USA’s portion of the losses incurred by the federal government on disposition of its pool tobacco stock and lower operating results from the food and financial services businesses.

 

Currency movements increased net revenues by $2.0 billion ($1.1 billion, after excluding the impact of currency movements on excise taxes) and operating income by $421 million. Currency related increases in net revenues and operating income were due primarily to the weakness versus prior year of the U.S. dollar against the euro, Japanese yen and Central and Eastern European currencies.

 

Altria Group, Inc.’s effective tax rate decreased by 2.5 percentage points to 29.9%. The 2005 effective tax rate includes a $372 million benefit related to dividend repatriation under the Jobs Act in 2005, the reversal of $82 million of tax accruals no longer required at Kraft, as well as other benefits, including the impact of the domestic manufacturers’ deduction under the Jobs Act and lower repatriation costs. The 2004 effective tax rate includes the reversal of $355 million of tax accruals that are no longer required due to foreign tax events that were resolved during 2004 and an $81 million favorable resolution of an outstanding tax item at Kraft.

 

Minority interest in earnings from continuing operations, and equity earnings, net, was $149 million of expense for 2005, compared with $44 million of expense for 2004. The change primarily reflected ALG’s share of SABMiller’s gains from sales of investments in 2004.

 

Earnings from continuing operations of $10.7 billion increased $1.2 billion (13.2%), due primarily to higher operating income and a lower effective tax rate, partially offset by lower equity earnings from SABMiller. Diluted and basic EPS from continuing operations of $5.10 and $5.15, respectively, increased by 11.6% and 12.0%, respectively.

 

Loss from discontinued operations, net of income taxes and minority interest, was $233 million for 2005, compared with a loss of $4 million for 2004, due primarily to the recording of a loss on sale of Kraft’s sugar confectionery business in the second quarter of 2005.

 

Net earnings of $10.4 billion increased $1.0 billion (10.8%). Diluted and basic EPS from net earnings of $4.99 and $5.04, respectively, increased by 9.4% and 9.6%, respectively.

 

2004 compared with 2003

 

The following discussion compares consolidated operating results for the year ended December 31, 2004, with the year ended December 31, 2003.

 

Net revenues, which include excise taxes billed to customers, increased $8.3 billion (10.2%). Excluding excise taxes, net revenues increased $3.8 billion (6.3%), due primarily to increases from the tobacco and North American food businesses and favorable currency.

 

Operating income decreased $579 million (3.7%), due primarily to asset impairment and exit costs, primarily related to the Kraft restructuring program, the 2004 pre-tax charges for the international tobacco E.C. agreement and the provision for airline industry exposure, and lower operating results from the food businesses. These decreases were partially offset by the favorable impact of currency, 2003 pre-tax charges for the domestic tobacco legal settlement and higher operating results from the tobacco businesses.

 

Currency movements increased net revenues by $3.3 billion ($1.9 billion, after excluding the impact of currency movements on excise taxes) and operating income by $638 million. Increases in net revenues and operating income were due primarily to the weakness versus prior year of the U.S. dollar, primarily against the euro, Japanese yen and Russian ruble.

 

Altria Group, Inc.’s effective tax rate decreased by 2.5 percentage points to 32.4%. This decrease was due primarily to the reversal of $355 million of tax accruals that are no longer required due to foreign tax events that were resolved during the year and the $81 million favorable resolution of an outstanding tax item at Kraft.

 

Minority interest in earnings from continuing operations, and equity earnings, net, was $44 million of expense for 2004, compared with $391 million of expense for 2003. The change from 2003 was due to lower 2004 net earnings at Kraft and higher equity earnings from SABMiller, which included $111 million of gains from the sales of investments.

 

Earnings from continuing operations of $9.4 billion increased $299 million (3.3%), due primarily to the favorable impact of currency, a lower effective tax rate, 2003 pre-tax charges for the domestic tobacco legal settlement, higher equity earnings from SABMiller and higher operating income from the tobacco businesses, partially offset by the 2004 pre-tax charges for asset impairment and exit costs, primarily related to the Kraft restructuring program, the international tobacco E.C. agreement and a provision for airline industry exposure, and lower operating income from the food businesses. Diluted and basic EPS from continuing operations of $4.57 and $4.60, respectively, increased by 2.0% and 2.2%, respectively.

 

(Loss) earnings from discontinued operations, net of income taxes and minority interest, was a loss of $4 million for 2004 compared to earnings of $83 million for 2003, due primarily to a pre-tax non-cash asset impairment charge of $107 million in 2004.

 

Net earnings of $9.4 billion increased $212 million (2.3%). Diluted and basic EPS from net earnings of $4.56 and $4.60, respectively, increased by 0.9% and 1.3%, respectively.

 

23


Exhibit 13

 

 

Operating Results by Business Segment

 

Tobacco

 

Business Environment

 

Taxes, Legislation, Regulation and Other Matters Regarding Tobacco and Smoking

 

The tobacco industry, both in the United States and abroad, faces a number of challenges that may continue to adversely affect the business, volume, results of operations, cash flows and financial position of PM USA, PMI and ALG. These challenges, which are discussed below and in Cautionary Factors That May Affect Future Results, include:

 

    the civil lawsuit, filed by the United States government against various cigarette manufacturers and others, including PM USA and ALG, discussed in Note 19. Contingencies (“Note 19”);

 

    a $74 billion punitive damages judgment against PM USA in the Engle smoking and health class action, which has been overturned by a Florida district court of appeal and is currently on appeal to the Florida Supreme Court;

 

    a compensatory and punitive damages judgment totaling approximately $10.1 billion against PM USA in the Price Lights/Ultra Lights class action. The Illinois Supreme Court has reversed the trial court’s judgment in favor of the plaintiffs in the Price case and remanded the case to the trial court with instructions that the case be dismissed. However, plaintiffs have filed a motion for rehearing with the Illinois Supreme Court;

 

    punitive damages verdicts against PM USA in other smoking and health cases discussed in Note 19;

 

    pending and threatened litigation and bonding requirements as discussed in Note 19;

 

    competitive disadvantages related to price increases in the United States attributable to the settlement of certain tobacco litigation;

 

    actual and proposed excise tax increases worldwide as well as changes in tax structures in foreign markets;

 

    the sale of counterfeit cigarettes by third parties;

 

    the sale of cigarettes by third parties over the Internet and by other means designed to avoid the collection of applicable taxes;

 

    price gaps and changes in price gaps between premium and lowest price brands;

 

    diversion into one market of products intended for sale in another;

 

    the outcome of proceedings and investigations, and the potential assertion of claims, relating to contraband shipments of cigarettes;

 

    governmental investigations;

 

    actual and proposed requirements regarding the use and disclosure of cigarette ingredients and other proprietary information;

 

    actual and proposed restrictions on imports in certain jurisdictions outside the United States;

 

    actual and proposed restrictions affecting tobacco manufacturing, marketing, advertising and sales;

 

    governmental and private bans and restrictions on smoking;

 

    the diminishing prevalence of smoking and increased efforts by tobacco control advocates to further restrict smoking;

 

    governmental regulations setting ignition propensity standards for cigarettes; and

 

    other actual and proposed tobacco legislation both inside and outside the United States.

 

In the ordinary course of business, PM USA and PMI are subject to many influences that can impact the timing of sales to customers, including the timing of holidays and other annual or special events, the timing of promotions, customer incentive programs and customer inventory programs, as well as the actual or speculated timing of pricing actions and tax-driven price increases.

 

·  Excise Taxes: Cigarettes are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in cigarette-related taxes or fees have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the European Union (the “EU”) and in other foreign jurisdictions. In addition, in certain jurisdictions, PMI’s products are subject to discriminatory tax structures and inconsistent rulings and interpretations on complex methodologies to determine excise and other tax burdens.

 

Tax increases are expected to continue to have an adverse impact on sales of cigarettes by PM USA and PMI, due to lower consumption levels and to a shift in consumer purchases from the premium to the non-premium or discount segments or to other low-priced or low-taxed tobacco products or to counterfeit and contraband products.

 

·  Tar and Nicotine Test Methods and Brand Descriptors: A number of governments and public health organizations throughout the world have determined that the existing standardized machine-based methods for measuring tar and nicotine yields do not provide useful information about tar and nicotine deliveries and that such results are misleading to smokers. For example, in the 2001 publication of Monograph 13, the U.S. National Cancer Institute (“NCI”) concluded that measurements based on the Federal Trade Commission (“FTC”) standardized method “do not offer smokers meaningful information on the amount of tar and nicotine they will receive from a cigarette” or “on the relative amounts of tar and nicotine exposure likely to be received from smoking different brands of cigarettes.” Thereafter, the FTC issued a press release indicating that it would be working with the NCI to determine what changes should be made to its testing method to “correct the limitations” identified in Monograph 13. In 2002, PM USA petitioned the FTC to promulgate new rules governing the use of existing standardized machine-based methodologies for measuring tar and nicotine yields and descriptors. That petition remains pending. In addition, the World Health Organization (“WHO”) has concluded that these standardized measurements are “seriously flawed” and that measurements based upon the current standardized methodology “are misleading and should not be displayed.” The International Organization for Standardization (“ISO”) has set up a working group, chaired by the WHO, to develop a new measurement method which more accurately reflects human smoking behavior. The working group is scheduled to report to ISO in mid-2006.

 

24


Exhibit 13

 

 

In light of these conclusions, governments and public health organizations have increasingly challenged the use of descriptors — such as “light,” “mild,” and “low tar” — that are based on measurements produced by the standardized test methodologies. For example, the European Commission has concluded that descriptors based on standardized tar and nicotine yield measurements “may mislead the consumer” and has prohibited the use of descriptors. Public health organizations have also urged that descriptors be banned. For example, the Scientific Advisory Committee of the WHO concluded that descriptors such as “light, ultra-light, mild and low tar” are “misleading terms” and should be banned. In 2003, the WHO proposed the Framework Convention on Tobacco Control (“FCTC”), a treaty that requires signatory nations to adopt and implement measures to ensure that descriptive terms do not create “the false impression that a particular tobacco product is less harmful than other tobacco products.” Such terms “may include ‘low tar,’ ‘light,’ ‘ultra-light,’ or ‘mild.’” For a discussion of the FCTC, see below under the heading “The WHO’s Framework Convention on Tobacco Control.” In addition, public health organizations in Canada and the United States have advocated “a complete prohibition of the use of deceptive descriptors such as ‘light’ and ‘mild.’” In July 2005, PMI’s Australian affiliates agreed to refrain from using descriptors in Australia on cigarettes, cigarette packaging and on material intended to be disseminated to the general public in Australia in relation to the marketing, advertising or sale of cigarettes.

 

See Note 19, which describes pending litigation concerning the use of brand descriptors.

 

·  Food and Drug Administration (“FDA”) Regulations: ALG and PM USA endorsed federal legislation introduced in May 2004 in the Senate and the House of Representatives, known as the Family Smoking Prevention and Tobacco Control Act, which would have granted the FDA the authority to regulate the design, manufacture and marketing of cigarettes and disclosures of related information. The legislation also would have granted the FDA the authority to combat counterfeit and contraband tobacco products and would have imposed fees to pay for the cost of regulation and other matters. The legislation was passed by the Senate, but Congress adjourned in October 2004 without enacting it. In March 2005, bipartisan legislation was reintroduced in the Senate and House of Representatives that, if enacted, would grant the FDA the authority to broadly regulate tobacco products as described above. ALG and PM USA support this legislation. Whether Congress will grant the FDA authority over tobacco products in the future cannot be predicted.

 

·  Tobacco Quota Buy-Out: In October 2004, the Fair and Equitable Tobacco Reform Act of 2004 (“FETRA”) was signed into law. FETRA provides for the elimination of the federal tobacco quota and price support program through an industry-funded buy-out of tobacco growers and quota holders. The cost of the buy-out is approximately $9.6 billion and will be paid over 10 years by manufacturers and importers of each kind of tobacco product. The cost will be allocated based on the relative market shares of manufacturers and importers of each kind of tobacco product. The quota buy-out payments will offset already scheduled payments to the National Tobacco Grower Settlement Trust (the “NTGST”), a trust fund established in 1999 by four of the major domestic tobacco product manufacturers to provide aid to tobacco growers and quota holders. Manufacturers and importers of tobacco products are also obligated to cover any losses (up to $500 million) that the government may incur on the disposition of tobacco pool stock accumulated under the previous tobacco price support program. In September and December 2005, PM USA was billed a total of $138 million for its share of tobacco pool stock losses and recorded the amount as an expense. For a discussion of the NTGST, see Note 19. Altria Group, Inc. does not currently anticipate that the quota buy-out will have a material adverse impact on its consolidated results in 2006 and beyond.

 

Following the enactment of FETRA, the trustee of the NTGST and the state entities conveying NTGST payments to tobacco growers and quota holders sued tobacco product manufacturers, alleging that the offset provisions did not apply to payments due in 2004. In December 2004, a North Carolina trial court ruled that FETRA’s enactment had triggered the offset provisions and that the tobacco product manufacturers, including PM USA, were entitled to receive a refund of amounts paid to the NTGST during the first three quarters of 2004 and were not required to make the payments that would otherwise have been due during the fourth quarter of 2004. Plaintiffs appealed, and in August 2005, the North Carolina Supreme Court reversed the trial court’s ruling and remanded the case to the lower court for additional proceedings. In October 2005, the trial court ordered that the trustee could distribute the amounts that the tobacco companies had already paid to the NTGST during the first three quarters of 2004. PM USA’s portion of these payments was approximately $174 million. The trial court also ruled that the manufacturers must make the payment originally scheduled to be made to the NTGST in December 2004, with interest. PM USA’s portion of the principal was approximately $58 million, which PM USA paid in October 2005. In November 2005, PM USA paid $2 million in interest on the December 2004 payment.

 

·  Ingredient Disclosure Laws: Jurisdictions inside and outside the United States have enacted or proposed legislation or regulations that would require cigarette manufacturers to disclose the ingredients used in the manufacture of cigarettes and, in certain cases, to provide toxicological information. In some jurisdictions, governments have prohibited the use of certain ingredients, and proposals have been discussed to further prohibit the use of ingredients. Under an EU tobacco product directive, tobacco companies are now required to disclose ingredients and toxicological information to each Member State. In implementing the EU tobacco product directive, the Netherlands has issued a decree that would require tobacco companies to disclose the ingredients used in each brand of cigarettes, including quantities used. PMI and others are challenging this decree on the grounds of a lack of appropriate protection of proprietary information. Concurrently, PMI is discussing with the relevant authorities the appropriate implementation of the EU tobacco product directive.

 

·  Health Effects of Smoking and Exposure to Environmental Tobacco Smoke (“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. Most regulation of ETS exposure to date has been done at the local level through bans in public establishments. However, the state of California is in the process of regulating ETS exposure in the ambient air at the state level. In January 2006, the California Air Resources Board (“CARB”) listed ETS as a toxic contaminant under state law. CARB is now required to consider the adoption of appropriate control measures utilizing “best available control technology” in order to reduce public exposure to ETS in outdoor air to the “lowest level achievable.”

 

It is the policy of PM USA and PMI to support a single, consistent public health message on the health effects of cigarette smoking in the development of diseases in smokers, and on smoking and addiction, and on exposure to ETS. It is also their policy to defer to the judgment of public health authorities as to the content of warnings in advertisements and on product packaging regarding the health effects of smoking, addiction and exposure to ETS.

 

PM USA and PMI each have established websites that include, among other things, the views of public health authorities on smoking, disease

 

25


Exhibit 13

 

 

causation in smokers, addiction and ETS. These sites reflect PM USA’s and PMI’s agreement with the medical and scientific consensus that cigarette smoking is addictive, and causes lung cancer, heart disease, emphysema and other serious diseases in smokers. The websites advise smokers, and those considering smoking, to rely on the messages of public health authorities in making all smoking-related decisions. The website addresses are www.philipmorrisusa.com and www.philipmorrisinternational.com. The information on PMI’s and PM USA’s websites is not, and shall not be deemed to be, a part of this document or incorporated into any filings ALG makes with the Securities and Exchange Commission.

 

·  The WHO’s Framework Convention on Tobacco Control (“FCTC”): The FCTC entered into force on February 27, 2005. As of December 31, 2005, the FCTC had been signed by 168 countries and the EU, ratified by 115 countries and confirmed by the EU. The FCTC is the first treaty to establish a global agenda for tobacco regulation. The treaty recommends (and in certain instances, requires) signatory nations to enact legislation that would, among other things, establish specific actions to prevent youth smoking; restrict and gradually eliminate tobacco product advertising and promotion; inform the public about the health consequences of smoking and the benefits of quitting; regulate the ingredients of tobacco products; impose new package warning requirements that may include the use of pictures or graphic images; adopt measures that would eliminate cigarette smuggling and counterfeit cigarettes; restrict smoking in public places; increase cigarette taxes; adopt and implement measures that ensure that descriptive terms do not create the false impression that one brand of cigarettes is safer than another; phase out duty-free tobacco sales; and encourage litigation against tobacco product manufacturers.

 

Each country that ratifies the treaty must implement legislation reflecting the treaty’s provisions and principles. While not agreeing with all of the provisions of the treaty, such as a complete ban on tobacco advertising, excessive excise tax increases and regulation through litigation, PM USA and PMI have expressed hope that the treaty will lead to the implementation of meaningful, effective and coherent regulation of tobacco products around the world.

 

·  Reduced Cigarette Ignition Propensity Legislation: Effective June 28, 2004, all cigarettes sold or offered for sale in New York are required to meet certain reduced ignition propensity standards established in regulations issued by the New York State Office of Fire Prevention and Control. California and Vermont have each enacted legislation requiring cigarettes sold in their state to meet the same reduced cigarette ignition propensity standard. The Vermont law takes effect on May 1, 2006 and the California law is effective on January 1, 2007. Reduced cigarette ignition propensity legislation is being considered in several states, at the federal level, and in jurisdictions outside the United States. Similar legislation has been passed in Canada and took effect on October 1, 2005.

 

·  Other Legislation and Legislative Initiatives: Legislative and regulatory initiatives affecting the tobacco industry have been adopted or are being considered in a number of countries and jurisdictions. In 2001, the EU adopted a directive on tobacco product regulation requiring EU Member States to implement regulations that reduce maximum permitted levels of tar, nicotine and carbon monoxide yields; require manufacturers to disclose ingredients and toxicological data; and require cigarette packs to carry health warnings covering no less than 30% of the front panel and no less than 40% of the back panel. The directive also gives Member States the option of introducing graphic warnings as of 2005; requires tar, nicotine and carbon monoxide data to cover at least 10% of the side panel; and prohibits the use of texts, names, trademarks and figurative or other signs suggesting that a particular tobacco product is less harmful than others.

 

All 25 EU Member States have implemented these regulations. The European Commission has issued guidelines for optional graphic warnings on cigarette packaging that Member States may apply as of 2005. Graphic warning requirements have also been proposed or adopted in a number of other jurisdictions. In 2003, the EU adopted a new directive prohibiting radio, press and Internet tobacco marketing and advertising, which has now been implemented in most EU Member States. Tobacco control legislation addressing the manufacture, marketing and sale of tobacco products has been proposed or adopted in numerous other jurisdictions.

 

In the United States in recent years, various members of federal and state governments have introduced legislation that would: subject cigarettes to various regulations; establish educational campaigns relating to tobacco consumption or tobacco control programs, or provide additional funding for governmental tobacco control activities; further restrict the advertising of cigarettes; require additional warnings, including graphic 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.

 

It is not possible to predict what, if any, additional governmental legislation or regulations will be adopted relating to the manufacturing, advertising, sale or use of cigarettes, or the tobacco industry generally. If, however, any of the proposals were to be implemented, the business, volume, results of operations, cash flows and financial position of PM USA, PMI and their parent, ALG, could be materially adversely affected.

 

·  Governmental Investigations: From time to time, ALG and its subsidiaries are subject to governmental investigations on a range of matters, including those discussed below.

 

•     Canada:

   ALG believes that Canadian authorities are contemplating a legal proceeding based on an investigation of ALG entities relating to allegations of contraband shipments of cigarettes into Canada in the early to mid-1990s.

•     Greece:

   In 2003, the competition authorities in Greece initiated an investigation into cigarette price increases in that market. PMI’s Greek affiliates have responded to the authorities’ request for information.

 

ALG and its subsidiaries cannot predict the outcome of these investigations or whether additional investigations may be commenced.

 

·  Cooperation Agreement between PMI and the European Commission: In July 2004, PMI entered into an agreement with the European Commission (acting on behalf of the European Community) and 10 Member States of the EU that provides for broad cooperation with European law enforcement agencies on anti-contraband and anti-counterfeit efforts. Subsequently, 8 additional Member States have signed the agreement. The agreement resolves all disputes between the European Community and the 18 Member States that signed the agreement, on the one hand, and PMI and certain affiliates, on the other hand, relating to these issues. Under the terms of the agreement, PMI will make 13 payments over 12 years. In the second quarter of 2004, PMI recorded a pre-tax charge of $250 million for the initial payment. The agreement calls for payments of approximately $150 million on the first anniversary of the

 

26


Exhibit 13

 

 

agreement (this payment was made in July 2005), approximately $100 million on the second anniversary, and approximately $75 million each year thereafter for 10 years, each of which is to be adjusted based on certain variables, including PMI’s market share in the EU in the year preceding payment. PMI will record these payments as an expense in cost of sales when product is shipped.

 

·  State Settlement Agreements: As discussed in Note 19, during 1997 and 1998, PM USA and other major domestic tobacco product manufacturers entered into agreements with states and various United States jurisdictions settling asserted and unasserted health care cost recovery and other claims. These settlements require PM USA to make substantial annual payments. The settlements also place numerous restrictions on PM USA’s business operations, including prohibitions and restrictions on the advertising and marketing of cigarettes. Among these are prohibitions of outdoor and transit brand advertising; payments for product placement; and free sampling (except in adult-only facilities). Restrictions are also placed on the use of brand name sponsorships and brand name non-tobacco products. The State Settlement Agreements also place prohibitions on targeting youth and the use of cartoon characters. In addition, the State Settlement Agreements require companies to affirm corporate principles directed at reducing 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

 

     Net Revenues

   Operating Companies Income

(in millions)        


   2005

   2004

   2003

   2005

   2004

   2003

Domestic tobacco

   $ 18,134    $ 17,511    $ 17,001    $ 4,581    $ 4,405    $ 3,889

International tobacco

     45,288      39,536      33,389      7,825      6,566      6,286
    

  

  

  

  

  

Total tobacco

   $ 63,422    $ 57,047    $ 50,390    $ 12,406    $ 10,971    $ 10,175
    

  

  

  

  

  

 

2005 compared with 2004

 

The following discussion compares tobacco operating results for 2005 with 2004.

 

·  Domestic tobacco: PM USA’s net revenues, which include excise taxes billed to customers, increased $623 million (3.6%). Excluding excise taxes, net revenues increased $658 million (4.8%), due primarily to lower wholesale promotional allowance rates ($837 million), partially offset by lower volume ($189 million).

 

Operating companies income increased $176 million (4.0%), due primarily to the previously discussed lower wholesale promotional allowance rates, net of expenses related to the quota buy-out legislation and ongoing resolution costs (aggregating $419 million), the reversal of a 2004 accrual related to tobacco quota buy-out legislation ($115 million), and lower charges for the domestic tobacco headquarters relocation ($27 million), partially offset by a charge for PM USA’s portion of the losses incurred by the federal government on disposition of its pool tobacco stock ($138 million), lower volume ($137 million) and higher marketing, administration and research costs ($133 million, due primarily to a pre-tax provision of $56 million for the Boeken individual smoking case, and an increase in research and development expenses).

 

Marketing, administration and research costs include PM USA’s cost of administering and litigating product liability claims. Litigation defense costs are influenced by a number of factors, as more fully discussed in Note 19. Principal among these factors are the number and types of cases filed, the number of cases tried annually, the results of trials and appeals, the development of the law controlling relevant legal issues, and litigation strategy and tactics. For the years ended December 31, 2005, 2004 and 2003, product liability defense costs were $258 million, $268 million and $307 million, respectively. The factors that have influenced past product liability defense costs are expected to continue to influence future costs. While PM USA does not expect that product liability defense costs will increase significantly in the future, it is possible that adverse developments among the factors discussed above could have a material adverse effect on PM USA’s operating companies income.

 

PM USA’s shipment volume was 185.5 billion units, a decrease of 0.8%, but was estimated to be essentially flat when adjusted for the timing of promotional shipments and trade inventory changes, and two less shipping days versus 2004. In the premium segment, PM USA’s shipment volume decreased 0.6%. Marlboro shipment volume increased 0.1 billion units (0.1%) to 150.5 billion units. In the discount segment, PM USA’s shipment volume decreased 3.2%, while Basic shipment volume was down 2.7% to 15.2 billion units.

 

The following table summarizes PM USA’s retail share performance, based on data from the IRI/Capstone Total Retail Panel, which was developed to measure market share in retail stores selling cigarettes, but was not designed to capture Internet or direct mail sales:

 

For the Years Ended December 31,


   2005

    2004

 

Marlboro

   40.0 %   39.5 %

Parliament

   1.7     1.7  

Virginia Slims

   2.3     2.4  

Basic

   4.3     4.2  
    

 

Focus on Four Brands

   48.3     47.8  

Other

   1.7     2.0  
    

 

Total PM USA

   50.0 %   49.8 %
    

 

 

PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $0.50 per carton, from $5.50 to $5.00, effective December 19, 2005. In addition, effective December 27, 2005, PM USA increased the price of its other brands by $2.50 per thousand cigarettes or $0.50 per carton.

 

PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $1.00 per carton, from $6.50 to $5.50, effective December 12, 2004. In addition, effective January 16, 2005, PM USA increased the price of its other brands by $5.00 per thousand cigarettes or $1.00 per carton.

 

In April 2005, PM USA announced the construction of a research and technology center in Richmond, Virginia, which is estimated to cost $350 million. When completed in 2007, the facility will nearly double PM USA’s research space and will house more than 500 scientists, engineers and support staff.

 

PM USA cannot predict future changes or rates of change in domestic tobacco industry volume, the relative sizes of the premium and discount segments or its shipment or retail market share; however, it believes that its results may be materially adversely affected by price increases related to increased excise taxes and tobacco litigation settlements, as well as by the other items discussed under the caption Tobacco – Business Environment.

 

·  International tobacco: International tobacco net revenues, which include excise taxes billed to customers, increased $5.8 billion (14.5%). Excluding excise taxes, net revenues increased $2.4 billion (13.8%), due primarily to

 

27


Exhibit 13

 

 

price increases ($1.0 billion), the impact of acquisitions ($796 million) and favorable currency ($576 million).

 

Operating companies income increased $1.3 billion (19.2%), due primarily to price increases ($1.0 billion, including the benefit from the return of the Marlboro license in Japan), favorable currency ($331 million), the 2004 charge related to the international tobacco E.C. agreement ($250 million) and the impact of acquisitions ($341 million, which includes Sampoerna equity income earned from March to May of 2005), partially offset by higher marketing, administration and research costs ($246 million, due primarily to higher marketing, and research and development expenses), unfavorable volume/mix ($198 million, reflecting favorable volume but unfavorable mix), expenses related to the international tobacco E.C. agreement ($61 million), higher fixed manufacturing costs ($63 million) and higher pre-tax charges for asset impairment and exit costs ($46 million).

 

During the third quarter of 2005, PMI refined its organizational structure to bring greater focus to the enlarged European Union and the Asia region. Accordingly, in place of Western Europe and Central Europe regions, PMI now reports results for a European Union region, which includes the original European Union countries and the Baltic States, Cyprus, Czech Republic, Hungary, Malta, Norway, Poland, Slovak Republic and Switzerland. Other regions remain essentially unchanged. The region commentary throughout PMI’s section of this Management’s Discussion and Analysis of Financial Condition and Results of Operations reflects the revised organizational structure, with prior-year results restated for comparability.

 

PMI’s cigarette volume of 804.5 billion units increased 43.1 billion units (5.7%), due primarily to acquisition volumes in Indonesia and Colombia, and higher volume in Italy as a result of the one-time inventory sale to PMI’s new distributor. Excluding the volume related to acquisitions and the one-time inventory sale to the new distributor in Italy, shipments increased 0.3%. PMI’s total tobacco volume, which includes 7.1 billion cigarette equivalent units of other tobacco products, grew 6.1% overall, and 0.8% excluding acquisitions and the one-time inventory sale to the new distributor in Italy.

 

In the European Union, PMI’s cigarette volume decreased 2.7%, due primarily to declines in Germany, Portugal, Switzerland and Spain, partially offset by the 2005 inventory sale in Italy and higher shipments in France. Excluding the inventory sale in Italy, PMI’s volume decreased 3.8% in the European Union.

 

In Germany, PMI’s cigarette volume declined 15.9% and market share was down 0.2 share points to 36.6%, reflecting tax-driven price increases in March and December 2004, which accelerated down-trading to low-priced tobacco portions that currently are subject to favorable excise tax treatment compared with cigarettes. PMI captured a 16.9% share of the German tobacco portions segment, driven by Marlboro, Next, and f6 tobacco portions. During the fourth quarter of 2005, the European Court of Justice issued a mandate that requires the German government to equalize the tax burden between cigarettes and tobacco portions. As a result of this ruling, tobacco portions in Germany will be taxed at the same rate as cigarettes for products manufactured as of April 1, 2006. Nevertheless, lower-priced tobacco portions are expected to remain available at retail for some time due to anticipated high stock levels.

 

In Spain, PMI’s shipment volume decreased 2.2%, reflecting increased consumer down-trading to the deep-discount segment. As a result of growing price gaps, PMI’s market share in Spain declined 1.1 share points to 34.5%, with a pronounced product mix deterioration. On January 21, 2006, the Spanish government raised excise taxes on cigarettes, which would have resulted in even larger price gaps if the tax increase had been passed on to consumers. Accordingly, PMI reduced its cigarette prices on January 26, 2006 to restore the competitiveness of its brands. PMI expects that the price reduction will significantly reduce its income in Spain in 2006. Late in February the Spanish government again raised the level of excise taxes, but also established a minimum excise tax, following which PMI raised its prices back to prior levels. While the introduction of a minimum excise tax effectively raises the floor price of the cheapest brands, it still permits these brands to maintain sizeable price gaps. Accordingly, PMI must await further developments before being able to make a more accurate assessment of its 2006 volume and income projections from the Spanish market.

 

In Italy, the total cigarette market declined 6.1% in 2005, largely reflecting tax-driven pricing and the impact of indoor smoking restrictions in public places. PMI’s shipment volume in Italy increased 2.7%, mainly reflecting the one-time inventory sale to its new distributor. Excluding the one-time inventory sale, cigarette shipment volume in Italy declined 3.2%. However, market share in Italy increased 1.1 share points to 52.6%, driven by Diana.

 

In France, shipment volume increased 2.5% and market share increased 1.9 share points to 41.7%, reflecting the strong performance of Marlboro and the Philip Morris brands.

 

In Eastern Europe, Middle East and Africa, volume increased 6.4%, due to gains in Egypt, Russia, North Africa, Turkey and Ukraine. Higher shipments in Ukraine and Egypt reflect improved economic conditions. In Turkey, shipment volume increased 8.6% and market share increased 4.4 points to 41.4%, fueled by the growth of Marlboro, Parliament, Lark and Bond Street.

 

In Asia, volume increased 21.3%, due primarily to the acquisition in Indonesia, the strong performance of Marlboro in the Philippines and L&M growth in Thailand, partially offset by lower volumes in Korea and Japan. Excluding the acquisition in Indonesia, volume in Asia was essentially flat.

 

In Latin America, volume increased 5.5%, due primarily to the acquisition in Colombia, and higher shipments in Mexico, partially offset by declines in Argentina and Brazil. Excluding the acquisition in Colombia, volume in Latin America declined 3.8%.

 

PMI achieved market share gains in a number of important markets, including Egypt, France, Italy, Japan, Korea, Mexico, the Netherlands, the Philippines, Russia, Thailand, Turkey, Ukraine and the United Kingdom. In addition, in Indonesia, Sampoerna’s share in 2005 was significantly higher than the prior year.

 

Volume for Marlboro cigarettes grew 2.0%, due primarily to gains in Eastern Europe, the Middle East and Africa, higher inventories in Japan following the return of the Marlboro license in May 2005, and the one-time inventory sale in Italy, partially offset by lower volumes in Germany and worldwide duty-free. Excluding the one-time gains in Italy and Japan, Marlboro cigarette volume was essentially flat. Marlboro market share increased in many important markets, including Egypt, France, Japan, Mexico, Portugal, Russia, Turkey, Ukraine and the United Kingdom.

 

As discussed in Note 5. Acquisitions, during 2005, PMI acquired 98% of the outstanding shares of Sampoerna, an Indonesian tobacco company, and a 98.2% stake in Coltabaco, the largest tobacco company in Colombia.

 

During 2004, PMI purchased a tobacco business in Finland for a cost of approximately $42 million. During 2004, PMI also increased its ownership interest in a tobacco business in Serbia from 74.2% to 85.2%.

 

PMI’s license agreement with Japan Tobacco Inc. for the manufacture and sale of Marlboro cigarettes in Japan was not renewed when the agreement expired in April 2005. PMI has undertaken the manufacture and merchandising of Marlboro and has expanded its field force and vending machine infrastructure in Japan.

 

In December 2005, the China National Tobacco Corporation (“CNTC”) and PMI reached agreement on the licensed production in China of Marlboro

 

28


Exhibit 13

 

 

and the establishment of an international joint venture between China National Tobacco Import and Export Group Corporation (“CNTIEGC”), a wholly owned subsidiary of CNTC, and PMI. PMI and CNTIEGC will each hold 50% of the shares of the joint venture company, which will be based in Lausanne, Switzerland. Following its establishment, the joint venture company will offer consumers a comprehensive portfolio of Chinese heritage brands globally, expand the export of tobacco products and tobacco materials from China, and explore other business development opportunities. It is expected that the production and sale of Marlboro cigarettes under license in China and the sale of Chinese style brands in selected international markets through the joint venture company will commence in the first half of 2006. The agreements will not result in a material impact on PMI’s financial results.

 

2004 compared with 2003

 

The following discussion compares tobacco operating results for 2004 with 2003.

 

·  Domestic tobacco: PM USA’s net revenues, which include excise taxes billed to customers, increased $510 million (3.0%). Excluding excise taxes, net revenues increased $514 million (3.9%), due primarily to savings resulting from changes to the 2004 trade programs, including PM USA’s returned goods policy and lower Wholesale Leaders program discounts.

 

Operating companies income increased $516 million (13.3%), due primarily to savings resulting from changes to trade programs in 2004, including PM USA’s returned goods policy and lower Wholesale Leaders program discounts, net of increased costs including the State Settlement Agreements (aggregating $197 million), the 2003 pre-tax charges for the domestic tobacco legal settlement ($202 million), lower marketing, administration and research costs ($67 million), lower pre-tax charges for the domestic tobacco headquarters relocation ($38 million) and lower asset impairment and exit costs ($12 million).

 

PM USA’s shipment volume was 187.1 billion units, a decrease of 0.1%. In the premium segment, PM USA’s shipment volume increased 0.1%, as gains in Marlboro were essentially offset by declines in other premium brands. Marlboro shipment volume increased 2.5 billion units (1.7%) to 150.4 billion units with gains across the brand portfolio and the introduction of Marlboro Menthol 72mm. In the discount segment, PM USA’s shipment volume decreased 1.9%, while Basic shipment volume was down 0.7% to 15.6 billion units.

 

The following table summarizes PM USA’s retail share performance, based on data from the IRI/Capstone Total Retail Panel, which was developed to measure market share in retail stores selling cigarettes, but was not designed to capture Internet or direct mail sales:

 

For the Years Ended December 31,


   2004

    2003

 

Marlboro

   39.5 %   38.0 %

Parliament

   1.7     1.7  

Virginia Slims

   2.4     2.4  

Basic

   4.2     4.2  
    

 

Focus on Four Brands

   47.8     46.3  

Other

   2.0     2.4  
    

 

Total PM USA

   49.8 %   48.7 %
    

 

 

·  International tobacco: International tobacco net revenues, which include excise taxes billed to customers, increased $6.1 billion (18.4%). Excluding excise taxes, net revenues increased $1.6 billion (10.2%), due primarily to favorable currency ($1.0 billion), price increases ($538 million) and the impact of acquisitions ($285 million), partially offset by lower volume/mix ($300 million), reflecting lower volume in France, Germany and Italy.

 

Operating companies income increased $280 million (4.5%), due primarily to favorable currency ($540 million), price increases ($538 million) and the impact of acquisitions ($71 million), partially offset by higher marketing, administration and research costs ($373 million), the 2004 pre-tax charges for the international tobacco E.C. agreement ($250 million), unfavorable volume/mix ($201 million), reflecting lower volume in the higher-margin markets of France, Germany and Italy, and asset impairment and exit costs for the closures of facilities in Hungary and Belgium, as well as the streamlining of PMI’s Benelux operations ($44 million).

 

PMI’s cigarette volume of 761.4 billion units increased 25.6 billion units (3.5%), due primarily to incremental volume from acquisitions made during 2003. Excluding acquisition volume, shipments increased 9.1 billion units (1.2%).

 

In the European Union, PMI’s cigarette volume declined 4.8%, due primarily to decreases in France, Germany and Italy, partially offset by higher volume in Poland and an acquisition in Greece. Shipment volume decreased 19.5% in France, due to tax-driven price increases since January 1, 2003, that continued to drive an overall market decline. PMI’s market share in France increased 0.7 share points to 39.9%. In Italy, volume decreased 6.4% and market share fell 2.6 share points to 51.5%, as PMI’s brands were adversely impacted by low-price competitive brands and a lower total market. In Germany, volume declined, reflecting a lower total cigarette market due mainly to tax-driven price increases and the resultant consumer shifts to low-price tobacco products, particularly tobacco portions which benefit from lower excise taxes than cigarettes. PMI entered the tobacco portions market during the second quarter of 2004 with the Marlboro and Next brands.

 

In Eastern Europe, Middle East and Africa, volume increased due to gains in Kazakhstan, Romania, Russia, Saudi Arabia, Turkey and Ukraine, and an acquisition in Serbia. In worldwide duty-free, volume increased, reflecting the global recovery in travel and a favorable comparison to the prior year, which was depressed by the effects of SARS and the Iraq war.

 

In Asia, volume grew, due primarily to increases in Korea, Malaysia, Thailand and the Philippines. In Japan, PMI’s volume was up slightly, while the total market was down due to the adverse impact of the July 2003 tax-driven retail price increase and a lower incidence of smoking.

 

In Latin America, volume decreased, driven mainly by declines in Argentina, partially offset by an increase in Mexico.

 

PMI achieved market share gains in a number of important markets, including Austria, Belgium, Egypt, France, Greece, Japan, Mexico, the Netherlands, Poland, Russia, Saudi Arabia, Spain, Turkey and Ukraine.

 

Volume for Marlboro declined 1.3%, as lower volume in the European Union, mainly France and Germany, was partially offset by gains in Eastern Europe, Middle East and Africa, and Asia. Marlboro market share increased in many important markets, including Argentina, Belgium, Japan, Mexico, Poland, Portugal, Russia, Spain, Turkey, Ukraine and the United Kingdom.

 

During 2004, PMI purchased a tobacco business in Finland for a cost of approximately $42 million. During 2003, PMI purchased approximately 74.2% of a tobacco business in Serbia for a cost of approximately $486 million, and in 2004, PMI increased its ownership interest to 85.2%. During 2003, PMI also purchased 99% of a tobacco business in Greece for approximately $387 million and increased its ownership interest in its affiliate in Ecuador from less than 50% to approximately 98% for a cost of $70 million.

 

29


Exhibit 13

 

 

Food

 

Business Environment

 

Kraft manufactures and markets packaged food products, consisting principally of beverages, cheese, snacks, convenient meals and various packaged grocery products. Kraft manages and reports operating results through two units, Kraft North America Commercial (“KNAC”) and Kraft International Commercial (“KIC”). KNAC represents the North American food segment (United States and Canada) and KIC represents the international food segment.

 

KNAC and KIC are subject to a number of challenges that may adversely affect their businesses. These challenges, which are discussed below and in the Cautionary Factors That May Affect Future Results section include:

 

    fluctuations in commodity prices;

 

    movements of foreign currencies;

 

    competitive challenges in various products and markets, including price gaps with competitor products and the increasing price-consciousness of consumers;

 

    a rising cost environment and the limited ability to increase prices;

 

    a trend toward increasing consolidation in the retail trade and consequent pricing pressure and inventory reductions;

 

    a growing presence of discount retailers, primarily in Europe, with an emphasis on private label products;

 

    changing consumer preferences, including diet trends;

 

    competitors with different profit objectives and less susceptibility to currency exchange rates; and

 

    concerns and/or regulations regarding food safety, quality and health, including genetically modified organisms, trans-fatty acids and obesity. Increased government regulation of the food industry could result in increased costs to Kraft.

 

Fluctuations in commodity costs can lead to retail price volatility and intense price competition, and can influence consumer and trade buying patterns. During 2005, Kraft’s commodity costs on average have been higher than those incurred in 2004 (most notably coffee, nuts, energy and packaging), and have adversely affected earnings. For 2005, Kraft had a negative pre-tax earnings impact from all commodities of approximately $800 million as compared with 2004, following an increase of approximately $900 million for 2004 compared with 2003.

 

In the ordinary course of business, Kraft is subject to many influences that can impact the timing of sales to customers, including the timing of holidays and other annual or special events, seasonality of certain products, significant weather conditions, timing of Kraft or customer incentive programs and pricing actions, customer inventory programs, Kraft’s initiatives to improve supply chain efficiency, including efforts to align product shipments more closely with consumption by shifting some of its customer marketing programs to a consumption based approach, the financial condition of customers and general economic conditions. Kraft’s operating subsidiaries generally report year-end results as of the Saturday closest to the end of each year. This resulted in fifty-three weeks of operating results for Kraft in the consolidated statement of earnings for the year ended December 31, 2005, versus fifty-two weeks for the years ended December 31, 2004 and 2003.

 

In January 2004, Kraft announced a three-year restructuring program with the objectives of leveraging Kraft’s global scale, realigning and lowering its cost structure, and optimizing capacity utilization. As part of this program (which is discussed further in Note 3. Asset Impairment and Exit Costs), Kraft anticipated the closure or sale of up to 20 plants and the elimination of approximately 6,000 positions. From 2004 through 2006, Kraft expects to incur approximately $1.2 billion in pre-tax charges, reflecting asset disposals, severance and other implementation costs, including $297 million and $641 million incurred in 2005 and 2004, respectively. Total pre-tax charges for the program incurred through December 31, 2005 were $938 million. Approximately 60% of the pre-tax charges are expected to require cash payments.

 

In addition, Kraft expects to incur approximately $170 million in capital expenditures from 2004 through 2006 to implement the restructuring program. From January 2004 through December 31, 2005, Kraft spent $144 million, including $98 million spent in 2005, in capital to implement the restructuring program. Cost savings as a result of the restructuring program were approximately $131 million in 2005 and $127 million in 2004, and were anticipated to reach cumulative annualized cost savings of approximately $450 million by 2006, all of which were expected to be used to support brand-building initiatives.

 

In January 2006, Kraft announced plans to expand its restructuring efforts beyond those originally contemplated. Additional pre-tax charges are anticipated to be $2.5 billion from 2006 to 2009, of which approximately $1.6 billion are expected to require cash payments. These charges will result in the anticipated closure of up to 20 additional facilities and the elimination of approximately 8,000 additional positions. Initiatives under the expanded program include additional organizational streamlining and facility closures. The expanded initiatives are expected to add approximately $700 million in annualized cost savings by 2009. Capitalized expenditures required for the expanded restructuring program will be included within Kraft’s overall capital spending budget, which is expected to remain flat in 2006 versus 2005 at $1.2 billion. The entire restructuring program is expected to ultimately result in $3.7 billion in pre-tax charges, the closure of up to 40 facilities, the elimination of approximately 14,000 positions and cumulative annualized cost savings at the completion of the program of approximately $1.15 billion. Approximately $2.3 billion of the $3.7 billion in pre-tax charges are expected to require cash payments.

 

One element of Kraft’s growth strategy is to strengthen its brand portfolio through a disciplined program of selective acquisitions and divestitures. Kraft is constantly reviewing potential acquisition candidates and from time to time sells businesses that are outside its core categories or that do not meet its growth or profitability targets. The impact of any future acquisition or divestiture could have a material impact on Altria Group, Inc.’s consolidated financial position, results of operations or cash flows, and future sales of businesses could in some cases result in losses on sale.

 

As previously discussed, Kraft sold substantially all of its sugar confectionery business in June 2005, for pre-tax proceeds of approximately $1.4 billion. The sale included the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings for all years presented. The assets related to the sugar confectionery business were reflected as assets of discontinued operations held for sale on the consolidated balance sheet at December 31, 2004. Kraft recorded a net loss on sale of discontinued operations of $297 million in the second quarter of 2005, related largely to

 

30


Exhibit 13

 

 

taxes on the transaction. ALG’s share of the loss, net of minority interest, was $255 million.

 

During 2005, Kraft sold its fruit snacks assets and incurred a pre-tax asset impairment charge of $93 million in recognition of this sale. Additionally, during 2005, Kraft sold its U.K. desserts assets and its U.S. yogurt brand. The aggregate proceeds received from the sales of other businesses during 2005 were $238 million, on which pre-tax gains of $108 million were recorded. In December 2005, Kraft announced the sales of certain Canadian assets and a small U.S. biscuit brand and incurred pre-tax asset impairment charges of $176 million in recognition of these sales. These transactions closed in the first quarter of 2006.

 

During 2004, Kraft sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway. The aggregate proceeds received from the sales of these businesses were $18 million, on which pre-tax losses of $3 million were recorded.

 

During 2004, Kraft acquired a U.S.-based beverage business for a total cost of $137 million. During 2003, Kraft acquired trademarks associated with a small U.S.-based natural foods business and also acquired a biscuits business in Egypt. The total cost of these and other smaller businesses purchased by Kraft during 2003 was $98 million.

 

During 2003, Kraft sold a European rice business and a branded fresh cheese business in Italy. The aggregate proceeds received from the sales of businesses in 2003 were $96 million, on which pre-tax gains of $31 million were recorded.

 

The operating results of businesses acquired and sold, excluding Kraft’s sugar confectionery business, in the aggregate, were not material to Altria Group, Inc.’s consolidated financial position, results of operations or cash flows in any of the years presented.

 

Operating Results

 

     Net Revenues

   Operating Companies
Income


(in millions)


   2005

   2004

   2003

   2005

   2004

   2003

North American food

   $ 23,293    $ 22,060    $ 20,937    $ 3,831    $ 3,870    $ 4,658

International food

     10,820      10,108      9,561      1,122      933      1,393
    

  

  

  

  

  

Total food

   $ 34,113    $ 32,168    $ 30,498    $ 4,953    $ 4,803    $ 6,051
    

  

  

  

  

  

 

2005 compared with 2004

 

The following discussion compares food operating results for 2005 with 2004.

 

·  North American food: North American food included 53 weeks of operating results in 2005 compared with 52 weeks in 2004. Kraft estimates that this extra week positively impacted net revenues and operating companies income in 2005 by approximately $435 million and $80 million, respectively.

 

Net revenues increased $1.2 billion (5.6%), due primarily to higher volume/mix ($873 million, including the benefit of the 53rd week), higher net pricing ($239 million, primarily reflecting commodity-driven price increases on coffee, nuts, cheese and meats, partially offset by increased promotional spending), favorable currency ($172 million) and the impact of acquisitions ($41 million), partially offset by the impact of divestitures ($97 million).

 

Operating companies income decreased $39 million (1.0%), due primarily to higher marketing, administration and research costs ($367 million, including higher benefit and marketing costs, as well as costs associated with the 53rd week), higher fixed manufacturing costs ($94 million), the net impact of higher implementation costs associated with the restructuring program ($15 million), the impact of divestitures ($9 million) and unfavorable costs, net of higher pricing ($3 million, including higher commodity costs and increased promotional spending), partially offset by favorable volume/mix ($364 million, including the benefit of the 53rd week), lower pre-tax charges for asset impairment and exit costs ($56 million) and favorable currency ($31 million).

 

Volume increased 2.0%, including the benefit of 53 weeks in 2005 results. Excluding acquisitions and divestitures, and the 53rd week of shipments, volume was essentially flat. In U.S. Beverages, volume increased, driven primarily by an acquisition in 2004, partially offset by volume declines in coffee due to the impact of commodity-driven price increases on category consumption. In U.S. Snacks & Cereals, volume increased, due primarily to higher biscuit shipments, and new product introductions and expanded distribution in cereals, partially offset by lower snack nut shipments, due to commodity-driven price increases and increased competitive activity. Volume increased in U.S. Convenient Meals, due primarily to new product introductions and higher shipments of cold cuts, and higher shipments of pizza and meals due primarily to the impact of the 53rd week. In U.S. Grocery, volume increased due primarily to the 53rd week of shipments. In U.S. Cheese, Canada & North America Foodservice, volume decreased, due primarily to the impact of divestitures and lower volume in Canada.

 

·  International food: International food included 53 weeks of operating results in 2005 compared with 52 weeks in 2004. Kraft estimates that this extra week positively impacted net revenues and operating companies income in 2005 by approximately $190 million and $20 million, respectively.

 

Net revenues increased $712 million (7.0%), due primarily to favorable currency ($361 million), higher pricing ($214 million, including higher commodity-driven pricing) and favorable volume/mix ($213 million, including the benefit of the 53rd week), partially offset by the impact of divestitures ($77 million). Net revenues were up in developing markets, driven by significant growth in Russia, Ukraine and the Middle East. In addition, net revenues increased in several Western European markets, partially offset by a decline in volume, particularly in Germany.

 

Operating companies income increased $189 million (20.3%), due primarily to favorable volume/mix ($115 million, including the benefit of the 53rd week), net gains on the sale of businesses ($112 million), lower pre-tax charges for asset impairment and exit costs ($68 million), favorable currency ($59 million) and a 2004 equity investment impairment charge related to a joint venture in Turkey ($47 million), partially offset by unfavorable costs and increased promotional spending, net of higher pricing ($99 million, including higher commodity costs), higher marketing, administration and research costs ($53 million, including higher marketing and benefit costs, and costs associated with the 53rd week, partially offset by a $16 million recovery of receivables previously written off), the impact of divestitures ($24 million), the net impact of higher implementation costs associated with the Kraft restructuring program ($22 million) and higher fixed manufacturing costs ($16 million).

 

Volume decreased 1.2%, including the benefit of 53 weeks in 2005 results. Excluding the 53rd week of shipments in 2005 and the impact of divestitures, volume decreased approximately 2%, due primarily to higher commodity-driven pricing.

 

In Europe, Middle East & Africa, volume decreased, due primarily to lower volume in Germany and the divestiture of the U.K. desserts assets in the first quarter of 2005, partially offset by growth in developing markets, including

 

31


Exhibit 13

 

 

Russia, Ukraine and the Middle East. In grocery, volume declined, due to the divestiture of the U.K. desserts assets in the first quarter of 2005 and lower results in Egypt and Germany. Beverages volume decreased, driven by lower coffee shipments in Germany, due to commodity-driven price increases, partially offset by higher shipments of refreshment beverages in the Middle East and higher shipments of coffee in Russia and Ukraine. Convenient meals volume declined, due primarily to lower category performance in the U.K. and lower promotions in Germany. Cheese volume increased due to higher shipments in the U.K., Italy and the Middle East. In snacks, volume increased, as gains in confectionery, benefiting from growth in Russia and Ukraine, were partially offset by lower biscuits volume in Egypt.

 

Volume decreased in Latin America & Asia Pacific, due primarily to lower shipments in China, partially offset by growth in Southeast Asia. Grocery volume declined, due primarily to lower shipments in Brazil and Central America. Snacks volume also declined, impacted by increased biscuit competition in China and resizing of biscuit products in Latin America, partially offset by higher shipments in Venezuela. In beverages, volume increased, due primarily to refreshment beverage gains in the Philippines, Argentina and Puerto Rico.

 

2004 compared with 2003

 

The following discussion compares food operating results for 2004 with 2003.

 

·  North American food: Net revenues increased $1.1 billion (5.4%), due primarily to higher volume/mix ($537 million), higher net pricing ($312 million, reflecting commodity-driven price increases, partially offset by increased promotional spending), favorable currency ($164 million) and the impact of acquisitions ($117 million). Higher net revenues were driven by cheese, meats and nuts due to higher volume in response to consumer nutrition trends and higher commodity-driven pricing net of increased promotional spending.

 

Operating companies income decreased $788 million (16.9%), due primarily to the 2004 pre-tax charges for asset impairment and exit costs ($391 million), cost increases, net of higher pricing ($356 million, including higher commodity costs and increased promotional spending), higher marketing, administration and research costs ($214 million, including higher benefit costs), and the 2004 implementation costs associated with the Kraft restructuring program ($40 million), partially offset by higher volume/mix ($197 million) and favorable currency ($29 million).

 

Volume increased 4.3%, of which 2.6% was due to acquisitions. In U.S. Beverages, volume increased, driven primarily by an acquisition in beverages, growth in coffee and new product introductions. Volume gains were achieved in U.S. Cheese, Canada & North America Foodservice, due primarily to promotional reinvestment spending in cheese and higher volume in Foodservice, due to the impact of an acquisition and higher shipments to national accounts. In U.S. Convenient Meals, volume increased, due primarily to higher cold cuts shipments and new product introductions in pizza, partially offset by lower shipments of meals. In U.S. Grocery, volume increased, due primarily to growth in enhancers, partially offset by declines in desserts. In U.S. Snacks & Cereals, volume increased, due primarily to higher snack nuts and biscuits shipments, partially offset by lower cereals volumes.

 

·  International food: Net revenues increased $547 million (5.7%), due primarily to favorable currency ($674 million), favorable volume/mix ($23 million) and the impact of acquisitions ($23 million), partially offset by the impact of divestitures ($126 million) and increased promotional spending, net of higher pricing ($47 million). Lower pricing and higher promotional spending on coffee in Europe and lower shipments of refreshment beverages in Mexico negatively impacted net revenues.

 

Operating companies income decreased $460 million (33.0%), due primarily to the pre-tax charges for asset impairment and exit costs ($206 million), cost increases and increased promotional spending, net of higher pricing ($113 million), higher marketing, administration and research costs ($92 million, including higher benefit costs and infrastructure investment in developing markets), an investment impairment charge relating to a joint venture in Turkey ($47 million), the 2004 loss and 2003 gain on sales of businesses (aggregating $34 million) and the impact of divestitures, partially offset by favorable currency ($69 million).

 

Volume decreased 1.1%, due primarily to the impact of the divestitures of a rice business and a branded fresh cheese business in Europe in 2003, as well as price competition and trade inventory reductions in several markets, partially offset by the impact of acquisitions.

 

In Europe, Middle East and Africa, volume decreased, impacted by divestitures, price competition in France and trade inventory reductions in Russia, partially offset by growth in Germany, Austria, Italy and Romania, and the impact of acquisitions. Beverages volume declined, impacted by price competition in coffee in France and lower shipments of refreshment beverages in the Middle East. In cheese, volume decreased, due primarily to the divestiture of a branded fresh cheese business in Italy, partially offset by higher shipments of cream cheese in Germany, Italy and the United Kingdom, and higher process cheese shipments in the United Kingdom. In convenient meals, volume declined, due primarily to the divestiture of a European rice business. In grocery, volume declined across several markets, including Germany and Italy, partially offset by an acquisition in Egypt. Snacks volume increased, benefiting from acquisitions and new product introductions across the region, partially offset by trade inventory reductions in Russia.

 

Volume decreased in Latin America & Asia Pacific, due primarily to declines in Mexico, Peru, and Venezuela, partially offset by gains in Brazil and China. Snacks volume decreased, impacted by price competition and trade inventory reductions in Peru and Venezuela. In grocery, volume decreased across several markets, including Peru, Australia and the Philippines. In beverages, volume increased, impacted by gains in Brazil and China, partially offset by price competition in Mexico. Cheese volume increased, with gains across several markets, including Japan, Australia and the Philippines.

 

Financial Services

 

Business Environment

 

In 2003, PMCC shifted its strategic focus and is no longer making new investments but is instead focused on managing its existing portfolio of finance assets in order to maximize gains and generate cash flow from asset sales and related activities. Accordingly, PMCC’s operating companies income will fluctuate over time as investments mature or are sold. During 2005, 2004 and 2003, PMCC received proceeds from asset sales and maturities of $476 million, $644 million and $507 million, respectively, and recorded gains of $72 million, $112 million and $45 million respectively, in operating companies income.

 

Among its leasing activities, PMCC leases a number of aircraft, predominantly to major United States passenger carriers. At December 31, 2005, $2.1 billion of PMCC’s finance asset balance related to aircraft. Two of PMCC’s aircraft lessees, Delta Air Lines, Inc. (“Delta”) and Northwest Airlines, Inc. (“Northwest”) are currently under bankruptcy protection and a third lessee, United

 

32


Exhibit 13

 

 

Air Lines, Inc. (“United”) exited bankruptcy on February 1, 2006. In addition, PMCC leases various natural gas-fired power plants to indirect subsidiaries of Calpine Corporation (“Calpine”), also currently under bankruptcy protection. PMCC is not recording income on any of these leases.

 

PMCC leases 24 Boeing 757 aircraft to United with an aggregate finance asset balance of $541 million at December 31, 2005. PMCC has entered into an agreement with United to amend 18 direct finance leases and United has assumed the 18 amended leases. There is no third-party debt associated with these leases. United remains current on lease payments due to PMCC on these 18 amended leases. PMCC continues to monitor the situation at United with respect to the six remaining aircraft financed under leveraged leases, in which PMCC has an aggregate finance asset balance of $92 million. United and the public debtholders have a court approved agreement that calls for the public debtholders to foreclose on PMCC’s interests in these six aircraft and transfer them to United. The foreclosure, expected to occur in 2006, subsequent to United’s emergence from bankruptcy, would result in the write-off of the $92 million finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments in the amount of approximately $55 million on these leases.

 

In addition, PMCC has an aggregate finance asset balance of $257 million at December 31, 2005, relating to six Boeing 757, nine Boeing 767 and four McDonnell Douglas (MD-88) aircraft leased to Delta under leveraged leases. In November 2004, PMCC, along with other aircraft lessors, entered into restructuring agreements with Delta on all 19 aircraft. As a result of its agreement, PMCC recorded a charge to the allowance for losses of $40 million in the fourth quarter of 2004. As a result of Delta’s bankruptcy filing in September 2005, the restructuring agreement is no longer in effect and PMCC is at risk of having its interest in these aircraft foreclosed upon by the senior lenders under the leveraged leases. Should a foreclosure occur, it would also result in the write-off of the finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments on these leases, and may require further provisions to increase the allowance for losses.

 

PMCC also leases three Airbus A-320 aircraft and five British Aerospace RJ85 aircraft to Northwest financed under leveraged leases with an aggregate finance asset balance of $62 million at December 31, 2005. Northwest filed for bankruptcy protection in September 2005. As a result of Northwest’s bankruptcy filing, PMCC is at risk of having its interest in these aircraft foreclosed upon by the senior lenders under the leveraged leases. Should a foreclosure occur, it would also result in the write-off of the finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments on these leases.

 

In addition, PMCC’s leveraged leases for ten Airbus A-319 aircraft with Northwest have been rejected in the bankruptcy. As a result of the lease rejection, PMCC, as owner of the aircraft, recorded these assets on its consolidated balance sheet at the lower of net book value or fair market value. The adjustment to fair market value resulted in a $100 million charge against the allowance for losses in the fourth quarter of 2005. The assets are classified as held for sale and reflected in Financial Services other assets on the consolidated balance sheet until such time as the assets are either sold or foreclosed upon by the lenders. In addition, the related nonrecourse debt is reflected in Financial Services other liabilities on the consolidated balance sheet until such time as the underlying assets are either sold or foreclosed upon by the senior lenders. Should a foreclosure occur, it would result in the acceleration of tax payments on these aircraft of approximately $57 million.

 

In addition, PMCC leases 16 Airbus A-319 aircraft to US Airways, Inc. (“US Airways”) financed under leveraged leases with an aggregate finance asset balance of $150 million at December 31, 2005. In September 2005, US Airways emerged from bankruptcy protection and assumed the leases on PMCC’s aircraft without any changes. Also in September 2005, US Airways and America West Holdings Corp. (“America West”) completed a merger. PMCC leases five Airbus A-320 aircraft and three engines to America West with an aggregate finance asset balance of $44 million at December 31, 2005.

 

PMCC also leases two 265 megawatt (“MW”) natural gas-fired power plants (located in Tiverton, Rhode Island, and Rumford, Maine) and one 750 MW natural gas-fired power plant (located in Pasadena, Texas) to indirect subsidiaries of Calpine financed under leveraged leases with an aggregate finance asset balance of $206 million at December 31, 2005. On December 20, 2005, Calpine filed for bankruptcy protection. In the initial bankruptcy filing, PMCC’s lessees of the Tiverton and Rumford projects were included. On February 6, 2006, these leases were rejected. The Pasadena lessee did not file for bankruptcy but could file at a future date. Should a foreclosure on any of these projects occur, it would result in the write-off of the finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments on these leases, and may require further provisions to increase the allowance for losses.

 

Due to continuing uncertainty within its airline portfolio and bankruptcy filings by Delta and Northwest, PMCC recorded a provision for losses of $200 million in September 2005. As a result of this provision, PMCC’s fixed charges coverage ratio did not meet its 1.25:1 requirement under a support agreement with ALG. Accordingly, as required by the support agreement, a support payment of $150 million was made by ALG to PMCC in September 2005.

 

Previously, PMCC recorded provisions for losses of $140 million in the fourth quarter of 2004 and $290 million in the fourth quarter of 2002 for its airline industry exposure. At December 31, 2005, PMCC’s allowance for losses, which includes the provisions recorded by PMCC for its airline industry exposure, was $596 million. It is possible that adverse developments in the airline or other industries may require PMCC to increase its allowance for losses.

 

Operating Results

 

     Net Revenues

   Operating
Companies Income


(in millions)


   2005

   2004

   2003

   2005

   2004

   2003

Financial Services

   $ 319    $ 395    $ 432    $ 31    $ 144    $ 313
    

  

  

  

  

  

 

PMCC’s net revenues for 2005 decreased $76 million (19.2%) from 2004, due primarily to the previously discussed change in strategy which resulted in lower lease portfolio revenues and lower gains from asset management activity. PMCC’s operating companies income for 2005 decreased $113 million (78.5%) from 2004. Operating companies income for 2005 includes a $200 million increase to the provision for airline industry exposure as discussed above, an increase of $60 million over the prior year’s provision, and lower gains from asset sales, partially offset by lower interest expense.

 

PMCC’s net revenues for 2004 decreased $37 million (8.6%) from 2003, due primarily to the previously discussed change in strategy which resulted in lower lease portfolio revenues, partially offset by an increase of $66 million from gains on asset sales. PMCC’s operating companies income for 2004 decreased $169 million (54.0%) from 2003, due primarily to the 2004 provision for airline industry exposure discussed above, and the decrease in net revenues.

 

33


Exhibit 13

 

 

Financial Review

 

·  Net Cash Provided by Operating Activities: During 2005, net cash provided by operating activities was $11.1 billion, compared with $10.9 billion during 2004. The increase in cash provided by operating activities was due primarily to higher earnings from continuing operations and lower escrow bond deposits related to the Price domestic tobacco case, partially offset by a higher use of cash to fund working capital and increased pension plan contributions.

 

During 2004, net cash provided by operating activities was $10.9 billion, compared with $10.8 billion during 2003. The increase of $74 million was due primarily to higher net earnings in 2004, partially offset by higher escrow deposits for the Price domestic tobacco case and lower cash from the financial services business.

 

·  Net Cash Used in Investing Activities: One element of the growth strategy of ALG’s subsidiaries is to strengthen their brand portfolios through active programs of selective acquisitions and divestitures. These subsidiaries are constantly investigating potential acquisition candidates and from time to time Kraft sells businesses that are outside its core categories or that do not meet its growth or profitability targets. The impact of future acquisitions or divestitures could have a material impact on Altria Group, Inc.’s consolidated cash flows, and future sales of businesses could in some cases result in losses on sale.

 

During 2005, 2004 and 2003, net cash used in investing activities was $4.9 billion, $1.4 billion and $2.4 billion, respectively. The increase in 2005 primarily reflects the purchase of 98% of the outstanding shares of Sampoerna in 2005, partially offset by proceeds from the sales of businesses (primarily Kraft’s sugar confectionery business) in 2005. The decrease in 2004 primarily reflects lower amounts used for the purchase of businesses. The discontinuation of finance asset investments, as well as the increased proceeds from finance asset sales also contributed to a lower level of cash used in investing activities.

 

Capital expenditures for 2005 increased 15.3% to $2.2 billion. Approximately 44% related to tobacco operations and approximately 53% related to food operations; the expenditures were primarily for modernization and consolidation of manufacturing facilities, and expansion of certain production capacity. In 2006, capital expenditures are expected to be approximately 20% above 2005 expenditures and are expected to be funded by operating cash flows.

 

·  Net Cash Used in Financing Activities: During 2005, net cash used in financing activities was $5.1 billion, compared with $8.0 billion in 2004 and $5.5 billion in 2003. The decrease of $2.9 billion from 2004 was due primarily to increased borrowings in 2005, which were primarily related to the acquisition of Sampoerna, partially offset by higher dividends paid on Altria Group, Inc. common stock and an increase in share repurchases at Kraft. The increase of $2.5 billion over 2003 was due primarily to the repayment of debt in 2004, as compared with 2003 when ALG and Kraft borrowed against their revolving credit facilities, while their access to commercial paper markets was temporarily eliminated following a $10.1 billion judgment against PM USA.

 

·  Debt and Liquidity:

 

Credit Ratings: Following a $10.1 billion judgment on March 21, 2003, against PM USA in the Price litigation, which is discussed in Note 19, the three major credit rating agencies took a series of ratings actions resulting in the lowering of ALG’s short-term and long-term debt ratings. During 2003, Moody’s lowered ALG’s short-term debt rating from “P-1” to “P-3” and its long-term debt rating from “A2” to “Baa2.” Standard & Poor’s lowered ALG’s short-term debt rating from “A-1” to “A-2” and its long-term debt rating from “A-” to “BBB.” Fitch Rating Services lowered ALG’s short-term debt rating from “F-1” to “F-2” and its long-term debt rating from “A” to “BBB.”

 

While Kraft is not a party to, and has no exposure to, this litigation, its credit ratings were also lowered, but to a lesser degree. As a result of the rating agencies’ actions, borrowing costs for ALG and Kraft have increased. None of ALG’s or Kraft’s debt agreements require accelerated repayment as a result of a decrease in credit ratings. The credit rating downgrades by Moody’s, Standard & Poor’s, and Fitch Rating Services had no impact on any of ALG’s or Kraft’s other existing third-party contracts.

 

Credit Lines: ALG and Kraft each maintain separate revolving credit facilities that they have historically used to support the issuance of commercial paper. However, as a result of the rating agencies’ actions discussed above, ALG’s and Kraft’s access to the commercial paper market was temporarily eliminated in 2003. Subsequently, in April 2003, ALG and Kraft began to borrow against existing credit facilities to repay maturing commercial paper and to fund normal working capital needs. By the end of May 2003, Kraft regained its access to the commercial paper market. ALG’s access to the commercial paper market has improved since it regained limited access in November 2003, but not to the levels achieved prior to the ratings downgrades.

 

As discussed in Note 5. Acquisitions, the purchase price of the Sampoerna acquisition was primarily financed through a euro 4.5 billion bank credit facility arranged for PMI and its subsidiaries in May 2005, consisting of a euro 2.5 billion three-year term loan facility and a euro 2.0 billion five-year revolving credit facility. These facilities, which are not guaranteed by ALG, require PMI to maintain an earnings before interest, taxes, depreciation and amortization (“EBITDA”) to interest ratio of not less than 3.5 to 1.0. At December 31, 2005, PMI exceeded this ratio by a significant amount and is expected to continue to exceed it.

 

In April 2005, ALG negotiated a 364-day revolving credit facility in the amount of $1.0 billion and a new multi-year credit facility in the amount of $4.0 billion, which expires in April 2010. In addition, ALG terminated its existing $5.0 billion multi-year credit facility, which was due to expire in July 2006. The new ALG facilities require the maintenance of an earnings to fixed charges ratio, as defined by the agreements, of 2.5 to 1.0. At December 31, 2005, the ratio calculated in accordance with the agreements was 10.0 to 1.0.

 

In April 2005, Kraft negotiated a new multi-year revolving credit facility to replace both its $2.5 billion 364-day facility that was due to expire in July 2005 and its $2.0 billion multi-year facility that was due to expire in July 2006. The new Kraft facility, which is for the sole use of Kraft, in the amount of $4.5 billion, expires in April 2010 and requires the maintenance of a minimum net worth of $20.0 billion. At December 31, 2005, Kraft’s net worth was $29.6 billion.

 

ALG, PMI and Kraft expect to continue to meet their respective covenants. These facilities do not include any credit rating triggers or any provisions that could require the posting of collateral. The multi-year facilities enable the respective companies to reclassify short-term debt on a long-term basis.

 

At December 31, 2005, $2.4 billion of short-term borrowings that PMI expects to remain outstanding at December 31, 2006 were reclassified as long-term debt.

 

34


Exhibit 13

 

 

At December 31, 2005, credit lines for ALG, Kraft and PMI, and the related activity were as follows:

 

ALG

 

Type

(in billions of dollars)


   Credit Lines

   Amount
Drawn


   Commercial
Paper
Outstanding


   Lines
Available


364-day

   $ 1.0    $ -    $ -    $ 1.0

Multi-year

     4.0                    4.0
    

  

  

  

     $ 5.0    $ -    $ -    $ 5.0
    

  

  

  

Kraft

                           

Type

(in billions of dollars)


   Credit Lines

   Amount
Drawn


   Commercial
Paper
Outstanding


   Lines
Available


Multi-year

   $ 4.5    $ -    $ 0.4    $ 4.1
    

  

  

  

PMI

                           

Type

(in billions of dollars)


        Credit Lines

   Amount
Drawn


   Lines
Available


euro 2.5 billion, 3-year term loan

          $ 3.0    $ 3.0    $ -

euro 2.0 billion, 5-year revolving credit

            2.3      0.8      1.5
           

  

  

            $ 5.3    $ 3.8    $ 1.5
           

  

  

 

In addition to the above, certain international subsidiaries of ALG and Kraft maintain credit lines to meet their respective working capital needs. These credit lines, which amounted to approximately $2.2 billion for ALG subsidiaries (other than Kraft) and approximately $1.3 billion for Kraft subsidiaries, are for the sole use of these international businesses. Borrowings on these lines amounted to approximately $1.0 billion at December 31, 2005.

 

Debt: Altria Group, Inc.’s total debt (consumer products and financial services) was $23.9 billion and $23.0 billion at December 31, 2005 and 2004, respectively. Total consumer products debt was $21.9 billion and $20.8 billion at December 31, 2005 and 2004, respectively. Total consumer products debt includes third-party debt in Kraft’s consolidated balance sheet of $10.5 billion and $12.3 billion, at December 31, 2005 and 2004, respectively, and PMI third-party debt of $4.9 billion and $0.7 billion at December 31, 2005 and 2004, respectively. At December 31, 2005 and 2004, Altria Group, Inc.’s ratio of consumer products debt to total equity was 0.61 and 0.68, respectively. The ratio of total debt to total equity was 0.67 and 0.75 at December 31, 2005 and 2004, respectively. Fixed-rate debt constituted approximately 75% and 90% of total consumer products debt at December 31, 2005 and 2004, respectively. The weighted average interest rate on total consumer products debt, including the impact of swap agreements, was approximately 5.4% at December 31, 2005 and 2004.

 

In November 2004, Kraft issued $750 million of 5-year notes bearing interest at 4.125%. The net proceeds of the offering were used by Kraft to refinance maturing debt. Kraft has a Form S-3 shelf registration statement on file with the SEC, under which Kraft may sell debt securities and/or warrants to purchase debt securities in one or more offerings. At December 31, 2005, Kraft had $3.5 billion of capacity remaining under its shelf registration.

 

At December 31, 2005, ALG had approximately $2.8 billion of capacity remaining under its existing shelf registration statement.

 

ALG does not guarantee the debt of Kraft or PMI.

 

Taxes: The IRS is examining the consolidated tax returns for Altria Group, Inc., which includes PMCC, for years 1996 through 1999. Recently, the IRS has proposed to disallow certain transactions, and may in the future challenge and disallow several more, of PMCC’s leveraged leases based on recent Revenue Rulings and a recent IRS Notice addressing specific types of leveraged leases (lease-in/lease-out transactions, qualified technological equipment transactions, and sale-in/lease-out transactions). Altria Group, Inc. is expecting an assessment regarding these transactions for the years 1996 to 1999. PMCC believes that the position and supporting case law described in the Revenue Rulings and the IRS Notice as well as those asserted in the proposed adjustments, are incorrectly applied to PMCC’s transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRS’s position. PMCC and ALG intend to vigorously defend against any challenges based on that position through administrative appeals and litigation, if necessary, and ALG believes that, given the strength of PMCC’s position, it should ultimately prevail. However, litigation is subject to many uncertainties and an adverse outcome could have a material adverse effect on Altria Group, Inc.’s consolidated results of operations, cash flows or financial position.

 

·  Off-Balance Sheet Arrangements and Aggregate Contractual Obligations: Altria Group, Inc. has no off-balance sheet arrangements, including special purpose entities, other than guarantees and contractual obligations that are discussed below.

 

Guarantees: As discussed in Note 19, at December 31, 2005, Altria Group, Inc.’s third-party guarantees, which are primarily related to excise taxes, and acquisition and divestiture activities, approximated $328 million, of which $296 million have no specified expiration dates. The remainder expire through 2023, with $17 million expiring during 2006. Altria Group, Inc. is required to perform under these guarantees in the event that a third party fails to make contractual payments or achieve performance measures. Altria Group, Inc. has a liability of $41 million on its consolidated balance sheet at December 31, 2005, relating to these guarantees. In the ordinary course of business, certain subsidiaries of ALG have agreed to indemnify a limited number of third parties in the event of future litigation. At December 31, 2005, subsidiaries of ALG were also contingently liable for $1.8 billion of guarantees related to their own performance, consisting of the following:

 

    $1.5 billion of guarantees of excise tax and import duties related primarily to international shipments of tobacco products. In these agreements, a financial institution provides a guarantee of tax payments to the respective governments. PMI then issues a guarantee to the respective financial institution for the payment of the taxes. These are revolving facilities that are integral to the shipment of tobacco products in international markets, and the underlying taxes payable are recorded on Altria Group, Inc.’s consolidated balance sheet.

 

    $0.3 billion of other guarantees related to the tobacco and food businesses.

 

Although Altria Group, Inc.’s guarantees of its own performance are frequently short-term in nature, the short-term guarantees are expected to be replaced, upon expiration, with similar guarantees of similar amounts. These items have not had, and are not expected to have, a significant impact on Altria Group, Inc.’s liquidity.

 

35


Exhibit 13

 

 

Aggregate Contractual Obligations: The following table summarizes Altria Group, Inc.’s contractual obligations at December 31, 2005:

 

     Payments Due

(in millions)


   Total

   2006

   2007-
2008


   2009-
2010


   2011 and
Thereafter


Long-term debt (1):

                                  

Consumer products

   $ 16,738    $ 3,430    $ 4,864    $ 1,052    $ 7,392

Financial services

     2,014      943      572      499       
    

  

  

  

  

       18,752      4,373      5,436      1,551      7,392

Operating leases (2)

     1,619      436      561      278      344

Purchase obligations (3):

                                  

Inventory and production costs

     5,868      3,170      1,682      533      483

Other

     5,273      2,912      1,346      689      326
    

  

  

  

  

       11,141      6,082      3,028      1,222      809

Other long-term liabilities (4)

     158      6      107      21      24
    

  

  

  

  

     $ 31,670    $ 10,897    $ 9,132    $ 3,072    $ 8,569
    

  

  

  

  


(1) Amounts represent the expected cash payments of Altria Group, Inc.’s long-term debt and do not include short-term borrowings reclassified as long-term debt, bond premiums or discounts, or nonrecourse debt issued by PMCC. Amounts include capital lease obligations, primarily associated with the expansion of PMI’s vending machine distribution in Japan.

 

(2) Amounts represent the minimum rental commitments under non-cancelable operating leases.

 

(3) Purchase obligations for inventory and production costs (such as raw materials, indirect materials and supplies, packaging, co-manufacturing arrangements, storage and distribution) are commitments for projected needs to be utilized in the normal course of business. Other purchase obligations include commitments for marketing, advertising, capital expenditures, information technology and professional services. Arrangements are considered purchase obligations if a contract specifies all significant terms, including fixed or minimum quantities to be purchased, a pricing structure and approximate timing of the transaction. Most arrangements are cancelable without a significant penalty, and with short notice (usually 30 days). Any amounts reflected on the consolidated balance sheet as accounts payable and accrued liabilities are excluded from the table above.

 

(4) Other long-term liabilities primarily consist of specific severance and incentive compensation arrangements. The following long-term liabilities included on the consolidated balance sheet are excluded from the table above: accrued pension, postretirement health care and postemployment costs, income taxes, minority interest, insurance accruals and other accruals. Altria Group, Inc. is unable to estimate the timing of payments for these items. Currently, Altria Group, Inc. anticipates making U.S. pension contributions of approximately $410 million in 2006 and non-U.S. pension contributions of approximately $216 million in 2006, based on current tax law (as discussed in Note 16. Benefit Plans).

 

The State Settlement Agreements and related legal fee payments, and payments for tobacco growers, as discussed below and in Note 19, are excluded from the table above, as the payments are subject to adjustment for several factors, including inflation, market share and industry volume. In addition, the international tobacco E.C. agreement payments discussed below are excluded from the table above, as the payments are subject to adjustment based on certain variables including PMI’s market share in the European Union. Litigation escrow deposits, as discussed below and in Note 19. Contingencies, are also excluded from the table above since these deposits will be returned to PM USA should it prevail on appeal.

 

International Tobacco E.C. Agreement: In July 2004, PMI entered into an agreement with the E.C. and 10 member states of the European Union that provides for broad cooperation with European law enforcement agencies on anti-contraband and anti-counterfeit efforts. This agreement resolves all disputes between the parties relating to these issues. Under the terms of the agreement, PMI will make 13 payments over 12 years, including an initial payment of $250 million, which was recorded as a pre-tax charge against its earnings in 2004. The agreement calls for additional payments of approximately $150 million on the first anniversary of the agreement (this payment was made in July 2005), approximately $100 million on the second anniversary and approximately $75 million each year thereafter for 10 years, each of which is to be adjusted based on certain variables, including PMI’s market share in the European Union in the year preceding payment. Because the additional payments are subject to these variables, PMI records charges for them as an expense in cost of sales when product is shipped. During the third quarter of 2004, PMI began accruing for payments due on the first anniversary of the agreement.

 

Payments Under State Settlement and Other Tobacco Agreements: As discussed previously and in Note 19, PM USA has entered into State Settlement Agreements with the states and territories of the United States and had entered into agreements for the benefit of United States tobacco growers which have now been replaced by obligations imposed by FETRA. During 2004, PMI entered into a cooperation agreement with the European Community. Each of these agreements calls for payments that are based on variable factors, such as cigarette volume, market shares and inflation. PM USA and PMI account for the cost of these agreements as a component of cost of sales as product is shipped.

 

As a result of these agreements, PM USA and PMI recorded the following amounts in cost of sales for the years ended December 31, 2005, 2004 and 2003:

 

(in billions)


   PM USA

   PMI

   Total

2005

   $ 5.0    $ 0.1    $ 5.1

2004

     4.6      0.1      4.7

2003

     4.4             4.4
    

  

  

 

In addition, during 2004, PMI recorded a pre-tax charge of $250 million at the signing of the cooperation agreement with the European Community, and PM USA recorded a one-time pre-tax charge of $202 million in 2003 related to the settlement of litigation with tobacco growers.

 

Based on current agreements and current estimates of volume and market share, the estimated amounts that PM USA and PMI may charge to cost of sales under these agreements will be approximately as follows:

 

(in billions)


   PM USA

   PMI

   Total

2006

   $ 5.1    $ 0.1    $ 5.2

2007

     5.6      0.1      5.7

2008

     5.8      0.1      5.9

2009

     5.8      0.1      5.9

2010

     5.9      0.1      6.0

2011 to 2016

     5.9 annually      0.1 annually      6.0 annually

Thereafter

     6.1 annually             6.1 annually
    

  

  

 

The estimated amounts charged to cost of sales in each of the years above would generally be paid in the following year. As previously stated, the payments due under the terms of these agreements are subject to adjustment for several factors, including cigarette volume, inflation and certain contingent events and, in general, are allocated based on each manufacturer’s market share. The amounts shown in the table above are estimates, and actual amounts will differ as underlying assumptions differ from actual future results.

 

36


Exhibit 13

 

 

Litigation Escrow Deposits: As discussed in Note 19, in connection with obtaining a stay of execution in May 2001 in the Engle class action, PM USA placed $1.2 billion into an interest-bearing escrow account. The $1.2 billion escrow account and a deposit of $100 million related to the bonding requirement are included in the December 31, 2005 and 2004 consolidated balance sheets as other assets. These amounts will be returned to PM USA should it prevail in its appeal of the case. Interest income on the $1.2 billion escrow account is paid to PM USA quarterly and is being recorded as earned in interest and other debt expense, net, in the consolidated statements of earnings.

 

In addition, in connection with obtaining a stay of execution in the Price case, PM USA placed a pre-existing 7.0%, $6 billion long-term note from ALG to PM USA into an escrow account with an Illinois financial institution. Since this note is the result of an intercompany financing arrangement, it does not appear on the consolidated balance sheet of Altria Group, Inc. In addition, PM USA agreed to make cash deposits with the clerk of the Madison County Circuit Court in the following amounts: beginning October 1, 2003, an amount equal to the interest earned by PM USA on the ALG note ($210 million every six months), an additional $800 million in four equal quarterly installments between September 2003 and June 2004 and the payments of the principal of the note which are due in equal installments in April 2008, 2009 and 2010. Through December 31, 2005, PM USA made $1.85 billion in cash deposits due under the judge’s order. Cash deposits into the account are included in other assets on the consolidated balance sheet. If PM USA prevails on appeal, the escrowed note and all cash deposited with the court will be returned to PM USA, with accrued interest less administrative fees payable to the court.

 

With respect to certain adverse verdicts and judicial decisions currently on appeal, other than the Engle and the Price cases discussed above, as of December 31, 2005, PM USA has posted various forms of security totaling approximately $329 million, the majority of which have been collateralized with cash deposits, to obtain stays of judgments pending appeals. In addition, as discussed in Note 19, PMI placed 51 million euro in an escrow account pending appeal of an adverse administrative court decision in Italy. These cash deposits are included in other assets on the consolidated balance sheets.

 

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 ALG, PM USA and PMI. Assuming there are no material adverse developments in the legislative and litigation environment, Altria Group, Inc. expects its cash flow from operations to provide sufficient liquidity to meet the ongoing needs of the business.

 

·  Equity and Dividends: Following the rating agencies’ actions in the first quarter of 2003, discussed above in “Credit Ratings,” ALG suspended its share repurchase program.

 

During December 2004, Kraft completed its $700 million share repurchase program and began a $1.5 billion two-year share repurchase program. During 2005 and 2004, Kraft repurchased 39.2 million and 21.5 million shares, respectively, of its Class A common stock at a cost of $1.2 billion and $700 million, respectively. As of December 31, 2005, Kraft had repurchased 40.6 million shares of its Class A common stock, under its $1.5 billion authority, at an aggregate cost of $1.25 billion.

 

As discussed in Note 12. Stock Plans, in January 2005 and January 2004, Altria Group, Inc. granted approximately 1.2 million and 1.4 million shares of restricted stock, respectively, to eligible U.S.-based employees and Directors of Altria Group, Inc. and also issued to eligible non-U.S. employees and Directors rights to receive approximately 1.0 million equivalent shares each year. Restrictions on the stock and rights granted in 2005 and 2004 lapse in the first quarter of 2008 and the first quarter of 2007, respectively.

 

At December 31, 2005, the number of shares to be issued upon exercise of outstanding stock options and vesting of non-U.S. rights to receive equivalent shares was 54.8 million, or 2.6% of shares outstanding.

 

Dividends paid in 2005 and 2004 were $6.2 billion and $5.7 billion, respectively, an increase of 9.2%, primarily reflecting a higher dividend rate in 2005. During the third quarter of 2005, Altria Group, Inc.’s Board of Directors approved a 9.6% increase in the quarterly dividend rate to $0.80 per share. As a result, the annualized dividend rate increased to $3.20 from $2.92.

 

Market Risk

 

ALG’s subsidiaries operate globally, with manufacturing and sales facilities in various locations around the world. ALG and its subsidiaries utilize certain financial instruments to manage foreign currency and commodity exposures. Derivative financial instruments are used by ALG and its subsidiaries, principally to reduce exposures to market risks resulting from fluctuations in foreign exchange rates and commodity prices, by creating offsetting exposures. Altria Group, Inc. is not a party to leveraged derivatives and, by policy, does not use derivative financial instruments for speculative purposes.

 

A substantial portion of Altria Group, Inc.’s derivative financial instruments are effective as hedges. Hedging activity affected accumulated other comprehensive earnings (losses), net of income taxes, during the years ended December 31, 2005, 2004 and 2003, as follows:

 

(in millions)


   2005

    2004

    2003

 

Loss as of January 1

   $ (14 )   $ (83 )   $ (77 )

Derivative (gains) losses transferred to earnings

     (95 )     86       (42 )

Change in fair value

     133       (17 )     36  
    


 


 


Gain (loss) as of December 31

   $ 24     $ (14 )   $ (83 )
    


 


 


 

The fair value of all derivative financial instruments has been calculated based on market quotes.

 

·  Foreign exchange rates: Altria Group, Inc. uses forward foreign exchange contracts and foreign currency options to mitigate its exposure to changes in exchange rates from third-party and intercompany actual and forecasted transactions. The primary currencies to which Altria Group, Inc. is exposed include the Japanese yen, Swiss franc and the euro. At December 31, 2005 and 2004, Altria Group, Inc. had foreign exchange option and forward contracts with aggregate notional amounts of $4.8 billion and $9.7 billion, respectively. In addition, Altria Group, Inc. uses foreign currency swaps to mitigate its exposure to changes in exchange rates related to foreign currency denominated debt. These swaps typically convert fixed-rate foreign currency denominated debt to fixed-rate debt denominated in the functional currency of the borrowing entity. A substantial portion of the foreign currency swap agreements is accounted for as cash flow hedges. The unrealized gain (loss) relating to foreign currency swap agreements that do not qualify for hedge accounting treatment under U.S. GAAP was insignificant as of December 31, 2005 and 2004. At December 31, 2005 and 2004, the notional amounts of foreign currency swap agreements aggregated $2.3 billion and $2.7 billion, respectively. Aggregate maturities of foreign currency swap agreements at December 31, 2005, were $1.0 billion in 2006 and $1.3 billion in 2008.

 

Altria Group, Inc. also designates certain foreign currency denominated debt as net investment hedges of foreign operations. During the year ended

 

37


Exhibit 13

 

 

December 31, 2005, these hedges of net investments resulted in a gain, net of income taxes, of $369 million, and in the years ended December 31, 2004 and 2003, resulted in losses, net of income taxes, of $344 million and $286 million, respectively. These gains and losses were reported as a component of accumulated other comprehensive earnings (losses) within currency translation adjustments.

 

·  Commodities: Kraft is exposed to price risk related to forecasted purchases of certain commodities used as raw materials. Accordingly, Kraft uses commodity forward contracts as cash flow hedges, primarily for coffee and cocoa. Commodity futures and options are also used to hedge the price of certain commodities, including milk, coffee, cocoa, wheat, corn, sugar and soybean oil. At December 31, 2005 and 2004, Kraft had net long commodity positions of $521 million and $443 million, respectively. In general, commodity forward contracts qualify for the normal purchase exception under U.S. GAAP, and are therefore not subject to the provisions of SFAS No. 133. The effective portion of unrealized gains and losses on commodity futures and option contracts is deferred as a component of accumulated other comprehensive earnings (losses) and is recognized as a component of cost of sales when the related inventory is sold. Unrealized gains or losses on net commodity positions were immaterial at December 31, 2005 and 2004.

 

·  Value at Risk: Altria Group, Inc. uses a value at risk (“VAR”) computation to estimate the potential one-day loss in the fair value of its interest rate-sensitive financial instruments and to estimate the potential one-day loss in pre-tax earnings of its foreign currency and commodity price-sensitive derivative financial instruments. The VAR computation includes Altria Group, Inc.’s debt; short-term investments; foreign currency forwards, swaps and options; and commodity futures, forwards and options. Anticipated transactions, foreign currency trade payables and receivables, and net investments in foreign subsidiaries, which the foregoing instruments are intended to hedge, were excluded from the computation.

 

The VAR estimates were made assuming normal market conditions, using a 95% confidence interval. Altria Group, Inc. used a “variance/co-variance” model to determine the observed interrelationships between movements in interest rates and various currencies. These interrelationships were determined by observing interest rate and forward currency rate movements over the preceding quarter for the calculation of VAR amounts at December 31, 2005 and 2004, and over each of the four preceding quarters for the calculation of average VAR amounts during each year. The values of foreign currency and commodity options do not change on a one-to-one basis with the underlying currency or commodity, and were valued accordingly in the VAR computation.

 

The estimated potential one-day loss in fair value of Altria Group, Inc.’s interest rate-sensitive instruments, primarily debt, under normal market conditions and the estimated potential one-day loss in pre-tax earnings from foreign currency and commodity instruments under normal market conditions, as calculated in the VAR model, were as follows:

 

     Pre-Tax Earnings Impact

(in millions)


  

At

12/31/05


   Average

   High

   Low

Instruments sensitive to:

                           

Foreign currency rates

   $ 23    $ 21    $ 24    $ 19

Commodity prices

     7      6      12      3
    

  

  

  

     Fair Value Impact

(in millions)


  

At

12/31/05


   Average

   High

   Low

Instruments sensitive to:

                           

Interest rates

   $ 43    $ 63    $ 75    $ 43
    

  

  

  

     Pre-Tax Earnings Impact

(in millions)


  

At

12/31/04


   Average

   High

   Low

Instruments sensitive to:

                           

Foreign currency rates

   $ 16    $ 21    $ 35    $ 16

Commodity prices

     4      6      8      4
    

  

  

  

     Fair Value Impact

(in millions)


   At
12/31/04


   Average

   High

   Low

Instruments sensitive to:

                           

Interest rates

   $ 72    $ 96    $ 113    $ 72
    

  

  

  

 

The VAR computation is a risk analysis tool designed to statistically estimate the maximum probable daily loss from adverse movements in interest rates, foreign currency rates and commodity prices under normal market conditions. The computation does not purport to represent actual losses in fair value or earnings to be incurred by Altria Group, Inc., nor does it consider the effect of favorable changes in market rates. Altria Group, Inc. cannot predict actual future movements in such market rates and does not present these VAR results to be indicative of future movements in such market rates or to be representative of any actual impact that future changes in market rates may have on its future results of operations or financial position.

 

New Accounting Standards

 

See Note 2 to the consolidated financial statements for a discussion of new accounting standards.

 

Contingencies

 

See Note 19 to the consolidated financial statements for a discussion of contingencies.

 

38


Exhibit 13

 

 

Cautionary Factors That May Affect Future Results

 

Forward-Looking and Cautionary Statements

 

We* may from time to time make written or oral forward-looking statements, including statements contained in filings with the Securities and Exchange Commission, in reports to stockholders and in press releases and investor Webcasts. You can identify these forward-looking statements by use of words such as “strategy,” “expects,” “continues,” “plans,” “anticipates,” “believes,” “will,” “estimates,” “intends,” “projects,” “goals,” “targets” and other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts.

 

We cannot guarantee that any forward-looking statement will be realized, although we believe we have been prudent in our plans and assumptions. Achievement of future results is subject to risks, uncertainties and inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements and whether to invest in or remain invested in Altria Group, Inc.’s securities. In connection with the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995, we are identifying important factors that, individually or in the aggregate, could cause actual results and outcomes to differ materially from those contained in any forward-looking statements made by us; any such statement is qualified by reference to the following cautionary statements. We elaborate on these and other risks we face throughout this document, particularly in the “Business Environment” sections preceding our discussion of operating results of our subsidiaries’ businesses. You should understand that it is not possible to predict or identify all risk factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties. We do not undertake to update any forward-looking statement that we may make from time to time.

 

·  Tobacco-Related Litigation: There is substantial litigation related to tobacco products in the United States and certain foreign jurisdictions. We anticipate that new cases will continue to be filed. Damages claimed in some of the tobacco-related litigation range into the billions of dollars. There are presently 12 cases on appeal in which verdicts were returned against PM USA, including a compensatory and punitive damages verdict totaling approximately $10.1 billion in the Price case in Illinois, which was reversed by the Illinois Supreme Court in December 2005. Generally, in order to prevent a plaintiff from seeking to collect a judgment while the verdict is being appealed, the defendant must post an appeal bond or negotiate an alternative arrangement with plaintiffs. In the event of future losses at trial, we may not always be able to obtain the required bond or to negotiate an acceptable alternative arrangement.

 

The present litigation environment is substantially uncertain, and it is possible that our business, volume, results of operations, cash flows or financial position could be materially affected by an unfavorable outcome of pending litigation, including certain of the verdicts against us that are on appeal. We intend to continue vigorously defending all tobacco-related litigation, although we may enter into settlement discussions in particular cases if we believe it is in the best interest of our stockholders to do so. The entire litigation environment may not improve sufficiently to enable the Board of Directors to implement any contemplated restructuring alternatives. Please see Note 19 for a discussion of pending tobacco-related litigation.

 

·  Anti-Tobacco Action in the Public and Private Sectors: Our tobacco subsidiaries face significant governmental action aimed at reducing the incidence of smoking and seeking to hold us responsible for the adverse health effects associated with both smoking and exposure to environmental tobacco smoke. Governmental actions, combined with the diminishing social acceptance of smoking and private actions to restrict smoking, have resulted in reduced industry volume, and we expect this decline to continue.

 

·  Excise Taxes: Cigarettes are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in cigarette-related taxes have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the EU and in other foreign jurisdictions. In addition, in certain jurisdictions, PMI’s products are subject to discriminatory tax structures, and inconsistent rulings and interpretations on complex methodologies to determine excise and other tax burdens.

 

Tax increases are expected to continue to have an adverse impact on sales of cigarettes by our tobacco subsidiaries, due to lower consumption levels and to a shift in consumer purchases from the premium to the non-premium or discount segments or to other low-priced or low-taxed tobacco products or to counterfeit or contraband products.

 

·  Increased Competition in the Domestic Tobacco Market: Settlements of certain tobacco litigation in the United States have resulted in substantial cigarette price increases. PM USA faces competition from lowest-priced brands sold by certain domestic and foreign manufacturers that have cost advantages because they are not parties to these settlements. These manufacturers may fail to comply with related state escrow legislation or may take advantage of certain provisions in the legislation that permit the non-settling manufacturers to concentrate their sales in a limited number of states and thereby avoid escrow deposit obligations on the majority of their sales. Additional competition has resulted from diversion into the United States market of cigarettes intended for sale outside the United States, the sale of counterfeit cigarettes by third parties, the sale of cigarettes by third parties over the Internet and by other means designed to avoid collection of applicable taxes and increased imports of foreign lowest-priced brands.

 

·  Governmental Investigations: From time to time, ALG and its tobacco subsidiaries are subject to governmental investigations on a range of matters. Ongoing investigations include allegations of contraband shipments of cigarettes and allegations of unlawful pricing activities within certain international markets. We cannot predict the outcome of those investigations or whether additional investigations may be commenced, and it is possible that our business could be materially affected by an unfavorable outcome of pending or future investigations.

 

·  New Tobacco Product Technologies: Our tobacco subsidiaries continue to seek ways to develop and to commercialize new product technologies that have the objective of reducing constituents in tobacco smoke identified by public health authorities as harmful while continuing to offer adult smokers products that meet their taste expectations. We cannot guarantee that our tobacco subsidiaries will succeed in these efforts. If they do not succeed, but one or more of their competitors do, our tobacco subsidiaries may be at a competitive disadvantage.

 


 

* This section uses the terms “we,” “our” and “us” when it is not necessary to distinguish among ALG and its various operating subsidiaries or when any distinction is clear from the context.

 

39


Exhibit 13

 

 

·  Foreign Currency: Our international food and tobacco subsidiaries conduct their businesses in local currency and, for purposes of financial reporting, their results are translated into U.S. dollars based on average exchange rates prevailing during a reporting period. During times of a strengthening U.S. dollar, our reported net revenues and operating income will be reduced because the local currency will translate into fewer U.S. dollars.

 

·  Competition and Economic Downturns: Each of our consumer products subsidiaries is subject to intense competition, changes in consumer preferences and local economic conditions. To be successful, they must continue to:

 

    promote brand equity successfully;

 

    anticipate and respond to new consumer trends;

 

    develop new products and markets and to broaden brand portfolios in order to compete effectively with lower-priced products;

 

    improve productivity; and

 

    respond effectively to changing prices for their raw materials.

 

The willingness of consumers to purchase premium cigarette brands and premium food and beverage brands depends in part on local economic conditions. In periods of economic uncertainty, consumers tend to purchase more private label and other economy brands, and the volume of our consumer products subsidiaries could suffer accordingly.

 

Our finance subsidiary, PMCC, holds investments in finance leases, principally in transportation (including aircraft), power generation and manufacturing equipment and facilities. Its lessees are also subject to intense competition and economic conditions. If counterparties to PMCC’s leases fail to manage through difficult economic and competitive conditions, PMCC may have to increase its allowance for losses, which would adversely affect our profitability.

 

·  Grocery Trade Consolidation: As the retail grocery trade continues to consolidate and retailers grow larger and become more sophisticated, they demand lower pricing and increased promotional programs. Further, these customers are reducing their inventories and increasing their emphasis on private label products. If Kraft fails to use its scale, marketing expertise, branded products and category leadership positions to respond to these trends, its volume growth could slow or it may need to lower prices or increase promotional support of its products, any of which would adversely affect our profitability.

 

·  Continued Need to Add Food and Beverage Products in Faster-Growing and More Profitable Categories: The food and beverage industry’s growth potential is constrained by population growth. Kraft’s success depends in part on its ability to grow its business faster than populations are growing in the markets that it serves. One way to achieve that growth is to enhance its portfolio by adding products that are in faster-growing and more profitable categories. If Kraft does not succeed in making these enhancements, its volume growth may slow, which would adversely affect our profitability.

 

·  Strengthening Brand Portfolios Through Acquisitions and Divestitures: One element of the growth strategy of our consumer products subsidiaries is to strengthen their brand portfolios through active programs of selective acquisitions and divestitures. These subsidiaries are constantly investigating potential acquisition candidates and from time to time Kraft sells businesses that are outside its core categories or that do not meet its growth or profitability targets. Acquisition opportunities are limited and acquisitions present risks of failing to achieve efficient and effective integration, strategic objectives and anticipated revenue improvements and cost savings. There can be no assurance that we will be able to continue to acquire attractive businesses on favorable terms or that all future acquisitions will be quickly accretive to earnings.

 

·  Food Raw Material Prices: The raw materials used by our food businesses are largely commodities that experience price volatility caused by external conditions, commodity market fluctuations, currency fluctuations and changes in governmental agricultural programs. Commodity price changes may result in unexpected increases in raw material and packaging costs (which are significantly affected by oil costs), and our operating subsidiaries may be unable to increase their prices to offset these increased costs without suffering reduced volume, net revenues and operating companies income. We do not fully hedge against changes in commodity prices and our hedging strategies may not work as planned.

 

·  Food Safety, Quality and Health Concerns: We could be adversely affected if consumers in Kraft’s principal markets lose confidence in the safety and quality of certain food products. Adverse publicity about these types of concerns, whether or not valid, may discourage consumers from buying Kraft’s products or cause production and delivery disruptions. Recent publicity concerning the health implications of obesity and trans-fatty acids could also reduce consumption of certain of Kraft’s products. In addition, Kraft may need to recall some of its products if they become adulterated or misbranded. Kraft may also be liable if the consumption of any of its products causes injury. A widespread product recall or a significant product liability judgment could cause products to be unavailable for a period of time and a loss of consumer confidence in Kraft’s food products and could have a material adverse effect on Kraft’s business and results.

 

·  Limited Access to Commercial Paper Market: As a result of actions by credit rating agencies during 2003, ALG currently has limited access to the commercial paper market, and may have to rely on its revolving credit facilities.

 

·  Asset Impairment: We periodically calculate the fair value of our goodwill and intangible assets to test for impairment. This calculation may be affected by the market conditions noted above, as well as interest rates and general economic conditions. If an impairment is determined to exist, we will incur impairment losses, which will reduce our earnings.

 

·  IRS Challenges to PMCC Leases: Recently, the IRS has proposed to disallow certain transactions, and may in the future challenge and disallow several more, of PMCC’s leveraged leases based on recent Revenue Rulings and a recent IRS Notice addressing specific types of leveraged leases (lease-in/lease-out transactions, qualified technological equipment transactions, and sale-in/lease-out transactions). PMCC believes that the position and supporting case law described in the Revenue Rulings and the IRS Notice, as well as those asserted in the proposed adjustments, are incorrectly applied to PMCC’s transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRS’s position. PMCC and ALG intend to vigorously defend against any challenges based on that position through administrative appeals and litigation, if necessary, and ALG believes that, given the strength of PMCC’s position, it should ultimately prevail. However, should PMCC’s position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and lower its earnings to reflect the recalculation of the income from the affected leveraged leases.

 

40


Exhibit 13

 

 

Selected Financial Data–Five-Year Review

(in millions of dollars, except per share data)

 

        2005

    2004

    2003

    2002

    2001

 

Summary of Operations:

                                       

Net revenues

  $ 97,854     $ 89,610     $ 81,320     $ 79,933     $ 80,376  

United States export sales

    3,630       3,493       3,528       3,654       3,866  

Cost of sales

    36,764       33,959       31,573       32,491       33,644  

Federal excise taxes on products

    3,659       3,694       3,698       4,229       4,418  

Foreign excise taxes on products

    25,275       21,953       17,430       13,997       12,791  
   


 


 


 


 


Operating income

    16,592       15,180       15,759       16,448       15,535  

Interest and other debt expense, net

    1,157       1,176       1,150       1,134       1,418  

Earnings from continuing operations before income taxes, minority interest, equity earnings, net, and cumulative effect of accounting change

    15,435       14,004       14,609       17,945       14,117  

Pre-tax profit margin from continuing operations

    15.8 %     15.6 %     18.0 %     22.5 %     17.6 %

Provision for income taxes

    4,618       4,540       5,097       6,368       5,326  
   


 


 


 


 


Earnings from continuing operations before minority interest, equity earnings, net, and cumulative effect of accounting change

    10,817       9,464       9,512       11,577       8,791  

Minority interest in earnings from continuing operations, and equity earnings, net

    149       44       391       556       302  

Earnings from continuing operations before cumulative effect of accounting change

    10,668       9,420       9,121       11,021       8,489  

(Loss) earnings from discontinued operations, net of income taxes and minority interest

    (233 )     (4 )     83       81       77  

Cumulative effect of accounting change

                                    (6 )

Net earnings

    10,435       9,416       9,204       11,102       8,560  
       


 


 


 


 


Basic earnings per share

 

– continuing operations

    5.15       4.60       4.50       5.22       3.89  
   

– discontinued operations

    (0.11 )             0.04       0.04       0.04  
   

– cumulative effect of accounting change

                                    (0.01 )
   

– net earnings

    5.04       4.60       4.54       5.26       3.92  

Diluted earnings per share

 

– continuing operations

    5.10       4.57       4.48       5.18       3.84  
   

– discontinued operations

    (0.11 )     (0.01 )     0.04       0.03       0.04  
   

– cumulative effect of accounting change

                                    (0.01 )
   

– net earnings

    4.99       4.56       4.52       5.21       3.87  

Dividends declared per share

    3.06       2.82       2.64       2.44       2.22  

Weighted average shares (millions) – Basic

    2,070       2,047       2,028       2,111       2,181  

Weighted average shares (millions) – Diluted

    2,090       2,063       2,038       2,129       2,210  
   


 


 


 


 


Capital expenditures

    2,206       1,913       1,974       2,009       1,922  

Depreciation

    1,647       1,590       1,431       1,324       1,323  

Property, plant and equipment, net (consumer products)

    16,678       16,305       16,067       14,846       15,137  

Inventories (consumer products)

    10,584       10,041       9,540       9,127       8,923  

Total assets

    107,949       101,648       96,175       87,540       84,968  

Total long-term debt

    17,667       18,683       21,163       21,355       18,651  

Total debt – consumer products

    21,919       20,759       22,329       21,154       20,098  

                 – financial services

    2,014       2,221       2,210       2,166       2,004  
   


 


 


 


 


Stockholders’ equity

    35,707       30,714       25,077       19,478       19,620  

Common dividends declared as a % of Basic EPS

    60.7 %     61.3 %     58.1 %     46.4 %     56.6 %

Common dividends declared as a % of Diluted EPS

    61.3 %     61.8 %     58.4 %     46.8 %     57.4 %

Book value per common share outstanding

    17.13       14.91       12.31       9.55       9.11  

Market price per common share – high/low

    78.68-60.40       61.88-44.50       55.03-27.70       57.79-35.40       53.88-38.75  
       


 


 


 


 


Closing price of common share at year end

    74.72       61.10       54.42       40.53       45.85  

Price/earnings ratio at year end – Basic

    15       13       12       8       12  

Price/earnings ratio at year end – Diluted

    15       13       12       8       12  

Number of common shares outstanding at year end (millions)

    2,084       2,060       2,037       2,039       2,153  

Number of employees

    199,000       156,000       165,000       166,000       175,000  
       


 


 


 


 


 

41


Exhibit 13

 

 

Consolidated Balance Sheets

(in millions of dollars, except share and per share data)

 

at December 31,      


   2005

   2004

Assets

             

Consumer products

             

Cash and cash equivalents

   $ 6,258    $ 5,744

Receivables (less allowances of $112 in 2005 and $139 in 2004)

     5,361      5,754

Inventories:

             

Leaf tobacco

     4,060      3,643

Other raw materials

     2,232      2,170

Finished product

     4,292      4,228
    

  

       10,584      10,041

Assets of discontinued operations held for sale

            1,458

Other current assets

     3,578      2,904
    

  

Total current assets

     25,781      25,901

Property, plant and equipment, at cost:

             

Land and land improvements

     989      889

Buildings and building equipment

     7,428      7,366

Machinery and equipment

     20,050      19,566

Construction in progress

     1,489      1,266
    

  

       29,956      29,087

Less accumulated depreciation

     13,278      12,782
    

  

       16,678      16,305

Goodwill

     31,219      28,056

Other intangible assets, net

     12,196      11,056

Other assets

     14,667      12,485
    

  

Total consumer products assets

     100,541      93,803

Financial services

             

Finance assets, net

     7,189      7,827

Other assets

     219      18
    

  

Total financial services assets

     7,408      7,845
    

  

Total Assets

   $ 107,949    $ 101,648
    

  

 

See notes to consolidated financial statements.

 

42


Exhibit 13

 

 

at December 31,    


   2005

    2004

 

Liabilities

                

Consumer products

                

Short-term borrowings

   $ 2,836     $ 2,546  

Current portion of long-term debt

     3,430       1,751  

Accounts payable

     3,645       3,466  

Accrued liabilities:

                

Marketing

     2,382       2,516  

Taxes, except income taxes

     2,871       2,909  

Employment costs

     1,296       1,325  

Settlement charges

     3,503       3,501  

Other

     3,130       3,072  

Income taxes

     1,393       983  

Dividends payable

     1,672       1,505  
    


 


Total current liabilities

     26,158       23,574  

Long-term debt

     15,653       16,462  

Deferred income taxes

     8,492       8,295  

Accrued postretirement health care costs

     3,412       3,285  

Minority interest

     4,141       4,764  

Other liabilities

     6,260       6,238  
    


 


Total consumer products liabilities

     64,116       62,618  

Financial services

                

Long-term debt

     2,014       2,221  

Non-recourse debt

     201       112  

Deferred income taxes

     5,737       5,876  

Other liabilities

     174       107  
    


 


Total financial services liabilities

     8,126       8,316  
    


 


Total liabilities

     72,242       70,934  
    


 


Contingencies (Note 19)

                

Stockholders’ Equity

                

Common stock, par value $0.33 1/3 per share
(2,805,961,317 shares issued)

     935       935  

Additional paid-in capital

     6,061       5,176  

Earnings reinvested in the business

     54,666       50,595  

Accumulated other comprehensive losses
(including currency translation of ($1,317) in 2005 and ($610) in 2004)

     (1,853 )     (1,141 )

Cost of repurchased stock
(721,696,918 shares in 2005 and 746,433,841 shares in 2004)

     (24,102 )     (24,851 )
    


 


Total stockholders’ equity

     35,707       30,714  
    


 


Total Liabilities And Stockholders’ Equity

   $ 107,949     $ 101,648  
    


 


 

43


Exhibit 13

 

 

Consolidated Statements of Earnings

(in millions of dollars, except per share data)

 

for the years ended December 31,            


   2005

    2004

    2003

 

Net revenues

   $ 97,854     $ 89,610     $ 81,320  

Cost of sales

     36,764       33,959       31,573  

Excise taxes on products

     28,934       25,647       21,128  
    


 


 


Gross profit

     32,156       30,004       28,619  

Marketing, administration and research costs

     14,799       13,665       12,525  

Domestic tobacco headquarters relocation charges

     4       31       69  

Domestic tobacco loss on U.S. tobacco pool

     138                  

Domestic tobacco quota buy-out

     (115 )                

Domestic tobacco legal settlement

                     202  

International tobacco E.C. agreement

             250          

Asset impairment and exit costs

     618       718       86  

(Gains) losses on sales of businesses, net

     (108 )     3       (31 )

Provision for airline industry exposure

     200       140          

Amortization of intangibles

     28       17       9  
    


 


 


Operating income

     16,592       15,180       15,759  

Interest and other debt expense, net

     1,157       1,176       1,150  
    


 


 


Earnings from continuing operations before income taxes, minority interest, and equity earnings, net

     15,435       14,004       14,609  

Provision for income taxes

     4,618       4,540       5,097  
    


 


 


Earnings from continuing operations before minority interest, and equity earnings, net

     10,817       9,464       9,512  

Minority interest in earnings from continuing operations, and equity earnings, net

     149       44       391  
    


 


 


Earnings from continuing operations

     10,668       9,420       9,121  

(Loss) earnings from discontinued operations, net of income taxes and minority interest

     (233 )     (4 )     83  
    


 


 


Net earnings

   $ 10,435     $ 9,416     $ 9,204  
    


 


 


Per share data:

                        

Basic earnings per share:

                        

Continuing operations

   $ 5.15     $ 4.60     $ 4.50  

Discontinued operations

     (0.11 )             0.04  
    


 


 


Net earnings

   $ 5.04     $ 4.60     $ 4.54  
    


 


 


Diluted earnings per share:

                        

Continuing operations

   $ 5.10     $ 4.57     $ 4.48  

Discontinued operations

     (0.11 )     (0.01 )     0.04  
    


 


 


Net earnings

   $ 4.99     $ 4.56     $ 4.52  
    


 


 


 

See notes to consolidated financial statements.

 

44


Exhibit 13

 

 

Consolidated Statements of Stockholders’ Equity

(in millions of dollars, except per share data)

 

     Common
Stock


   Additional
Paid-in
Capital


   Earnings
Reinvested in
the Business


    Accumulated Other     Cost of
Repurchased
Stock


    Total
Stockholders’
Equity


 
           Comprehensive Earnings (Losses)

     
           Currency
Translation
Adjustments


    Other

    Total

     

Balances, January 1, 2003

   $ 935    $ 4,642    $ 43,259     $ (2,951 )   $ (1,005 )   $ (3,956 )   $ (25,402 )   $ 19,478  

Comprehensive earnings:

                                                              

Net earnings

                   9,204                                       9,204  

Other comprehensive earnings (losses), net of income taxes:

                                                              

Currency translation adjustments

                           1,373               1,373               1,373  

Additional minimum pension liability

                                   464       464               464  

Change in fair value of derivatives accounted for as hedges

                                   (6 )     (6 )             (6 )
                                                          


Total other comprehensive earnings

                                                           1,831  
                                                          


Total comprehensive earnings

                                                           11,035  
                                                          


Exercise of stock options and issuance of other stock awards

            171      (93 )                             537       615  

Cash dividends declared ($2.64 per share)

                   (5,362 )                                     (5,362 )

Stock repurchased

                                                   (689 )     (689 )
    

  

  


 


 


 


 


 


Balances, December 31, 2003

     935      4,813      47,008       (1,578 )     (547 )     (2,125 )     (25,554 )     25,077  

Comprehensive earnings:

                                                              

Net earnings

                   9,416                                       9,416  

Other comprehensive earnings (losses), net of income taxes:

                                                              

Currency translation adjustments

                           968               968               968  

Additional minimum pension liability

                                   (53 )     (53 )             (53 )

Change in fair value of derivatives accounted for as hedges

                                   69       69               69  
                                                          


Total other comprehensive earnings

                                                           984  
                                                          


Total comprehensive earnings

                                                           10,400  
                                                          


Exercise of stock options and issuance of other stock awards

            363      (39 )                             703       1,027  

Cash dividends declared ($2.82 per share)

                   (5,790 )                                     (5,790 )
    

  

  


 


 


 


 


 


Balances, December 31, 2004

     935      5,176      50,595       (610 )     (531 )     (1,141 )     (24,851 )     30,714  

Comprehensive earnings:

                                                              

Net earnings

                   10,435                                       10,435  

Other comprehensive earnings (losses), net of income taxes:

                                                              

Currency translation adjustments

                           (707 )             (707 )             (707 )

Additional minimum pension liability

                                   (54 )     (54 )             (54 )

Change in fair value of derivatives accounted for as hedges

                                   38       38               38  

Other

                                   11       11               11  
                                                          


Total other comprehensive losses

                                                           (712 )
                                                          


Total comprehensive earnings

                                                           9,723  
                                                          


Exercise of stock options and issuance of other stock awards

            519      (6 )                             749       1,262  

Cash dividends declared ($3.06 per share)

                   (6,358 )                                     (6,358 )
                                                                

Other

            366                                              366  
    

  

  


 


 


 


 


 


Balances, December 31, 2005

   $ 935    $ 6,061    $ 54,666     $ (1,317 )   $ (536 )   $ (1,853 )   $ (24,102 )   $ 35,707  
    

  

  


 


 


 


 


 


 

See notes to consolidated financial statements.

 

45


Exhibit 13

 

 

Consolidated Statements of Cash Flows

(in millions of dollars)

 

for the years ended December 31,            


   2005

    2004

    2003

 

Cash Provided By (Used in) Operating Activities

                        

Net earnings – Consumer products

   $ 10,418     $ 9,330     $ 8,934  

  – Financial services

     17       86       270  
    


 


 


Net earnings

     10,435       9,416       9,204  

Adjustments to reconcile net earnings to operating cash flows:

                        

Consumer products

                        

Depreciation and amortization

     1,675       1,607       1,440  

Deferred income tax (benefit) provision

     (863 )     381       717  

Minority interest in earnings from continuing operations, and equity earnings, net

     149       44       405  

Domestic tobacco legal settlement, net of cash paid

             (57 )     57  

Domestic tobacco headquarters relocation charges, net of cash paid

     (9 )     (22 )     35  

Domestic tobacco quota buy-out

     (115 )                

Escrow bond for the Price domestic tobacco case

     (420 )     (820 )     (610 )

Integration costs, net of cash paid

     (1 )     (1 )     (26 )

Asset impairment and exit costs, net of cash paid

     382       510       62  

Impairment loss on discontinued operations

             107          

Loss on sale of discontinued operations

     32                  

(Gains) losses on sales of businesses, net

     (108 )     3       (31 )

Cash effects of changes, net of the effects from acquired and divested companies:

                        

Receivables, net

     253       (193 )     295  

Inventories

     (524 )     (140 )     251  

Accounts payable

     27       49       (220 )

Income taxes

     203       (502 )     (119 )

Accrued liabilities and other current assets

     (555 )     785       (588 )

Domestic tobacco accrued settlement charges

     (30 )     (31 )     497  

Pension plan contributions

     (1,234 )     (1,078 )     (1,183 )

Pension provisions and postretirement, net

     793       425       278  

Other

     874       314       33  

Financial services

                        

Deferred income tax (benefit) provision

     (126 )     7       267  

Provision for airline industry exposure

     200       140          

Other

     22       (54 )     52  
    


 


 


Net cash provided by operating activities

     11,060       10,890       10,816  
    


 


 


Cash Provided By (Used in) Investing Activities

                        

Consumer products

                        

Capital expenditures

   $ (2,206 )   $ (1,913 )   $ (1,974 )

Purchase of businesses, net of acquired cash

     (4,932 )     (179 )     (1,041 )

Proceeds from sales of businesses

     1,668       18       96  

Other

     112       24       125  

Financial services

                        

Investments in finance assets

     (3 )     (10 )     (140 )

Proceeds from finance assets

     476       644       507  
    


 


 


Net cash used in investing activities

     (4,885 )     (1,416 )     (2,427 )
    


 


 


 

See notes to consolidated financial statements.

 

46


Exhibit 13

 

 

for the years ended December 31,        


   2005

    2004

    2003

 

Cash Provided By (Used in) Financing Activities

                        

Consumer products

                        

Net issuance (repayment) of short-term borrowings

     3,114       (1,090 )     (419 )

Long-term debt proceeds

     69       833       3,077  

Long-term debt repaid

     (1,779 )     (1,594 )     (1,871 )

Financial services

                        

Long-term debt repaid

             (189 )     (147 )

Repurchase of Altria Group, Inc. common stock

                     (777 )

Repurchase of Kraft Foods Inc. common stock

     (1,175 )     (688 )     (372 )

Dividends paid on Altria Group, Inc. common stock

     (6,191 )     (5,672 )     (5,285 )

Issuance of Altria Group, Inc. common stock

     985       827       443  

Other

     (157 )     (409 )     (108 )
    


 


 


Net cash used in financing activities

     (5,134 )     (7,982 )     (5,459 )
    


 


 


Effect of exchange rate changes on cash and cash equivalents

     (527 )     475       282  
    


 


 


Cash and cash equivalents:

                        

Increase

     514       1,967       3,212  

Balance at beginning of year

     5,744       3,777       565  
    


 


 


Balance at end of year

   $ 6,258     $ 5,744     $ 3,777  
    


 


 


Cash paid:    Interest – Consumer products

   $ 1,628     $ 1,397     $ 1,336  
    


 


 


     – Financial services

   $ 106     $ 97     $ 120  
    


 


 


  Income taxes

   $ 5,397     $ 4,448     $ 4,158  
    


 


 


 

47


Exhibit 13

 

 

Notes to Consolidated Financial Statements

 

Note 1.

 

Background and Basis of Presentation:

 

·  Background: Throughout these financial statements, the term “Altria Group, Inc.” refers to the consolidated financial position, results of operations and cash flows of the Altria family of companies, and the term “ALG” refers solely to the parent company. ALG’s wholly-owned subsidiaries, Philip Morris USA Inc. (“PM USA”) and Philip Morris International Inc. (“PMI”), and its majority-owned (87.2% as of December 31, 2005) subsidiary, Kraft Foods Inc. (“Kraft”), are engaged in the manufacture and sale of various consumer products, including cigarettes and other tobacco products, packaged grocery products, snacks, beverages, cheese and convenient meals. Philip Morris Capital Corporation (“PMCC”), another wholly-owned subsidiary, maintains a portfolio of leveraged and direct finance leases. In addition, ALG had a 28.7% economic interest in SABMiller plc (“SABMiller”) as of December 31, 2005. ALG’s access to the operating cash flows of its subsidiaries consists of cash received from the payment of dividends and interest, and the repayment of amounts borrowed from ALG by its subsidiaries.

 

In June 2005, Kraft sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings for all years presented. The assets related to the sugar confectionery business were reflected as assets of discontinued operations held for sale on the consolidated balance sheet at December 31, 2004.

 

·  Basis of presentation: The consolidated financial statements include ALG, as well as its wholly-owned and majority-owned subsidiaries. Investments in which ALG exercises significant influence (20%-50% ownership interest), are accounted for under the equity method of accounting. Investments in which ALG has an ownership interest of less than 20%, or does not exercise significant influence, are accounted for with the cost method of accounting. All intercompany transactions and balances have been eliminated.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent liabilities at the dates of the financial statements and the reported amounts of net revenues and expenses during the reporting periods. Significant estimates and assumptions include, among other things, pension and benefit plan assumptions, lives and valuation assumptions of goodwill and other intangible assets, marketing programs, income taxes, and the allowance for loan losses and estimated residual values of finance leases. Actual results could differ from those estimates.

 

Balance sheet accounts are segregated by two broad types of business. 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.

 

Kraft’s operating subsidiaries generally report year-end results as of the Saturday closest to the end of each year. This resulted in fifty-three weeks of operating results for Kraft in the consolidated statement of earnings for the year ended December 31, 2005, versus fifty-two weeks for the years ended December 31, 2004 and 2003.

 

As discussed in Note 14. Income Taxes, classification of certain prior years’ amounts have been revised to conform with the current year’s presentation.

 

Note 2.

 

Summary of Significant Accounting Policies:

 

·  Cash and cash equivalents: Cash equivalents include demand deposits with banks and all highly liquid investments with original maturities of three months or less.

 

·  Depreciation, amortization and goodwill valuation: Property, plant and equipment are stated at historical cost and depreciated by the straight-line method over the estimated useful lives of the assets. Machinery and equipment are depreciated over periods ranging from 3 to 20 years, and buildings and building improvements over periods up to 50 years.

 

    Definite life intangible assets are amortized over their estimated useful lives. Altria Group, Inc. is required to conduct an annual review of goodwill and intangible assets for potential impairment. Goodwill impairment testing requires a comparison between the carrying value and fair value of each reporting unit. If the carrying value exceeds the fair value, goodwill is considered impaired. The amount of impairment loss is measured as the difference between the carrying value and implied fair value of goodwill, which is determined using discounted cash flows. Impairment testing for non-amortizable intangible assets requires a comparison between the fair value and carrying value of the intangible asset. If the carrying value exceeds fair value, the intangible asset is considered impaired and is reduced to fair value. During 2005, Altria Group, Inc. completed its annual review of goodwill and intangible assets, and no charges resulted from this review. However, as part of the sale or pending sale of certain Canadian assets and two brands, Kraft recorded total non-cash pre-tax asset impairment charges of $269 million in 2005, which included impairment of goodwill and intangible assets of $13 million and $118 million, respectively, as well as $138 million of asset write-downs. The 2004 review of goodwill and intangible assets resulted in a $29 million non-cash pre-tax charge at Kraft related to an intangible asset impairment for a small confectionery business in the United States and certain brands in Mexico. A portion of this charge, $12 million, was recorded as asset impairment and exit costs on the consolidated statement of earnings. The remainder of the charge, $17 million, was included in discontinued operations.

 

Goodwill by segment was as follows:

 

(in millions)    


   December 31,
2005


   December 31,
2004


International tobacco

   $ 5,571    $ 2,222

North American food

     20,803      20,511

International food

     4,845      5,323
    

  

Total goodwill

   $ 31,219    $ 28,056
    

  

 

48


Exhibit 13

 

 

Intangible assets were as follows :

 

     December 31, 2005

   December 31, 2004

(in millions)                


  

Gross

Carrying

Amount


   Accumulated
Amortization


  

Gross

Carrying

Amount


   Accumulated
Amortization


Non-amortizable intangible assets

   $ 11,867           $ 10,901       

Amortizable intangible assets

     410    $ 81      212    $ 57
    

  

  

  

Total intangible assets

   $ 12,277    $ 81    $ 11,113    $ 57
    

  

  

  

 

Non-amortizable intangible assets substantially consist of brand names from Kraft’s acquisition of Nabisco Holdings Corp. (“Nabisco”) in 2000 and PMI’s 2005 acquisition in Indonesia. Amortizable intangible assets consist primarily of certain trademark licenses and non-compete agreements. Pre-tax amortization expense for intangible assets during the years ended December 31, 2005, 2004 and 2003, was $28 million, $17 million and $9 million, respectively. Amortization expense for each of the next five years is estimated to be $30 million or less, assuming no additional transactions occur that require the amortization of intangible assets.

 

The movement in goodwill and gross carrying amount of intangible assets is as follows:

 

     2005

    2004

 

(in millions)                


   Goodwill

   

Intangible

Assets


    Goodwill

   

Intangible

Assets


 

Balance at January 1

   $ 28,056     $ 11,113     $ 27,742     $ 11,842  

Changes due to:

                                

Divestitures

     (18 )                        

Acquisitions

     3,707       1,346       90       74  

Reclassification to assets held for sale

                     (814 )     (485 )

Currency

     (866 )     (64 )     640       3  

Asset impairment

     (13 )     (118 )             (29 )

Other

     353               398       (292 )
    


 


 


 


Balance at December 31

   $ 31,219     $ 12,277     $ 28,056     $ 11,113  
    


 


 


 


 

As a result of Kraft’s common stock repurchases, ALG’s ownership percentage of Kraft has increased from 85.4% at December 31, 2004 to 87.2% at December 31, 2005, thereby resulting in an increase in goodwill. Other, above, includes this additional goodwill, as well as the 2004 reclassification to goodwill of certain amounts previously classified as indefinite life intangible assets, and 2004 tax adjustments related to the Nabisco acquisition. The increase in goodwill and intangible assets from acquisitions during 2005 is related to preliminary allocations of purchase price for PMI’s acquisitions in Indonesia and Colombia. The allocations are based upon preliminary estimates and assumptions and are subject to revision when appraisals are finalized, which will be in the first half of 2006.

 

·  Environmental costs: Altria Group, Inc. is subject to laws and regulations relating to the protection of the environment. Altria Group, Inc. provides for expenses associated with environmental remediation obligations on an undiscounted basis when such amounts are probable and can be reasonably estimated. Such accruals are adjusted as new information develops or circumstances change.

 

While it is not possible to quantify with certainty the potential impact of actions regarding environmental remediation and compliance efforts that Altria Group, Inc. may undertake in the future, in the opinion of management, environmental remediation and compliance costs, before taking into account any recoveries from third parties, will not have a material adverse effect on Altria Group, Inc.’s consolidated financial position, results of operations or cash flows.

 

·  Finance leases: Income attributable to leveraged leases is initially recorded as unearned income and subsequently recognized as revenue over the terms of the respective leases at constant after-tax rates of return on the positive net investment balances. Investments in leveraged leases are stated net of related nonrecourse debt obligations.

 

Income attributable to direct finance leases is initially recorded as unearned income and subsequently recognized as revenue over the terms of the respective leases at constant pre-tax rates of return on the net investment balances.

 

Finance leases include unguaranteed residual values that represent PMCC’s estimates at lease inception as to the fair values of assets under lease at the end of the non-cancelable lease terms. The estimated residual values are reviewed annually by PMCC’s management based on a number of factors and activity in the relevant industry. If necessary, revisions are recorded to reduce the residual values. Such reviews resulted in no adjustments in 2005 and a decrease of $25 million to PMCC’s net revenues and results of operations in 2004. There were also no adjustments in 2003.

 

·  Foreign currency translation: Altria Group, Inc. translates the results of operations of its foreign subsidiaries using average exchange rates during each period, whereas balance sheet accounts are translated using exchange rates at the end of each period. Currency translation adjustments are recorded as a component of stockholders’ equity. Transaction gains and losses are recorded in the consolidated statements of earnings and were not significant for any of the periods presented.

 

·  Guarantees: Altria Group, Inc. accounts for guarantees in accordance with Financial Accounting Standards Board (“FASB”) Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” Interpretation No. 45 requires the disclosure of certain guarantees and requires the recognition of a liability for the fair value of the obligation of qualifying guarantee activities. See Note 19. Contingencies for a further discussion of guarantees.

 

·  Hedging instruments: Derivative financial instruments are recorded at fair value on the consolidated balance sheets as either assets or liabilities. Changes in the fair value of derivatives are recorded each period either in accumulated other comprehensive earnings (losses) or in earnings, depending on whether a derivative is designated and effective as part of a hedge transaction and, if it is, the type of hedge transaction. Gains and losses on derivative instruments reported in accumulated other comprehensive earnings (losses) are reclassified to the consolidated statements of earnings in the periods in which operating results are affected by the hedged item. Cash flows from hedging instruments are classified in the same manner as the affected hedged item in the consolidated statements of cash flows.

 

·  Impairment of long-lived assets: Altria Group, Inc. reviews long-lived assets, including amortizable intangible assets, for impairment whenever events or changes in business circumstances indicate that the carrying amount of the assets may not be fully recoverable. Altria Group, Inc. performs undiscounted operating cash flow analyses to determine if an impairment

 

49


Exhibit 13

 

 

exists. For purposes of recognition and measurement of an impairment for assets held for use, Altria Group, Inc. groups assets and liabilities at the lowest level for which cash flows are separately identifiable. If an impairment is determined to exist, any related impairment loss is calculated based on fair value. Impairment losses on assets to be disposed of, if any, are based on the estimated proceeds to be received, less costs of disposal.

 

·  Income taxes: Altria Group, Inc. accounts for income taxes in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Under SFAS No. 109, deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities, using enacted tax rates in effect for the year in which the differences are expected to reverse. Significant judgment is required in determining income tax provisions and in evaluating tax positions. ALG and its subsidiaries establish additional provisions for income taxes when, despite the belief that their tax positions are fully supportable, there remain certain positions that are likely to be challenged and that may not be sustained on review by tax authorities. Upon the closure of current and future tax audits in various jurisdictions, significant income tax accrual reversals could continue to occur in 2006. ALG and its subsidiaries evaluate and potentially adjust these accruals in light of changing facts and circumstances. The consolidated tax provision includes the impact of changes to accruals that are considered appropriate.

 

·  Inventories: Inventories are stated at the lower of cost or market. The last-in, first-out (“LIFO”) method is used to cost substantially all domestic inventories. The cost of other inventories is principally determined by the average cost method. It is a generally recognized industry practice to classify leaf tobacco inventory as a current asset although part of such inventory, because of the duration of the aging process, ordinarily would not be utilized within one year.

 

In 2004, the FASB issued SFAS No. 151, “Inventory Costs.” SFAS No. 151 requires that abnormal idle facility expense, spoilage, freight and handling costs be recognized as current-period charges. In addition, SFAS No. 151 requires that allocation of fixed production overhead costs to inventories be based on the normal capacity of the production facility. Altria Group, Inc. is required to adopt the provisions of SFAS No. 151 prospectively as of January 1, 2006, but the effect of adoption will not have a material impact on its consolidated results of operations, financial position or cash flows.

 

·  Marketing costs: ALG’s subsidiaries promote their products with advertising, consumer incentives and trade promotions. Such programs include, but are not limited to, discounts, coupons, rebates, in-store display incentives and volume-based incentives. Advertising costs are expensed as incurred. Consumer incentive and trade promotion activities are recorded as a reduction of revenues based on amounts estimated as being due to customers and consumers at the end of a period, based principally on historical utilization and redemption rates. For interim reporting purposes, advertising and certain consumer incentive expenses are charged to operations as a percentage of sales, based on estimated sales and related expenses for the full year.

 

·  Revenue recognition: The consumer products businesses recognize revenues, net of sales incentives and including shipping and handling charges billed to customers, upon shipment or delivery of goods when title and risk of loss pass to customers. ALG’s tobacco subsidiaries also include excise taxes billed to customers in revenues. Shipping and handling costs are classified as part of cost of sales.

 

·  Software costs: Altria Group, Inc. capitalizes certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use. Capitalized software costs are included in property, plant and equipment on the consolidated balance sheets and are amortized on a straight-line basis over the estimated useful lives of the software, which do not exceed five years.

 

·  Stock-based compensation: Altria Group, Inc. accounts for employee stock compensation plans in accordance with the intrinsic value-based method permitted by SFAS No. 123, “Accounting for Stock-Based Compensation,” which has not resulted in compensation cost for stock options. The market value at date of grant of restricted stock and rights to receive shares of stock is recorded as compensation expense over the period of restriction, which is generally three years.

 

At December 31, 2005, Altria Group, Inc. had stock-based employee compensation plans, which are described more fully in Note 12. Stock Plans. Altria Group, Inc. applies the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations in accounting for stock options within those plans. No compensation expense for employee stock options is reflected in net earnings, as all stock options granted under those plans had an exercise price not less than the market value of the common stock on the date of the grant. Net earnings, as reported, includes pre-tax compensation expense related to restricted stock and rights to receive shares of stock of $263 million, $185 million and $99 million for the years ended December 31, 2005, 2004 and 2003, respectively. The following table illustrates the effect on net earnings and earnings per share (“EPS”) if Altria Group, Inc. had applied the fair value recognition provisions of SFAS No. 123 to measure compensation expense for outstanding stock option awards for the years ended December 31, 2005, 2004 and 2003:

 

 

 

 

 

(in millions, except per share data)    


   2005

   2004

   2003

Net earnings, as reported

   $ 10,435    $ 9,416    $ 9,204

Deduct:

                    

Total stock-based employee compensation expense determined under fair value method for all stock option awards, net of related tax effects

     15      12      19
    

  

  

Pro forma net earnings

   $ 10,420    $ 9,404    $ 9,185
    

  

  

Earnings per share:

                    

Basic - as reported

   $ 5.04    $ 4.60    $ 4.54
    

  

  

Basic - pro forma

   $ 5.03    $ 4.59    $ 4.53
    

  

  

Diluted - as reported

   $ 4.99    $ 4.56    $ 4.52
    

  

  

Diluted - pro forma

   $ 4.98    $ 4.56    $ 4.51
    

  

  

 

Altria Group, Inc. has not granted stock options to employees since 2002. The amounts shown above as stock-based compensation expense in 2005 and 2004 relate primarily to Executive Ownership Stock Options (“EOSOs”). Under certain circumstances, senior executives who exercise outstanding stock options, using shares to pay the option exercise price and taxes, receive EOSOs equal to the number of shares tendered. During the years ended December 31, 2005, 2004 and 2003, Altria Group, Inc. granted 2.0 million, 1.7 million and 1.3 million EOSOs, respectively.

 

In 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123R”). SFAS No. 123R requires companies to measure compensation cost for share-based payments at fair value. Altria Group, Inc. will adopt this new standard prospectively, on January 1, 2006, and it will not have a material impact on Altria Group, Inc.’s consolidated financial position, results of operations or cash flows.

 

50


Exhibit 13

 

 

Note 3.

 

Asset Impairment and Exit Costs:

 

For the years ended December 31, 2005, 2004 and 2003, pre-tax asset impairment and exit costs consisted of the following:

 

(in millions)    


        2005

   2004

   2003

Separation program    Domestic tobacco    $ -    $ 1    $ 13
Separation program    International tobacco*      55      31       
Separation program    General corporate**      49      56      26
Restructuring program    North American food      66      383       
Restructuring program    International food      144      200       
Asset impairment    International tobacco*      35      13       
Asset impairment    North American food      269      8       
Asset impairment    International food             12      6
Asset impairment    General corporate**             10      41
Lease termination    General corporate**             4       
         

  

  

Asset impairment and exit costs         $ 618    $ 718    $ 86
         

  

  


*  During 2005, PMI recorded pre-tax charges of $90 million, primarily related to the write-off of obsolete equipment, severance benefits and impairment charges associated with the closure of a factory in the Czech Republic, and the streamlining of various operations. During 2004, PMI recorded pre-tax charges of $44 million for severance benefits and impairment charges related to the closure of its Eger, Hungary facility and a factory in Belgium, and the streamlining of its Benelux operations.

 

**In 2005, 2004 and 2003, Altria Group, Inc. recorded pre-tax charges of $49 million, $70 million and $26 million, respectively, primarily related to the streamlining of various corporate functions in each year, and the write-off of an investment in an e-business consumer products purchasing exchange in 2004. In addition, during 2004, Altria Group, Inc. sold its office facility in Rye Brook, New York. In connection with this sale, Altria Group, Inc. recorded a pre-tax charge in 2003 of $41 million to write down the facility and the related fixed assets to fair value.

 

Kraft Restructuring Program

 

In January 2004, Kraft announced a multi-year restructuring program with the objectives of leveraging Kraft’s global scale, realigning and lowering its cost structure, and optimizing capacity utilization. As part of this program, Kraft anticipates the closing or sale of up to twenty plants and the elimination of approximately six thousand positions. From 2004 through 2006, Kraft expects to incur approximately $1.2 billion in pre-tax charges for the program, reflecting asset disposals, severance and other implementation costs, including $297 million and $641 million incurred in 2005 and 2004, respectively. Approximately sixty percent of the pre-tax charges are expected to require cash payments. In addition, in January 2006, Kraft announced plans to continue its restructuring efforts beyond those originally contemplated. Additional pre-tax charges are anticipated to be $2.5 billion from 2006 to 2009, of which approximately $1.6 billion are expected to require cash payments. These charges will result in the anticipated closure of up to 20 additional facilities and the elimination of approximately 8,000 additional positions. Initiatives under the expanded program include additional organizational streamlining and facility closures. The entire restructuring program is expected to ultimately result in $3.7 billion in pre-tax charges, the closure of up to 40 facilities and the elimination of approximately 14,000 positions. Approximately $2.3 billion of the $3.7 billion in pre-tax charges are expected to require cash payments.

 

During 2005, Kraft recorded $479 million of asset impairment and exit costs on the consolidated statement of earnings. These pre-tax charges were composed of $210 million of costs under the restructuring program, and $269 million of asset impairment charges related to the sale of Kraft’s fruit snacks assets in 2005 and Kraft’s pending sale of certain assets in Canada and a small biscuit brand in the United States. The 2005 pre-tax restructuring charges reflect the announcement of the closing of 6 plants, for a total of 19 since January 2004, and the continuation of a number of workforce reduction programs. Approximately $170 million of the pre-tax charges incurred in 2005 will require cash payments. During 2004, Kraft recorded $603 million of asset impairment and exit costs in the consolidated statement of earnings. These pre-tax charges were composed of $583 million of costs under the restructuring program, $12 million of impairment charges relating to intangible assets and $8 million of impairment charges related to the sale of Kraft’s yogurt brand. The 2004 restructuring charges resulted from the 2004 announcement of the closing of 13 plants, the termination of co-manufacturing agreements and the commencement of a number of workforce reduction programs.

 

Pre-tax restructuring liability activity for 2005 and 2004 was as follows:

 

 

 

 

(in millions)    


   Severance

   

Asset

Write-
downs


    Other

    Total

 

Liability balance, January 1, 2004

   $ -     $ -     $ -     $ -  

Charges

     176       363       44       583  

Cash spent

     (84 )             (26 )     (110 )

Charges against assets

     (5 )     (363 )             (368 )

Currency

     4               1       5  
    


 


 


 


Liability balance, December 31, 2004

     91       -       19       110  

Charges

     154       30       26       210  

Cash spent

     (114 )             (50 )     (164 )

Charges against assets

     (12 )     (30 )             (42 )

Currency/other

     (5 )             6       1  
    


 


 


 


Liability balance, December 31, 2005

   $ 114     $ -     $ 1     $ 115  
    


 


 


 


 

Severance costs in the above schedule, which relate to the workforce reduction programs, include the cost of related benefits. Specific programs announced during 2004 and 2005, as part of the overall restructuring program, will result in the elimination of approximately 5,500 positions. At December 31, 2005, approximately 4,900 of these positions have been eliminated. Asset write-downs relate to the impairment of assets caused by the plant closings and related activity. Other costs incurred relate primarily to contract termination costs associated with the plant closings and the

 

51


Exhibit 13

 

 

termination of co-manufacturing and leasing agreements. Severance charges taken against assets relate to incremental pension costs, which reduce prepaid pension assets.

 

During 2005 and 2004, Kraft recorded pre-tax implementation costs associated with the restructuring program. These costs include the discontinuance of certain product lines and incremental costs related to the integration and streamlining of functions and closure of facilities. Substantially all implementation costs incurred in 2005 will require cash payments. These costs were recorded on the consolidated statements of earnings as follows:

 

(in millions)        


   2005

   2004

Net revenues

   $ 2    $ 7

Cost of sales

     56      30

Marketing, administration and research costs

     29      13
    

  

Total - continuing operations

     87      50

Discontinued operations

            8
    

  

Total implementation costs

   $ 87    $ 58
    

  

 

Kraft Asset Impairment Charges

 

During 2005, Kraft sold its fruit snacks assets for approximately $30 million and incurred a pre-tax asset impairment charge of $93 million in recognition of the sale. During December 2005, Kraft reached agreements to sell certain assets in Canada and a small biscuit brand in the United States. These transactions are expected to close in the first quarter of 2006. Kraft incurred pre-tax asset impairment charges of $176 million in recognition of these pending sales. These charges, which include the write-off of all associated intangible assets, were recorded as asset impairment and exit costs on the consolidated statement of earnings.

 

During 2004, Kraft recorded a $29 million non-cash pre-tax charge related to an intangible asset impairment for a small confectionery business in the United States and certain brands in Mexico. A portion of this charge, $17 million, was reclassified to earnings from discontinued operations on the consolidated statement of earnings in the fourth quarter of 2004.

 

In November 2004, following discussions between Kraft and its joint venture partner in Turkey, and an independent valuation of its equity investment, it was determined that a permanent decline in value had occurred. This valuation resulted in a $47 million non-cash pre-tax charge. This charge was recorded as marketing, administration and research costs on the consolidated statement of earnings. During 2005, Kraft’s interest in the joint venture was sold.

 

In 2004, as a result of the anticipated sale of the sugar confectionery business in 2005, Kraft recorded non-cash asset impairments totaling $107 million. This charge was included in loss from discontinued operations on the consolidated statement of earnings.

 

In 2004, as a result of the anticipated sale of a yogurt brand in 2005, Kraft recorded asset impairments totaling $8 million. This charge was recorded as asset impairment and exit costs on the consolidated statement of earnings.

 

Note 4.

 

Divestitures:

 

Discontinued Operations

 

In June 2005, Kraft sold substantially all of its sugar confectionery business for pre-tax proceeds of approximately $1.4 billion. The sale included the Life Savers, Creme Savers, Altoids, Trolli and Sugus brands. Altria Group, Inc. has reflected the results of Kraft’s sugar confectionery business prior to the closing date as discontinued operations on the consolidated statements of earnings for all years presented. Pursuant to the sugar confectionery sale agreement, Kraft has agreed to provide certain transition and supply services to the buyer. These service arrangements are primarily for terms of one year or less, with the exception of one supply arrangement with a term of not more than three years. The expected cash flow from this supply arrangement is not significant.

 

Summary results of operations for the sugar confectionery business for the years ended December 31, 2005, 2004 and 2003, were as follows:

 

(in millions)        


   2005

    2004

    2003

 

Net revenues

   $ 228     $ 477     $ 512  
    


 


 


Earnings before income taxes and minority interest

   $ 41     $ 103     $ 151  

Impairment loss on assets of discontinued operations held for sale

             (107 )        

Provision for income taxes

     (16 )             (54 )

Loss on sale of discontinued operations

     (297 )                

Minority interest in loss (earnings) from discontinued operations

     39               (14 )
    


 


 


(Loss) earnings from discontinued operations, net of income taxes and minority interest

   $ (233 )   $ (4 )   $ 83  
    


 


 


 

As a result of the sale, Kraft recorded a net loss on sale of discontinued operations of $297 million in 2005, related largely to taxes on the transaction. ALG’s share of the loss, net of minority interest, was $255 million.

 

The assets of the sugar confectionery business, which were reflected as assets of discontinued operations held for sale on the consolidated balance sheet at December 31, 2004, were as follows (in millions):

 

Inventories

   $ 65  

Property, plant and equipment, net

     201  

Goodwill

     814  

Other intangible assets, net

     485  

Impairment loss on assets of discontinued operations held for sale

     (107 )
    


Assets of discontinued operations held for sale

   $ 1,458  
    


 

Other

 

During 2005, Kraft sold its fruit snacks assets and incurred a pre-tax asset impairment charge of $93 million in recognition of this sale. Additionally, during 2005, Kraft sold its desserts assets in the U.K. and its U.S. yogurt brand. The aggregate proceeds received from other divestitures during 2005 were $238 million, on which pre-tax gains of $108 million were recorded. In December 2005, Kraft announced the sale of certain Canadian assets and a small U.S. biscuit brand, incurring pre-tax asset impairment charges of $176 million in recognition of these sales. These transactions are expected to close in the first quarter of 2006.

 

During 2004, Kraft sold a Brazilian snack nuts business and trademarks associated with a candy business in Norway. The aggregate proceeds received from the sales of these businesses were $18 million, on which pre-tax losses of $3 million were recorded.

 

52


Exhibit 13

 

 

During 2003, Kraft sold a European rice business and a branded fresh cheese business in Italy. The aggregate proceeds received from the sales of businesses in 2003 were $96 million, on which pre-tax gains of $31 million were recorded.

 

The operating results of the other divestitures, discussed above, in the aggregate, were not material to Altria Group, Inc.’s consolidated financial position, operating results or cash flows in any of the periods presented.

 

Note 5.

 

Acquisitions:

 

Sampoerna

 

In March 2005, a subsidiary of PMI acquired 40% of the outstanding shares of PT HM Sampoerna Tbk (“Sampoerna”), an Indonesian tobacco company. In May 2005, PMI purchased an additional 58%, for a total of 98%. The total cost of the transaction was approximately $4.8 billion, including Sampoerna’s cash of approximately $0.3 billion and debt of the U.S. dollar equivalent of approximately $0.2 billion. The purchase price was primarily financed through a euro 4.5 billion bank credit facility arranged for PMI and its subsidiaries in May 2005, consisting of a euro 2.5 billion three-year term loan facility and a euro 2.0 billion five-year revolving credit facility. These facilities are not guaranteed by ALG.

 

The acquisition of Sampoerna allowed PMI to enter the profitable kretek cigarette segment in Indonesia. Sampoerna’s financial position and results of operations have been fully consolidated with PMI as of June 1, 2005. From March 2005 to May 2005, PMI recorded equity earnings in Sampoerna. Sampoerna contributed $315 million of operating income and $128 million of net earnings since March 2005.

 

Assets purchased consist primarily of goodwill of $3.5 billion, other intangible assets of $1.3 billion, inventories of $0.5 billion and property, plant and equipment of $0.4 billion. Liabilities assumed in the acquisition consist principally of long-term debt of $0.2 billion and accrued liabilities. These amounts represent the preliminary allocation of purchase price and are subject to revision when appraisals are finalized, which will be in the first half of 2006.

 

Other

 

During 2005, PMI acquired a 98.2% stake in Coltabaco, the largest tobacco company in Colombia, with a 48% market share, for approximately $300 million.

 

During 2004, Kraft purchased a U.S.-based beverage business, and PMI purchased a tobacco business in Finland. The total cost of acquisitions during 2004 was $179 million.

 

During 2003, PMI purchased approximately 74.2% of a tobacco business in Serbia for a cost of $486 million and purchased 99% of a tobacco business in Greece for approximately $387 million. PMI also increased its ownership interest in its affiliate in Ecuador from less than 50% to approximately 98% for a cost of $70 million. In addition, Kraft acquired a biscuits business in Egypt and acquired trademarks associated with a small U.S.-based natural foods business. The total cost of acquisitions during 2003 was $1.0 billion.

 

The effects of these other acquisitions were not material to Altria Group, Inc.’s consolidated financial position, results of operations or operating cash flows in any of the periods presented.

 

Note 6.

 

Inventories:

 

The cost of approximately 34% and 35% of inventories in 2005 and 2004, respectively, was determined using the LIFO method. The stated LIFO amounts of inventories were approximately $0.6 billion and $0.8 billion lower than the current cost of inventories at December 31, 2005 and 2004, respectively.

 

Note 7.

 

Investment in SABMiller:

 

At December 31, 2005, ALG had a 28.7% economic and voting interest in SABMiller. ALG’s ownership interest in SABMiller is being accounted for under the equity method. Accordingly, ALG’s investment in SABMiller of approximately $3.4 billion and $2.5 billion is included in other assets on the consolidated balance sheets at December 31, 2005 and 2004, respectively. In October 2005, SABMiller purchased a 71.8% interest in Bavaria SA, the second-largest brewer in South America, in exchange for the issuance of 225 million SABMiller ordinary shares. The ordinary shares had a value of approximately $3.5 billion. The remaining shares of Bavaria SA were acquired via a cash tender offer. Following the completion of the share issuance, ALG’s economic ownership interest in SABMiller was reduced from 33.9% to approximately 28.7%. In addition, ALG elected to convert all of its non-voting shares into voting shares, and as a result increased its voting interest from 24.9% to 28.7%. The issuance of SABMiller ordinary shares in exchange for a controlling interest in Bavaria SA resulted in a change of ownership gain for ALG of $402 million, net of income taxes, that was recorded in stockholders’ equity in the fourth quarter of 2005. ALG records its share of SABMiller’s net earnings, based on its economic ownership percentage, in minority interest in earnings from continuing operations and equity earnings, net, on the consolidated statements of earnings.

 

Note 8.

 

Finance Assets, net:

 

In 2003, PMCC shifted its strategic focus and is no longer making new investments but is instead focused on managing its existing portfolio of finance assets in order to maximize gains and generate cash flow from asset sales and related activities. Accordingly, PMCC’s operating companies income will fluctuate over time as investments mature or are sold. During 2005, 2004 and 2003, PMCC received proceeds from asset sales and maturities of $476 million, $644 million and $507 million, respectively, and recorded gains of $72 million, $112 million and $45 million, respectively, in operating companies income.

 

At December 31, 2005, finance assets, net, of $7,189 million were comprised of investments in finance leases of $7,737 million and other receivables of $48 million, reduced by allowance for losses of $596 million. At December 31, 2004, finance assets, net, of $7,827 million were comprised of investments in finance leases of $8,266 million and other receivables of $58 million, reduced by allowance for losses of $497 million.

 

53


Exhibit 13

 

 

A summary of the net investment in finance leases at December 31, before allowance for losses, was as follows:

 

(in millions)            


   Leveraged Leases

   

Direct

Finance Leases


    Total

 
   2005

    2004

    2005

    2004

    2005

    2004

 

Rentals receivable, net

   $ 8,237     $ 8,726     $ 628     $ 747     $ 8,865     $ 9,473  

Unguaranteed residual values

     1,846       2,139       101       110       1,947       2,249  

Unearned income

     (2,878 )     (3,237 )     (159 )     (177 )     (3,037 )     (3,414 )

Deferred investment tax credits

     (38 )     (42 )                     (38 )     (42 )
    


 


 


 


 


 


Investments in finance leases

     7,167       7,586       570       680       7,737       8,266  

Deferred income taxes

     (5,666 )     (5,739 )     (320 )     (351 )     (5,986 )     (6,090 )
    


 


 


 


 


 


Net investments in finance leases

   $ 1,501     $ 1,847     $ 250     $ 329     $ 1,751     $ 2,176  
    


 


 


 


 


 


 

For leveraged leases, rentals receivable, net, represent unpaid rentals, net of principal and interest payments on third-party nonrecourse debt. PMCC’s rights to rentals receivable are subordinate to the third-party nonrecourse debtholders, and the leased equipment is pledged as collateral to the debtholders. The payment of the nonrecourse debt is collateralized by lease payments receivable and the leased property, and is nonrecourse to the general assets of PMCC. As required by U.S. GAAP, the third-party nonrecourse debt of $16.7 billion and $18.3 billion at December 31, 2005 and 2004, respectively, has been offset against the related rentals receivable. There were no leases with contingent rentals in 2005, 2004 and 2003.

 

At December 31, 2005, PMCC’s investment in finance leases was principally comprised of the following investment categories: aircraft (27%), electric power (26%), surface transport (21%), manufacturing (13%), real estate (11%) and energy (2%). Investments located outside the United States, which are primarily dollar-denominated, represent 20% and 19% of PMCC’s investments in finance leases in 2005 and 2004, respectively.

 

Among its leasing activities, PMCC leases a number of aircraft, predominantly to major United States passenger carriers. At December 31, 2005, $2.1 billion of PMCC’s finance asset balance related to aircraft. Two of PMCC’s aircraft lessees, Delta Air Lines, Inc. (“Delta”) and Northwest Airlines, Inc. (“Northwest”) are currently under bankruptcy protection, and a third lessee, United Air Lines, Inc. (“United”), exited bankruptcy on February 1, 2006. PMCC is not recording income on these leases. In addition, PMCC leases various natural gas-fired power plants to indirect subsidiaries of Calpine Corporation (“Calpine”), also currently under bankruptcy protection. PMCC is not recording income on these leases.

 

PMCC leases 24 Boeing 757 aircraft to United with an aggregate finance asset balance of $541 million at December 31, 2005. PMCC has entered into an agreement with United to amend 18 direct finance leases and United has assumed the 18 amended leases. There is no third-party debt associated with these leases. United remains current on lease payments due to PMCC on these 18 amended leases. PMCC continues to monitor the situation at United with respect to the six remaining aircraft financed under leveraged leases, in which PMCC has an aggregate finance asset balance of $92 million. United and the public debtholders have a court approved agreement that calls for the public debtholders to foreclose on PMCC’s interests in these six aircraft and transfer them to United. The foreclosure, expected to occur in 2006, subsequent to United’s emergence from bankruptcy, would result in the write-off of the $92 million finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments in the amount of approximately $55 million on these leases.

 

In addition, PMCC has an aggregate finance asset balance of $257 million at December 31, 2005, relating to six Boeing 757, nine Boeing 767 and four McDonnell Douglas (MD-88) aircraft leased to Delta under leveraged leases. In November 2004, PMCC, along with other aircraft lessors, entered into restructuring agreements with Delta on all 19 aircraft. As a result of its agreement, PMCC recorded a charge to the allowance for losses of $40 million in the fourth quarter of 2004. As a result of Delta’s bankruptcy filing in September 2005, the restructuring agreement is no longer in effect and PMCC is at risk of having its interest in these aircraft foreclosed upon by the senior lenders under the leveraged leases. Should a foreclosure occur, it would also result in the write-off of the finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments on these leases, and may require further provisions to increase the allowance for losses.

 

PMCC also leases three Airbus A-320 aircraft and five British Aerospace RJ85 aircraft to Northwest financed under leveraged leases with an aggregate finance asset balance of $62 million at December 31, 2005. Northwest filed for bankruptcy protection in September 2005. As a result of Northwest’s bankruptcy filing, PMCC is at risk of having its interest in these aircraft foreclosed upon by the senior lenders under the leveraged leases. Should a foreclosure occur, it would also result in the write-off of the finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments on these leases.

 

In addition, PMCC’s leveraged leases for ten Airbus A-319 aircraft with Northwest have been rejected in the bankruptcy. As a result of the lease rejection, PMCC, as owner of the aircraft, recorded these assets on its consolidated balance sheet at the lower of net book value or fair market value. The adjustment to fair market value resulted in a $100 million charge against the allowance for losses in the fourth quarter of 2005. The assets are classified as held for sale and reflected in other assets on the consolidated balance sheet until such time as the assets are either sold or foreclosed upon by the lenders. In addition, the related nonrecourse debt is reflected in other liabilities on the consolidated balance sheet until such time as the underlying assets are either sold or foreclosed upon by the senior lenders. Should a foreclosure occur, it would result in the acceleration of tax payments on these aircraft of approximately $57 million.

 

In addition, PMCC leases 16 Airbus A-319 aircraft to US Airways, Inc. (“US Airways”) financed under leveraged leases with an aggregate finance asset balance of $150 million at December 31, 2005. In September 2005, US Airways emerged from bankruptcy protection and assumed the leases on PMCC’s aircraft without any changes. Also in September 2005, US Airways and America West Holdings Corp. (“America West”) completed a merger. PMCC leases five Airbus A-320 aircraft and three engines to America West with an aggregate finance asset balance of $44 million at December 31, 2005.

 

54


Exhibit 13

 

 

PMCC also leases two 265 megawatt (“MW”) natural gas-fired power plants (located in Tiverton, Rhode Island, and Rumford, Maine) and one 750 MW natural gas-fired power plant (located in Pasadena, Texas) to indirect subsidiaries of Calpine financed under leveraged leases with an aggregate finance asset balance of $206 million at December 31, 2005. On December 20, 2005, Calpine filed for bankruptcy protection. In the initial bankruptcy filing, PMCC’s lessees of the Tiverton and Rumford projects were included. On February 6, 2006, these leases were rejected. The Pasadena lessee did not file for bankruptcy but could file at a future date. Should a foreclosure on any of these projects occur, it would result in the write-off of the finance asset balance against PMCC’s allowance for losses and the acceleration of tax payments on these leases, and may require further provisions to increase the allowance for losses.

 

Due to continuing uncertainty within its airline portfolio and bankruptcy filings by Delta and Northwest, PMCC recorded a provision for losses of $200 million in September 2005. As a result of this provision, PMCC’s fixed charges coverage ratio did not meet its 1.25:1 requirement under a support agreement with ALG. Accordingly, as required by the support agreement, a support payment of $150 million was made by ALG to PMCC in September 2005.

 

Previously, PMCC recorded provisions for losses of $140 million in the fourth quarter of 2004 and $290 million in the fourth quarter of 2002 for its airline industry exposure. At December 31, 2005, PMCC’s allowance for losses, which includes the provisions recorded by PMCC for its airline industry exposure, was $596 million. It is possible that adverse developments in the airline or other industries may require PMCC to increase its allowance for losses.

 

Rentals receivable in excess of debt service requirements on third-party nonrecourse debt related to leveraged leases and rentals receivable from direct finance leases at December 31, 2005, were as follows:

 

(in millions)      


   Leveraged
Leases


   Direct
Finance
Leases


   Total

2006

   $ 233    $ 48    $ 281

2007

     209      32      241

2008

     329      19      348

2009

     298      19      317

2010

     348      17      365

2011 and thereafter

     6,820      493      7,313
    

  

  

Total

   $ 8,237    $ 628    $ 8,865
    

  

  

 

Included in net revenues for the years ended December 31, 2005, 2004 and 2003, were leveraged lease revenues of $303 million, $351 million and $333 million, respectively, and direct finance lease revenues of $11 million, $38 million and $90 million, respectively. Income tax expense on leveraged lease revenues for the years ended December 31, 2005, 2004 and 2003, was $108 million, $136 million and $120 million, respectively.

 

Income from investment tax credits on leveraged leases and initial direct costs and executory costs on direct finance leases were not significant during the years ended December 31, 2005, 2004 and 2003.

 

Note 9.

 

Short-Term Borrowings and Borrowing Arrangements:

 

At December 31, 2005 and 2004, Altria Group, Inc.’s short-term borrowings and related average interest rates consisted of the following (in millions):

 

     2005

    2004

 
     Amount
Outstanding


    Average
Year-End
Rate


    Amount
Outstanding


   Average
Year-End
Rate


 

Consumer products:

                           

Bank loans

   $ 4,809     4.2 %   $ 878    4.9 %

Commercial pa