EX-13 7 dex13.htm PAGES 17 TO 93 OF THE 2007 ANNUAL REPORT Pages 17 to 93 of the 2007 Annual Report

Exhibit 13

 

FINANCIAL REVIEW

 

   

Financial Contents

    
    Management’s Discussion and Analysis of Financial Condition and Results of Operations    page 18
    Selected Financial Data — Five-Year Review    page 47
    Consolidated Balance Sheets    page 48
    Consolidated Statements of Earnings    page 50
    Consolidated Statements of Stockholders’ Equity    page 51
    Consolidated Statements of Cash Flows    page 52
    Notes to Consolidated Financial Statements    page 54
    Report of Independent Registered Public Accounting Firm    page 92
    Report of Management on Internal Control Over Financial Reporting    page 93
          

Guide To Select Disclosures

    
    For easy reference, areas that may be of interest to investors are highlighted in the index below.     
    Acquisitions — Note 5    page 60
    Benefit Plans — Note 16 includes a discussion of pension plans    page 70
    Contingencies — Note 19 includes a discussion of litigation    page 76
    Finance Assets, net — Note 8 includes a discussion of leasing activities    page 62
    Philip Morris International Spin-Off    Inside cover/page 18
    Kraft Spin-Off    page 19
    Segment Reporting — Note 15    page 69
    Stock Plans — Note 12 includes a discussion of stock compensation    page 65

 

 

17


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”), Philip Morris International Inc. (“PMI”) and John Middleton, Inc. are engaged in the manufacture and sale of cigarettes and other tobacco products. Philip Morris Capital Corporation (“PMCC”), another wholly-owned subsidiary, maintains a portfolio of leveraged and direct finance leases. In addition, ALG held a 28.6% economic and voting interest in SABMiller plc (“SABMiller”) at December 31, 2007. 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 2007, ALG received $6.6 billion in cash dividends from PMI.

 

On March 30, 2007, Altria Group, Inc. distributed all of its remaining interest in Kraft Foods, Inc. (“Kraft”) on a pro-rata basis to Altria Group, Inc. stockholders in a tax-free distribution. For further discussion, please refer to the Kraft Spin-Off discussion below. Altria Group, Inc. has reclassified and reflected the results of Kraft prior to the Kraft Distribution Date as discontinued operations on the consolidated statements of earnings and the consolidated statements of cash flows for all periods presented. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the consolidated balance sheet at December 31, 2006.

 

PMI Spin-Off

 

On January 30, 2008, the Board of Directors announced that Altria Group, Inc. plans to spin off all of its interest in PMI to Altria Group, Inc. stockholders in a tax-free distribution. The distribution of all the PMI shares owned by Altria Group, Inc. is expected to be made on March 28, 2008 (the “PMI Distribution Date”), to Altria Group, Inc. stockholders of record as of the close of business on March 19, 2008 (the “PMI Record Date”). Altria Group, Inc. will distribute one share of PMI common stock for every share of Altria Group, Inc. common stock outstanding as of the PMI Record Date. Following the PMI Distribution Date, Altria Group, Inc. will not own any shares of PMI common stock. Altria Group, Inc. intends to adjust its current dividend so that its stockholders who retain their Altria Group, Inc. and PMI shares will receive, in the aggregate, the same dividend dollars as before the PMI Distribution Date. Following the distribution, PMI’s initial annualized dividend rate will be $1.84 per common share and Altria Group, Inc.’s initial annualized dividend rate will be $1.16 per common share. All decisions regarding future dividends will be made independently by the Altria Group, Inc. Board of Directors and the PMI Board of Directors, for their respective companies.

 

Holders of Altria Group, Inc. stock options will be treated similarly to public stockholders and will, accordingly, have their stock awards split into two instruments. Holders of Altria Group, Inc. stock options will receive the following stock options, which, immediately after the spin-off, will have an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:

 

   

a new PMI option to acquire the same number of shares of PMI common stock as the number of Altria Group, Inc. options held by such person on the PMI Distribution Date; and

 

   

an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price.

 

Holders of Altria Group, Inc. restricted stock or deferred stock awarded prior to January 30, 2008, will retain their existing awards and will receive the same number of shares of restricted or deferred stock of PMI. The restricted stock and deferred stock will not vest until the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. deferred stock awarded on January 30, 2008, who will be employed by Altria Group, Inc. after the PMI Distribution Date, will receive additional shares of deferred stock of Altria Group, Inc. to preserve the intrinsic value of the award. Recipients of Altria Group, Inc. deferred stock awarded on January 30, 2008, who will be employed by PMI after the PMI Distribution Date, will receive substitute shares of deferred stock of PMI to preserve the intrinsic value of the award.

 

        To the extent that employees of the remaining Altria Group, Inc. receive PMI stock options, Altria Group, Inc. will reimburse PMI in cash for the Black-Scholes fair value of the stock options to be received. To the extent that PMI employees hold Altria Group, Inc. stock options, PMI will reimburse Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that employees of the remaining Altria Group, Inc. receive PMI deferred stock, Altria Group, Inc. will pay to PMI the fair value of the PMI deferred stock less the value of projected forfeitures. To the extent that PMI employees hold Altria Group, Inc. restricted stock or deferred stock, PMI will reimburse Altria Group, Inc. in cash for the fair value of the restricted or deferred stock less the value of projected forfeitures and any amounts previously charged to PMI for the restricted or deferred stock. Based upon the number of Altria Group, Inc. stock awards outstanding at December 31, 2007, the net amount of these reimbursements is estimated to be approximately $427 million from Altria Group, Inc. to PMI. However, this estimate is subject to change as stock awards vest (in the case of restricted and deferred stock) or are exercised (in the case of stock options) prior to the PMI Record Date.

 

PMI is currently included in the Altria Group, Inc. consolidated federal income tax return, and PMI’s federal income tax contingencies are recorded as liabilities on the balance sheet of ALG (the parent company). Prior to the distribution of PMI shares, ALG will reimburse PMI in cash for these liabilities, which are approximately $97 million.

 

A subsidiary of ALG currently provides PMI with certain corporate services at cost plus a management fee. After the PMI Distribution Date, PMI will independently undertake these activities, and services provided to PMI will cease in 2008. All intercompany accounts will be settled in cash.

 

Certain employees of PMI participate in the U.S. benefit plans offered by Altria Group, Inc. After the PMI Distribution Date, the benefits previously

 

18


Exhibit 13

 

provided by Altria Group, Inc. will be provided by PMI. As a result, new plans will be established by PMI, and the related plan assets (to the extent that the benefit plans were previously funded) and liabilities will be transferred to the new plans. The transfer of these benefits will result in PMI recording an additional liability of approximately $98 million in its consolidated balance sheet, partially offset by the related deferred tax assets ($37 million) and the corresponding SFAS 158 adjustment to stockholders’ equity ($23 million). Altria Group, Inc. will pay PMI a corresponding amount of $38 million in cash, which is net of the related tax benefit.

 

Altria Group, Inc. currently estimates that, if the distribution had occurred on December 31, 2007, it would have resulted in a net decrease to Altria Group, Inc.’s stockholders’ equity of approximately $15 billion.

 

Dividends and Share Repurchases

 

In conjunction with its announcement of the PMI spin-off, the Board of Directors reaffirmed its intention to adjust Altria Group, Inc.’s dividend immediately following the spin-off so that Altria Group, Inc. stockholders who retain their PMI shares will receive, in the aggregate, the same annual cash dividend rate of $3.00 per common share that existed before the spin-off. Altria Group, Inc. is expected to pay a dividend at the initial rate of $0.29 per common share per quarter, or $1.16 per common share on an annualized basis. Altria Group, Inc. has established a dividend policy that anticipates a payout ratio of approximately 75% post-spin. PMI is expected to pay a dividend at the initial rate of $0.46 per common share per quarter, or $1.84 per common share on an annualized basis. PMI has established a dividend policy that anticipates a payout ratio of approximately 65% post-spin. Payment of future cash dividends will be at the discretion of the Boards of Directors of the respective companies.

 

In addition, the Board of Directors approved share repurchase programs as follows:

 

   

for Altria Group, Inc. a $7.5 billion two-year share repurchase program that is expected to begin in April 2008, after completion of the spin-off; and

 

   

for PMI, a $13.0 billion two-year share repurchase program that is expected to begin in May 2008.

 

Tender Offer for Altria Group, Inc. Notes

 

In connection with Altria Group, Inc.’s planned spin-off of PMI, on January 31, 2008, Altria Group, Inc. and its subsidiary, Altria Finance (Cayman Islands) Ltd. commenced tender offers to purchase for cash $2.6 billion of notes and debentures denominated in U.S. dollars and approximately €1.0 billion in euro-denominated bonds.

 

While Altria Group, Inc. believes that the proposed spin-off of PMI is not prohibited by the indentures, it believes that it is desirable to eliminate any uncertainty by amending the indentures with the consent of note holders.

 

In order to finance the tender offer, Altria Group, Inc. arranged a $4.0 billion, 364-day bridge loan agreement with substantially the same terms as its existing credit facilities. Subsequent to the spin-off of PMI, Altria Group, Inc. intends to issue new public debt to refinance debt incurred under the bridge loan agreement. The tender offer and consent solicitation is expected to result in first quarter 2008 charges of approximately $400 million.

 

Kraft Spin-Off

 

On March 30, 2007 (the “Kraft Distribution Date”), Altria Group, Inc. distributed all of its remaining interest in Kraft on a pro-rata basis to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 (the “Kraft Record Date”) in a tax-free distribution. The distribution ratio was 0.692024 of a share of Kraft for each share of Altria Group, Inc. common stock outstanding. Altria Group, Inc. stockholders received cash in lieu of fractional shares of Kraft. Following the distribution, Altria Group, Inc. does not own any shares of Kraft. During the second quarter of 2007, Altria Group, Inc. adjusted its quarterly dividend to $0.69 per share, so that its stockholders who retained their Altria Group, Inc. and Kraft shares would receive, in the aggregate, the same dividend dollars as before the distribution. In August 2007, Altria Group, Inc. increased its quarterly dividend to $0.75 per share.

 

Holders of Altria Group, Inc. stock options were treated similarly to public stockholders and accordingly, had their stock awards split into two instruments. Holders of Altria Group, Inc. stock options received the following stock options, which, immediately after the spin-off, had an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:

 

   

a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Kraft Distribution Date and (b) the distribution ratio of 0.692024; and

 

   

an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price.

 

    The new Kraft option has an exercise price equal to the Kraft market price at the time of the distribution ($31.66) multiplied by the Option Conversion Ratio, which represents the exercise price of the original Altria Group, Inc. option divided by the Altria Group, Inc. market price immediately before the distribution ($87.81). The reduced exercise price of the adjusted Altria Group, Inc. option was determined by multiplying the Altria Group, Inc. market price immediately following the distribution ($65.90) by the Option Conversion Ratio.

 

Holders of Altria Group, Inc. restricted stock or deferred stock awarded prior to January 31, 2007, retained their existing award and received restricted stock or deferred stock of Kraft Class A common stock. The amount of Kraft restricted stock or deferred stock awarded to such holders was calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and deferred stock will vest at the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. deferred stock awarded on January 31, 2007, did not receive restricted stock or deferred stock of Kraft. Rather, they received additional deferred shares of Altria Group, Inc. to preserve the intrinsic value of the original award.

 

To the extent that employees of the remaining Altria Group, Inc. received Kraft stock options, Altria Group, Inc. reimbursed Kraft in cash for the Black-Scholes fair value of the stock options received. To the extent that Kraft employees held Altria Group, Inc. stock options, Kraft reimbursed Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. deferred stock received Kraft deferred stock, Altria Group, Inc. paid to Kraft the fair value of the Kraft deferred stock less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at the Kraft Distribution Date, the net amount of these reimbursements resulted in a payment of

 

19


Exhibit 13

 

$179 million from Kraft to Altria Group, Inc. in April 2007. The reimbursement from Kraft is reflected as an increase to the additional paid-in capital of Altria Group, Inc. on the December 31, 2007 consolidated balance sheet.

 

Kraft was previously included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies were recorded as liabilities on the balance sheet of ALG. As part of the intercompany account settlement discussed below, ALG reimbursed Kraft in cash for these liabilities, which as of March 30, 2007, were approximately $305 million, plus pre-tax interest of $63 million ($41 million after taxes). ALG also reimbursed Kraft in cash for the federal income tax consequences of the adoption of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”) (approximately $70 million plus pre-tax interest of $14 million, $9 million after taxes). See Note 14. Income Taxes for a discussion of the FIN 48 adoption and the Tax Sharing Agreement between Altria Group, Inc. and Kraft.

 

A subsidiary of ALG previously provided Kraft with certain services at cost plus a 5% management fee. After the Kraft Distribution Date, Kraft undertook these activities, and any remaining limited services provided to Kraft ceased during 2007. All intercompany accounts were settled in cash within 30 days of the Kraft Distribution Date. The settlement of the intercompany accounts (including the amounts discussed above related to stock awards and tax contingencies) resulted in a net payment from Kraft to ALG of $85 million in April 2007.

 

The distribution resulted in a net decrease to Altria Group, Inc.’s stockholders’ equity of $27.4 billion on the Kraft Distribution Date.

 

Other

 

On December 11, 2007, in conjunction with PM USA’s adjacency strategy, Altria Group, Inc. acquired 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, for $2.9 billion in cash. The acquisition was financed with existing cash. John Middleton, Inc.’s balance sheet has been consolidated with Altria Group, Inc.’s as of December 31, 2007. Earnings from December 12, 2007 to December 31, 2007, the amounts of which were insignificant, have been included in Altria Group, Inc.’s consolidated operating results.

 

In November 2007, Altria Group, Inc. announced that it had signed an agreement to sell its headquarters building in New York City for approximately $525 million and will record a pre-tax gain of approximately $400 million upon closing the transaction. Under the terms of the agreement, Altria Group, Inc. plans to close the sale no later than April 1, 2008.

 

Beginning with the second quarter of 2007, Altria Group, Inc. revised its reportable segments to reflect PMI’s operations by geographic region. Altria Group, Inc.’s revised segments are U.S. tobacco; European Union; Eastern Europe, Middle East and Africa; Asia; Latin America; and Financial Services. Accordingly, prior year segment results have been revised.

 

Certain subsidiaries of PMI have always reported their results up to ten days before the end of December, rather than on December 31.

 

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, 2007, from the year ended December 31, 2006, 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, 2006

   $ 9,329     $ 4.43  

2006 Italian antitrust charge

     61       0.03  

2006 Asset impairment, exit and implementation costs

     118       0.05  

2006 Gain on sale of business

     (317 )     (0.15 )

2006 Interest on tax reserve transfers to Kraft

     29       0.01  

2006 Tax items

     (757 )     (0.35 )

2006 Provision for airline industry exposure

     66       0.03  
    


 


Subtotal 2006 items

     (800 )     (0.38 )

2007 Asset impairment, exit and implementation costs

     (452 )     (0.21 )

2007 Recoveries from airline industry exposure

     137       0.06  

2007 Interest on tax reserve transfers to Kraft

     (50 )     (0.02 )

2007 Tax items

     251       0.12  
    


 


Subtotal 2007 items

     (114 )     (0.05 )

Currency

     316       0.15  

Change in effective tax rate

     (41 )     (0.02 )

Higher shares outstanding

             (0.02 )

Operations

     471       0.22  
    


 


For the year ended December 31, 2007

   $ 9,161     $ 4.33  
    


 


 

See discussion of events affecting the comparability of statement of earnings amounts in the Consolidated Operating Results section of the following Discussion and Analysis.

 

·  Asset Impairment, Exit and Implementation Costs In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMI’s decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. From 2007 through 2011, PM USA expects to incur total pre-tax asset impairment, exit and implementation charges of approximately $670 million for the program, including $371 million ($234 million after taxes) incurred during 2007. During 2006, PM USA recorded pre-tax asset impairment and exit costs of $10 million ($6 million after taxes). During 2007 and 2006, PMI recorded pre-tax asset impairment and exit costs of $195 million ($143 million after taxes) and $126 million ($86 million after taxes), respectively. In addition, during 2007 and 2006, pre-tax asset impairment and exit costs of $111 million ($75 million after taxes) and $42 million ($26 million after taxes) were recorded in general corporate expense. For further details on asset impairment, exit and implementation costs, see Note 3 to the Consolidated Financial Statements.

 

20


Exhibit 13

 

·  Recoveries/Provision from/for Airline Industry Exposure – As discussed in Note 8. Finance Assets, net, (“Note 8”) PMCC recorded a pre-tax gain of $214 million ($137 million after taxes) on the sale of its ownership interests and bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down. During 2006, PMCC increased its allowance for losses by $103 million ($66 million after taxes), due to issues within the airline industry.

 

·  Interest on Tax Reserve Transfers to Kraft – As further discussed in Note 1. Background and Basis of Presentation and Note 14. Income Taxes, the interest on tax reserves transferred to Kraft is related to the Kraft spin-off, the adoption of FIN 48 in 2007 and the conclusion of an IRS audit in 2006.

 

·  Italian Antitrust Charge During the first quarter of 2006, PMI recorded a $61 million charge related to an Italian antitrust action.

 

·   Gain on Sale of Business The 2006 gain on sale of a business was due to a $488 million pre-tax gain ($317 million after taxes) on the exchange of PMI’s interest in a beer business in return for cash proceeds of $427 million and 100% ownership of a cigarette business in the Dominican Republic.

 

·  Currency The favorable currency impact is due primarily to the weakness of the U.S. dollar versus the euro, Russian ruble and Turkish lira, partially offset by the strength of the U.S. dollar versus the Japanese yen.

 

·  Income Taxes Altria Group, Inc.’s effective tax rate increased 4.3 percentage points to 31.5%. The 2007 effective tax rate includes net tax benefits of $111 million related to the reversal of tax reserves and associated interest resulting from the expiration of statutes of limitations ($55 million in the third quarter and $56 million in the fourth quarter) and $42 million related to the reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany in the third quarter. The tax rate in 2007 also includes the reversal of tax accruals of $98 million no longer required in the fourth quarter. The 2006 effective tax rate includes $631 million of non-cash tax benefits principally representing the reversal of tax reserves after the U.S. Internal Revenue Service (“IRS”) concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999 in the first quarter of 2006. The 2006 rate also includes the reversal of foreign tax reserves no longer required at PMI of $105 million.

 

·  Shares Outstanding – Higher shares outstanding during 2007 primarily reflects exercises of employee stock options (which become outstanding when exercised) and the incremental share impact of stock options outstanding.

 

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

 

   

Higher Eastern Europe, Middle East and Africa income, reflecting higher pricing and higher volume/mix, partially offset by higher marketing, administration and research costs;

 

   

Higher European Union income, reflecting higher pricing, and lower marketing, administration and research costs, partially offset by lower volume/mix;

 

   

Higher U.S. tobacco income, reflecting lower wholesale promotional allowance rates and lower marketing, administration and research costs, partially offset by lower volume and higher ongoing resolution costs; and

 

   

Higher Latin America income, reflecting higher pricing, partially offset by higher marketing, administration and research costs;

 

partially offset by:

 

   

Lower financial services income (after excluding the impact of the recoveries/provision from/for airline industry exposure), reflecting lower gains from asset management activity and lower lease revenues; and

 

   

Lower Asia income, reflecting lower volume/mix and higher marketing, administration and research costs, partially offset by higher pricing.

 

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

 

·  2008 Forecasted Results – In January 2008, Altria Group, Inc. announced that it forecasts 2008 full-year diluted earnings per share from continuing operations, excluding PMI, which will be accounted for as a discontinued operation for the full-year 2008, following the PMI spin-off, to be in the range of $1.63 to $1.67, representing a growth rate of approximately 9% to 11% for the full-year 2008, from a base of $1.50 per share in 2007. This forecast reflects a higher effective tax rate, the contribution of income from recently acquired John Middleton, Inc. and the impact of share repurchases. Earnings per share growth is expected to be stronger in the second half of 2008.

 

Reconciliation of 2007 Reported Diluted EPS from Continuing Operations to 2007 Adjusted Diluted EPS from Continuing Operations

 

2007 Reported diluted EPS from continuing operations

   $ 4.33  

2007 Total PMI continuing operations impact

     (2.85 )

Tax items

     (0.09 )

PMCC recoveries from airline industry exposure

     (0.06 )

Interest on tax reserve transfers to Kraft

     0.02  

Asset impairment, exit and implementation costs

     0.15  
    


2007 Adjusted diluted EPS from continuing operations

   $ 1.50  
    


 

The forecast excludes the impact of any potential future acquisitions or divestitures (other than the PMI spin-off), Altria Group, Inc.’s gain on the sale of its headquarters in New York City, charges related to the tender offer for Altria Group, Inc.’s notes and a number of other factors including the items shown in the table above. 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.

 

21


Exhibit 13

 

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 consumer products businesses 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 2007, 2006 and 2005, Altria Group, Inc. completed its annual review of goodwill and intangible assets, and no charges resulted from these reviews.

 

·  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. Contingencies (“Note 19”) to the consolidated financial statements, legal proceedings covering a wide range of matters are pending or threatened in various U.S. 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 U.S. 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 U.S. 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, 2007, 2006 and 2005, PM USA recorded expenses of $5.5 billion, $5.0 billion and $5.0 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 outcome is probable and the amount of the loss can be reasonably estimated. Except as discussed in Note 19: at the present time, while it is reasonably possible that an unfavorable outcome in a case may occur, (i) management has concluded that it is not probable that a loss has been incurred in any of the pending tobacco-related cases; (ii) management is unable to estimate the possible loss or range of loss that could result from an unfavorable outcome of any of the pending tobacco-related cases; and (iii) accordingly, management has not provided any amounts in the consolidated financial statements for unfavorable outcomes, if any. Legal defense costs are expensed as incurred.

 

·  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

 

22


Exhibit 13

 

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 September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 158, “Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans” (“SFAS No. 158”). SFAS No. 158 requires that employers recognize the funded status of their defined benefit pension and other postretirement plans on the consolidated balance sheet and record as a component of other comprehensive income, net of tax, the gains or losses and prior service costs or credits that have not been recognized as components of net periodic benefit cost. Altria Group, Inc. adopted the recognition and related disclosure provisions of SFAS No. 158, prospectively, on December 31, 2006. The adoption of SFAS No. 158 by Altria Group, Inc. resulted in a decrease to total assets of $3,096 million, an increase in total liabilities of $290 million and a decrease to stockholders’ equity of $3,386 million. Included in these amounts were a decrease to Kraft’s total assets of $2,286 million, a decrease to Kraft’s total liabilities of $235 million and a decrease to Kraft’s stockholders’ equity of $2,051 million.

 

SFAS No. 158 also requires an entity to measure plan assets and benefit obligations as of the date of its fiscal year-end statement of financial position for fiscal years ending after December 15, 2008. Altria Group, Inc.’s non-U.S. pension plans are measured at September 30 of each year. Subsidiaries of PMI will adopt the measurement date provision in 2008 and will record the impact of the measurement date change, which is not expected to be significant, as an adjustment to retained earnings.

 

At December 31, 2007, Altria Group, Inc.’s discount rate assumption increased to 6.20%, from 5.90% at December 31, 2006, for its U.S. pension and postretirement plans, and its weighted average discount rate assumption for non-U.S. pension plans increased to 4.66%, from 3.88% at December 31, 2006. Altria Group, Inc. presently anticipates that this and other less significant assumption changes, coupled with the amortization of deferred gains and losses, will result in a decrease in 2008 pre-tax U.S. and non-U.S. pension and postretirement expense of approximately $30 million, which is due primarily to PMI, and does not include amounts in 2007 related to early retirement programs. A fifty basis point decrease in Altria Group, Inc.’s discount rate would increase Altria Group, Inc.’s pension and postretirement expense by approximately $81 million, whereas, a fifty basis point increase would lower expense by approximately $54 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 $46 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 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.

 

On January 1, 2007, Altria Group, Inc. adopted the provisions of FIN 48. The Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. As a result of the January 1, 2007 adoption of FIN 48, Altria Group, Inc. lowered its liability for unrecognized tax benefits by $1,021 million. This resulted in an increase to stockholders’ equity of $857 million ($835 million, net of minority interest), a reduction of Kraft’s goodwill of $85 million and a reduction of federal deferred tax benefits of $79 million.

 

Altria Group, Inc. adopted the provisions of FASB Staff Position No. FAS 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction” (“FAS 13-2”) effective January 1, 2007. This Staff Position requires the revenue recognition calculation to be reevaluated if there is a revision to the projected timing of income tax cash flows generated by a leveraged lease. The adoption of this Staff Position by Altria Group, Inc. resulted in a reduction to stockholders’ equity of $124 million as of January 1, 2007.

 

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 $5.5 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 $344 million in the 2005 consolidated income tax provision.

 

    The tax provision in 2007 includes net tax benefits of $111 million related to the reversal of tax reserves and associated interest resulting from the expiration of statutes of limitations ($55 million in the third quarter and $56 million in the fourth quarter) and $42 million related to the reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany in the third quarter. The 2007 tax provision also includes the reversal in the fourth quarter of tax accruals of $98 million no longer required. The tax provision in 2006 includes $631 million of non-cash tax benefits principally representing the reversal of tax reserves after the U.S. IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999 in the first quarter of 2006. The 2006 rate also includes the reversal in the fourth quarter of foreign tax reserves no longer required at PMI of $105 million. The tax provision in 2005 includes the $344 million benefit related to dividend repatriation under the Jobs Act in 2005, as well as other benefits, including the impact of the domestic manufacturers’ deduction under the Jobs Act and lower repatriation costs.

 

·  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 by creating offsetting exposures. Altria Group, Inc. meets the requirements of U.S. GAAP where it has elected to apply hedge accounting to derivatives. 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

 

23


Exhibit 13

 

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 in stockholders’ equity as of December 31, 2007, 2006 and 2005, would have been recorded in net earnings.

 

·  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 of 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 93% of PMCC’s net revenues in 2007 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 consists 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 to the consolidated financial statements, PMCC leases certain 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, 2007 and 2006. At December 31, 2007, PMCC’s net finance receivable of $5.8 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 ($19.4 billion) and the residual value of assets under lease ($1.5 billion), reduced by third-party nonrecourse debt ($12.8 billion) and unearned income ($2.3 billion). The repayment of the nonrecourse debt is collateralized by lease payments receivable and the leased property, and is non-recourse 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, 2007, also include net finance receivables for direct finance leases ($0.4 billion) and an allowance for losses ($0.2 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 decreases of $11 million and $14 million in 2007 and 2006, respectively, to PMCC’s net revenues and results of operations. Such residual reviews resulted in no adjustment in 2005. To the extent that lease receivables due PMCC may be uncollectible, PMCC records an allowance for losses against its finance assets. During 2007, PMCC recorded a pre-tax gain of $214 million on the sale of its ownership interests and bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down. During 2006 and 2005, PMCC increased this allowance for losses by $103 million and $200 million, respectively, primarily in recognition of issues within the airline industry. It is possible that additional adverse developments may require PMCC to increase its allowance for losses in future periods.

 

Consolidated Operating Results

 

See pages 44 - 46 for a discussion of Cautionary Factors That May Affect Future Results.

 

(in millions)            


   2007

    2006

    2005

 

Net Revenues

                        

U.S. tobacco

   $ 18,485     $ 18,474     $ 18,134  

European Union

     26,682       23,752       23,874  

Eastern Europe, Middle East and Africa

     12,149       9,972       8,869  

Asia

     11,099       10,142       8,609  

Latin America

     5,166       4,394       3,936  
    


 


 


Total International tobacco

     55,096       48,260       45,288  
    


 


 


Financial services

     220       317       319  
    


 


 


Net revenues

   $ 73,801     $ 67,051     $ 63,741  
    


 


 


(in millions)            


   2007

    2006

    2005

 

Excise Taxes on Products

                        

U.S. tobacco

   $ 3,452     $ 3,617     $ 3,659  

European Union

     17,869       15,859       15,372  

Eastern Europe, Middle East and Africa

     5,801       4,365       3,825  

Asia

     5,452       4,603       3,682  

Latin America

     3,176       2,639       2,396  
    


 


 


Total International tobacco

     32,298       27,466       25,275  
    


 


 


Excise taxes on products

   $ 35,750     $ 31,083     $ 28,934  
    


 


 


(in millions)            


   2007

    2006

    2005

 

Operating Income

                        

Operating companies income:

                        

U.S. tobacco

   $ 4,518     $ 4,812     $ 4,581  

European Union

     4,173       3,516       3,934  

Eastern Europe, Middle East and Africa

     2,427       2,065       1,635  

Asia

     1,802       1,869       1,793  

Latin America

     520       1,008       463  
    


 


 


Total International tobacco

     8,922       8,458       7,825  
    


 


 


Financial services

     421       176       31  

Amortization of intangibles

     (28 )     (23 )     (18 )

General corporate expenses

     (598 )     (536 )     (579 )
    


 


 


Operating income

   $ 13,235     $ 12,887     $ 11,840  
    


 


 


 

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.

 

24


Exhibit 13

 

The following events that occurred during 2007, 2006 and 2005 affected the comparability of statement of earnings amounts.

 

·  Asset Impairment and Exit Costs – For the years ended December 31, 2007, 2006 and 2005, pre-tax asset impairment and exit costs consisted of the following:

 

(in millions)            


   2007

   2006

   2005

Separation program

                    

U.S. tobacco

   $ 309    $ 10    $ -

European Union

     137      99      30

Eastern Europe, Middle East and Africa

     12      2      14

Asia

     28      19      7

Latin America

     18      1      4

General corporate

     17      32      49
    

  

  

Total separation programs

     521      163      104
    

  

  

Asset impairment

                    

U.S. tobacco

     35              

European Union

            5      19

Eastern Europe, Middle East and Africa

                   5

Asia

                   9

Latin America

                   2

General corporate

            10       
    

  

  

Total asset impairment

     35      15      35
    

  

  

Spin-off fees

                    

General corporate

     94              
    

  

  

Asset impairment and exit costs

   $ 650    $ 178    $ 139
    

  

  

 

Manufacturing Optimization Program

 

In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMI’s decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. PMI expects to shift all of its PM USA-sourced production, which approximates 57 billion cigarettes to PMI facilities in Europe by October 2008 and PM USA will close its Cabarrus manufacturing facility by the end of 2010.

 

As a result of this program, from 2007 through 2011, PM USA expects to incur total pre-tax charges of approximately $670 million, comprised of accelerated depreciation of $143 million (including the above mentioned asset impairment charge of $35 million recorded in 2007), employee separation costs of $353 million and other charges of $174 million, primarily related to the relocation of employees and equipment, net of estimated gains on sales of land and buildings. Approximately $440 million, or 66% of the total pre-tax charges, will result in cash expenditures. PM USA recorded total pre-tax charges of $371 million in 2007 related to this program. These charges were comprised of pre-tax asset impairment and exit costs of $344 million, and $27 million of pre-tax implementation costs associated with the program. The pre-tax implementation costs primarily related to accelerated depreciation and were included in cost of sales in the consolidated statement of earnings for the year ended December 31, 2007. Pre-tax charges of approximately $140 million are expected during 2008 for the program. The program is expected to generate pre-tax cost savings beginning in 2008, with total estimated annual cost savings of approximately $335 million by 2011, of which $179 million will be realized by PMI (by 2009) and $156 million will be realized by PM USA (by 2011).

 

Philip Morris International Asset Impairment and Exit Costs

 

During 2007, 2006 and 2005, PMI announced plans for the streamlining of various administrative functions and operations. These plans resulted in the announced closure or partial closure of 9 production facilities through December 31, 2007, the largest of which is the closure of a factory in Munich, Germany announced in 2006. As a result of these announcements, PMI recorded pre-tax charges of $195 million, $126 million and $90 million for the years ended December 31, 2007, 2006 and 2005, respectively. The 2007 pre-tax charges primarily related to severance costs. The 2006 pre-tax charges included $57 million of costs related to PMI’s Munich, Germany factory closure. The 2005 pre-tax charges 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. Pre-tax charges, primarily related to severance, of approximately $65 million related to these previously announced plans are expected during 2008.

 

Cash payments related to exit costs at PMI were $124 million, $44 million and $40 million for the years ended December 31, 2007, 2006 and 2005, respectively. Future cash payments for exit costs incurred to date are expected to be approximately $170 million.

 

The streamlining of these various functions and operations is expected to result in the elimination of approximately 3,400 positions. As of December 31, 2007, approximately 2,400 of these positions have been eliminated.

 

Corporate Asset Impairment and Exit Costs

 

In 2007, 2006 and 2005, general corporate pre-tax charges were $111 million, $42 million and $49 million, respectively. These charges were primarily related to investment banking and legal fees in 2007 associated with the Kraft and contemplated PMI spin-off, as well as the streamlining of various corporate functions in each year.

 

·  Italian Antitrust Charge – During the first quarter of 2006, PMI recorded a $61 million charge related to an Italian antitrust action. This charge was included in the operating companies income of the European Union segment.

 

·  Loss on U.S. Tobacco Pool As further discussed in Note 19 to the consolidated financial statements, 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.

 

·  U.S. 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 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 enact-

 

25


Exhibit 13

 

ment 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. PM USA had accrued for 2004 FETRA charges and after the clarification of the court ruling, PM USA reversed a 2004 accrual for FETRA payments in the amount of $115 million.

 

·  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 benefit to operating companies income for the European Union 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 the European Union segment pre-tax operating companies income of approximately $70 million for the year ended December 31, 2005.

 

·  Gain on Sale of a Business – During 2006, operating companies income of the Latin America segment included a pre-tax gain of $488 million related to the exchange of PMI’s interest in a beer business in return for cash proceeds of $427 million and 100% ownership of a cigarette business in the Dominican Republic.

 

·  Recoveries/Provision from/for Airline Industry Exposure – As discussed in Note 8 to the consolidated financial statements, during 2007, PMCC recorded pre-tax gains of $214 million on the sale of its ownership interests and bankruptcy claims in certain leveraged lease investments in aircraft, which represented a partial recovery, in cash, of amounts that had been previously written down. During 2006, PMCC increased its allowance for losses by $103 million, due to issues within the airline industry. During 2005, PMCC increased its allowance for losses by $200 million, reflecting its exposure to the airline industry, particularly Delta Air Lines, Inc. (“Delta”) and Northwest Airlines, Inc. (“Northwest”), both of which filed for bankruptcy protection during 2005.

 

·  Income Tax Benefit – The tax provision in 2007 included net tax benefits of $111 million related to the reversal of tax reserves and associated interest resulting from the expiration of statutes of limitations ($55 million in the third quarter and $56 million in the fourth quarter) and $42 million related to the reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany in the third quarter. The tax provision in 2007 also included the reversal in the fourth quarter of tax accruals of $98 million no longer required. The IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999, and issued a final Revenue Agent’s Report (“RAR”) on March 15, 2006. Consequently, in March 2006, Altria Group, Inc. recorded non-cash tax benefits of $1.0 billion, which principally represented the reversal of tax reserves following the issuance of and agreement with the RAR. Altria Group, Inc. reimbursed $337 million in cash to Kraft for its portion of the $1.0 billion in tax benefits, as well as pre-tax interest of $46 million. The amounts related to Kraft were reclassified to earnings from discontinued operations. The tax reversal resulted in an increase to earnings from continuing operations of approximately $631 million for the year ended December 31, 2006. The 2006 tax provision also included the reversal in the fourth quarter of foreign tax reserves no longer required at PMI of $105 million. The tax provision in 2005 included a $344 million benefit related to dividend repatriation under the American Jobs Creation Act.

 

·  Discontinued Operations – As a result of the Kraft spin-off, which is more fully discussed in Note 1. Background and Basis of Presentation, to the consolidated financial statements, Altria Group, Inc., has reclassified and reflected the results of Kraft prior to the Kraft Distribution Date as discontinued operations on the consolidated statements of earnings and the consolidated statements of cash flows for all periods presented. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the consolidated balance sheet at December 31, 2006.

 

2007 compared with 2006

 

The following discussion compares consolidated operating results for the year ended December 31, 2007, with the year ended December 31, 2006.

 

Net revenues, which include excise taxes billed to customers, increased $6.8 billion (10.1%). Excluding excise taxes, net revenues increased $2.1 billion (5.8%), due primarily to the favorable impact of currency and higher revenues from the Eastern Europe, Middle East and Africa segment, the European Union segment, the Latin America segment and the Asia segment, and the impact of acquisitions at PMI, partially offset by lower revenues from the financial services segment.

 

Excise taxes on products increased $4.7 billion (15.0%) due primarily to currency movements ($2.3 billion) and higher excise tax rates ($2.4 billion). As discussed in Tobacco Business Environment, there is a trend toward governments’ increasing excise taxes in all of the markets in which Altria Group, Inc. operates. Excise taxes are expected to continue to rise.

 

Cost of sales increased $1.0 billion (6.5%), due primarily to higher ongoing resolution costs ($489 million), currency movements ($447 million) and acquisitions ($85 million). Generally, tobacco and materials costs have not increased significantly and productivity initiatives have tended to offset higher depreciation and salary expenses.

 

Marketing, administration and research costs increased $141 million (1.8%), due primarily to currency movements ($260 million), acquisitions and divestitures ($124 million), expenses related to the termination of a distributor relationship in Indonesia ($30 million), and higher research and development costs ($27 million), partially offset by lower marketing expenses and lower general and administrative costs. Generally, research and development costs have tended to increase, reflecting efforts to develop products that may reduce the risk of tobacco use. Marketing and selling expenses were lower, reflecting regulatory restrictions on advertising and promotion activities, and productivity initiatives.

 

Operating income increased $348 million (2.7%), due primarily to higher operating results from the Eastern Europe, Middle East and Africa segment, the European Union segment, the Latin America segment and the U.S. Tobacco segment; an increase at PMCC due to cash recoveries in 2007 from assets which had previously been written down versus a provision in 2006 for its airline industry exposure; the favorable impact of currency; and the 2006 Italian antitrust charge. These items were partially offset by higher charges for asset impairment, exit and implementation costs, and the 2006 gain on sale of a business.

 

Currency movements increased net revenues by $3,513 million ($1,178 million, after excluding the impact of currency movements on excise taxes) and operating income by $471 million. These increases were due primarily to the weakness versus prior year of the U.S. dollar against the euro, Russian ruble and the Turkish lira, partially offset by the strength of the U.S. dollar against the Japanese yen.

 

26


Exhibit 13

 

Interest and other debt expense, net, of $215 million decreased $152 million, due primarily to lower average debt levels throughout most of 2007.

 

Altria Group, Inc.’s effective tax rate increased 4.3 percentage points to 31.5%. The 2007 effective tax rate includes net tax benefits of $111 million related to the reversal of tax reserves and associated interest resulting from the expiration of statutes of limitations ($55 million in the third quarter and $56 million in the fourth quarter) and $42 million related to the reduction of deferred tax liabilities resulting from future lower tax rates enacted in Germany in the third quarter. The tax provision in 2007 also includes the reversal of tax accruals of $98 million no longer required in the fourth quarter. The 2006 effective tax rate includes $631 million of non-cash tax benefits principally representing the reversal of tax reserves after the U.S. IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999 in the first quarter of 2006. The 2006 rate also includes the reversal of foreign tax reserves no longer required at PMI of $105 million.

 

Equity earnings and minority interest, net, was $237 million for 2007, compared with $209 million for 2006. The change primarily reflected higher equity earnings from SABMiller.

 

Earnings from continuing operations of $9.2 billion decreased $168 million (1.8%), due primarily to a higher effective tax rate, partially offset by higher operating income and lower interest and other debt expense, net. Diluted and basic EPS from continuing operations of $4.33 and $4.36, respectively, decreased by 2.3% and 2.5%, respectively.

 

Earnings from discontinued operations, net of income taxes and minority interest (which represent the results of Kraft prior to the spin-off), decreased $2.1 billion.

 

Net earnings of $9.8 billion decreased $2.2 billion (18.6%). Diluted and basic EPS from net earnings of $4.62 and $4.66, respectively, decreased by 19.1%. These decreases reflect the spin-off of Kraft at the end of March 2007.

 

2006 compared with 2005

 

The following discussion compares consolidated operating results for the year ended December 31, 2006, with the year ended December 31, 2005.

 

Net revenues, which include excise taxes billed to customers, increased $3.3 billion (5.2%). Excluding excise taxes, net revenues increased $1.2 billion (3.3%), due primarily to increases from the Asia segment (including the impact of acquisitions), Eastern Europe, Middle East and Africa segment, U.S. tobacco segment and Latin America segment (including the impact of acquisitions), partially offset by lower revenues from the European Union segment and unfavorable currency.

 

Excise taxes on products increased $2.1 billion (7.4%), due primarily to higher excise tax rates ($1.9 billion) and acquisitions ($571 million), partially offset by currency movements ($311 million).

 

Cost of sales increased $621 million (4.2%), due primarily to acquisitions ($290 million), higher volume ($231 million) and higher product costs ($135 million).

 

Marketing, administration and research costs were flat, due primarily to favorable currency ($153 million) and lower marketing expenses, offset by acquisitions ($115 million), higher general and administrative expenses, and higher research and development costs.

 

Operating income increased $1,047 million (8.8%), due primarily to the 2006 gain on sale of a business, higher operating results from all segments except the European Union segment, the 2005 charge for PM USA’s portion of the losses incurred by the federal government on disposition of its pool tobacco stock, and a lower provision for airline industry exposure at PMCC. These increases were partially offset by the unfavorable impact of currency, an unfavorable comparison with 2005, when PM USA benefited from the reversal of a 2004 accrual related to the tobacco quota buy-out legislation, and the 2006 Italian antitrust charge in the European Union segment.

 

Currency movements decreased net revenues by $651 million ($340 million after excluding the impact of currency movements on excise taxes) and operating income by $183 million. These decreases were due primarily to the strength versus prior year of the U.S. dollar against the Japanese yen and the Turkish lira.

 

Interest and other debt expense, net, of $367 million decreased $154 million (29.6%), due primarily to lower debt levels and higher interest income.

 

    Altria Group, Inc.’s effective tax rate decreased by 2.9 percentage points to 27.2%. The 2006 effective tax rate includes $631 million of non-cash tax benefits principally representing the reversal of tax reserves after the U.S. IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999 in the first quarter of 2006. The 2006 rate also includes the reversal of foreign tax accruals no longer required at PMI of $105 million in the fourth quarter. The 2005 effective tax rate includes a $344 million benefit related to dividend repatriation under the Jobs Act, as well as other benefits, including lower repatriation costs.

 

Equity earnings and minority interest, net, was $209 million for 2006, compared with $260 million for 2005. The change primarily reflected higher minority interest in earnings in Turkey and Mexico, partially offset by higher equity earnings from SABMiller.

 

Earnings from continuing operations of $9.3 billion increased $1.2 billion (14.2%), due primarily to higher operating income, lower interest and other debt expense, net, and a lower effective tax rate. Diluted and basic EPS from continuing operations of $4.43 and $4.47, respectively, increased by 13.3% and 13.2%, respectively.

 

Earnings from discontinued operations, net of income taxes and minority interest, of $2.7 billion increased $428 million (18.9%), due to higher net earnings at Kraft.

 

Net earnings of $12.0 billion increased $1.6 billion (15.2%). Diluted and basic EPS from net earnings of $5.71 and $5.76, respectively, increased by 14.4% and 14.3%, respectively.

 

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 adversely affect the business, volume, results of operations, cash flows and financial position of ALG and our tobacco companies. These challenges, which are discussed below and in the Cautionary Factors That May Affect Future Results section, include:

 

   

pending and threatened litigation and bonding requirements as discussed in Note 19. Contingencies (“Note 19”);

 

   

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

 

27


Exhibit 13

 

   

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

 

   

the sale of counterfeit cigarettes by third parties;

 

   

the sale of tobacco products 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 tobacco product ingredients, flavors 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 requirements setting ignition propensity standards for cigarettes; and

 

   

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

 

In the ordinary course of business, our tobacco companies 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: Tobacco products are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in tobacco-related taxes or fees have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the Member States of the European Union (the “EU”) and in other foreign jurisdictions. Legislation has been passed by the United States Congress that would increase the federal excise tax on cigarettes by $0.61 a pack. The President has vetoed this legislation. It is not possible to predict whether such legislation will be reintroduced and become law. In addition, in certain jurisdictions, PMI’s products are subject to tax structures that discriminate against premium priced products and manufactured cigarettes and to inconsistent rulings and interpretations on complex methodologies to determine excise and other tax burdens.

 

Tax increases and discriminatory tax structures are expected to continue to have an adverse impact on sales of tobacco products 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 and contraband products.

 

·  Minimum Retail Selling Price Laws: Several EU Member States have enacted laws establishing a minimum retail selling price for cigarettes and, in some cases, other tobacco products. The European Commission has commenced infringement proceedings against these Member States, claiming that minimum retail selling price systems infringe EU law. Subsequently, in March 2007, the European Commission announced that it was bringing an action against France, and on January 31, 2008, against Austria and Ireland in the European Court of Justice claiming that these countries’ minimum retail selling price systems infringe EU law. The European Commission previously announced that it had formally called upon Austria, Ireland and Italy to amend their legislation setting minimum retail selling prices for cigarettes. Should the European Commission prevail in the European Court of Justice, excise tax levels and/or price gaps in those markets could be adversely affected.

 

·  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 in cigarettes 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”) established a working group, chaired by the WHO, to propose a new measurement method that would more accurately reflect human smoking behavior. PM USA and PMI have supported the concept of supplementing the ISO test method with a more intensive method, which PM USA and PMI believe would better illustrate the wide variability in the delivery of tar, nicotine and carbon monoxide, depending on how an individual smokes a cigarette.

 

The working group has issued a final report proposing two alternative measurement methods. Currently, ISO is in the process of deciding whether to begin further development of the two methods or to wait for additional guidance from the Conference of the Parties.

 

In light of public health concerns about the limitations of current machine measurement methodologies, 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 those methods. 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

 

28


Exhibit 13

 

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.’” Many countries prohibit or are in the process of prohibiting descriptors such as “lights.” In most countries where descriptors are banned, tar, nicotine and carbon monoxide yields are still required to be printed on packs of cigarettes. PMI advocates that where descriptors are banned, governments should also prohibit the printing of tar, nicotine and carbon monoxide yields on packs of cigarettes. See Note 19, which describes pending litigation concerning the use of brand descriptors. As discussed in Note 19, in August 2006, a federal trial court entered judgment in favor of the United States government in its lawsuit against various cigarette manufacturers and others, including PM USA and ALG, and enjoined the defendants from using brand descriptors, such as “lights,” “ultra-lights” and “low tar.” In October 2006, the Court of Appeals stayed enforcement of the judgment pending its review of the trial court’s decision.

 

·  Food and Drug Administration (“FDA”) Regulations: In February 2007, bipartisan legislation was introduced in the United States Senate and House of Representatives that, if enacted, would grant the FDA broad authority to regulate the design, manufacture and marketing of tobacco products and disclosures of related information. This legislation would also grant the FDA the authority to impose certain recordkeeping and reporting obligations to address counterfeit and contraband tobacco products and would impose fees to pay for the cost of regulation and other matters. ALG and PM USA support this legislation. In August 2007, the Senate Health, Education, Labor and Pensions Committee approved a revised version of this legislation. Whether Congress will grant the FDA broad authority over tobacco products, and the precise nature of that authority if granted, 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 $9.5 billion and is being paid over 10 years by manufacturers and importers of each kind of tobacco product. The cost is being 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. PM USA has paid $138 million for its share of the tobacco pool stock losses. For a discussion of the NTGST, see Note 19. The quota buy-out did not have a material adverse impact on the Altria Group, Inc.’s consolidated results in 2007 and Altria Group, Inc. does not anticipate that the quota buyout will have a material adverse impact on its consolidated results in 2008 and beyond.

 

·  The WHO’s Framework Convention on Tobacco Control (“FCTC”): The FCTC entered into force on February 27, 2005. As of January 2008, 152 countries, as well as the European Community, have become parties to the FCTC. The FCTC is the first international public health treaty and its objective is to establish a global agenda for tobacco regulation with the purpose of reducing initiation of tobacco use and encouraging cessation. 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/or eliminate all tobacco product advertising, marketing, promotions and sponsorships;

 

   

initiate public education campaigns to inform the public about the health consequences of smoking and the benefits of quitting;

 

   

implement regulations imposing product testing, disclosure and performance standards;

 

   

impose health warning requirements on packaging;

 

   

adopt measures that would eliminate cigarette smuggling and counterfeit cigarettes;

 

   

restrict smoking in public places;

 

   

implement fiscal policies (tax and price increases);

 

   

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.

 

In addition, some of the proposals currently under consideration by the Conference of the Parties, the governing body of the FCTC, could have the potential to substantially restrict the ability of our tobacco subsidiaries to manufacture and market their products. It is not possible to predict the outcome of regulations under consideration.

 

·  Ingredient Laws: Jurisdictions inside and outside the United States have enacted or proposed legislation or regulations that would require tobacco product manufacturers to disclose to the government and, in some instances, publicly the ingredients used in the manufacture of tobacco products 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 or limit the use of ingredients and flavors. Under an EU tobacco product directive, tobacco companies are now required to disclose ingredients and toxicological information to each Member State. In May 2007, the Commission published guidelines for full by-brand reporting requirements. PMI has made ingredient disclosures in compliance with the laws of all Member States, and has followed the guidelines in most Member States, making full by-brand disclosures in a manner that protects trade secrets in those Member States.

 

·  Laws Addressing Flavor Varieties or Characterizing Flavors: In certain U.S. states, legislation has been proposed which would prohibit the sale of certain flavor varieties of tobacco products or tobacco products with characterizing flavors. The proposed legislation varies in terms of the type of tobacco products subject to prohibition, the conditions under which the sale of such products would be prohibited, and exceptions to the prohibitions. To date, Maine is the only state in which such a prohibition has been enacted, but its provisions affecting cigarette and cigar products do not take effect until July 1, 2009, and covered products also may be granted exemptions

 

29


Exhibit 13

 

under that state’s law. Whether other states will enact legislation in this area, and the precise nature of such legislation if enacted, cannot be predicted.

 

·  Restrictions and Bans on the Use of Ingredients: Some governments have prohibited the use of certain ingredients and propose further prohibitions or limits. For example, the Conference of the Parties is considering guidelines providing detailed product regulation requirements that are likely to include standards for the use of tobacco product ingredients, including flavorings. PM USA and PMI support regulations requiring all manufacturers to determine that the use of ingredients does not increase the inherent toxicity in cigarette smoke.

 

·  Bans and Restrictions on Advertising, Marketing, Promotions and Sponsorships: For many years, countries have imposed partial or total bans on tobacco advertising, marketing and promotion. The FCTC calls for a “comprehensive ban on advertising, promotion and sponsorship” and requires governments that have no constitutional constraints to ban all forms of advertising. Where constitutional constraints exist, the FCTC requires governments to restrict or ban radio, television, print media, other media, including the internet, and sponsorships of international events within 5 years. The FCTC also requires disclosure of expenditures on advertising, promotion and sponsorship that are not prohibited. Some public health groups have called for bans of product displays, which some countries have adopted, and for generic packaging. PM USA and PMI oppose complete bans on advertising, but support limitations on marketing, provided that the limitations are within constitutional constraints and manufacturers are able to communicate appropriately with adult smokers.

 

·  Health Warning Requirements: Many countries require substantial health warnings on tobacco product packs. In the EU, for example, health warnings must cover 30% of the front and 40% of the back of cigarette packs. The FCTC requires health warnings that cover, at a minimum, 30% of the front and back of the pack. However, the treaty recommends warnings covering 50% of the front and back of the pack. PM USA and PMI support health warning requirements and defer to the governments on the content of the warnings. In countries where health warnings are not required, PMI places them on packaging voluntarily in the official language or languages of the country. For example, PMI is voluntarily placing health warnings in many African countries in official local languages and occupying 30% of the front and back of the pack. PM USA and PMI do not support warning sizes that deprive them of the ability to use their distinctive trademarks and pack designs which differentiate their products from those of their competitors.

 

·  Health Effects of Smoking and Exposure to Environmental Tobacco Smoke (“ETS”): Reports with respect to the health effects of cigarette smoking have been publicized for many years, including in a June 2006 United States Surgeon General report on ETS entitled “The Health Consequences of Involuntary Exposure to Tobacco Smoke.” Many countries have restricted smoking in public places. The pace and scope of public smoking bans has increased significantly, particularly in the EU, where Italy, Ireland, the UK, France, Finland and Sweden have banned virtually all indoor public smoking. Other countries around the world have adopted or are likely to adopt substantial public smoking restrictions. Some public health groups have called for, and some municipalities have adopted or proposed, bans on smoking in outdoor places, and some tobacco control groups have advocated banning smoking in cars with minors in them. The FCTC requires parties to the treaty to adopt restrictions on public smoking, and the Conference of Parties has proposed guidelines on regulations which are based on the premise that any exposure to ETS is harmful and call for total bans in all indoor public places, defines “indoor” broadly, and rejects any exemptions based on type of venue (e.g., nightclubs). On private place smoking, such as cars and homes, the guidelines call for increased education on the risk of exposure to ETS.

 

It is not possible to predict the results of ongoing scientific research or the types of future scientific research into the health risks of tobacco exposure. Although most regulation of ETS exposure to date has been done at the local level through bans in public establishments, 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 air 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.” In addition, in June 2006, the California Office of Environmental Health Hazard Assessment (“OEHHA”) listed ETS as a contaminant known to the State of California to cause reproductive toxicity. Consequently, under California Proposition 65, businesses employing 10 or more persons must post warning signs in certain areas stating that ETS is known to the State of California to be a reproductive toxicant.

 

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, 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 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.pmintl.com. The information on PM USA’s and PMI’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.

 

·  Testing and Reporting of Other Smoke Constituents: In addition to tar, nicotine and carbon monoxide, public health authorities have classified between 45 and 70 other smoke constituents as potential causes of tobacco-related diseases. Several countries require manufacturers to provide by-brand yields of these constituents. The FCTC requires signatory nations to adopt and implement guidelines for “testing and measuring the contents and emissions of tobacco products.” PM USA and PMI measure most of these constituents for their product research and development purposes, and support such regulation. However, the capacity to conduct by-brand testing on a global basis does not exist today, and the cost of by-brand annual testing would be significant.

 

·  Ceilings on Tar, Nicotine, Carbon Monoxide and Other Smoke Constituents: A number of countries and the EU have established maximum yields of tar, nicotine and/or carbon monoxide, as measured by the ISO standard test method. As discussed above, public health authorities have questioned whether reducing machine-measured tar, nicotine and carbon monoxide yields results in meaningful reductions in risk. Further, some

 

30


Exhibit 13

 

public health groups have questioned the appropriateness of imposing nicotine ceilings per cigarette.

 

To date, no country has proposed or adopted ceilings for other smoke constituents. However, in June 2007, the panel advising the Conference of the Parties issued a report that recommends limiting specific smoke constituents. The advisory panel stated that ceilings do not have to be based on proof of benefit, but only on a showing that “the substance be known to be harmful and that processes exist for its diminution or removal.” The advisory panel proposed ceilings on tobacco specific nitrosamines, or TSNA, smoke constituents unique to tobacco, based on data showing that there is a wide variation in TSNA yields across brands. The advisory panel stated that the levels of the TSNAs are “higher in air-cured/processed Burley tobacco than in flue-cured bright tobacco” and that levels of TSNAs are much lower in markets where the predominant brands are Virginia cigarettes, such as Australia and Canada, as opposed to markets, such as the EU, where American blended cigarettes are predominantly sold. The recommended ceilings are “the lower of the median values for a sample of international brands or the median for the brands for the country implementing the regulation.” Subsequently, members of the panel recommended that ceilings be established for seven additional smoke constituents, also based on the median in the market. It is not possible to predict whether or when this recommendation will be endorsed by the Conference of the Parties and, if so, implemented by governments.

 

·  Reduced Cigarette Ignition Propensity Legislation: Legislation or regulation requiring cigarettes to meet reduced ignition propensity standards is being considered in many states, at the federal and local levels and in jurisdictions outside the United States. New York State implemented ignition propensity standards in June 2004. To date, the same standards have been enacted by twenty-one other states, effective as follows: Vermont (May 2006), California (January 2007), Oregon (April 2007), New Hampshire (October 2007), Illinois (January 2008), Maine (January 2008), Massachusetts (January 2008), Kentucky (April 2008), Montana (May 2008), Alaska (August 2008), New Jersey (June 2008), Maryland (July 2008), Utah (July 2008), Connecticut (July 2008), Rhode Island (August 2008), Delaware (January 2009), Iowa (January 2009), Minnesota (January 2009), Texas (January 2009), Louisiana (August 2009) and North Carolina (January 2010). Similar legislation has been enacted in Canada and is being considered in several other countries, notably Australia and several Member States of the EU. In late 2007, the European Commission began an official process through the General Product Safety Directive to adopt reduced cigarette ignition propensity standards such as those implemented in New York, Canada and other jurisdictions. PM USA supports the enactment of federal legislation mandating a uniform and technically feasible national standard for reduced ignition propensity cigarettes that would preempt state standards and apply to all cigarettes sold in the United States. Although PM USA believes that a national standard is the most appropriate way to address the issue, it has been actively supporting the adoption of laws at the state level that require all manufacturers to comply with the standard first adopted in New York. PMI believes that reduced ignition propensity standards should be the same as those applied in New York and other jurisdictions to ensure that they are uniform and technically feasible, and that they are applied equally to all manufacturers and all tobacco products.

 

·  Illicit Trade: Regulatory measures and related governmental actions to prevent the illicit manufacture and trade of tobacco products are being considered by a number of jurisdictions. Article 15 of the FCTC requires parties to the treaty to take steps to eliminate all forms of illicit trade, including counterfeiting, and states that national, regional and global agreements on this issue are “essential components of tobacco control.” The Conference of the Parties has announced that it is working on a protocol on illicit trade to be negotiated in 2008 and proposed in 2009. According to a draft template, topics that the protocol will address include:

 

   

licensing schemes for participants in the tobacco business, measures to eliminate money laundering and the development of an international system that enables the tracking and tracing of tobacco products;

 

   

the implementation of laws governing record keeping and internet sales of tobacco products;

 

   

the criminalization of participation in illicit trade in various forms;

 

   

obligations for tobacco manufacturers to control their supply chain with penalties for those that fail to do so;

 

   

programs to increase the capacity of law enforcement bodies; and

 

   

programs to increase cooperation and technical assistance with respect to investigation and prosecutions and the sharing of information.

 

    PM USA and PMI support strict regulations and enforcement measures to prevent all forms of illicit trade in tobacco products. They agree that manufacturers should implement monitoring systems of their sales and distribution practices, and that where appropriately confirmed, manufacturers should stop supplying vendors who have knowingly engaged in illicit trade. For example, PM USA is engaged in a number of initiatives to help prevent contraband trade in cigarettes, including: enforcement of PM USA wholesale and retail trade policies on trade in contraband cigarettes and Internet/remote sales; engagement with and support of law enforcement and regulatory agencies; litigation to protect the Company’s trademarks; and support for federal and state legislation. PM USA’s legislative initiatives to address contraband trade in cigarettes are designed to better control and protect the legitimate channels of distribution, impose more stringent penalties for the violation of laws and provide additional tools for law enforcement. While PMI believes the best approach is for all these measures to be adopted through legislation, it is also working with a number of governments around the world on specific agreements and memoranda of understanding to address the illegal trade in cigarettes. PMI has entered into agreements with several countries, including China, Senegal, Switzerland, Thailand, Turkey, and, as described below, the EU.

 

·  PMI Cooperation Agreements to Combat Illicit Trade of Cigarettes: PMI has entered into agreements with several governments to combat the illicit trade of cigarettes and may continue to do so. 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. To date, 26 of the 27 Member States have signed the agreement. The agreement resolves all disputes between the European Community and the 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

 

31


Exhibit 13

 

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 agreement (this payment was made in July 2005), approximately $100 million on the second anniversary (this payment was made in July 2006), 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. PMI is also responsible to pay the excise taxes, VAT and customs duties on qualifying product seizures of up to 90 million cigarettes and is subject to payments of five times the applicable taxes and duties if product seizures exceed 90 million cigarettes in a given year. To date, PMI’s payments related to product seizures have been immaterial.

 

·  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.

 

·  Other Legislation or Governmental 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 27 EU Member States have implemented the directive.

 

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 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 and other tobacco products to various regulations; restrict or eliminate the use of descriptors for cigarettes such as “lights” or “ultra lights;” 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 and other tobacco products; require additional warnings, including graphic warnings, on packages and in advertising of cigarettes and other tobacco products; eliminate or reduce the tax deductibility of tobacco product 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; allow state and local governments to restrict the use of flavors in tobacco products; and allow state and local governments to restrict the sale and distribution of tobacco products.

 

It is not possible to predict what, if any, additional legislation, regulation or other governmental action will be enacted or implemented relating to the manufacturing, advertising, sale or use of tobacco products, or the tobacco industry generally. It is possible, however, that legislation, regulation or other governmental action could be enacted or implemented in the United States and in other countries and jurisdictions that might materially affect the business, volume, results of operations and cash flows of our tobacco subsidiaries, and ultimately their parent, ALG.

 

·  Governmental Investigations: From time to time, ALG and its subsidiaries are subject to governmental investigations on a range of matters. In this regard, 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. ALG and its subsidiaries cannot predict the outcome of this investigation or whether additional investigations may be commenced.

 

Manufacturing Optimization Program

 

In June 2007, Altria Group, Inc. announced plans by its tobacco subsidiaries to optimize worldwide cigarette production by moving U.S.-based cigarette production for non-U.S. markets to PMI facilities in Europe. Due to declining U.S. cigarette volume, as well as PMI’s decision to re-source its production, PM USA will close its Cabarrus, North Carolina manufacturing facility and consolidate manufacturing for the U.S. market at its Richmond, Virginia manufacturing center. PMI expects to shift all of its PM USA-sourced production, which approximates 57 billion cigarettes, to PMI facilities in Europe by October 2008, and PM USA will close its Cabarrus manufacturing facility by the end of 2010.

 

As a result of this program, from 2007 through 2011, PM USA expects to incur total pre-tax charges of approximately $670 million, comprised of accelerated depreciation of $143 million, employee separation costs of $353 million and other charges of $174 million, primarily related to the relocation of employees and equipment, net of estimated gains on sales of land and buildings. Approximately $440 million, or 66% of the total pre-tax charges, will result in cash expenditures. PM USA recorded total pre-tax charges of $371 million in 2007 related to this program. These charges were comprised of pre-tax asset impairment and exit costs of $344 million, and $27 million of pre-tax implementation costs associated with the program. The pre-tax implementation costs primarily related to accelerated depreciation and were included in cost of sales in the consolidated statement of earnings for the year ended December 31, 2007. Pre-tax charges of approximately $140 million are expected during 2008 for the program. In addition,

 

32


Exhibit 13

 

the program will entail capital expenditures of approximately $230 million at PM USA and $50 million at PMI.

 

The program is expected to generate pre-tax cost savings beginning in 2008, with total estimated annual cost savings of approximately $335 million by 2011, of which $179 million will be realized by PMI (by 2009) and $156 million by PM USA (by 2011).

 

Philip Morris International Asset Impairment and Exit Costs

 

During 2007, 2006 and 2005, PMI announced plans for the streamlining of various administrative functions and operations. These plans resulted in the announced closure or partial closure of 9 production facilities through December 31, 2007, the largest of which was the closure of a factory in Munich, Germany announced in 2006. As a result of these announcements, PMI recorded pre-tax charges of $195 million, $126 million and $90 million for the years ended December 31, 2007, 2006 and 2005, respectively. The 2007 pre-tax charges primarily related to severance costs. The 2006 pre-tax charges included $57 million of costs related to PMI’s Munich, Germany factory closure. The 2005 pre-tax charges 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. Pre-tax charges, primarily related to severance, of approximately $65 million related to these previously announced plans are expected during 2008.

 

In 2007, asset impairment and exit costs also included general corporate pre-tax charges of $13 million related to fees associated with the PMI spin-off.

 

Cash payments related to exit costs at PMI were $131 million, $44 million and $40 million for the years ended December 31, 2007, 2006 and 2005, respectively. Future cash payments for exit costs incurred to date are expected to be approximately $170 million.

 

The streamlining of these various functions and operations is expected to result in the elimination of approximately 3,400 positions. As of December 31, 2007, approximately 2,400 of these positions have been eliminated. These actions generated pre-tax cost savings beginning in 2005, with cumulative estimated annual cost savings of approximately $185 million through December 31, 2007, of which $130 million are incremental savings in 2007. Cumulative estimated annual cost savings of approximately $329 million are expected by the end of 2008.

 

Acquisitions

 

As discussed in Note 5. Acquisitions, to the consolidated financial statements, the following acquisitions occurred during 2007, 2006 and 2005.

 

On December 11, 2007, in conjunction with PM USA’s adjacency strategy, Altria Group, Inc. acquired 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, for $2.9 billion in cash. The acquisition was financed with existing cash. John Middleton, Inc.’s balance sheet has been consolidated with Altria Group, Inc.’s as of December 31, 2007. Earnings from December 12, 2007 to December 31, 2007, the amounts of which were insignificant, have been included in Altria Group, Inc.’s consolidated operating results.

 

In November 2007, PMI acquired an additional 30% stake in its Mexican tobacco business from Grupo Carso, S.A.B. de C.V. (“Grupo Carso”), which increased PMI’s ownership interest to 80%, for $1.1 billion. After this transaction was completed, Grupo Carso retained a 20% stake in the business. PMI also entered into an agreement with Grupo Carso which provides the basis for PMI to potentially acquire, or for Grupo Carso to potentially sell to PMI, Grupo Carso’s remaining 20% in the future. The effect of this acquisition was not material to Altria Group, Inc.’s consolidated financial position, results of operations or operating cash flows in 2007.

 

During the first quarter of 2007, PMI acquired an additional 50.2% stake in a Pakistan cigarette manufacturer, Lakson Tobacco Company Limited (“Lakson Tobacco”), and completed a mandatory tender offer for the remaining shares, which increased PMI’s total ownership interest in Lakson Tobacco from 40% to approximately 98%, for $388 million. The effect of this acquisition was not material to Altria Group, Inc.’s consolidated financial position, results of operations or operating cash flows in 2007.

 

    In November 2006, a subsidiary of PMI exchanged its 47.5% interest in E. León Jimenes, C. por. A. (“ELJ”), which included a 40% indirect interest in ELJ’s beer subsidiary, Cerveceria Nacional Dominicana, C. por. A., for 100% ownership of ELJ’s cigarette subsidiary, Industria de Tabaco León Jimenes, S.A. (“ITLJ”) and $427 million of cash, which was contributed to ITLJ prior to the transaction. As a result of the transaction, PMI now owns 100% of the cigarette business and no longer holds an interest in ELJ’s beer business. The exchange of PMI’s interest in ELJ’s beer subsidiary resulted in a pre-tax gain on sale of $488 million, which increased Altria Group, Inc.’s 2006 net earnings by $0.15 per diluted share. The operating results of ELJ’s cigarette subsidiary for the year ended December 31, 2007 and from November 2006 to December 31, 2006, the amounts of which were not material, were included in Altria Group, Inc.’s operating results in the respective years.

 

In the fourth quarter of 2006, PMI purchased from British American Tobacco the Muratti and Ambassador trademarks in certain markets, as well as the rights to L&M and Chesterfield in Hong Kong, in exchange for the rights to Benson & Hedges in certain African markets and a payment of $115 million.

 

In 2005 PMI acquired 98% of the outstanding shares of Sampoerna, an Indonesian tobacco company, for a cost of $4.8 billion, and a 98% stake in Coltabaco, the largest tobacco company in Colombia, for a cost of $300 million.

 

Other

 

In December 2005, PMI reached agreements with the China National Tobacco Corporation (“CNTC”) on the licensed production of Marlboro in the People’s Republic of China and the establishment of an international joint venture. PMI and CNTC each hold 50% of the shares of the joint venture company, which is based in Lausanne, Switzerland. The joint venture company will support the commercialization and distribution of a portfolio of Chinese heritage brands in international markets, expand the export of tobacco products and packaging materials from China, and explore other business development opportunities. While PMI views these agreements as important strategic milestones, PMI does not expect them to have a significant impact on its financial results for some time.

 

33


Exhibit 13

 

Operating Results

 

     Net Revenues

   Operating Companies
Income


(in millions)            


   2007

   2006

   2005

   2007

   2006

   2005

U.S. tobacco

   $ 18,485    $ 18,474    $ 18,134    $ 4,518    $ 4,812    $ 4,581

European Union

     26,682      23,752      23,874      4,173      3,516      3,934

Eastern Europe, Middle East and Africa

     12,149      9,972      8,869      2,427      2,065      1,635

Asia

     11,099      10,142      8,609      1,802      1,869      1,793

Latin America

     5,166      4,394      3,936      520      1,008      463
    

  

  

  

  

  

Total tobacco

   $ 73,581    $ 66,734    $ 63,422    $ 13,440    $ 13,270    $ 12,406
    

  

  

  

  

  

 

2007 compared with 2006

 

The following discussion compares tobacco operating results for 2007 with 2006.

 

·  U.S. tobacco: Net revenues, which include excise taxes billed to customers, increased $11 million (0.1%). Excluding excise taxes, net revenues increased $176 million (1.2%) to $15.0 billion, due primarily to lower wholesale promotional allowance rates ($1.1 billion), partially offset by lower volume ($906 million).

 

Operating companies income decreased $294 million (6.1%), due primarily to lower volume ($608 million) and higher pre-tax charges in 2007 for asset impairment, exit and implementation costs related to the announced closing of the Cabarrus, North Carolina cigarette manufacturing facility ($361 million), partially offset by lower wholesale promotional allowance rates, net of higher ongoing resolution costs ($329 million) and lower marketing, administration and research costs ($311 million, net of a $26 million provision for the Scott case in Louisiana in 2007).

 

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, 2007, 2006 and 2005, product liability defense costs were $200 million, $195 million and $258 million, respectively. The factors that have influenced past product liability defense costs are expected to continue to influence future costs. PM USA does not expect that product liability defense costs will increase significantly in the future.

 

PM USA’s shipment volume was 175.1 billion units, a decrease of 4.6% or 8.3 billion units, but was estimated to be down approximately 3.6% when adjusted for changes in trade inventories and calendar differences. For the full year 2007, PM USA estimates a decline of about 4% in total cigarette industry volume. In the premium segment, PM USA’s shipment volume decreased 4.3%. Marlboro shipment volume decreased 5.9 billion units (3.9%) to 144.4 billion units. In the discount segment, PM USA’s shipment volume also decreased, with Basic shipment volume down 8.8% to 13.2 billion units. PM USA estimates that cigarette consumption in 2008 may decline by 2.5% to 3.0%.

 

The following table summarizes PM USA’s cigarette volume performance by brand for 2007 and 2006:

 

For the Years Ended December 31, (in billion units)            


     2007

     2006

Marlboro

     144.4      150.3

Parliament

     6.0      6.0

Virginia Slims

     7.0      7.5

Basic

     13.2      14.5
      
    

Focus on Four Brands

     170.6      178.3

Other

     4.5      5.1
      
    

Total PM USA

     175.1      183.4
      
    

 

    The following table summarizes PM USA’s retail share performance, based on data from the IRI/Capstone Total Retail Panel, which is a tracking service that uses a sample of stores to project market share performance in retail stores selling cigarettes. This panel was not designed to capture sales through other channels, including Internet and direct mail:

 

For the Years Ended December 31,            


   2007

    2006

 

Marlboro

   41.0 %   40.5 %

Parliament

   1.9     1.8  

Virginia Slims

   2.2     2.3  

Basic

   4.1     4.2  
    

 

Focus on Four Brands

   49.2     48.8  

Other

   1.4     1.5  
    

 

Total PM USA

   50.6 %   50.3 %
    

 

 

Effective September 10, 2007, PM USA reduced its wholesale promotional allowances on Marlboro, Parliament and Basic by $0.50 per carton, from $4.00 to $3.50, and Virginia Slims by $2.00 per carton, from $4.00 to $2.00. In addition, PM USA raised the price on its other brands by $2.50 per thousand cigarettes or $0.50 per carton effective September 10, 2007 and by $9.95 per thousand cigarettes or $1.99 per carton effective February 12, 2007.

 

Effective December 18, 2006, PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $1.00 per carton, from $5.00 to $4.00, and increased the price of its other brands by $1.00 per carton.

 

Effective December 19, 2005, PM USA reduced its wholesale promotional allowance on its Focus on Four brands by $0.50 per carton, from $5.50 to $5.00. 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 anticipates that U.S. industry volume will decline by approximately 2.5% to 3.0% annually over the next few years. PM USA cannot predict the relative sizes of the premium and discount segments or its shipment or retail market share. PM USA believes that its results may be materially adversely affected by the items discussed under the caption Tobacco – Business Environment.

 

·  European Union: Net revenues, which include excise taxes billed to customers, increased $2.9 billion (12.3%). Excluding excise taxes, net revenues increased $920 million (11.7%) to $8.8 billion, due primarily to favorable currency ($748 million) and price increases ($374 million), partially offset by lower volume/mix ($202 million).

 

Operating companies income increased $657 million (18.7%), due primarily to favorable currency ($417 million), price increases, net of higher costs ($363 million), lower marketing, administration and research costs ($75 million) and the Italian antitrust charge in 2006 ($61 million), partially offset by lower volume/mix ($201 million), higher pre-tax charges for asset

 

34


Exhibit 13

 

impairment and exit costs ($33 million) and higher fixed manufacturing costs ($23 million).

 

In the European Union, PMI’s cigarette shipment volume decreased 0.7%, due primarily to declines in Germany and Poland, and unfavorable distributor inventory movements in France, partially offset by gains in Hungary, the Baltic States, and the impact of favorable inventory movements in Italy. PMI’s cigarette market share in the European Union was 39.3%, down 0.1 share point from 2006, due primarily to trade inventory distortions in the Czech Republic. Absent these distortions, market share in the European Union was flat.

 

In France, PMI’s shipment volume decreased 4.8%, due primarily to a lower market due to higher pricing. PMI’s market share decreased 0.3 share points to 42.4%, due primarily to declines in Marlboro, reflecting the temporary adverse impact of crossing the €5.00 per pack threshold. In the mid-price segment, the Philip Morris brand grew market share.

 

In Germany, PMI’s cigarette shipment volume declined 4.6%. The total cigarette market in Germany declined 4.0%, due mainly to the tax-driven price increase in October 2006. PMI’s cigarette market share declined 0.4 share points to 36.5%, due to lower Marlboro share, partially offset by share gains for L&M.

 

In Italy, the total cigarette market was down 1.1%. PMI’s cigarette shipment volume increased 2.9%, due primarily to the favorable timing of shipments, and its market share in Italy increased 0.8 share points to 54.6%, driven by Chesterfield and Merit.

 

In Poland, the total cigarette market declined 3.5%, due to consumer price sensitivity within the low-price segment following significant tax-driven price increases, as consumers switched to other tobacco products. PMI’s shipment volume was down 6.0% and market share decreased 1.0 share point to 39.0%, primarily reflecting share declines for PMI’s low-price and local 70mm brands. However, Marlboro market share rose 0.4 share points to 8.5%.

 

In Spain, the total cigarette market declined 1.2%. PMI’s shipment volume increased 0.7%, due mainly to the favorable timing of shipments. PMI’s market share declined 0.2 share points to 32.1%, primarily reflecting declines in Marlboro, partially offset by gains for Chesterfield, L&M and the Philip Morris brand.

 

·  Eastern Europe, Middle East and Africa: Net revenues, which include excise taxes billed to customers, increased $2.2 billion (21.8%). Excluding excise taxes, net revenues increased $741 million (13.2%) to $6.3 billion, due primarily to favorable currency ($321 million), price increases ($246 million) and higher volume/mix ($174 million).

 

Operating companies income increased $362 million (17.5%), due primarily to price increases and lower costs ($285 million), higher volume/mix ($95 million) and favorable currency ($90 million), partially offset by higher marketing, administration and research costs ($80 million), higher fixed manufacturing costs ($18 million) and higher pre-tax charges for asset impairment and exit costs ($10 million).

 

In Eastern Europe, Middle East and Africa, shipment volume increased 0.9%, driven by gains in Algeria, Bulgaria, Egypt and Ukraine, partially offset by declines in Romania, Russia, Serbia and Turkey.

 

In Egypt, improved economic conditions and increased tourism continued to fuel the growth of the total cigarette industry and premium brands. PMI’s shipments rose 25.6% and share advanced 1.9 points to 12.0%, driven by Marlboro, L&M and Merit.

 

In Russia, shipments were down 2.0%, due largely to L&M. This decline was partially offset by continued growth of higher-margin brands, including Marlboro, Parliament, Chesterfield and Muratti. PMI’s market share was unchanged at 26.6%. In September 2007, PMI replaced the entire L&M brand family with a completely new, smoother tasting product line-up in response to changing adult consumer preferences.

 

In Turkey, shipments declined 1.6% and market share declined 2.1 share points to 40.4%, due primarily to a volume decline of the lower-margin brands in PMI’s portfolio.

 

In Ukraine, shipments grew 4.7% and share rose 0.8 share points to 33.9%, driven by consumer up-trading to premium brands, particularly Marlboro, Parliament and Chesterfield.

 

In Algeria, shipments increased, driven by an expanded distribution network.

 

In Bulgaria, shipments increased, driven by PMI’s market entry in July 2006 as well as higher sales of Marlboro following price repositioning, and portfolio expansion following the lifting of import duties in January 2007.

 

In Romania, shipments were down 9.6%, due primarily to a lower total market and lower market share. PMI’s volume decline was driven by declines in L&M, partially offset by gains in Marlboro and Parliament.

 

·  Asia: Net revenues, which include excise taxes billed to customers, increased $957 million (9.4%). Excluding excise taxes, net revenues increased $108 million (1.9%) to $5.6 billion, due primarily to price increases ($146 million), the Lakson Tobacco acquisition ($118 million) and favorable currency ($75 million), partially offset by lower volume/mix ($231 million).

 

Operating companies income decreased $67 million (3.6%), due primarily to lower volume/mix ($179 million), higher marketing, administration and research costs ($70 million, including $30 million for a distributor termination in Indonesia), unfavorable currency ($36 million) and higher pre-tax charges for asset impairment and exit costs ($9 million), partially offset by price increases and lower costs ($171 million), lower fixed manufacturing costs ($44 million) and the Lakson Tobacco acquisition ($12 million).

 

In Asia, shipment volume increased 8.8%, due to the Lakson Tobacco acquisition in Pakistan. Excluding this acquisition, volume in Asia was down 3.2%, due primarily to the negative impact of inventory movements and lower shipments in Japan, partially offset by gains in Indonesia and Korea.

 

In Japan, the total cigarette market declined 4.8%, driven by the July 1, 2006 tax-driven price increase. Market share in Japan decreased 0.4 share points to 24.3%, due mainly to Lark. PMI’s shipments were down 12.6%, reflecting lower in-market sales and a reduction in distributor inventory durations at the end of 2007.

 

In Indonesia, the total cigarette market increased 3.9%. PMI’s market share decreased 0.3 share points to 28.0%, reflecting the share decline of A Mild and Dji Sam Soe, due to a temporary stick-price disadvantage versus competitor brands, partially offset by the growth of Marlboro, which gained 0.4 share points to 4.0%. PMI shipment volume rose 2.8%, driven by the July 2007 launch of Marlboro kretek.

 

In Korea, the total market increased 4.6%. PMI’s shipments increased 20.3%, due primarily to the performance of Marlboro, Parliament and Virginia Slims, driven by new line extensions, including Marlboro Filter Plus. Market share in Korea increased 1.3 share points to 9.9% with Marlboro market share up 0.8 share points to 4.2%.

 

·  Latin America: Net revenues, which include excise taxes billed to customers, increased $772 million (17.6%). Excluding excise taxes, net revenues

 

35


Exhibit 13

 

increased $235 million (13.4%) to $2.0 billion, due primarily to price increases ($130 million), the impact of acquisitions ($51 million), favorable currency ($34 million) and favorable volume/mix ($20 million).

 

Operating companies income decreased $488 million (48.4%), due primarily to the gain in 2006 from the divestiture of the Dominican Republic beer business ($488 million), the impact of divestitures ($51 million), higher marketing, administration and research costs ($18 million), and higher pre-tax charges for asset impairment and exit costs ($17 million), partially offset by price increases, net of higher costs ($87 million).

 

In Latin America, shipment volume increased 0.8%, driven by gains in Argentina, partially offset by declines in Mexico and the Dominican Republic.

 

In Argentina, the total cigarette market was up 3.0%, while PMI shipments grew 7.1% and share was up 2.6 share points to 68.9%, driven by Marlboro and the Philip Morris brand.

 

In Mexico, the total market declined 6.3%, due to lower consumption following the price increases in January and October 2007, as well as an unfavorable comparison with the prior year, which included trade purchases in advance of the January 2007 tax-driven price increase. PMI shipments declined 2.1%, reflecting the decline in the overall market. However, PMI’s market share rose 0.8 share points to 64.3%, driven by Benson & Hedges and Delicados.

 

In the Dominican Republic, shipment volume declined 20.2%, reflecting a lower total market following price increases in January and February 2007 to partially compensate for a very significant excise tax increase imposed on cigarettes in January 2007.

 

2006 compared with 2005

 

The following discussion compares tobacco operating results for 2006 with 2005.

 

·  U.S. tobacco: Net revenues, which include excise taxes billed to customers, increased $340 million (1.9%). Excluding excise taxes, net revenues increased $382 million (2.6%) to $14.9 billion, due primarily to lower wholesale promotional allowance rates ($604 million), partially offset by lower volume ($239 million).

 

Operating companies income increased $231 million (5.0%), due primarily to lower wholesale promotional allowance rates, net of higher ongoing resolution costs ($424 million) and several other items (aggregating $79 million), partially offset by lower volume ($170 million), higher fixed manufacturing costs ($47 million) and higher marketing, administration and research costs (including spending in 2006 for various excise tax ballot initiatives). The other items reflect a pre-tax provision in 2005 for the Boeken individual smoking case ($56 million) and the previously mentioned 2005 net charges related to tobacco quota buy-out legislation ($23 million).

 

PM USA’s shipment volume was 183.4 billion units, a decrease of 1.1%, but was estimated to be down approximately 1.5% when adjusted for trade inventory changes and the timing of promotional shipments. In the premium segment, PM USA’s shipment volume decreased 0.7%. Marlboro shipment volume decreased 0.2 billion units (0.2%) to 150.3 billion units. In the discount segment, PM USA’s shipment volume decreased 6.2%, while Basic shipment volume was down 5.0% to 14.5 billion units.

 

The following table summarizes PM USA’s cigarette volume performance by brand for 2006 and 2005:

 

For the Years Ended December 31, (in billion units)            


   2006

     2005

Marlboro

   150.3      150.5

Parliament

   6.0      5.8

Virginia Slims

   7.5      7.9

Basic

   14.5      15.2
    
    

Focus on Four Brands

   178.3      179.4

Other

   5.1      6.1
    
    

Total PM USA

   183.4      185.5
    
    

 

The following table summarizes PM USA’s retail share performance, based on data from the IRI/Capstone Total Retail Panel, which is a tracking service that uses a sample of stores to project market share performance in retail stores selling cigarettes. The panel was not designed to capture sales through other channels, including Internet or direct mail:

 

For the Years Ended December 31,            


   2006

    2005

 

Marlboro

   40.5 %   40.0 %

Parliament

   1.8     1.7  

Virginia Slims

   2.3     2.3  

Basic

   4.2     4.3  
    

 

Focus on Four Brands

   48.8     48.3  

Other

   1.5     1.7  
    

 

Total PM USA

   50.3 %   50.0 %
    

 

 

·  European Union: Net revenues, which include excise taxes billed to customers, decreased $122 million (0.5%). Excluding excise taxes, net revenues decreased $609 million (7.2%) to $7.9 billion, due primarily to lower volume/mix ($254 million), net price decreases ($203 million) and unfavorable currency ($152 million).

 

Operating companies income decreased $418 million (10.6%), due primarily to lower volume/mix ($243 million), price decreases, net of cost savings ($179 million), the Italian antitrust charge ($61 million) and higher pre-tax charges for asset impairment and exit costs ($55 million), partially offset by lower marketing, administration and research costs ($90 million) and lower fixed manufacturing costs ($29 million).

 

In the European Union, PMI’s cigarette shipment volume decreased 2.8%. Excluding the inventory sale in Italy, PMI’s volume decreased 1.7% in the European Union due largely to declines in Spain, Portugal, Germany and the Czech Republic, partially offset by gains in France, Hungary and Poland.

 

In Spain, the total cigarette market was down 2.9%, due primarily to the impact of excise tax increases and a new tobacco law implemented on January 1, 2006. PMI’s shipment volume decreased 12.8%, reflecting increased consumer down-trading to the low-price segment. As a result of growing price gaps, PMI’s market share in Spain declined 2.3 share points to 32.3%. 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. In late 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. On November 10, 2006, the Spanish government announced an increase in the minimum excise tax to 70 euros per thousand cigarettes. Effective December 30, 2006, PMI raised prices on all its brands.

 

36


Exhibit 13

 

In Portugal, the total cigarette market declined 8.2%, reflecting a tax-driven price increase that resulted in lower overall consumption and higher consumer cross-border purchases in Spain. PMI’s shipment volume decreased 13.0% and market share was down 5.0 share points to 82.0%, due to severe price competition, partially arising from competitors continuing to sell lower priced product from inventory that was accumulated prior to the tax increase.

 

In Germany, PMI’s total tobacco volume (which includes other tobacco products) increased 0.9%; however, PMI’s cigarette volume declined 2.8%. Total tobacco consumption in Germany was down 5.9% in 2006, reflecting the decline and ultimate exit of tobacco portions from the market. The total cigarette market decreased 4.0%, affected by the September 2005 tax-driven price increase as well as the sale of illicit cigarettes as reported by the German cigarette manufacturers’ association. PMI’s cigarette market share increased 0.2 share points to 36.9%, driven by the price repositioning of L&M in January 2006. During the fourth quarter of 2005, the European Court of Justice ruled that the German government’s favorable tax treatment of tobacco portions was against EU law. Accordingly, tobacco portions manufactured as of April 1, 2006 now incur the same excise tax as that levied on cigarettes, and as of October 2006, PMI’s shipments of tobacco portions ceased.

 

In the Czech Republic, shipment volume was down 9.7% and market share was lower, reflecting intense price competition.

 

In Italy, the total cigarette market rose 1.1% versus a low base in 2005, when it was adversely impacted by the compounding effects of the January 2005 legislation restricting smoking in public places and the December 2004 tax-driven price increase. PMI’s shipment volume in Italy decreased 3.9%, reflecting the one-time inventory sale in 2005. Adjusting for the one-time inventory sale, cigarette shipment volume in Italy increased 1.9%. Market share in Italy increased 1.3 share points to 53.8%, driven by Marlboro, Diana and Chesterfield.

 

In Poland, shipment volume was up 6.3% and market share increased 2.8 share points to 40.0%, driven by L&M and Next.

 

In France, shipment volume increased 7.0%, driven by price stability, moderate price gaps and favorable timing of shipments. Market share increased 1.0 share point to 42.7%, reflecting the strong performance of Marlboro and the Philip Morris brand.

 

·   Eastern Europe, Middle East and Africa: Net revenues, which include excise taxes billed to customers, increased $1.1 billion (12.4%). Excluding excise taxes, net revenues increased $563 million (11.2%) to $5.6 billion, due primarily to price increases ($391 million) and higher volume/mix ($195 million), partially offset by unfavorable currency ($23 million).

 

Operating companies income increased $430 million (26.3%), due primarily to price increases, net of higher costs ($381 million) and higher volume/mix ($130 million), partially offset by higher marketing, administration and research costs ($85 million).

 

In Eastern Europe, Middle East and Africa, shipment volume increased 1.6%, driven by gains in Russia, Ukraine and Egypt, partially offset by declines in Romania and Turkey. In Russia, shipments were up 3.4%, driven by Marlboro, Muratti, Parliament, and Chesterfield, while market share was down 0.4 share points to 26.6%, due primarily to declines of low-price brands and L&M. Higher shipments in Ukraine mainly reflect higher market share, as well as up-trading to higher margin brands. In Romania, shipments declined 15.1% and market share was down 1.8 share points to 32.3%. In Turkey, shipments declined 3.5%, reflecting the continued decline of low-price Bond Street. However, PMI market share in Turkey rose 1.1 share points to 42.4%, as consumers traded up to its higher margin brands, Parliament and Muratti.

 

·  Asia: Net revenues, which include excise taxes billed to customers, increased $1.5 billion (17.8%). Excluding excise taxes, net revenues increased $612 million (12.4%) to $5.5 billion, due primarily to the impact of acquisitions ($587 million) and price increases ($197 million), partially offset by unfavorable currency ($179 million).

 

Operating companies income increased $76 million (4.2%), due primarily to the impact of acquisitions ($219 million) and price increases ($185 million), partially offset by unfavorable currency ($188 million), lower volume/mix ($81 million) and higher marketing, administration and research costs ($53 million).

 

In Asia, shipment volume increased 12.3%, reflecting the acquisition of Sampoerna in Indonesia. Excluding this acquisition, volume in Asia was down 1.0%, due primarily to lower volume in Japan and Thailand. In Japan, the total market declined 4.4%, driven by the July 1, 2006 price increase. Market share in Japan decreased 0.1 share point to 24.7%. Market share in Indonesia grew 1.9 share points to 28.3%, led by A Hijau and A Mild. In Thailand, a lower total market reflected a December 2005 excise tax increase.

 

·  Latin America: Net revenues, which include excise taxes billed to customers, increased $458 million (11.6%). Excluding excise taxes, net revenues increased $215 million (14.0%) to $1.8 billion, due primarily to higher volume/mix ($144 million), the impact of acquisitions ($50 million) and favorable currency ($14 million).

 

    Operating companies income increased $545 million (117.7%), due primarily to a pre-tax gain related to the exchange of PMI’s interest in a beer business in the Dominican Republic ($488 million), higher volume/mix ($37 million), price increases ($23 million) and the impact of acquisitions ($13 million), partially offset by higher marketing, administration and research costs ($24 million).

 

In Latin America, shipment volume increased 10.8%, driven by strong gains in Argentina and Mexico, as well as higher volume in Colombia due to the 2005 acquisition of Coltabaco. Excluding this acquisition, volume was up 6.3% in Latin America. In Argentina, the total market advanced approximately 7.0%, while PMI shipments grew 15.9% and share was up 4.9 share points, due mainly to the Philip Morris brand. In Mexico, the total market was up approximately 2.0% and PMI shipments grew 6.0%. Market share rose 1.4 share points to 63.5%, reflecting the continued strong performance of Marlboro and Benson & Hedges.

 

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 2007, 2006 and 2005, proceeds from asset sales, maturities and bankruptcy recoveries totaled $569 million, $357 million and $476 million, respectively, and gains totaled $326 million, $132 million and $72 million, respectively, in operating companies income.

 

37


Exhibit 13

 

Included in the proceeds for 2007 were partial recoveries of amounts previously charged to earnings in the allowance for losses related to PMCC’s airline exposure. The operating companies income associated with these recoveries, which is included in the gains shown above, was $214 million for the year ended December 31, 2007.

 

PMCC leases one 750 megawatt (“MW”) natural gas-fired power plant (located in Pasadena, Texas) to an indirect subsidiary of Calpine Corporation (“Calpine”). Calpine, which has guaranteed the lease, is currently operating under bankruptcy protection. The subsidiary was not included as part of the bankruptcy filing of Calpine. PMCC does not record income on leases when the lessee or its guarantor is in bankruptcy. At December 31, 2007, PMCC’s finance asset balance for this lessee was $60 million. Based on PMCC’s assessment of the prospect for recovery on the Pasadena plant, a portion of the outstanding finance asset balance has been provided for in the allowance for losses. In July 2007, PMCC’s interest in two 265 MW natural gas-fired power plants (located in Tiverton, Rhode Island, and Rumford, Maine), which were part of the bankruptcy filing, were foreclosed upon. These leases were rejected and written off during 2006.

 

None of PMCC’s aircraft lessees are operating under bankruptcy protection at December 31, 2007. One of PMCC’s aircraft lessees, Northwest Airlines, Inc. (“Northwest”), exited bankruptcy on May 31, 2007 and assumed PMCC’s leveraged leases for three Airbus A-320 aircraft. PMCC’s leases for 19 aircraft with Delta Air Lines, Inc. (“Delta”) were sold in early 2007.

 

The activity in the allowance for losses on finance assets for the years ended December 31, 2007, 2006, 2005 was as follows:

 

(in millions)              


   2007

    2006

    2005

 

Balance at beginning of the year

   $ 480     $ 596     $ 497  

Amounts (recovered)/charged to earnings

     (129 )     103       200  

Amounts written-off

     (147 )     (219 )     (101 )
    


 


 


Balance at end of the year

   $ 204     $ 480     $ 596  
    


 


 


 

The net impact to the allowance for losses in 2007, 2006 and 2005 related primarily to various airline leases. Amounts recovered of $129 million in 2007 related to partial recoveries of amounts charged to earnings in the allowance for losses in prior years. In addition, PMCC recovered $85 million related to amounts previously charged to earnings and written-off in prior years. In total, these recoveries resulted in additional operating companies income of $214 million for the year ended December 31, 2007. As a result of the $200 million charge in 2005, 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. It is possible that additional adverse developments may require PMCC to increase its allowance for losses. Acceleration of taxes on the foreclosures of leveraged leases written-off amounted to approximately $50 million and $80 million in 2007 and 2006, respectively. There were no foreclosures in 2005.

 

As discussed further in Note 14. Income Taxes, the IRS has disallowed benefits pertaining to several PMCC leverage lease transactions for the years 1996 through 1999.

 

Operating Results

 

(in millions)              


   Net Revenues

   Operating
Companies Income


     2007

   2006

   2005

   2007

   2006

   2005

Financial Services

   $ 220    $ 317    $ 319    $ 421    $ 176    $ 31
    

  

  

  

  

  

 

PMCC’s net revenues for 2007 decreased $97 million (30.6%) from 2006, due primarily to lower lease revenues due to lower investment balances, and to lower gains from asset management activity. PMCC’s operating companies income for 2007 of $421 million increased $245 million (100.0+%) from 2006, due primarily to cash recoveries in 2007 on aircraft leases previously written down versus an increase to the loss provision in 2006, partially offset by lower revenues.

 

    PMCC’s net revenues for 2006 decreased $2 million (0.6%) from 2005, due primarily to lower lease revenues as a result of lower investment balances, partially offset by higher gains from asset sales. PMCC’s operating companies income for 2006 of $176 million increased $145 million (100.0+%) from 2005. Operating companies income for 2006 includes a $103 million increase to the provision for airline industry exposure as discussed above, a decrease of $97 million from the 2005 provision, and higher gains from asset sales.

 

Financial Review

 

·  Net Cash Provided by Operating Activities, Continuing Operations: During 2007, net cash provided by operating activities on a continuing operations basis was $10.2 billion, compared with $9.9 billion during 2006. The increase in cash provided by operating activities was due primarily to higher earnings from continuing operations (after excluding the non-cash reversal of income tax reserves in 2006), the return of $1.3 billion of escrow bond deposits in December 2007 related to the Engle U.S. tobacco case and lower pension plan contributions, partially offset by the return in 2006 of approximately $2 billion of escrow bond deposits related to the Price U.S. tobacco case and a higher use of cash to fund working capital. The change in working capital was due primarily to higher receivables at PMI from additional trade purchases in anticipation of 2008 tax-driven price increases in many markets and higher finished goods inventories at PMI in anticipation of further trade purchases prior to excise tax increases.

 

During 2006, net cash provided by operating activities on a continuing operations basis was $9.9 billion, compared with $7.6 billion during 2005. The increase in cash provided by operating activities was due primarily to the return of the escrow bond deposit related to the Price U.S. tobacco case, lower pension plan contributions and higher earnings from continuing operations, partially offset by the reimbursement of Kraft’s portion of income tax benefits related to the RAR and a higher use of cash to fund working capital. The increase in working capital reflects PMI’s increase in inventories in anticipation of 2007 excise tax-driven increases in many markets.

 

·  Net Cash Used in Investing Activities, Continuing Operations: One element of PMI’s growth strategy is to strengthen its brand portfolio and/or expand its geographic reach through active programs of selective acquisitions. ALG and PM USA from time to time consider acquisitions as part of their adjacency strategy, as evidenced by ALG’s 2007 acquisition of John Middleton, Inc.

 

38


Exhibit 13

 

During 2007, 2006 and 2005, net cash used in investing activities on a continuing operations basis was $5.3 billion, $0.5 billion and $5.4 billion, respectively. In 2007, the net cash used primarily reflects the purchases of John Middleton, Inc., and Lakson Tobacco in Pakistan, as well as PMI’s increased investment in its Mexican tobacco business. In 2006, proceeds from sales of businesses of $520 million were primarily from the sale of PMI’s interest in a beer business in the Dominican Republic. The net cash used in 2005 reflects the purchase of 98% of the outstanding shares of Sampoerna.

 

On December 11, 2007, in conjunction with PM USA’s adjacency strategy, Altria Group, Inc. acquired 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, for $2.9 billion in cash. The acquisition was financed with existing cash. In November 2007, PMI acquired an additional 30% stake in its Mexican tobacco business from Grupo Carso, which increased PMI’s ownership interest to 80%, for $1.1 billion. During the first quarter of 2007, PMI acquired an additional 50.2% stake in a Pakistan cigarette manufacturer, Lakson Tobacco, and completed a mandatory tender offer for the remaining shares, which increased PMI’s total ownership interest in Lakson Tobacco from 40% to approximately 98%, for $388 million.

 

In November 2006, a subsidiary of PMI exchanged its 47.5% interest in E. León Jimenes, C. por. A. (“ELJ”), which included a 40% indirect interest in ELJ’s beer subsidiary, Cerveceria Nacional Dominicana, C. por. A., for 100% ownership of ELJ’s cigarette subsidiary, Industria de Tabaco León Jimenes, S.A. (“ITLJ”) and $427 million of cash, which was contributed to ITLJ prior to the transaction. As a result of the transaction, PMI now owns 100% of the cigarette business and no longer holds an interest in ELJ’s beer business.

 

Capital expenditures for 2007 increased 13.5% to $1.5 billion (of which $1.1 billion related to PMI). The expenditures were primarily for modernization and consolidation of manufacturing facilities, expansion of research and development, and expansion of certain production capacity. Excluding PMI, 2008 capital expenditures are expected to be slightly below 2007 expenditures, and are expected to be funded by operating cash flows.

 

·  Net Cash Used in Financing Activities, Continuing Operations: During 2007, 2006 and 2005 net cash used in financing activities on a continuing operations basis was $3.5 billion, $10.6 billion and $1.2 billion, respectively. The decrease of $7.1 billion from 2006 was due primarily to the issuance of debt in 2007 as opposed to the repayment of debt in 2006. The increase of $9.4 billion from 2005 to 2006 was due primarily to the repayment of short and long-term debt in 2006 ($5.6 billion) and the issuance of debt for the Sampoerna acquisition in 2005 ($4.1 billion).

 

·  Debt and Liquidity:

 

Credit Ratings: At December 31, 2007, ALG’s debt ratings by major credit rating agencies were as follows:

 

     Short-term

   Long-term

   Outlook

Moody’s

   P-2    Baa1    Stable

Standard & Poor’s

   A-2    BBB    Stable

Fitch

   F-2    BBB+    Stable
    
  
  

 

On January 30, 2008, the major credit rating agencies listed in the table above affirmed ALG’s debt ratings following the announcement of the PMI spin-off, and Fitch upgraded ALG’s outlook to positive.

 

ALG’s credit quality, measured by 5 year credit default swaps, has improved dramatically over the past two years with levels that approximate those of Single-A rated issuers.

 

Moody’s expects that, should PMI be spun-off from Altria Group, Inc. as expected, PMI’s long-term and short-term ratings could be as high as A2 and Prime-1, respectively. Standard & Poor’s believes that the potential corporate credit rating for PMI could be as high as A+ based solely on its business risk assessment. Fitch expects that, should PMI be spun-off from Altria Group, Inc., PMI’s long-term and short-term ratings could be A+ and F1, respectively.

 

Credit Lines: ALG and PMI maintain separate revolving credit facilities. ALG intends to use its revolving credit facilities to support the issuance of commercial paper.

 

    As discussed in Note 9. Short-Term Borrowings and Borrowing Arrangements, the purchase price of the Sampoerna acquisition was primarily financed through euro 4.5 billion of bank credit facilities arranged for PMI and its subsidiaries in May 2005, consisting of a euro 2.5 billion three-year term loan facility (which, through repayments had been reduced to euro 1.5 billion) and a euro 2.0 billion five-year revolving credit facility. On December 4, 2007, PMI entered into new credit agreements consisting of a $3.0 billion five-year revolving credit facility, a $1.0 billion three-year revolving credit facility and a euro 1.5 billion 364-day term loan facility. On December 4, 2007, PMI borrowed euro 1.5 billion under the new term loan facility to repay the debt outstanding under its 2005 term loan 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, 2007, PMI’s ratio calculated in accordance with the agreements was 44.6 to 1.0.

 

ALG has a 364-day revolving credit facility in the amount of $1.0 billion, which expires on March 27, 2008. In addition, ALG maintains a multi-year credit facility in the amount of $4.0 billion, which expires April 15, 2010. The ALG facilities require the maintenance of an earnings to fixed charges ratio, as defined by the agreements, of not less than 2.5 to 1.0. At December 31, 2007, the ratio calculated in accordance with the agreements was 19.6 to 1.0. After the effectiveness of the spin-off of PMI, ALG’s multi-year credit facility will be reduced from $4.0 billion to $3.5 billion and the earnings to fixed charges ratio will be replaced with a ratio of EBITDA to interest expense of not less than 4.0 to 1.0. In addition, the facility will then require the maintenance of a ratio of debt to EBITDA of not more than 2.5 to 1.0. If the PMI spin-off had occurred as of December 31, 2007, the ratio of EBITDA to interest expense would have been 15.6 to 1.0, and the ratio of debt to EBITDA would have been 0.9 to 1.0. On January 28, 2008, Altria Group, Inc. entered into a $4.0 billion, 364-day bridge loan agreement to finance a tender offer and consent solicitation expenses related to its outstanding consumer products debt prior to the spin-off of PMI. The agreement contains the same covenants mentioned above, and is required to be prepaid or reduced by the net amount of any capital markets transactions.

 

ALG and PMI 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, 2007, $2,205 million of short-term borrowings that PMI expects to remain outstanding at December 31, 2008 were reclassified as long-term debt.

 

39


Exhibit 13

 

At December 31, 2007, credit lines for ALG 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 revolving credit, expiring 3/27/08

   $ 1.0    $ -      $ -      $ 1.0

Multi-year revolving credit, expiring 4/15/10

     4.0      -        -        4.0
    

  

  

  

     $ 5.0    $ -      $ -      $ 5.0
    

  

  

  

 

PMI

 

Type
(in billions of dollars)            


   Credit Lines

   Amount
Drawn


   Lines
Available


$3.0 billion, 5-year revolving credit, expiring 12/4/12

   $ 3.0    $ -      $ 3.0

$1.0 billion, 3-year revolving credit, expiring 12/4/10

     1.0      0.6      0.4

euro 1.5 billion, 364-day term loan, expiring 12/2/08

     2.2      2.2      -  

euro 2.0 billion, 5-year revolving credit, expiring 5/12/10

     2.9      2.4      0.5
    

  

  

     $ 9.1    $ 5.2    $ 3.9
    

  

  

 

In addition to the above, certain international subsidiaries of PMI maintain credit lines to meet their respective working capital needs. These credit lines, which amounted to approximately $2.6 billion are for the sole use of these international businesses. Borrowings on these lines amounted to approximately $0.6 billion and $0.4 billion at December 31, 2007 and 2006, respectively.

 

Debt: Altria Group, Inc.’s total debt (consumer products and financial services) was $11.0 billion and $8.5 billion at December 31, 2007 and 2006, respectively. Total consumer products debt was $10.5 billion and $7.4 billion at December 31, 2007 and 2006, respectively. Total consumer products debt includes PMI’s third-party debt of $6.3 billion and $2.8 billion at December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006 (after giving effect to the Kraft spin-off), Altria Group, Inc.’s ratio of consumer products debt to total equity was 0.57 and 0.58, respectively. The ratio of total debt to total equity was 0.60 and 0.67 at December 31, 2007 and 2006 (after giving effect to the Kraft spin-off), respectively. Fixed-rate debt constituted approximately 44% and 65% of total consumer products debt at December 31, 2007 and 2006, respectively. The weighted average interest rate on total consumer products debt, including the impact of swap agreements, was approximately 5.6% and 5.8% at December 31, 2007 and 2006, respectively.

 

At December 31, 2007, ALG had approximately $2.8 billion of capacity remaining under its existing shelf registration statement.

 

ALG does not guarantee the debt of PMI.

 

On January 31, 2008, Altria Group, Inc. and its subsidiary, Altria Finance (Cayman Islands) Ltd. commenced tender offers to purchase for cash $2.6 billion of notes and debentures denominated in U.S. dollars and approximately €1.0 billion in euro-denominated bonds. Altria Group, Inc. expects to record a charge of approximately $400 million upon completion of the tender offer. In order to finance the tender offer, Altria Group, Inc. has arranged a $4.0 billion, 364-day bridge loan. Subsequent to the spin-off, Altria Group, Inc. intends to access the public debt market to refinance debt incurred in connection with the tender offer.

 

Taxes: The IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999, and issued a final RAR on March 15, 2006. Altria Group, Inc. agreed with the RAR, with the exception of certain leasing matters discussed below. Consequently, in March 2006, Altria Group, Inc. recorded non-cash tax benefits of $1.0 billion, which principally represented the reversal of tax reserves following the issuance of and agreement with the RAR. Altria Group, Inc. reimbursed $337 million in cash to Kraft for its portion of the $1.0 billion in tax benefits, as well as pre-tax interest of $46 million. The amounts related to Kraft were reclassified to earnings from discontinued operations. The tax reversal resulted in an increase to earnings from continuing operations of $631 million for the year ended December 31, 2006.

 

    Altria Group, Inc. has agreed with all conclusions of the RAR, with the exception of the disallowance of benefits pertaining to several PMCC leveraged lease transactions for the years 1996 through 1999. PMCC will continue to assert its position regarding these leveraged lease transactions and contest approximately $150 million of tax and net interest assessed and paid with regard to them. The IRS may in the future challenge and disallow more of PMCC’s leveraged leases based on Revenue Rulings, an IRS Notice and subsequent case law addressing specific types of leveraged leases (lease-in/lease-out (“LILO”) and sale-in/lease-out (“SILO”) transactions). PMCC believes that the position and supporting case law described in the RAR, Revenue Rulings and the IRS Notice 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 litigation. In this regard, on October 16, 2006, PMCC filed a complaint in the U.S. District Court for the Southern District of New York to claim refunds for a portion of these tax payments and associated interest. However, should PMCC’s position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and significantly lower its earnings to reflect the recalculation of the income from the affected leveraged leases, which could have a material effect on the earnings and cash flows of Altria Group, Inc. in a particular fiscal quarter or fiscal year. PMCC considered this matter in its adoption of FIN 48 and FASB Staff Position No. FAS 13-2.

 

·  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, 2007, Altria Group, Inc.’s third-party guarantees, which are primarily related to excise taxes and divestiture activities, were $72 million, of which $67 million have no specified expiration dates. The remainder expire through 2011, with none expiring during 2008. Altria Group, Inc. is required to perform under these guarantees in the event that a third party fails to make contractual payments or

 

40


Exhibit 13

 

achieve performance measures. Altria Group, Inc. has a liability of $22 million on its consolidated balance sheet at December 31, 2007, relating to these guarantees. For the remainder of these guarantees there is no liability on the consolidated balance sheet at December 31, 2007 as the fair value of these guarantees is insignificant, due to the fact that the probability of future payments under these guarantees is remote. 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, 2007, subsidiaries of ALG were also contingently liable for $3.0 billion of guarantees related to their own performance, consisting of the following:

 

   

$ 2.7 billion of guarantees for excise tax and import duties related primarily to international shipments of tobacco products. In these agreements, financial institutions provide guarantees of tax payments to the respective government agency. PMI then issues guarantees to the respective financial institutions 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, consisting principally of guarantees of lines of credit for certain PMI subsidiaries.

 

Although Altria Group, Inc.’s guarantees of its own performance are frequently short-term in nature, they 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.

 

Aggregate Contractual Obligations: The following table summarizes Altria Group, Inc.’s contractual obligations from continuing operations at December 31, 2007:

 

     Payments Due

(in millions)            


   Total

   2008

   2009-
2010


   2011-
2012


   2013 and
Thereafter


Long-term debt(1):

                                  

Consumer products

   $ 7,703    $ 2,445    $ 3,441    $ 57    $ 1,760

Financial services

     500             500              
    

  

  

  

  

       8,203      2,445      3,941      57      1,760

Interest on borrowings(2)

     2,317      585      561      258      913

Operating leases(3)

     639      133      180      79      247

Purchase obligations(4):

                                  

Inventory and production costs

     2,142      1,324      707      61      50

Other

     3,950      2,018      1,311      509      112
    

  

  

  

  

       6,092      3,342      2,018      570      162

Other long-term liabilities(5)

     1,528      137      297      306      788
    

  

  

  

  

     $ 18,779    $ 6,642    $ 6,997    $ 1,270    $ 3,870
    

  

  

  

  


(1) Amounts represent the expected cash payments of Altria Group, Inc.’s long-term debt, excluding short-term borrowings reclassified as long-term debt. Amounts include capital lease obligations, primarily associated with the expansion of PMI’s vending machines in Japan.

 

(2) Amounts represent the expected cash payments of Altria Group, Inc.’s interest expense on its long-term debt, including the current portion of long-term debt. Interest on Altria Group, Inc.’s fixed-rate debt is presented using the stated interest rate. Interest on Altria Group, Inc.’s variable rate debt is estimated using the rate in effect at December 31, 2007. Amounts exclude the amortization of debt discounts, the amortization of loan fees and fees for lines of credit that would be included in interest expense in the consolidated statements of earnings.

 

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

 

(4) 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.

 

(5) Other long-term liabilities primarily consist of postretirement health care costs. The following long-term liabilities included on the consolidated balance sheet are excluded from the table above: accrued pension and post employment costs, income taxes and tax contingencies, minority interest, insurance accruals and other accruals. Altria Group, Inc. is unable to estimate the timing of payments (or contributions in the case of accrued pension costs) for these items. Currently, Altria Group, Inc. anticipates making U.S. pension contributions of approximately $16 million in 2008 and non-U.S. pension contributions of approximately $97 million in 2008, 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, are also excluded from the table above since these deposits will be returned to PM USA should it prevail on appeal.

 

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 also entered into a trust agreement to provide certain aid to U.S. tobacco growers and quota holders, but PM USA’s obligations under this trust have now been eliminated by the obligations imposed on PM USA 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 and the enactment of FETRA, PM USA and PMI recorded the following amounts in cost of sales for the years ended December 31, 2007, 2006 and 2005:

 

(in billions)            


   PM USA

   PMI

   Total

2007

   $ 5.5    $ 0.1    $ 5.6

2006

     5.0      0.1      5.1

2005

     5.0      0.1      5.1
    

  

  

 

 

41


Exhibit 13

 

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

2008

   $ 5.6    $ 0.1    $ 5.7

2009

     5.5      0.1      5.6

2010

     5.6      0.1      5.7

2011

     5.6      0.1      5.7

2012

     5.6      0.1      5.7

2013 to 2017

     5.6 annually      0.1 annually ending in 2016      5.7 annually

Thereafter

     5.7 annually      —        5.7 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. See Note 19 for a discussion of proceedings that may result in a downward adjustment of amounts paid under State Settlement Agreements for the years 2003 and 2004.

 

·  Litigation Escrow Deposits: As discussed in Note 19, in December 2007, $1.2 billion of funds held in an interest-bearing escrow account in connection with obtaining a stay of execution in the Engle class action was returned to PM USA. In addition, the $100 million relating to the bonding requirement in the same case has been discharged. The $1.2 billion escrow account and the deposit of $100 million related to the bonding requirement were included in the December 31, 2006 consolidated balance sheet as other assets. Interest income on the $1.2 billion escrow account, prior to its return to PM USA, was paid to PM USA quarterly and was being recorded as earned in interest and other debt expense, net, in the consolidated statements of earnings.

 

Also, in June 2006 under the order of the Illinois Supreme Court, the cash deposits of approximately $2.2 billion related to the Price case were returned to PM USA, and PM USA’s obligations to deposit further cash payments were terminated.

 

With respect to certain adverse verdicts currently on appeal, as of December 31, 2007, PM USA has posted various forms of security totaling approximately $193 million, the majority of which have been collateralized with cash deposits, to obtain stays of judgments pending appeals. These cash deposits are included in other assets on the consolidated balance sheets.

 

Although litigation is subject to uncertainty and could result in material adverse consequences for the financial condition, cash flows or results of operations of PM USA or Altria Group, Inc. in a particular fiscal quarter or fiscal year, management believes the litigation environment has substantially improved and expects cash flow from operations, together with existing credit facilities, to provide sufficient liquidity to meet the ongoing needs of the business.

 

·  Equity and Dividends: As discussed in Note 1. Background and Basis of Presentation, on March 30, 2007, Altria Group, Inc. distributed all of its remaining interest in Kraft on a pro rata basis to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 in a tax-free distribution. The distribution resulted in a net decrease to Altria Group, Inc.’s stockholders’ equity of $27.4 billion on March 30, 2007.

 

As discussed in Note 12. Stock Plans, in January 2007, Altria Group, Inc. issued 1.7 million shares of deferred stock to eligible U.S.-based and non-U.S. employees. Restrictions on these shares lapse in the first quarter of 2010. The market value per share was $87.36 on the date of grant. Recipients of these Altria Group, Inc. deferred shares did not receive restricted stock or deferred stock of Kraft upon the Kraft spin-off. Rather, they received 0.6 million additional deferred shares of Altria Group, Inc. to preserve the intrinsic value of the original award.

 

At December 31, 2007, the number of shares to be issued upon exercise of outstanding stock options and vesting of deferred stock was 33.2 million, or 1.6% of shares outstanding.

 

Dividends paid in 2007 and 2006 were $6.7 billion and $6.8 billion, respectively, a decrease of 2.4%, primarily reflecting a lower dividend rate in 2007 due to the Kraft spin-off, partially offset by a greater number of shares outstanding in 2007. During the second quarter of 2007, Altria Group, Inc. adjusted its quarterly dividend to $0.69 per share so that its stockholders who retained their Altria Group, Inc. and Kraft shares would receive in the aggregate the same dividend dollars as before the distribution. During the third quarter of 2007, Altria Group, Inc.’s Board of Directors approved an 8.7% increase in the quarterly dividend rate to $0.75 per share. As a result, the present annualized dividend rate is $3.00 per share.

 

As a result of the PMI spin-off discussed above, Altria Group, Inc. intends to adjust its current dividend so that its stockholders who retain their Altria Group, Inc. and PMI shares will receive, in the aggregate, the same dividend dollars as before the PMI Distribution. In that regard, PMI’s annualized dividend rate will be $1.84 per common share and Altria Group, Inc.’s annualized dividend rate will be $1.16 per common share.

 

On January 30, 2008, the Altria Group, Inc. Board of Directors approved a $7.5 billion two-year share repurchase program which is expected to begin in April 2008, after completion of the PMI spin-off. The Board of Directors also approved a $13.0 billion two-year share repurchase program for PMI, which is expected to begin in May 2008.

 

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 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, 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.

 

Hedging activity affected accumulated other comprehensive earnings (losses), net of income taxes, during the years ended December 31, 2007, 2006 and 2005, as follows:

 

(in millions)            


   2007

    2006

    2005

 

Gain (loss) as of January 1

   $ 13     $ 24     $ (14 )

Derivative gains transferred to earnings

     (45 )     (35 )     (95 )

Change in fair value

     25       24       133  

Kraft spin-off

     2                  
    


 


 


(Loss) gain as of December 31

   $ (5 )   $ 13     $ 24  
    


 


 


 

42


Exhibit 13

 

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, foreign currency swaps 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, euro, Turkish lira, Russian ruble and Indonesian rupiah. At December 31, 2007 and 2006, Altria Group, Inc. had contracts with aggregate notional amounts of $6.9 billion and $3.2 billion, respectively, of which $6.9 billion and $3.1 billion, respectively, were at PMI. A portion of Altria Group, Inc.’s foreign currency swaps, while effective as economic hedges, do not qualify for hedge accounting and therefore the unrealized gain (loss) relating to these contracts are reported in Altria Group, Inc.’s consolidated statements of earnings. For the years ended December 31, 2007, 2006 and 2005, the unrealized gain (loss) with regard to the contracts that do not qualify for hedge accounting was insignificant.

 

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, and are accounted for as cash flow hedges. At December 31, 2007 and 2006, the notional amounts of foreign currency swap agreements aggregated $1.5 billion and $1.4 billion, respectively.

 

Altria Group, Inc. also designates certain foreign currency denominated debt and forwards as net investment hedges of foreign operations. During the years ended December 31, 2007 and 2006, these hedges of net investments resulted in losses, net of income taxes, of $45 million and $164 million, respectively, and during the year ended December 31, 2005, resulted in a gain, net of income taxes, of $369 million. These gains and losses were reported as a component of accumulated other comprehensive earnings (losses) within currency translation adjustments.

 

·  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 derivative financial instruments. The VAR computation includes Altria Group, Inc.’s debt; short-term investments; and foreign currency forwards, swaps 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, 2007 and 2006, and over each of the four preceding quarters for the calculation of average VAR amounts during each year. The values of foreign currency options do not change on a one-to-one basis with the underlying currency, 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 instruments under normal market conditions, as calculated in the VAR model, were as follows:

 

     Pre-Tax Earnings Impact

(in millions)            


   At
12/31/07


   Average

   High

   Low

Instruments sensitive to:

                           

Foreign currency rates

   $ 32    $ 17    $ 32    $ 6
    

  

  

  

     Fair Value Impact

(in millions)            


   At
12/31/07


   Average

   High

   Low

Instruments sensitive to:

                           

Interest rates

   $ 16    $ 11    $ 16    $ 9
    

  

  

  

     Pre-Tax Earnings Impact

(in millions)            


   At
12/31/06


   Average

   High

   Low

Instruments sensitive to:

                           

Foreign currency rates

   $ 12    $ 10    $ 13    $ 7
    

  

  

  

     Fair Value Impact

(in millions)            


   At
12/31/06


   Average

   High

   Low

Instruments sensitive to:

                           

Interest rates

   $ 13    $ 16    $ 17    $ 13
    

  

  

  

 

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, Note 16 and Note 18 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.

 

43


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 SEC, 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. Damages claimed in some of the tobacco-related litigation are significant, and in certain cases, range into the billions of dollars. We anticipate that new cases will continue to be filed. It is possible that there could be adverse developments in pending cases. An unfavorable outcome or settlement of pending tobacco-related litigation could encourage the commencement of additional litigation. Although PM USA has historically been able to obtain required bonds or relief from bonding requirements in order to prevent plaintiffs from seeking to collect judgments while adverse verdicts have been appealed, there remains a risk that such relief may not be obtainable in all cases. This risk has been substantially reduced given that 42 states now limit the dollar amount of bonds or require no bond at all.

 

It is possible that the consolidated results of operations, cash flows or financial position of PM USA, PMI or Altria Group, Inc. could be materially affected in a particular fiscal quarter or fiscal year by an unfavorable outcome or settlement of certain pending litigation. Nevertheless, although litigation is subject to uncertainty, management believes the litigation environment has substantially improved. ALG and each of its subsidiaries named as a defendant believe, and each has been so advised by counsel handling the respective cases, that it has a number of valid defenses to the litigation pending against it, as well as valid bases for appeal of adverse verdicts against it. All such cases are, and will continue to be, vigorously defended. However, ALG and its subsidiaries may enter into settlement discussions in particular cases if they believe it is in the best interests of ALG’s stockholders to do so. Please see Note 19 for a discussion of pending tobacco-related litigation.

 

·  Corporate Restructuring: On January 30, 2008, the Board of Directors of ALG authorized the spin-off of PMI to ALG shareholders. The distribution will be made on March 28, 2008 to ALG shareholders of record as of 5:00 p.m. Eastern Time on March 19, 2008. It is possible that an action may be brought seeking to enjoin the spin-off. Any such injunction would have to be based on a finding that Altria is insolvent or would be insolvent after giving effect to the spin-off or intends to delay, hinder or defraud creditors. In the event the spin-off is challenged, ALG will defend such action vigorously, including by prosecuting any necessary appeals. Although litigation is subject to uncertainty, management believes that Altria should ultimately prevail against such action.

 

·  Tobacco Control Action in the Public and Private Sectors: Our tobacco subsidiaries face significant governmental action, including efforts aimed at reducing the incidence of smoking, restricting marketing and advertising, imposing regulations on warnings and disclosure of ingredients and flavors, 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 that such actions will continue to reduce consumption levels. Significant regulatory developments will take place over the next few years in most of PMI’s markets, driven principally by the World Health Organization’s Framework Convention for Tobacco Control, or FCTC. The FCTC is the first international public health treaty, and its objective is to establish a global agenda for tobacco regulation with the purpose of reducing initiation of tobacco use and encouraging cessation. In addition, the FCTC has led to increased efforts by tobacco control advocates and public health organizations to reduce the palatability and appeal of tobacco products to adult smokers.

 

Regulatory initiatives affecting our tobacco subsidiaries that have been proposed, introduced or enacted include:

 

   

the levying of substantial and increasing tax and duty charges;

 

   

restrictions or bans on advertising, marketing and sponsorship;

 

   

the display of larger health warnings, graphic health warnings and other labeling requirements;

 

   

restrictions on packaging design, including the use of colors and generic packaging;

 

   

restrictions or bans on the display of tobacco product packaging at the point of sale, and restrictions or bans on cigarette vending machines;

 

   

requirements regarding testing, disclosure and performance standards for tar, nicotine, carbon monoxide and other smoke constituents levels;

 


* 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.

 

44


Exhibit 13

 

   

requirements regarding testing, disclosure and use of tobacco product ingredients and flavors;

 

   

increased restrictions on smoking in public and work places and, in some instances, in private places and outdoors;

 

   

implementation of measures that ensure that descriptive terms do not create the false impression that one brand of cigarettes is safer than another;

 

   

elimination of duty free allowances for travelers; and

 

   

encouraging litigation against tobacco companies.

 

Partly because of some or a combination of these measures, unit sales of tobacco products in certain markets, principally Western Europe and Japan, have been in general decline and PMI expects this trend to continue. PMI’s operating income could be significantly affected by any significant decrease in demand for its products, any significant increase in the cost of complying with new regulatory requirements and requirements that lead to a commoditization of tobacco products.

 

·  Excise Taxes: Tobacco products are subject to substantial excise taxes in the United States and to substantial taxation abroad. Significant increases in tobacco product-related taxes or fees have been proposed or enacted and are likely to continue to be proposed or enacted within the United States, the Member States of the European Union (the “EU”) and in other foreign jurisdictions. For example, legislation was passed by the United States Congress in 2007 that would increase the federal excise tax on cigarettes by $0.61 a pack. The President vetoed this legislation. It is not possible to predict whether such legislation will be reintroduced and become law. In addition, in certain jurisdictions, PMI’s products are subject to tax structures that discriminate against premium priced products and manufactured cigarettes and to inconsistent rulings and interpretations on complex methodologies to determine excise and other tax burdens.

 

Tax increases and discriminatory tax structures are expected to continue to have an adverse impact on sales of our tobacco products 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.

 

·  Minimum Retail Selling Price Laws: Several EU Member States have enacted laws establishing a minimum retail selling price for cigarettes and, in some cases, other tobacco products. The European Commission has commenced infringement proceedings against these Member States, claiming that minimum retail selling price systems infringe EU law. If the European Commission’s actions are successful, they could adversely impact excise tax levels and/or price gaps in those markets.

 

·  Increased Competition in the United States 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 United States 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 avoid escrow deposit obligations on the majority of their sales by concentrating on certain states where escrow deposits are not required or are required on fewer than all such manufacturers’ cigarettes sold in such states. 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.

 

·  International Competition: PMI competes primarily on the basis of product quality, taste, brand recognition, brand loyalty, service, marketing, advertising and price. PMI is subject to highly competitive conditions in all aspects of its business. The competitive environment and PMI’s competitive position can be significantly influenced by weak economic conditions, erosion of consumer confidence, competitors’ introduction of low priced products or innovative products, higher cigarette taxes, higher absolute prices and larger gaps between price categories, and products regulation that diminishes the ability to differentiate tobacco products. Competitors include three large international tobacco companies and several regional and local tobacco companies and, in some instances, government-owned tobacco monopolies, principally in the PRC, Egypt, Thailand, Taiwan and Algeria. Industry consolidation and privatizations of governmental monopolies have led to an overall increase in competitive pressures. Some competitors have different profit and volume objectives and some international competitors are less susceptible to changes in currency exchange rates.

 

·  Counterfeit Cigarettes in International Markets: Large quantities of counterfeit cigarettes are sold in the international market. PMI believes that Marlboro is the most heavily counterfeited international cigarette brand, although PMI cannot quantify the amount of revenue it loses as a result of this activity. In addition, PMI’s revenues are reduced by contraband and legal cross-border transactions.

 

·  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, allegations of unlawful pricing activities within certain international markets and false or misleading usage of descriptors such as “Lights” and “Ultra Lights.” We cannot predict the outcome of those investigations or whether additional investigations may be commenced, and it is possible that our tobacco subsidiaries’ businesses 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 may reduce the risk of tobacco use while continuing to offer adult consumers products that meet their taste expectations. Potential solutions being researched include attempting to reduce constituents in tobacco smoke identified by public health authorities as harmful and seeking to produce products that reduce or eliminate exposure to tobacco smoke. Our tobacco subsidiaries may not 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. Further, we cannot predict whether regulators will permit the marketing of products with claims of reduced risk to consumers, which could significantly undermine the commercial viability of any products that might be developed.

 

·  Adjacency Strategy: ALG, PM USA and PMI have adjacency growth strategies involving moves and potential moves into complementary tobacco or tobacco-related products or processes. We cannot guarantee that these strategies, or any products introduced in connection with these strategies, will be successful.

 

·  Foreign Currency: PMI conducts its business in local currency and, for purposes of financial reporting, its 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

 

45


Exhibit 13

 

fewer U.S. dollars. During periods of economic crises internationally, foreign currencies may be devalued significantly against the U.S. dollar, reducing PMI’s margins. Actions to recover margins may result in lower volume and a weaker competitive position for PMI.

 

·  Tobacco Availability and Quality: Government mandated prices, production control programs, shifts in crops driven by economic conditions and adverse weather patterns may increase or decrease the cost or reduce the quality of tobacco and other agricultural products used to manufacture our products. As with other agriculture commodities, the price of tobacco leaf and cloves can be influenced by imbalances in supply and demand and crop quality can be influenced by variations in weather patterns. Tobacco production in certain countries is subject to a variety of controls, including governmental mandated prices and production control programs. Changes in the patterns of demand for agricultural products could cause farmers to plant less tobacco. Any significant change in tobacco leaf and clove prices, quality and quantity could affect our tobacco subsidiaries’ profitability and business.

 

·  Attracting and Retaining Talent: Our ability to implement our strategy of attracting and retaining the best global talent may be impaired by the decreasing social acceptance of cigarette smoking. The tobacco industry competes for talent with the consumer products industry and other companies that enjoy greater societal acceptance. As a result, our tobacco subsidiaries may be unable to attract and retain the best global talent.

 

·  Competition and Economic Downturns: Each of our tobacco 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

 

   

be able to protect or enhance margins through price increases.

 

The willingness of consumers to purchase premium cigarette 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.

 

·  Acquisitions: One element of PMI’s growth strategy is to strengthen its brand portfolio and/or expand its geographic reach through active programs of selective acquisitions. ALG and PM USA from time to time consider acquisitions as part of their adjacency strategy, as evidenced by ALG’s 2007 acquisition of John Middleton, Inc. 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.

 

·  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: The IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999 and issued a final Revenue Agent’s Report (“RAR”) on March 15, 2006. The RAR disallowed benefits pertaining to certain PMCC leveraged lease transactions for the years 1996 through 1999. Altria Group, Inc. has agreed with all conclusions of the RAR, with the exception of the disallowance of benefits pertaining to several PMCC leveraged lease transactions for the years 1996 through 1999. PMCC will continue to assert its position regarding these leveraged lease transactions and contest approximately $150 million of tax and net interest assessed and paid with regard to them. The IRS may in the future challenge and disallow more of PMCC’s leveraged leases based on Revenue Rulings, an IRS Notice and subsequent case law addressing specific types of leveraged leases (lease-in/lease-out (“LILO”) and sale-in/lease-out (“SILO”) transactions). PMCC believes that the position and supporting case law described in the RAR, Revenue Rulings and the IRS Notice 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 litigation. In this regard, on October 16, 2006, PMCC filed a complaint in the U.S. District Court for the Southern District of New York to claim refunds for a portion of these tax payments and associated interest. However, should PMCC’s position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and significantly lower its earnings to reflect the recalculation of the income from the affected leveraged leases, which could have a material effect on the earnings and cash flows of Altria Group, Inc. in a particular fiscal quarter or fiscal year. PMCC considered this matter in its adoption of FIN 48 and FASB Staff Position No. FAS 13-2.

 

46


Exhibit 13

 

Selected Financial Data – Five-Year Review

(in millions of dollars, except per share data)

 

         2007

    2006

    2005

    2004

    2003

 

Summary of Operations:

                                        

Net revenues

   $ 73,801     $ 67,051     $ 63,741     $ 57,442     $ 50,822  

United States export sales

     2,569       3,459       3,502       3,371       3,430  

Cost of sales

     16,547       15,540       14,919       13,678       13,042  

Federal excise taxes on products

     3,452       3,617       3,659       3,694       3,698  

Foreign excise taxes on products

     32,298       27,466       25,275       21,953       17,430  
        


 


 


 


 


Operating income

     13,235       12,887       11,840       10,568       9,899  

Interest and other debt expense, net

     215       367       521       510       485  

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

     13,020       12,520       11,319       10,058       9,414  

Pre-tax profit margin from continuing operations

     17.6 %     18.7 %     17.8 %     17.5 %     18.5 %

Provision for income taxes

     4,096       3,400       3,409       3,266       3,285  
        


 


 


 


 


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

     8,924       9,120       7,910       6,792       6,129  

Equity earnings and minority interest, net

     237       209       260       361       148  

Earnings from continuing operations

     9,161       9,329       8,170       7,153       6,277  

Earnings from discontinued operations, net of income taxes and minority interest

     625       2,693       2,265       2,263       2,927  

Net earnings

     9,786       12,022       10,435       9,416       9,204  
        


 


 


 


 


Basic earnings per share

 

– continuing operations

     4.36       4.47       3.95       3.49       3.10  
   

– discontinued operations

     0.30       1.29       1.09       1.11       1.44  
   

– net earnings

     4.66       5.76       5.04       4.60       4.54  

Diluted earnings per share

 

– continuing operations

     4.33       4.43       3.91       3.47       3.08  
   

– discontinued operations

     0.29       1.28       1.08       1.09       1.44  
   

– net earnings

     4.62       5.71       4.99       4.56       4.52  

Dividends declared per share

     3.05       3.32       3.06       2.82       2.64  

Weighted average shares (millions) – Basic

     2,101       2,087       2,070       2,047       2,028  

Weighted average shares (millions) – Diluted

     2,116       2,105       2,090       2,063       2,038  
        


 


 


 


 


Capital expenditures

     1,458       1,285       1,035       954       889  

Depreciation

     952       890       778       722       627  

Property, plant and equipment, net (consumer products)

     8,857       7,581       6,861       6,320       5,912  

Inventories (consumer products)

     10,571       8,680       7,241       6,594       6,197  

Total assets

     57,211       104,270       107,949       101,648       96,175  

Total long-term debt

     7,963       7,417       9,192       8,960       9,572  

Total debt – consumer products

     10,546       7,366       11,371       8,468       9,410  

                 – financial services

     500       1,119       2,014       2,221       2,210  
        


 


 


 


 


Stockholders’ equity

     18,554       39,619       35,707       30,714       25,077  

Common dividends declared as a % of Basic EPS

     65.5 %     57.6 %     60.7 %     61.3 %     58.1 %

Common dividends declared as a % of Diluted EPS

     66.0 %     58.1 %     61.3 %     61.8 %     58.4 %

Book value per common share outstanding

     8.80       18.89       17.13       14.91       12.31  

Market price per common share – high/low

    
 
90.50-
63.13
 
 
   
 
86.45-
68.36
 
 
   
 
78.68-
60.40
 
 
   
 
61.88-
44.50
 
 
   
 
55.03-
27.70
 
 
        


 


 


 


 


Closing price of common share at year end

     75.58       85.82       74.72       61.10       54.42  

Price/earnings ratio at year end – Basic

     16       15       15       13       12  

Price/earnings ratio at year end – Diluted

     16       15       15       13       12  

Number of common shares outstanding at year end (millions)

     2,108       2,097       2,084       2,060       2,037  

Number of employees

     84,000       175,000       199,000       156,000       165,000  
        


 


 


 


 


 

This Selected Financial Data should be read together with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Note 1. Background and Basis of Presentation to the consolidated financial statements.

 

47


Exhibit 13

 

Consolidated Balance Sheets

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

 

at December 31,            


   2007

   2006

Assets

             

Consumer products

             

Cash and cash equivalents

   $ 6,498    $ 4,781

Receivables (less allowances of $18 in 2007 and $17 in 2006)

     3,323      2,808

Inventories:

             

Leaf tobacco

     4,864      4,383

Other raw materials

     1,365      1,109

Finished product

     4,342      3,188
    

  

       10,571      8,680

Current assets of discontinued operations

            7,647

Other current assets

     2,498      2,236
    

  

Total current assets

     22,890      26,152

Property, plant and equipment, at cost:

             

Land and land improvements

     761      667

Buildings and building equipment

     5,132      4,316

Machinery and equipment

     10,257      8,826

Construction in progress

     1,161      1,073
    

  

       17,311      14,882

Less accumulated depreciation

     8,454      7,301
    

  

       8,857      7,581

Goodwill

     8,001      6,197

Other intangible assets, net

     4,953      1,908

Prepaid pension assets

     1,320      761

Investment in SABMiller

     3,960      3,674

Long-term assets of discontinued operations

            48,805

Other assets

     1,167      2,402
    

  

Total consumer products assets

     51,148      97,480

Financial services

             

Finance assets, net

     6,029      6,740

Other assets

     34      50
    

  

Total financial services assets

     6,063      6,790
    

  

Total Assets

   $ 57,211    $ 104,270
    

  

 

See notes to consolidated financial statements.

 

 

48


Exhibit 13

 

at December 31,            


   2007

    2006

 

Liabilities

                

Consumer products

                

Short-term borrowings

   $ 638     $ 420  

Current portion of long-term debt

     2,445       648  

Accounts payable

     1,463       1,414  

Accrued liabilities:

                

Marketing

     802       824  

Taxes, except income taxes

     4,593       3,620  

Employment costs

     756       849  

Settlement charges

     3,986       3,552  

Other

     1,857       1,641  

Income taxes

     654       782  

Dividends payable

     1,588       1,811  

Current liabilities of discontinued operations

             9,866  
    


 


Total current liabilities

     18,782       25,427  

Long-term debt

     7,463       6,298  

Deferred income taxes

     2,182       1,391  

Accrued pension costs

     388       541  

Accrued postretirement health care costs

     1,916       2,009  

Long-term liabilities of discontinued operations

             19,629  

Other liabilities

     2,323       2,658  
    


 


Total consumer products liabilities

     33,054       57,953  

Financial services

                

Long-term debt

     500       1,119  

Deferred income taxes

     4,911       5,530  

Other liabilities

     192       49  
    


 


Total financial services liabilities

     5,603       6,698  
    


 


Total liabilities

     38,657       64,651  
    


 


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

     6,884       6,356  

Earnings reinvested in the business

     34,426       59,879  

Accumulated other comprehensive losses

     (237 )     (3,808 )

Cost of repurchased stock
(698,284,555 shares in 2007 and 708,880,389 shares in 2006)

     (23,454 )     (23,743 )
    


 


Total stockholders’ equity

     18,554       39,619  
    


 


Total Liabilities and Stockholders’ Equity

   $ 57,211     $ 104,270  
    


 


 

49


Exhibit 13

 

Consolidated Statements of Earnings

(in millions of dollars, except per share data)

 

for the years ended December 31,            


   2007

    2006

    2005

 

Net revenues

   $ 73,801     $ 67,051     $ 63,741  

Cost of sales

     16,547       15,540       14,919  

Excise taxes on products

     35,750       31,083       28,934  
    


 


 


Gross profit

     21,504       20,428       19,888  

Marketing, administration and research costs

     7,805       7,664       7,664  

U.S. tobacco headquarters relocation charges

                     4  

Loss on U.S. tobacco pool

                     138  

U.S. tobacco quota buy-out

                     (115 )

Italian antitrust charge

             61          

Asset impairment and exit costs

     650       178       139  

Gain on sale of business

             (488 )        

(Recoveries) provision (from) for airline industry exposure

     (214 )     103       200  

Amortization of intangibles

     28       23       18  
    


 


 


Operating income

     13,235       12,887       11,840  

Interest and other debt expense, net

     215       367       521  
    


 


 


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

     13,020       12,520       11,319  

Provision for income taxes

     4,096       3,400       3,409  
    


 


 


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

     8,924       9,120       7,910  

Equity earnings and minority interest, net

     237       209       260  
    


 


 


Earnings from continuing operations

     9,161       9,329       8,170  

Earnings from discontinued operations, net of income taxes and minority interest

     625       2,693       2,265  
    


 


 


Net earnings

   $ 9,786     $ 12,022     $ 10,435  
    


 


 


Per share data:

                        

Basic earnings per share:

                        

Continuing operations

   $ 4.36     $ 4.47     $ 3.95  

Discontinued operations

     0.30       1.29       1.09  
    


 


 


Net earnings

   $ 4.66     $ 5.76     $ 5.04  
    


 


 


Diluted earnings per share:

                        

Continuing operations

   $ 4.33     $ 4.43     $ 3.91  

Discontinued operations

     0.29       1.28       1.08  
    


 


 


Net earnings

   $ 4.62     $ 5.71     $ 4.99  
    


 


 


 

See notes to consolidated financial statements.

 

50


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
Comprehensive Earnings (Losses)


    Cost of
Repurchased
Stock


    Total
Stockholders’
Equity


 
             Currency
Translation
Adjustments


    Other

    Total

     

Balances, January 1, 2005

   $ 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  

Comprehensive earnings:

                                                              

Net earnings

                   12,022                                       12,022  

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

                                                              

Currency translation adjustments

                           1,220               1,220               1,220  

Additional minimum pension liability

                                   233       233               233  

Change in fair value of derivatives accounted for as hedges

                                   (11 )     (11 )             (11 )

Other

                                   (11 )     (11 )             (11 )
                                                          


Total other comprehensive earnings

                                                           1,431  
                                                          


Total comprehensive earnings

                                                           13,453  
                                                          


Initial adoption of FASB Statement No. 158, net of income taxes (Note 16)

                                   (3,386 )     (3,386 )             (3,386 )

Exercise of stock options and issuance of other stock awards

            295      145                               359       799  

Cash dividends declared ($3.32 per share)

                   (6,954 )                                     (6,954 )
    

  

  


 


 


 


 


 


Balances, December 31, 2006

     935      6,356      59,879       (97 )     (3,711 )     (3,808 )     (23,743 )     39,619  

Comprehensive earnings:

                                                              

Net earnings

                   9,786                                       9,786  

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

                                                              

Currency translation adjustments

                           736               736               736  

Change in net loss and prior service cost

                                   744       744               744  

Change in fair value of derivatives accounted for as hedges

                                   (18 )     (18 )             (18 )
                                                          


Total other comprehensive earnings

                                                           1,462  
                                                          


Total comprehensive earnings

                                                           11,248  
                                                          


Adoption of FIN 48 and FAS 13-2

                   711                                       711  

Exercise of stock options and issuance of other stock awards(1)

            528                                      289       817  

Cash dividends declared ($3.05 per share)

                   (6,430 )                                     (6,430 )

Spin-off of Kraft Foods Inc.

                   (29,520 )     89       2,020       2,109               (27,411 )
    

  

  


 


 


 


 


 


Balances, December 31, 2007

   $ 935    $ 6,884    $ 34,426     $ 728     $ (965 )   $ (237 )   $ (23,454 )   $ 18,554  
    

  

  


 


 


 


 


 


 

(1) Includes $179 million increase to additional paid-in-capital for the reimbursement from Kraft for Altria stock awards. See Note 1.

 

See notes to consolidated financial statements.

 

51


Exhibit 13

 

Consolidated Statements of Cash Flows

(in millions of dollars)

 

for the years ended December 31,            


   2007

    2006

    2005

 

Cash Provided by (Used in) Operating Activities

                        

Earnings from continuing operations – Consumer products

   $ 8,936     $ 9,205     $ 8,153  

– Financial services

     225       124       17  

Earnings from discontinued operations, net of income taxes and minority interest

     625       2,693       2,265  
    


 


 


Net earnings

     9,786       12,022       10,435  

Impact of earnings from discontinued operations, net of income taxes and minority interest

     (625 )     (2,693 )     (2,265 )

Adjustments to reconcile net earnings to operating cash flows:

                        

Consumer products

                        

Depreciation and amortization

     980       913       796  

Deferred income tax provision (benefit)

     80       (106 )     (455 )

Equity earnings and minority interest, net

     (237 )     (209 )     (260 )

U.S. tobacco quota buy-out

                     (115 )

Escrow bond for the Engle U.S. tobacco case

     1,300                  

Escrow bond for the Price U.S. tobacco case

             1,850       (420 )

Asset impairment and exit costs, net of cash paid

     410       89       67  

Gain on sale of business

             (488 )        

Income tax reserve reversal

             (1,006 )        

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

                        

Receivables, net

     (705 )     62       (85 )

Inventories

     (889 )     (861 )     (482 )

Accounts payable

     (71 )     (133 )     (47 )

Income taxes

     (681 )     (399 )     236  

Accrued liabilities and other current assets

     81       381       (123 )

U.S. tobacco accrued settlement charges

     434       50       (30 )

Pension plan contributions

     (132 )     (425 )     (832 )

Pension provisions and postretirement, net

     249       415       401  

Other

     596       661       679  

Financial services

                        

Deferred income tax benefit

     (335 )     (234 )     (126 )

Provision for airline industry exposure

             103       200  

Other

     (86 )     (126 )     22  
    


 


 


Net cash provided by operating activities, continuing operations

     10,155       9,866       7,596  

Net cash provided by operating activities, discontinued operations

     161       3,720       3,464  
    


 


 


Net cash provided by operating activities

     10,316       13,586       11,060  
    


 


 


 

See notes to consolidated financial statements.

 

52


Exhibit 13

 

for the years ended December 31,            


   2007

    2006

    2005

 

Cash Provided by (Used in) Investing Activities

                        

Consumer products

                        

Capital expenditures

   $ (1,458 )   $ (1,285 )   $ (1,035 )

Purchase of businesses, net of acquired cash

     (4,417 )     (4 )     (4,932 )

Proceeds from sales of businesses

     4       520          

Other

     26       (75 )     84  

Financial services

                        

Investments in finance assets

     (5 )     (15 )     (3 )

Proceeds from finance assets

     569       357       476  
    


 


 


Net cash used in investing activities, continuing operations

     (5,281 )     (502 )     (5,410 )

Net cash provided by (used in) investing activities, discontinued operations

     26       (116 )     525  
    


 


 


Net cash used in investing activities

     (5,255 )     (618 )     (4,885 )
    


 


 


Cash Provided by (Used in) Financing Activities

                        

Consumer products

                        

Net issuance (repayment) of short-term borrowings

     2,389       (2,402 )     4,119  

Long-term debt issued

     4,160                  

Long-term debt repaid

     (3,881 )     (2,135 )     (1,004 )

Financial services

                        

Long-term debt repaid

     (617 )     (1,015 )        

Dividends paid on Altria Group, Inc. common stock

     (6,652 )     (6,815 )     (6,191 )

Issuance of Altria Group, Inc. common stock

     423       486       985  

Kraft Foods Inc. dividends paid to Altria Group, Inc.

     728       1,369       1,232  

Other

     (53 )     (134 )     (324 )
    


 


 


Net cash used in financing activities, continuing operations

     (3,503 )     (10,646 )     (1,183 )

Net cash used in financing activities, discontinued operations

     (176 )     (3,720 )     (3,951 )
    


 


 


Net cash used in financing activities

     (3,679 )     (14,366 )     (5,134 )
    


 


 


Effect of exchange rate changes on cash and cash equivalents

                        

Continuing operations

     346       121       (523 )

Discontinued operations

     1       39       (4 )
    


 


 


       347       160       (527 )
    


 


 


Cash and cash equivalents, continuing operations:

                        

Increase (Decrease)

     1,717       (1,161 )     480  

Balance at beginning of year

     4,781       5,942       5,462  
    


 


 


Balance at end of year

   $ 6,498     $ 4,781     $ 5,942  
    


 


 


Cash paid, continuing operations: Interest – Consumer products

   $ 649     $ 748     $ 949  
    


 


 


 – Financial services

   $ 62     $ 108     $ 106  
    


 


 


                                   Income taxes

   $ 4,456     $ 4,611     $ 3,440  
    


 


 


 

53


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”), Philip Morris International Inc. (“PMI”) and John Middleton, Inc. are engaged in the manufacture and sale of cigarettes and other tobacco products. Philip Morris Capital Corporation (“PMCC”), another wholly-owned subsidiary, maintains a portfolio of leveraged and direct finance leases. In addition, ALG held a 28.6% economic and voting interest in SABMiller plc (“SABMiller”) at December 31, 2007. 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.

 

On March 30, 2007, Altria Group, Inc. distributed all of its remaining interest in Kraft Foods, Inc. (“Kraft”) on a pro-rata basis to Altria Group, Inc. stockholders in a tax-free distribution. For further discussion, please refer to the Kraft Spin-Off discussion below. Altria Group, Inc. has reclassified and reflected the results of Kraft prior to the Kraft Distribution Date as discontinued operations on the consolidated statements of earnings and the consolidated statements of cash flows for all periods presented. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the consolidated balance sheet at December 31, 2006.

 

As further discussed in Note 21. Subsequent Events, on January 30, 2008, Altria Group, Inc.’s Board of Directors approved a tax-free distribution of PMI to Altria Group, Inc.’s stockholders.

 

In November 2007, Altria Group, Inc. announced that it had signed an agreement to sell its headquarters building in New York City for approximately $525 million and will record a pre-tax gain of approximately $400 million upon closing the transaction. Under the terms of the agreement, Altria Group, Inc. plans to close the sale no later than April 1, 2008.

 

·   Kraft Spin-Off: On March 30, 2007 (the “Kraft Distribution Date”), Altria Group, Inc. distributed all of its remaining interest in Kraft on a pro-rata basis to Altria Group, Inc. stockholders of record as of the close of business on March 16, 2007 (the “Kraft Record Date”) in a tax-free distribution. The distribution ratio was 0.692024 of a share of Kraft for each share of Altria Group, Inc. common stock outstanding. Altria Group, Inc. stockholders received cash in lieu of fractional shares of Kraft. Following the distribution, Altria Group, Inc. does not own any shares of Kraft. During the second quarter of 2007, Altria Group, Inc. adjusted its quarterly dividend to $0.69 per share, so that its stockholders who retained their Altria Group, Inc. and Kraft shares would receive, in the aggregate, the same dividend dollars as before the distribution. In August 2007, Altria Group, Inc. increased its quarterly dividend to $0.75 per share.

 

Holders of Altria Group, Inc. stock options were treated similarly to public stockholders and accordingly, had their stock awards split into two instruments. Holders of Altria Group, Inc. stock options received the following stock options, which, immediately after the spin-off, had an aggregate intrinsic value equal to the intrinsic value of the pre-spin Altria Group, Inc. options:

 

   

a new Kraft option to acquire the number of shares of Kraft Class A common stock equal to the product of (a) the number of Altria Group, Inc. options held by such person on the Kraft Distribution Date and (b) the distribution ratio of 0.692024 mentioned above; and

 

   

an adjusted Altria Group, Inc. option for the same number of shares of Altria Group, Inc. common stock with a reduced exercise price.

 

The new Kraft option has an exercise price equal to the Kraft market price at the time of the distribution ($31.66) multiplied by the Option Conversion Ratio, which represents the exercise price of the original Altria Group, Inc. option divided by the Altria Group, Inc. market price immediately before the distribution ($87.81). The reduced exercise price of the adjusted Altria Group, Inc. option is determined by multiplying the Altria Group, Inc. market price immediately following the distribution ($65.90) by the Option Conversion Ratio.

 

    Holders of Altria Group, Inc. restricted stock or deferred stock awarded prior to January 31, 2007, retained their existing award and received restricted stock or deferred stock of Kraft Class A common stock. The amount of Kraft restricted stock or deferred stock awarded to such holders was calculated using the same formula set forth above with respect to new Kraft options. All of the restricted stock and deferred stock will vest at the completion of the original restriction period (typically, three years from the date of the original grant). Recipients of Altria Group, Inc. deferred stock awarded on January 31, 2007, did not receive restricted stock or deferred stock of Kraft. Rather, they received additional deferred shares of Altria Group, Inc. to preserve the intrinsic value of the original award.

 

To the extent that employees of the remaining Altria Group, Inc. received Kraft stock options, Altria Group, Inc. reimbursed Kraft in cash for the Black-Scholes fair value of the stock options received. To the extent that Kraft employees held Altria Group, Inc. stock options, Kraft reimbursed Altria Group, Inc. in cash for the Black-Scholes fair value of the stock options. To the extent that holders of Altria Group, Inc. deferred stock received Kraft deferred stock, Altria Group, Inc. paid to Kraft the fair value of the Kraft deferred stock less the value of projected forfeitures. Based upon the number of Altria Group, Inc. stock awards outstanding at the Kraft Distribution Date, the net amount of these reimbursements resulted in a payment of $179 million from Kraft to Altria Group, Inc. in April 2007. The reimbursement from Kraft is reflected as an increase to the additional paid-in capital of Altria Group, Inc. on the December 31, 2007 consolidated balance sheet.

 

Kraft was previously included in the Altria Group, Inc. consolidated federal income tax return, and federal income tax contingencies were recorded as liabilities on the balance sheet of ALG. As part of the intercompany account settlement discussed below, ALG reimbursed Kraft in cash for these liabilities, which as of March 30, 2007, were approximately $305 million, plus pre-tax interest of $63 million ($41 million after taxes). ALG also reimbursed Kraft in cash for the federal income tax consequences of the adoption of Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109” (“FIN 48”) (approximately $70 million plus pre-tax

 

54


Exhibit 13

 

interest of $14 million, $9 million after taxes). See Note 14. Income Taxes for a discussion of the FIN 48 adoption and the Tax Sharing Agreement between Altria Group, Inc. and Kraft.

 

A subsidiary of ALG previously provided Kraft with certain services at cost plus a 5% management fee. After the Kraft Distribution Date, Kraft undertook these activities, and any remaining limited services provided to Kraft ceased during 2007. All intercompany accounts were settled in cash within 30 days of the Kraft Distribution Date. The settlement of the intercompany accounts (including the amounts discussed above related to stock awards and tax contingencies) resulted in a net payment from Kraft to ALG of $85 million in April 2007.

 

The distribution resulted in a net decrease to Altria Group, Inc.’s stockholders’ equity of $27.4 billion on the Kraft Distribution Date.

 

·  Basis of presentation: The consolidated financial statements include ALG, as well as its wholly-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 under the cost method of accounting. All intercompany transactions and balances have been eliminated. The results of Kraft prior to the Kraft Distribution Date have been reclassified and reflected as discontinued operations on the consolidated statements of earnings and statements of cash flows for all periods presented. The assets and liabilities related to Kraft were reclassified and reflected as discontinued operations on the consolidated balance sheet at December 31, 2006.

 

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.

 

Certain subsidiaries of PMI report their results up to ten days before the end of December, rather than on December 31.

 

Beginning with the second quarter of 2007, Altria Group, Inc. revised its reportable segments to reflect PMI’s operations by geographic region. Altria Group, Inc.’s revised segments, which are reflected in these financial statements, are U.S. tobacco; European Union; Eastern Europe, Middle East and Africa; Asia; Latin America; and Financial Services. Accordingly, prior year segment results have been revised.

 

    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 15 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 2007 and 2006, Altria Group, Inc. completed its annual review of goodwill and intangible assets, and no charges resulted from these reviews.

 

Goodwill and other intangible assets, net, by segment were as follows:

 

     Goodwill

   Other Intangible Assets, net

(in millions)            


   December 31,
2007


   December 31,
2006


   December 31,
2007


   December 31,
2006


U.S. tobacco

   $ 76    $ -    $ 3,047    $ 281

European Union

     1,510      1,307      69      65

Eastern Europe, Middle East and Africa

     714      657      205      164

Asia

     4,033      3,778      1,457      1,339

Latin America

     1,668      455      175      59
    

  

  

  

Total

   $ 8,001    $ 6,197    $ 4,953    $ 1,908
    

  

  

  

 

Intangible assets were as follows:

 

     December 31, 2007

   December 31, 2006

(in millions)            


   Gross
Carrying
Amount


   Accumulated
Amortization


   Gross
Carrying
Amount


   Accumulated
Amortization


Non-amortizable intangible assets

   $ 4,231           $ 1,566       

Amortizable intangible assets

     802    $ 80      388    $ 46
    

  

  

  

Total intangible assets

   $ 5,033    $ 80    $ 1,954    $ 46
    

  

  

  

 

Non-amortizable intangible assets substantially consist of brand names from Altria Group, Inc.’s 2007 acquisition of John Middleton, Inc. and PMI’s 2005 acquisition of a business in Indonesia. Amortizable intangible assets consist primarily of certain trademark licenses, non-compete agreements

 

55


Exhibit 13

 

and customer relationships. Pre-tax amortization expense for intangible assets during the years ended December 31, 2007, 2006 and 2005, was $28 million, $23 million, and $18 million, respectively. Amortization expense for each of the next five years is estimated to be $40 million or less, assuming no additional transactions occur that require the amortization of intangible assets.

 

Goodwill is due primarily to PMI’s acquisitions in Indonesia, Mexico, Greece, Serbia, Colombia and Pakistan. The movement in goodwill and gross carrying amount of intangible assets is as follows:

 

     2007

   2006

(in millions)            


   Goodwill

    Intangible
Assets


   Goodwill

   Intangible
Assets


Balance at January 1

   $ 6,197     $ 1,954    $ 5,571    $ 1,700

Changes due to:

                            

Acquisitions

     1,634       2,968      54      115

Currency

     183       8      531      129

Other

     (13 )     103      41      10
    


 

  

  

Balance at December 31

   $ 8,001     $ 5,033    $ 6,197    $ 1,954
    


 

  

  

 

The increase in goodwill from acquisitions during 2007 was primarily related to the preliminary allocations of the purchase price for PMI’s acquisitions in Mexico and Pakistan. The increase in intangible assets from acquisitions during 2007 was related primarily to Altria Group, Inc.’s acquisition of John Middleton, Inc. The allocations of purchase price for PMI’s acquisitions in Mexico and Pakistan, and Altria Group, Inc.’s acquisition of John Middleton, Inc. are based upon preliminary estimates and assumptions and are subject to revision when appraisals are finalized in 2008. The increase in goodwill from acquisitions during 2006 was primarily related to the exchange of PMI’s interest in a beer business for 100% ownership of a cigarette business in the Dominican Republic. The increase in intangible assets from acquisitions during 2006 was related to PMI’s purchase of various trademarks from British American Tobacco. See Note 5. Acquisitions for a further discussion of acquisitions.

 

·  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 decreases of $11 million and $14 million in 2007 and 2006, respectively, to PMCC’s net revenues and results of operations. Residual reviews in 2005 resulted in no adjustments.

 

·  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 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.

 

56


Exhibit 13

 

On January 1, 2007, Altria Group, Inc. adopted the provisions of FIN 48. The Interpretation prescribes a recognition threshold and a measurement attribute for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more-likely-than-not to be sustained upon examination by taxing authorities. The amount recognized is measured as the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. As a result of the January 1, 2007 adoption of FIN 48, Altria Group, Inc. lowered its liability for unrecognized tax benefits by $1,021 million. This resulted in an increase to stockholders’ equity of $857 million ($835 million, net of minority interest), a reduction of Kraft’s goodwill of $85 million and a reduction of federal deferred tax benefits of $79 million.

 

Altria Group, Inc. adopted the provisions of FASB Staff Position No. FAS 13-2, “Accounting for a Change or Projected Change in the Timing of Cash Flows Relating to Income Taxes Generated by a Leveraged Lease Transaction” (“FAS 13-2”) effective January 1, 2007. This Staff Position requires the revenue recognition calculation to be reevaluated if there is a revision to the projected timing of income tax cash flows generated by a leveraged lease. The adoption of this Staff Position by Altria Group, Inc. resulted in a reduction to stockholders’ equity of $124 million as of January 1, 2007.

 

·  Inventories: Inventories are stated at the lower of cost or market. The last-in, first-out (“LIFO”) method is used to cost substantially all U.S. tobacco inventories. The cost of inventories of the international tobacco segments is principally determined by the first-in, first-out and average cost methods. 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.

 

Altria Group, Inc. adopted the provisions of SFAS No. 151, “Inventory Costs” prospectively as of January 1, 2006. 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. The effect of adoption did not have a material impact on Altria Group, Inc.’s 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 consumer products businesses 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: Effective January 1, 2006, Altria Group, Inc. adopted the provisions of SFAS No. 123 (Revised 2004) “Share-Based Payment” (“SFAS No. 123(R)”) using the modified prospective method, which requires measurement of compensation cost for all stock-based awards at fair value on date of grant and recognition of compensation over the service periods for awards expected to vest. The fair value of restricted stock and deferred stock is determined based on the number of shares granted and the market value at date of grant. The fair value of stock options is determined using a modified Black-Scholes methodology. The impact of adoption was not material.

 

The adoption of SFAS No. 123(R) resulted in a cumulative effect gain of $3 million, which is net of $2 million in taxes, in the consolidated statement of earnings for the year ended December 31, 2006. This gain resulted from the impact of estimating future forfeitures on restricted stock and deferred stock in the determination of periodic expense for unvested awards, rather than recording forfeitures only when they occur. The gross cumulative effect was recorded in marketing, administration and research costs for the year ended December 31, 2006.

 

    Altria Group, Inc. previously applied the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” (“APB 25”) and provided the pro forma disclosures required by SFAS No. 123, “Accounting for Stock-Based Compensation” (“SFAS No. 123”). No compensation expense for employee stock options was reflected in net earnings in 2005, as all stock options granted under those plans had an exercise price not less than the fair market value of the common stock on the date of the grant. Historical consolidated statements of earnings already include the compensation expense for restricted stock and deferred stock. 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 stock option awards for the year ended December 31, 2005:

 

(in millions, except per share data)            


   2005

Net earnings, as reported

   $ 10,435

Deduct:

      

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

     15
    

Pro forma net earnings

   $ 10,420
    

Earnings per share:

      

Basic - as reported

   $ 5.04
    

Basic - pro forma

   $ 5.03
    

Diluted - as reported

   $ 4.99
    

Diluted - pro forma

   $ 4.98
    

 

57


Exhibit 13

 

Altria Group, Inc. has not granted stock options to employees since 2002. The amount shown above as stock-based compensation expense relates to Executive Ownership Stock Options (“EOSOs”). Under certain circumstances, senior executives who exercised outstanding stock options, using shares to pay the option exercise price and taxes, received EOSOs equal to the number of shares tendered. This feature ceased during 2007. During the years ended December 31, 2007, 2006 and 2005, Altria Group, Inc. granted 0.5 million, 0.7 million and 2.0 million EOSOs, respectively.

 

Altria Group, Inc. elected to calculate the initial pool of tax benefits resulting from tax deductions in excess of the stock-based employee compensation expense recognized in the statement of earnings (“excess tax benefits”) under the FASB Staff Position 123(R)-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards.” Excess tax benefits occur when the tax deduction claimed at vesting exceeds the fair value compensation expense accrued under SFAS No. 123(R). Excess tax benefits of $141 million and $195 million were recognized for the years ended December 31, 2007 and 2006, respectively, and were presented as financing cash flows. Previously, excess tax benefits were included in operating cash flows. Under SFAS No. 123(R), tax shortfalls occur when actual tax deductible compensation expense is less than cumulative stock-based compensation expense recognized in the financial statements. Tax shortfalls of $8 million at Kraft were recognized for the year ended December 31, 2006, and were recorded in additional paid-in capital.

 

·  New Accounting Standards: In December 2007, the FASB issued SFAS No. 141 (Revised 2007) “Business Combinations” (“SFAS 141(R)”). SFAS 141(R) is effective for business combinations that close on or after January 1, 2009, the first day of Altria Group, Inc.’s annual reporting period beginning after December 15, 2008. SFAS 141(R) requires the recognition of assets acquired, liabilities assumed and any noncontrolling interest in the acquiree to be measured at fair value as of the acquisition date. Additionally, costs incurred to effect the acquisition are to be recognized separately from the acquisition and expensed as incurred.

 

Additionally, in December 2007, the FASB issued SFAS No. 160 “Noncontrolling Interests in Consolidated Financial Statements” (“SFAS 160”). SFAS 160 changes the reporting for minority interests by reporting these as noncontrolling interests within equity. Moreover, SFAS 160 requires that any transactions between an entity and a noncontrolling interest are to be accounted for as equity transactions. SFAS 160 is effective for financial statements issued for fiscal years beginning after December 15, 2008. SFAS 160 is to be applied prospectively, except for the presentation and disclosure requirements, which shall be applied retrospectively for all periods presented.

 

Altria Group, Inc. is currently in the process of evaluating the impact of these pronouncements.

 

    Note 3.

 

Asset Impairment and Exit Costs:

 

For the years ended December 31, 2007, 2006 and 2005, pre-tax asset impairment and exit costs consisted of the following:

 

(in millions)            


   2007

   2006

   2005

Separation program

  

U.S. tobacco

   $ 309    $ 10    $ -

Separation program

  

European Union

     137      99      30

Separation program

  

Eastern Europe, Middle East and Africa

     12      2      14

Separation program

  

Asia

     28      19      7

Separation program

  

Latin America

     18      1      4

Separation program

  

General corporate

     17      32      49
         

  

  

Total separation programs

          521      163      104
         

  

  

Asset impairment

  

U.S. tobacco

     35              

Asset impairment

  

European Union

            5      19

Asset impairment

  

Eastern Europe, Middle East

                    
    

and Africa

                   5

Asset impairment

  

Asia

                   9

Asset impairment

  

Latin America

                   2

Asset impairment

  

General corporate

            10       
         

  

  

Total asset impairment

          35      15      35
         

  

  

Spin-off fees

  

General corporate

     94              
         

  

  

Asset impairment and exit costs

        $ 650    $ 178    $ 139
         

  

  

 

58


Exhibit 13

 

The movement in the asset impairment and exit cost liabilities for Altria Group, Inc. for the years ended December 31, 2007 and 2006 was as follows:

 

(in millions)            


   Severance

    Asset
Write-
downs


    Other

    Total

 

Liability balance, January 1, 2006

   $ 64     $ -     $ -     $ 64  

Charges

     138       15       25       178