10-K 1 g87383e10vk.htm RJ REYNOLDS TOBACCO HOLDINGS, INC. RJ REYNOLDS TOBACCO HOLDINGS, INC.
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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


FORM 10-K

               (Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

OR

o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF

THE SECURITIES EXCHANGE ACT OF 1934

Commission file number: 1-6388


(RJ REYNOLDS LOGO)

(Exact name of registrant as specified in its charter)
     
Delaware
  56-0950247
(State or other jurisdiction of incorporation or organization)   (I.R.S. Employer Identification Number)

401 North Main Street

Winston-Salem, NC 27102-2866
(Address of principal executive offices) (Zip Code)

(336) 741-5500

(Registrant’s telephone number, including area code)


Securities registered pursuant to Section 12(b) of the Act:

                     
Name of each Name of each
exchange on which exchange on which
Title of each class registered Title of each class registered




Common stock, par value $.01 per share
    New York     8 3/4 Notes due July 15, 2007     New York  
8 3/4 Senior Notes due April 15, 2004
    New York     9 1/4 Debentures due August 15, 2013     New York  
8 3/4 Notes due August 15, 2005
    New York              

Securities registered pursuant to Section 12(g) of the Act: None

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES x NO o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

     Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). YES x NO o

     The aggregate market value of common stock held by non-affiliates of R.J. Reynolds Tobacco Holdings, Inc. on June 30, 2003 was approximately $3.1 billion, based on the closing price of $37.21. Certain directors of R.J. Reynolds Tobacco Holdings, Inc. are considered affiliates for purposes of this calculation but should not necessarily be deemed affiliates for any other purpose.

     Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date: February 6, 2004: 85,080,693 shares of common stock, par value $.01 per share.




INDEX

             
           
   Business     3  
   Properties     38  
   Legal Proceedings     38  
   Submission of Matters to a Vote of Security Holders     38  
 
           
   Market for Registrant’s Common Equity and Related Stockholder Matters     38  
   Selected Financial Data     40  
   Management’s Discussion and Analysis of Financial Condition and Results of Operations     41  
   Quantitative and Qualitative Disclosures about Market Risk     65  
   Financial Statements and Supplementary Data     67  
   Changes in and Disagreements with Accountants on Accounting and Financial Disclosure     135  
   Controls and Procedures     135  
 
           
   Directors and Executive Officers of the Registrant     135  
   Executive Compensation     142  
   Security Ownership of Certain Beneficial Owners and Management     156  
   Certain Relationships and Related Transactions     158  
   Principal Accounting Fees and Services     158  
 
           
   Exhibits, Financial Statement Schedules and Reports on Form 8-K     159  
 Signatures     168  
 EX-2.2
 EX-2.4
 EX-10.52
 EX-10.54
 EX-10.57
 EX-10.58
 EX-12.1
 EX-21.1
 EX-23.1
 EX-31.1
 EX-31.2
 EX-32.1
 EX-99.1
 EX-99.2

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PART I

Item 1. Business

      R.J. Reynolds Tobacco Holdings, Inc. was incorporated as a holding company in 1970, and is listed on the New York Stock Exchange under the symbol RJR. RJR’s wholly owned subsidiaries include its operating subsidiaries, R. J. Reynolds Tobacco Company, referred to as RJR Tobacco, and Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe.

      RJR’s Internet website address is www.RJRHoldings.com. RJR’s annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, insider trading reports on Forms 3, 4 and 5 and all amendments to those reports are available free of charge through its web site, as soon as reasonably practicable after such material is electronically filed with, or furnished to, the SEC. RJR’s Internet web site and the information contained therein or connected thereto are not incorporated into this Annual Report on Form 10-K.

      RJR has one reportable operating segment, RJR Tobacco, which is the second largest cigarette manufacturer in the United States. RJR Tobacco’s largest selling cigarette brands, CAMEL, WINSTON, SALEM and DORAL, were four of the top ten best-selling brands of cigarettes in the United States in 2003. Those brands, and its other brands, including VANTAGE, MORE and NOW, are manufactured in a variety of styles and marketed in the United States to meet a range of adult smoker preferences. In September 2003, RJR announced a shift in its brand-portfolio strategy to focus on improving profitability through emphasis on two of its cigarette brands, CAMEL and SALEM, with more limited investments in WINSTON and DORAL. Concurrently, RJR implemented a restructuring plan in an effort to streamline its cost structure and improve long-term earnings. The restructuring plan included a significant workforce reduction, as well as asset impairments and associated exit activities. For a discussion of RJR’s restructuring and asset impairment charges related to its restructuring plan, see “Restructuring and asset impairment charges” and “Goodwill and trademark impairment charges” under “Results of Operations — 2003 Compared with 2002” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

      Prior to June 1999, RJR was a subsidiary of Nabisco Group Holding Corp., which was a public company listed on the NYSE under the symbol NGH. During 1999, RJR and NGH completed a series of transactions to reorganize their businesses and capital structures. In May 1999, RJR and RJR Tobacco sold the international tobacco business to Japan Tobacco Inc. A portion of the proceeds from the sale of the international tobacco business was used by RJR to repurchase $4 billion of its debt. Additionally, RJR transferred $1.6 billion in cash proceeds, together with its 80.5% interest in Nabisco Holdings Corp., referred to as Nabisco, to NGH through a merger transaction. In June 1999, NGH distributed all of the outstanding shares of RJR common stock to NGH common stockholders of record as of May 27, 1999. Shares of RJR began trading separately on June 15, 1999.

      On December 11, 2000, RJR acquired its former parent, NGH, a non-operating public shell company with no material assets or liabilities other than $11.8 billion in cash. RJR Acquisition Corp. paid $30 for each outstanding share of NGH, or $9.8 billion in the aggregate. Net cash proceeds to RJR Acquisition Corp. were $1.5 billion, after transaction costs and payments to NGH stockholders.

      On January 16, 2002, RJR acquired all of the voting stock of privately held Santa Fe for $354 million. Santa Fe manufactures and markets cigarettes and other tobacco products under the NATURAL AMERICAN SPIRIT brand, primarily in the United States. Although Santa Fe is an operating segment of RJR, its financial condition and results of operations do not meet the materiality criteria to be reportable. As a result, information related to Santa Fe is not generally disclosed separately in this document.

      On July 16, 2002, RJR acquired a 50% interest in R.J. Reynolds-Gallaher International Sarl, a joint venture created with Gallaher Group Plc, to manufacture and market a limited portfolio of American-blend cigarette brands. The joint venture, headquartered in Switzerland, initially marketed its products in France, Spain, the Canary Islands and Italy, and in 2003, expanded into Andorra and Belgium. RJR’s financial contribution during the first five years of the joint venture is expected to be $75 million to $100 million. RJR

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Tobacco licensed REYNOLDS, a new American-blend brand in a unique Slide Box pack, to the joint venture. This investment is accounted for using the equity method.

      RJR believes that the acquisition of NGH and Santa Fe, and the joint venture with Gallaher Group Plc, present meaningful opportunities for RJR to build shareholder value. The acquisition of NGH provided $1.5 billion of net cash proceeds to RJR, which has funded RJR’s share repurchase programs and the acquisition of Santa Fe. Santa Fe’s approach to building brand equity is consistent with RJR Tobacco’s strategy for its key brands, and the acquisition was originated in order to enhance RJR’s consolidated earnings. The joint venture provides RJR an opportunity to compete in the growing international American-blend market, and RJR believes the joint venture will be accretive to RJR’s earnings within two to three years from its inception.

      On October 27, 2003, RJR announced the signing of a definitive agreement with Brown & Williamson Tobacco Corporation, referred to as B&W, a subsidiary of British American Tobacco p.l.c., referred to as BAT, to combine RJR Tobacco and the U.S. assets, liabilities and operations of B&W, subject to specified exceptions.

      The agreement provides for establishing a new publicly traded holding company, Reynolds American Inc., referred to as Reynolds American, with approximately 150 million shares outstanding. Reynolds American will issue common shares to B&W in exchange for the U.S. assets, liabilities and operations of B&W, subject to specified exceptions, and will issue common shares to existing RJR stockholders in exchange for their existing RJR shares on a one-for-one basis. Upon completion of the combination, B&W will own approximately 42% of Reynolds American, and existing RJR stockholders will own approximately 58%. No indebtedness for borrowed money of B&W will be assumed by Reynolds American. The transaction is expected to be tax-free to RJR stockholders, and will be treated as a purchase for financial accounting purposes.

      The agreement provides for B&W to transfer with its U.S. operations cash in an amount equal to accrued expenses under the Master Settlement Agreement, referred to as the MSA. The cash contribution amount is contingent on the timing of closing the transaction, but averages approximately $750 million during the year. The RJR Tobacco and B&W U.S. cigarette and tobacco operations will be combined in an indirect subsidiary of Reynolds American, and that subsidiary will indemnify B&W for its historical and current liabilities related to its U.S. cigarette and tobacco business.

      Under a separate agreement, RJR will pay a foreign subsidiary of BAT $400 million in cash to acquire the stock of Lane Limited, a subsidiary that manufactures or distributes cigar, roll-your-own and pipe tobacco brands and other tobacco products, including DUNHILL and CAPTAIN BLACK tobacco products. BAT will retain the rights to use the BAT trademarks outside the United States. Santa Fe and Lane will operate as independent subsidiaries of Reynolds American.

      The combination transactions are expected to be completed in mid-2004, pending the necessary approvals from U.S. and European regulatory authorities and RJR stockholders, as well as satisfactory IRS rulings and other conditions. The headquarters and operations of Reynolds American are expected to be consolidated in Winston-Salem, North Carolina.

      RJR believes that the combination transactions will provide efficiencies and enhance the ability of Reynolds American to compete effectively in the U.S. market. The combination is expected to be accretive to earnings. Full integration of the two companies is expected to take 18 to 24 months after closing and to generate more than $500 million in annualized savings.

Industry Overview

      The U.S. cigarette market is a mature market in which overall consumer demand is expected to decline over time. U.S. cigarette shipments as tracked by Management Science Associates, Inc., referred to as MSAi, decreased at a compound annual rate of 1.6% from 1987 through 1997. After declining 4.6% in 1998 and 9% in 1999, shipments remained relatively stable in 2000, declined 3.2% in 2001 and 3.7% in 2002, and declined 5.1% to 371.4 billion units in 2003. RJR Tobacco believes that cigarette shipments in the United States are

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significantly higher than the units registered by MSAi with the difference primarily due to deep-discount brands, gray market imports and sales through alternative channels that are not effectively tracked by MSAi. From December 1999 to December 2003, wholesale cigarette prices of the major manufacturers increased $0.64 per pack overall. The average wholesale list price of a pack of RJR Tobacco’s full-price brands was $2.64 at December 31, 2001 and $2.76 at each of December 31, 2002 and 2003.

Competition

      In addition to declining sales volumes, profitability of the U.S. cigarette industry and RJR continues to be adversely impacted by increases in state excise taxes, competitive promotional spending and deep-discount brand growth. “Deep-discount brands” are brands manufactured by companies that are not original participants in the Master Settlement Agreement, and accordingly, do not have cost structures burdened with MSA-related payments to the same extent as the original participating manufacturers. While the premium, or full, price tier has been negatively impacted by widening price gaps between those brands and the deep-discount brands for several years, the price gap remained relatively level during 2003. For further discussion see “— Business Trends and Initiatives” and “— Governmental Activity” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7.

      RJR’s operating subsidiaries primarily conduct business in the highly competitive U.S. market with a few large participants and many smaller participants. Based on data collected by Information Resources Inc./Capstone, during 2003, 2002 and 2001, Philip Morris USA Incorporated had an overall retail share of the U.S. cigarette market of 49.37%, 49.35% and 50.45%, respectively. During these same years, RJR Tobacco had an overall share of 22.52%, 22.93% and 23.42%, respectively, and the remaining participants held lesser shares.

      Competition is primarily based on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other financial incentives to maintain or improve a brand’s market position or to introduce a new brand.

      Increased selling prices and higher cigarette taxes have resulted in the growth of deep-discount brands and competitive discounting. The growth in market share of the deep-discount brands since the MSA was signed in 1998 has had, and will continue to have, an adverse impact on the profitability of the remaining industry participants. For further information regarding the adverse impact of price increases on RJR Tobacco’s sales volume, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations” in Item 7.

      Historically, major manufacturers have had a competitive advantage in the United States because significant cigarette marketing restrictions and the scale of investment required to compete made gaining consumer awareness and trial of new brands difficult. However, since the MSA was signed in November 1998, the category of deep-discount brands manufactured by smaller manufacturers or supplied by importers has grown substantially. RJR Tobacco believes small manufacturers of deep-discount brands have increased their combined share of shipments to approximately 13% to 15% of U.S. industry unit sales. This growth was driven by their significantly lower prices due to cost advantages, including lower MSA payments.

Strategy

      RJR is focused on strengthening its core businesses and delivering an attractive return to stockholders. RJR’s key strategies are to:

  •  achieve sustainable earnings growth,
 
  •  grow share of market on RJR Tobacco’s and Santa Fe’s key brands and
 
  •  drive continuous cost improvement.

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Marketing

      RJR’s operating subsidiaries are committed to building strong brands. RJR Tobacco’s marketing programs are designed to strengthen each brand’s image, build brand awareness and loyalty, and attract adult smokers of competing brands. In September 2003 RJR announced a refocused brand portfolio strategy for RJR Tobacco and significant cost reduction initiatives. Marketing investments will now focus on two growth brands, CAMEL and SALEM, with more limited investments being made in WINSTON and DORAL, to optimize profitability. The new strategy is currently being implemented. In addition to building strong brand equity, RJR Tobacco’s marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend its brands’ shares of market against competitive pricing pressure. RJR Tobacco’s competitive pricing includes discounting programs, such as retail buydowns, free product promotions and consumer coupons. Retail buydowns refer to payments made to the retailer to reduce the price that consumers pay at retail. Free product promotions include offers such as “Buy 2 packs, Get 1 pack free.” Consumer coupons are distributed by a variety of methods, including in, or on, the cigarette pack and direct mail.

      In addition, RJR Tobacco provides trade incentives through trade terms, and wholesale partner programs and retail incentives. Trade discounts are provided to wholesalers based on compliance with certain terms. The wholesale partner programs provide incentives to RJR Tobacco’s direct buying customers based on performance levels. Retail incentives are paid to the retailer based on compliance with RJR Tobacco’s contract terms. During the fourth quarter of 2003, RJR Tobacco reevaluated its practices related to replacement of merchandising fixtures and transferred ownership of the fixtures to the cigarette retailers.

      The costs of RJR Tobacco’s sales incentive programs, with the exception of free product promotions, are recorded as a reduction of net sales in compliance with Emerging Issues Task Force Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” The cost of free product promotions is recorded in cost of goods sold. For further information about pricing, net of discounting and promotional costs, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations” in Item 7.

      During 2003, CAMEL’s filtered styles continued to grow based on the strength of the brand’s equity, driven by its “Pleasure to Burn” positioning. Initiatives launched in prior years to actively market CAMEL’s three distinct product families — Classic, Turkish and Exotic Blends — also contributed to the brand’s performance in 2003.

      SALEM’s share increased in 2003, reflecting steady momentum since a repositioning was launched in the second quarter of 2003. The “Stir the Senses” campaign and new packaging communicates that SALEM offers adult smokers a range of choices in menthol taste sensations. The brand has two distinct product lines: SALEM Green Label, with a lighter menthol taste, and SALEM Black Label, with a richer menthol-and-tobacco taste.

      Reflecting RJR Tobacco’s strategy of limited investment in WINSTON and DORAL, the retail promotion support of these brands was reduced and shifted to more targeted, and more efficient, direct mail offers.

      Additional RJR Tobacco full-price and savings products are offered to meet the diverse preferences of adult smokers. Other full-price brands include VANTAGE, MORE and NOW. In the savings category, MONARCH, BEST VALUE and various private-label brands are available for cost-conscious adult smokers.

      During April and May of 2003, RJR Tobacco expanded the distribution of ECLIPSE to 7-Eleven and Circle-K stores across the country. ECLIPSE was expanded into additional retail chains in June 2003, with the goal of making the brand more conveniently available to adult smokers. The expansion is being supported by a cost-efficient marketing plan that includes limited print advertising, point-of-sale and direct-marketing efforts. ECLIPSE is a new technology cigarette that primarily heats rather than burns tobacco.

      Anti-smoking groups have attempted to restrict cigarette sales, cigarette advertising and the testing and introduction of new cigarette products. The MSA and other federal, state and local laws restrict utilization of television, radio or billboard advertising or certain other marketing and promotional tools for cigarettes.

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RJR Tobacco continues to use advertisements in magazines read primarily by adults, direct mailings to age-verified adult smokers and other means to market its brands and enhance their appeal among adult smokers. RJR Tobacco continues to advertise and promote at retail cigarette locations and in adult venues where permitted. See note 1 to consolidated financial statements and “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Results of Operations” for further information, including advertising expense.

      During the year, Santa Fe’s NATURAL AMERICAN SPIRIT brand grew share and volume, demonstrating the power of the brand’s high-equity, premium positioning.

Manufacturing and Distribution

      RJR Tobacco owns both of its cigarette manufacturing facilities, which are located in the Winston-Salem, North Carolina area: Tobaccoville, a two-million-square-foot facility constructed in 1985; and the Whitaker Park complex, which includes a one-and-one-half-million-square-foot plant, RJR Tobacco’s Central Distribution Center and a pilot plant for trial manufacturing of new products. RJR Tobacco has a combined production capacity of approximately 150 billion cigarettes per year, and believes its cigarette manufacturing facilities are technologically advanced.

      RJR Tobacco sells its cigarettes primarily to distributors, wholesalers and other direct customers, some of which are retail chains. RJR Tobacco distributes its cigarettes primarily to public warehouses located throughout the United States that serve as local distribution centers for its customers. No significant backlog of orders existed at December 31, 2003 or 2002.

      Sales made by RJR Tobacco to McLane Company, Inc., a distributor to, and former affiliate of, Wal-Mart Stores, Inc., comprised 31%, 26% and 27% of RJR’s consolidated revenue in 2003, 2002 and 2001, respectively. No other customer accounted for 10% or more of RJR’s revenue during those years. RJR Tobacco has a good relationship with McLane Company. RJR Tobacco’s sales to McLane are not governed by any written supply contract; however, McLane and RJR Tobacco are parties to an arrangement, whereby RJR Tobacco observes McLane’s inventory to manage the supply and level of McLane’s inventory. McLane and RJR Tobacco also are parties to certain contracts in which consideration is based on McLane’s compliance with specified performance levels and incentive terms.

Raw Materials

      In its production of cigarettes, RJR Tobacco uses burley and flue-cured leaf tobaccos, as well as Oriental tobaccos grown primarily in Turkey and Greece. RJR Tobacco believes there is a sufficient supply in the worldwide tobacco market to satisfy its current and anticipated production requirements.

      Since 2001, RJR Tobacco has primarily purchased the majority of its U.S. flue-cured and burley leaf directly through contracts with tobacco growers. These short-term contracts are frequently renegotiated. RJR Tobacco believes the relationship with its suppliers is good.

      Tobacco leaf is an agricultural product subject in the United States to government production controls and price supports that can substantially affect market prices. The tobacco leaf price support program is subject to Congressional review and may be changed at any time. In December 1994, Congress enacted the Uruguay Round Agreements Act to replace a domestic content requirement with a tariff rate quota system that bases tariffs on import volumes. The tariff rate quotas have been established by the United States with overseas tobacco producers and became effective on September 13, 1995.

Research and Development

      RJR Tobacco’s research and development activities are located in its Bowman Gray Technical Center in its Whitaker Park complex. Scientists and engineers at these facilities continue to work to create more efficient methods of preparing tobacco blends, as well as develop product enhancements, new products and packaging innovations. A focus for research and development activity is the development of products that may present

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less risk associated with smoking. RJR Tobacco’s research and development expense for the years ended December 31, 2003, 2002 and 2001 was $54 million, $63 million and $64 million, respectively.

Intellectual Property

      RJR’s operating subsidiaries own or have the right to use numerous trademarks, including the brand names of their cigarettes and the distinctive elements of their packaging and displays. RJR’s operating subsidiaries’ material trademarks are registered with the U.S. Patent and Trademark Office. Rights in these trademarks in the United States will last as long as RJR’s subsidiaries continue to use the trademarks. The operating subsidiaries consider the blends and recipes used to make each of their brands to be trade secrets. These trade secrets are not patented.

      In 1999, RJR Tobacco sold most of its trademarks and patents outside the United States in connection with the sale of the international tobacco business to Japan Tobacco Inc. The sale agreement granted Japan Tobacco the right to use certain of RJR Tobacco’s trade secrets outside the United States, but details of the ingredients or formulas for flavors and the blends of tobacco may not be provided to any sub-licensees or sub-contractors. The agreement also prohibits Japan Tobacco and its licensees and sub-licensees from the sale or distribution of tobacco products of any description employing the purchased trademarks and other intellectual property rights in the United States.

Legislation and Other Matters Affecting the Cigarette Industry

      The tobacco industry is subject to a wide range of laws and regulations regarding the marketing, sale, taxation and use of tobacco products imposed by local, state, federal and foreign governments. Various state governments have adopted or are considering, among other things, legislation and regulations that would:

  •  increase their excise taxes on cigarettes;
 
  •  restrict displays and advertising of tobacco products;
 
  •  establish “fire safety” standards for cigarettes;
 
  •  raise the minimum age to possess or purchase tobacco products;
 
  •  require the disclosure of ingredients used in the manufacture of tobacco products;
 
  •  impose restrictions on smoking in public and private areas; and
 
  •  restrict the sale of tobacco products directly to consumers or other unlicensed recipients, including over the Internet.

      In addition, in 2004, the U.S. Congress may consider legislation regarding:

  •  further increases in the federal excise tax;
 
  •  regulation of cigarette manufacturing and sale by the U.S. Food and Drug Administration;
 
  •  amendments to the Federal Cigarette Labeling and Advertising Act to require additional warnings;
 
  •  reduction or elimination of the tax deductibility of advertising expenses;
 
  •  implementation of a national standard for “fire-safe” cigarettes;
 
  •  regulation of the retail sale of cigarettes over the Internet; and
 
  •  changes to the tobacco price-support program.

      Together with manufacturers’ price increases in recent years and substantial increases in state and federal excise taxes on cigarettes, these developments have had and will likely continue to have an adverse effect on cigarette sales. For further discussion of the regulatory and legislative environment applicable to the cigarette business, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Governmental Activity” in Item 7.

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Litigation Affecting the Cigarette Industry

Overview

      Introduction. Various legal actions, proceedings and claims, including litigation claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RJR’s operating subsidiaries’ products, are pending or may be instituted against RJR Tobacco or its affiliates, including RJR, or indemnitees. During the fourth quarter of 2003, 29 new cases were served against RJR Tobacco or its affiliates, including RJR, or indemnitees, and 32 cases were dismissed or otherwise resolved without trial in their favor. On December 31, 2003, there were 1,592 active cases pending (including approximately 1,061 individual smoker cases pending in West Virginia state court as a consolidated action), as compared with 1,650 on December 31, 2002, and 1,639 on December 31, 2001. As of January 23, 2004, 1,577 active tobacco-related cases were pending against RJR Tobacco and/or its affiliates or indemnitees: 1,551 in the United States; 20 in Puerto Rico; 2 in Israel; and 4 in Canada. The U.S. case number does not include the 2,737 Broin II cases, which involve individual flight attendants alleging injuries as a result of exposure to environmental tobacco smoke, referred to as ETS or secondhand smoke, in aircraft cabins, pending as of January 23, 2004, and discussed below.

      The U.S. cases, exclusive of the Broin II cases, are pending in the following 32 states and the District of Columbia.

         
Number of
State U.S. Cases


West Virginia
    1,071 *
Maryland
    186  
Florida
    72  
Mississippi
    49  
New York
    26  
Louisiana
    23  
California
    21  
Nevada
    14  
Alabama
    13  
Iowa
    10  
Missouri
    9  
Illinois
    8  
Massachusetts
    7  
District of Columbia
    5  
Tennessee
    4  
Connecticut
    3  
New Hampshire
    3  
New Jersey
    3  
Texas
    3  
Arizona
    2  
Kansas
    2  
Minnesota
    2  
North Carolina
    2  
Ohio
    2  
Pennsylvania
    2  
Washington
    2  
Georgia
    1  
New Mexico
    1  
Oklahoma
    1  
Oregon
    1  
South Carolina
    1  
South Dakota
    1  
Utah
    1  

* 1,061 of the 1,071 cases are pending as a consolidated action.

      Of the approximately 1,551 active U.S. cases, 89 are pending in federal court, 1,460 in state court and 2 in tribal court.

      The following table lists the categories of the U.S. tobacco-related cases pending against RJR Tobacco or its affiliates, including RJR, or indemnitees; the number of cases relating to each case type pending as of January 23, 2004; the changes in the number of cases by case type since October 15, 2003, the cut-off date used to calculate the number of cases pending against RJR Tobacco or its affiliates or indemnitees in RJR’s

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Quarterly Report on Form 10-Q for the quarter ended September 30, 2003; and a cross-reference to the discussion of each case type.
                         
Number of Change in
Cases as Number of
of Cases since
January 23, October 15, Page
Case Type 2004 2003 Reference




Individual Smoking and Health
    1,499       +1       18  
Flight Attendant — ETS (Broin II)
    2,737       -48       19  
Class Action
    18       -1       20  
Governmental Health-Care Cost Recovery
    8       -1       24  
Other Health-Care Cost Recovery and Aggregated Claims
    5       -2       27  
Master Settlement Agreement-Enforcement and Validity
    2       No Change       29  
Asbestos Contribution
    7       No Change       29  
Antitrust
    6       -26       30  
Other Litigation
    6       -5       32  

      In July 2000, a jury in the Florida state court case Engle v. R.J. Reynolds Tobacco Co. rendered a punitive damages verdict in favor of the “Florida class” of plaintiffs of approximately $145 billion, with approximately $36.3 billion being assigned to RJR Tobacco. RJR Tobacco and the other defendants appealed the verdict. On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Dade County Circuit Court with instructions to decertify the class and dismiss the individual cases. The appellate court denied the plaintiffs’ motion for rehearing on September 22, 2003. On October 23, 2003, the plaintiffs filed a notice asking the Florida Supreme Court to review the case. Briefing on whether the Florida Supreme Court should review the case is complete. It is not known when the Florida Supreme Court will issue a decision. Although RJR Tobacco remains confident in its bases for appeal in this case, RJR Tobacco cannot predict the final outcome of the appellate process. See “— Class-Action Suits” below for a further description of the Engle case.

      In November 1998, the major U.S. cigarette manufacturers, including RJR Tobacco, entered into the Master Settlement Agreement with 46 U.S. states and certain U.S. territories and possessions. These cigarette manufacturers previously settled four other cases scheduled to come to trial, brought on behalf of Mississippi, Florida, Texas and Minnesota, by separate agreements with each state. The MSA and other state settlement agreements:

  •  settled all health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions;
 
  •  released the major U.S. cigarette manufacturers from various additional present and potential future claims;
 
  •  imposed a stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers; and
 
  •  placed significant restrictions on their ability to market and sell cigarettes.

      The aggregate cash payments made by RJR Tobacco under the MSA and the other state settlement agreements during the years 2003, 2002 and 2001 were $1.8 billion, $2.5 billion and $2.4 billion, respectively. RJR Tobacco estimates these payments will be $1.9 billion in 2004, and will exceed $1.8 billion per year thereafter. However, these payments will be subject to adjustments for, among other things, the volume of cigarettes sold by RJR Tobacco, RJR Tobacco’s market share and inflation. See “— Governmental Health-Care Cost Recovery Cases — MSA and Other State Settlement Agreements” below for a detailed discussion of the MSA and the other state settlement agreements, including RJR Tobacco’s monetary obligations under these agreements.

      Certain Terms and Phrases. Certain terms and phrases that are used in this disclosure may require some explanation. The terms “judgment” or “final judgment” refer generally to the final decision of the court resolving the dispute and determining the rights and obligations of the parties. At the trial court level, for

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example, a final judgment generally is entered by the court after a jury verdict and after post-verdict motions have been decided. As a general proposition, the losing party can appeal a verdict only after a final judgment has been entered by the trial court.

      The term “damages” refers to the amount of money sought by a plaintiff in a complaint, or awarded to a party by a jury, or in some cases by a judge. “Compensatory damages” are awarded to compensate the prevailing party for actual losses suffered — if liability is proved. In cases in which there is a finding that a defendant has acted willfully, maliciously or fraudulently, generally based on a higher burden of proof than is required for a finding of liability for compensatory damages, a plaintiff also may be awarded “punitive damages.” Although damages may be awarded at the trial court stage, a losing party generally may be protected from paying any damages until all appellate avenues have been exhausted by posting a supersedeas bond. The amount of such a bond is governed by the law of the relevant jurisdiction and generally is set at the amount of damages plus some measure of statutory interest, modified at the discretion of the appropriate court or subject to a cap set by court or statute.

      The term “settlement” refers to certain types of cases in which cigarette manufacturers, including RJR Tobacco, have agreed to resolve disputes with certain plaintiffs without resolving the case through trial. The principal terms of settlements entered into by RJR Tobacco are explained in the following disclosure.

      Accounting for Tobacco-Related Litigation Contingencies. In accordance with applicable accounting principles, RJR and RJR Tobacco will record any loss related to tobacco litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. For the reasons set forth below, except for Kenyon v. R. J. Reynolds Tobacco Co., discussed below, RJR’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates, when viewed on an individual basis, is not probable. RJR Tobacco and its affiliates, including RJR, believe that they have a number of valid defenses to the tobacco-related litigation claims against them, as well as valid bases for appeal of adverse verdicts against RJR Tobacco. RJR and RJR Tobacco have, through their counsel, filed pleadings and memoranda in pending tobacco-related litigation that set forth and discuss a number of grounds and defenses that RJR, RJR Tobacco and their counsel believe have a valid basis in law and fact. Based on their experience in the tobacco-related litigation against them and the strength of the defenses available to them in such litigation, RJR Tobacco and its affiliates believe that their successful overall record in the defense of tobacco-related litigation in the past will continue in the future. Therefore, no liability for pending tobacco-related litigation currently is recorded in RJR’s consolidated financial statements.

      RJR Tobacco and its affiliates, including RJR, continue to win the majority of smoking and health tobacco litigation claims that reach trial, and a very high percentage of the tobacco-related litigation claims brought against them continue to be dismissed at or before trial. Generally, and except as specifically discussed below, RJR Tobacco and its affiliates, including RJR, have not settled, and currently do not intend to settle, any smoking and health tobacco litigation claims. It is the policy of RJR Tobacco and its affiliates, including RJR, to vigorously defend all tobacco-related litigation claims.

      The only material smoking and health tobacco litigation claims settled by RJR Tobacco involved:

  •  the MSA, the related settlements with the states of Mississippi, Florida, Texas and Minnesota, and the funding by various cigarette companies of a $5.2 billion trust fund contemplated by the MSA to benefit tobacco growers; and
 
  •  the original Broin flight attendant case discussed below under “— Class-Action Suits.”

Despite having valid legal defenses, RJR Tobacco settled these matters because of unique circumstances that do not apply to the other tobacco litigation cases pending against RJR Tobacco and its affiliates, including RJR.

      The circumstances surrounding the MSA, the other state settlement agreements and the funding of a trust fund to benefit the tobacco growers are readily distinguishable from the current categories of cases involving RJR Tobacco. The claims underlying the MSA and the other state settlement agreements were brought by the states to recover health-care costs paid on behalf of state citizens suffering from diseases and

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conditions allegedly related to tobacco use. The MSA and the other state settlement agreements settled all the health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions and contain releases of various additional present and future claims. In accordance with the MSA, various tobacco companies agreed to fund a $5.2 billion trust fund to be used to address the possible adverse economic impact of the MSA on tobacco growers. A discussion of the MSA and the other state settlement agreements, and a table depicting the related payment schedule under these agreements, is set forth below under “— Governmental Health-Care Cost Recovery Cases — MSA and Other State Settlement Agreements.”

      The states were a unique set of plaintiffs and are not plaintiffs in any of the smoking and health cases remaining against RJR or RJR Tobacco. Although RJR Tobacco continues to be a defendant in certain health-care cost recovery cases similar in theory to the state cases but involving other plaintiffs, such as unions, hospitals, Native American tribes, and local and foreign governments, the vast majority of such cases have been dismissed on legal grounds. Indeed, eight federal courts of appeals have ruled uniformly that unions cannot successfully pursue such cases. As a result, no union cases are pending against RJR or RJR Tobacco. RJR and RJR Tobacco believe that the same legal principles that have resulted in dismissal of union and other types of health-care cost recovery cases either at the trial court level or on appeal should compel the dismissal of the similar pending cases.

      Finally, in the U.S. Department of Justice case brought against various industry members, including RJR Tobacco, the United States District Court for the District of Columbia granted the non-Liggett defendants’ motion to dismiss plaintiff’s Medical Care Recovery Act and Medicare Secondary Payer claims. In these particular claims, the federal government made arguments similar to the states and sought to recover federal funds expended in providing health-care to smokers who have developed diseases and injuries alleged to be smoking-related. The only remaining claims in this case involve alleged violations of the federal RICO statute.

      Similarly, the original Broin case, discussed below under “— Class-Action Suits,” was settled in the middle of trial, at a time when discussions were underway with the federal government concerning the possible settlement of the claims underlying the MSA and the other state settlement agreements, among other things. The Broin case was settled at that time in an attempt to remove this case as a political distraction during the industry’s settlement discussions with the federal government and a belief that further Broin litigation would be resolved as part of a settlement at the federal level.

      Following is a description of the material pending tobacco-related litigation to which RJR Tobacco and its affiliates, including RJR, are subject. Even though RJR’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates, when viewed on an individual basis, is not probable, the possibility of material losses related to tobacco litigation is more than remote. However, RJR’s management is unable to predict the outcome of such litigation or to reasonably estimate the amount or range of any possible loss. Moreover, notwithstanding the quality of defenses available to it and its affiliates in tobacco-related litigation matters, it is possible that RJR’s results of operations, cash flows or financial condition could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters.

      Theories of Recovery. The plaintiffs seek recovery on a variety of legal theories, including negligence, strict liability in tort, design defect, special duty, voluntary undertaking, breach of warranty, failure to warn, fraud, misrepresentation, unfair trade practices, conspiracy, unjust enrichment, medical monitoring, public nuisance and violations of state and federal antitrust and RICO laws. In certain of these cases, plaintiffs claim that cigarette smoking exacerbated injuries caused by exposure to asbestos.

      Plaintiffs seek various forms of relief, including compensatory and punitive damages, treble/multiple damages and statutory damages and penalties, creation of medical monitoring and smoking cessation funds, disgorgement of profits, and injunctive and other equitable relief. Although pleaded damages often are not determinable from a complaint, and the law governing the pleading and calculation of damages varies from state to state and jurisdiction to jurisdiction, compensatory and punitive damages have been specifically pleaded in a number of cases, sometimes in amounts ranging into the hundreds of millions and even billions of dollars.

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      Defenses. The defenses raised by RJR Tobacco and/or its affiliates, including RJR, include, where applicable, preemption by the Federal Cigarette Labeling and Advertising Act of some or all claims arising after 1969, the lack of any defect in the product, assumption of the risk, contributory or comparative fault, lack of proximate cause, remoteness, lack of standing and statutes of limitations or repose. RJR has asserted additional defenses, including jurisdictional defenses, in many of the cases in which it is named.

      Scheduled Trials. Trial schedules are subject to change, and many cases are dismissed before trial. However, an increased number of cases have gone to trial each year since 2000 against RJR Tobacco and/or its affiliates, some involving claims for amounts ranging possibly into the hundreds of millions and even billions of dollars, and RJR Tobacco expects this trend to continue. The following table lists the trial schedule, as of January 23, 2004, for RJR Tobacco or its affiliates, through December 31, 2004.

             
Trial Date Case Name Case Type Jurisdiction




March 29, 2004
[Phase II]
 
Scott v. American Tobacco Co., Inc.
  Class Action   District Court, Orleans Parish (New Orleans, LA)
 
April 7, 2004
 
Prado Alvarez v. R. J. Reynolds Tobacco Co.
  Individual   United States District Court (San Juan, Puerto Rico)
 
April 19, 2004
 
DeLoach [Growers] v. R. J. Reynolds Tobacco Co.
  Antitrust   United States District Court, Middle District (Greensboro, NC)
 
April 28, 2004
 
Major v. Raybestos-Manhattan, Inc.
  Asbestos Contribution   Superior Court, Los Angeles County (Los Angeles, CA)
 
May 17, 2004
 
Frost v. Philip Morris, Inc.
  Flight Attendant-ETS (Broin II)   Circuit Court, Dade County (Miami, FL)
 
May 17, 2004
 
Roach v. Brown & Williamson Tobacco Corp.
  Individual   Circuit Court, Jackson County (Independence, MO)
 
June 1, 2004
 
Leslie H. Dial Ent., Inc. v. R. J. Reynolds Tobacco Co.
  Antitrust   United States District Court (Columbia, SC)
 
June 28, 2004
 
Gaston v. R. J. Reynolds Tobacco Co.
  Individual   Superior Court, Union County (Elizabeth, NJ)
 
June 28, 2004
 
Short v. R. J. Reynolds Tobacco Co.
  Individual   Superior Court, Union County (Elizabeth, NJ)
 
July 5, 2004
 
Rosol v. R. J. Reynolds Tobacco Co.
  Individual   United States District Court, Northern District (Waverly, IA)
 
July 12, 2004
 
Younger v. Philip Morris Inc.
  Flight Attendant-ETS (Broin II)   Circuit Court, Dade County (Miami, FL)
 
September 6, 2004
 
Torres-Rivera v. R. J. Reynolds Tobacco Co.
  Individual   Superior Court, Court of First Instance (San Juan, Puerto Rico)
 
September 13, 2004
 
Beckman v. Brown & Williamson Tobacco Corp.
  Individual   Circuit Court, Jackson County (Independence, MO)
 
September 13, 2004
 
Kimball v. R. J. Reynolds Tobacco Co.
  Individual   United States District, Western District (Seattle, WA)

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Trial Date Case Name Case Type Jurisdiction




 
September 13, 2004
 
United States of America [DOJ] v. Philip Morris USA Inc.
  Health-Care Cost Recovery   United States District Court (Washington, DC)
 
September 20, 2004
 
Coy v. Philip Morris Inc.
  ETS   United States District Court, Southern District (Miami, FL)
 
October 4, 2004
 
Mason v. British American Tobacco (Investments) Ltd.
  Individual   United States District Court, Southern District (Des Moines, IA)
 
October 26, 2004
 
Norris v. R. J. Reynolds Tobacco Co.
  Individual   United States District Court, Central District (Los Angeles, CA)
 
November 15, 2004
 
Booth v. R. J. Reynolds Tobacco Co.
  Individual   Circuit Court, Upshur County (Buckhannon, WV)
 
December 1, 2004
 
Smith Wholesale Co., Inc. v. R. J. Reynolds Tobacco Co.
  Antitrust   United States District Court, Eastern District, (Greenville, TN)
 
December 1, 2004
 
Gerrity v. R. J. Reynolds Tobacco Co.
  Individual   United States District Court (Hartford, CT)
 
December 1, 2004
 
Harju v. Philip Morris USA Inc.
  Individual   United States District Court (St. Paul, MN)

      Trial Results. Since January 1, 1999, 33 smoking and health and health-care cost recovery cases in which RJR Tobacco was a defendant have been tried. Verdicts in favor of RJR Tobacco and, in some cases, RJR Tobacco and other defendants, were returned in 20 of the 33 cases. Four of the cases resulted in mistrials. One of the cases resulted in a split decision. Of the 20 RJR Tobacco wins, seven were tried in Florida, two were tried in each of California, Mississippi and New York, and one was tried in each of Louisiana, Missouri, New Jersey, Ohio, South Carolina, Tennessee and West Virginia. Plaintiffs in the California, Florida, Mississippi and West Virginia cases have filed appeals or post-trial motions challenging the verdicts.

      The cases in which verdicts were returned in favor of RJR Tobacco, either by itself or with other defendants, since January 1, 2003, are described below:

  •  On February 7, 2003, state court juries in California and Florida, respectively, found in favor of RJR Tobacco and other cigarette manufacturers in Lucier v. Phillip Morris, Inc., an individual smoker case, and Seal v. Philip Morris, Inc., a Broin II case.
 
  •  On February 28, 2003, a Florida federal court jury found in favor of RJR Tobacco and Philip Morris in Allen v. R. J. Reynolds Tobacco Co., an individual smoker case.
 
  •  On June 17, 2003, a state court jury in Missouri found in favor of RJR Tobacco and other cigarette manufacturers in Welch v. Brown & Williamson Tobacco Corp., an individual smoker case. On July 18, 2003, the plaintiff in Welch filed a motion for a new trial, which was denied on September 18, 2003. On September 23, 2003, the plaintiff noticed an appeal to the Missouri Court of Appeals for the Western District.
 
  •  On July 28, 2003, a Louisiana state court jury returned a split verdict in Scott v. American Tobacco Co., a medical monitoring/smoking cessation class action. Specifically, the jury found that cigarettes were not defective and rejected the class’s claim for medical monitoring, but found that smoking cessation programs exist and have clinical value. A phase II trial is scheduled to begin March 29, 2004, to address the scope and cost of a statewide smoking cessation program.

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  •  On September 15, 2003, in Routh v. Philip Morris, Inc., a Broin II case, a Florida Circuit Court judge declared a mistrial. The case was retried and, on October 14, 2003, a Florida state court jury returned a verdict in favor of the defendants, including RJR Tobacco. Plaintiff filed a motion for a new trial on October 24, 2003, which was denied on December 16, 2003. The plaintiff will not appeal.
 
  •  Most recently, on December 10, 2003, a Florida state court jury returned a verdict in favor of defendants, including RJR Tobacco, in Hall v. R. J. Reynolds Tobacco Co., an individual smoker case. Plaintiffs’ motion for a new trial was denied on January 6, 2004.

      The following chart reflects the verdicts and post-trial developments in the eight cases that have been tried since January 1999 in which juries have returned verdicts in favor of plaintiffs and against RJR Tobacco. In addition, RJR Tobacco has been fined a total of $34.8 million in two other lawsuits filed by the Attorney General of California, discussed below under “— MSA — Enforcement and Validity” and “— Other Litigation and Developments.” RJR Tobacco is appealing both California cases.

                 
Date of Verdict Case Name/Type Jurisdiction Verdict Post-Trial Status





July 7, 1999 — Phase I
April 7, 2000 — Phase II
July 14, 2000 — Phase III
  Engle v. R. J. Reynolds Tobacco Co. [Class Action]   Circuit Court, Dade County (Miami, FL)   $12.7 million compensatory damages against all defendants; $145 billion punitive damages against all defendants, of which approximately $36.3 billion was assigned to RJR Tobacco   On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Dade County Circuit court with instructions to decertify the class. On July 16, 2003, plaintiffs filed a motion for rehearing which was denied on September 22, 2003. Mandate issued on October 8, 2003. Plaintiffs filed a notice seeking review by the Florida Supreme Court on October 23, 2003. Both sides have submitted briefs on whether the Florida Supreme Court should accept jurisdiction of the appeal.
 
March 20, 2000
  Whiteley v. Raybestos- Manhattan, Inc. [Individual]   Superior Court, San Francisco County (San Francisco, CA)   $1.72 million compensatory damages against RJR Tobacco and Philip Morris; $20 million punitive damages, of which $10 million was assigned to each of RJR Tobacco and Philip Morris, respectively   Final judgment on appeal to the California Court of Appeal; oral argument was heard on January 21, 2004.
 
October 12, 2000
  Jones v. Brown & Williamson Tobacco Corp. [Individual]   Circuit Court, Hillsborough County (Tampa, FL)   $200,000 compensatory damages against RJR Tobacco   RJR Tobacco granted new trial on December 28, 2000; new trial decision affirmed by Second District Court of Appeal of Florida on August 30, 2002; plaintiff’s opening brief filed with the Supreme Court of Florida on November 26, 2002. On December 9, 2002, the Supreme Court of Florida issued an order to show cause as to why Jones’ notice of appeal should not be treated as a notice to invoke discretionary jurisdiction. Jones filed his response to the order to show cause, and RJR Tobacco filed its reply on December 31, 2002.
 
June 4, 2001
  Blue Cross and Blue Shield of New Jersey v. Philip Morris, Inc.
[Health Care Cost Recovery]
  United States District Court, Eastern District (Brooklyn, NY)   $17.8 million compensatory damages against all defendants, of which $6.6 million was assigned to RJR Tobacco. Judge subsequently ordered plaintiffs’ attorneys entitled to $37.8 million in fees   On September 16, 2003, the United States Court of Appeals for the Second Circuit: (a) reversed judgment for Empire on its subrogation claim; and (b) reserved ruling on the direct claim pending resolution by the New York Court of Appeals of questions concerning whether third-party payers are too remote and, if the claims are not too remote, whether individual proof is required under the New York State Statute pursuant to which the jury found liability. On October 30, 2003, the New York Court of Appeals decided to review the certified questions. Defendants filed their initial brief on January 22, 2004.

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Date of Verdict Case Name/Type Jurisdiction Verdict Post-Trial Status





 
December 12, 2001
  Kenyon v. R. J. Reynolds Tobacco Co.
[Individual]
  Circuit Court, Hillsborough County (Tampa, FL)   $165,000 compensatory damages against RJR Tobacco   On May 30, 2003, the Second District Court of Appeal of Florida affirmed per curiam (that is, without writing an opinion) the trial court’s final judgment in favor of plaintiffs. RJR Tobacco filed a petition for rehearing or for a written opinion on June 16, 2003. That motion was denied on July 11, 2003. RJR Tobacco filed a motion for stay of proceedings pending the final outcome of the Engle appeal. That motion was denied on July 11, 2003. On August 28, 2003, Florida’s Second District Court of Appeal entered its mandate. RJR Tobacco deposited with the plaintiff’s counsel the amount of the judgment plus accrued interest ($196,000) in order to pursue further appeals without the risk of any effort by the plaintiff to execute on the judgment. On September 5, 2003, RJR Tobacco filed a petition with the Florida Supreme Court asking it to require the Second District Court of Appeal to write an opinion. That petition remains pending. On November 12, 2003, RJR Tobacco filed its petition for certiorari with the United States Supreme Court.
 
February 22, 2002
  Burton v. R. J. Reynolds Tobacco Co.
[Individual]
  United States District Court (Kansas City, KS)   $198,000 compensatory damages and $15 million punitive damages against RJR Tobacco   Final judgment on appeal to the United States Court of Appeals for the Tenth Circuit; oral argument was heard on January 12, 2004.
 
June 18, 2002
  French v. Philip Morris, Inc.
[Flight Attendant-ETS (Broin II)]
  Circuit Court, Dade County (Miami, FL)   $5.5 million compensatory damages against all defendants; reduced by judge to $500,000   Judge reduced damages award to $500,000, of which $123,500 was assigned to RJR Tobacco; final judgment on appeal to the Third District Court of Appeal of Florida; RJR Tobacco’s opening brief filed July 16, 2003. The appellee’s brief has not yet been filed.
 
September 25, 2002
  Figueroa-Cruz v. R. J. Reynolds Tobacco Co.
[Individual]
  United States District Court (San Juan, Puerto Rico)   $500,000 compensatory damages against RJR Tobacco   Trial judge granted RJR Tobacco’s motion for judgment as a matter of law on October 9, 2002. On October 28, 2003, the United States Court of Appeals for the First Circuit affirmed the trial court’s ruling. Plaintiffs filed a petition for rehearing on November 13, 2003, which was denied on December 12, 2003.

      Additionally, since January 1, 1999, verdicts have been returned in 26 tobacco-related cases in which neither RJR Tobacco nor its affiliates, including RJR, were defendants. Verdicts were returned in favor of defendants in 14 cases — three in Tennessee, two in Pennsylvania, and one in each of California, Connecticut, Florida, Missouri, New Hampshire, New York, Ohio, Rhode Island and Texas. Verdicts in favor of the plaintiffs were returned in 12 cases, four of which were tried in California, two in each of Florida and Oregon and one in each of Arkansas, Illinois, Missouri and New York. The defendants’ appeals or post-trial motions are pending in these cases.

      The cases in which verdicts were returned in favor of the plaintiffs since January 1, 2003, are described below:

  •  On March 21, 2003, an Illinois state trial judge entered judgment against Philip Morris in Price v. Philip Morris (formerly known as Miles v. Philip Morris), a “lights” class-action case discussed below under “— Class-Action Suits.”

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  •  On April 3, 2003, a Florida state court jury returned a verdict against Philip Morris and Brown & Williamson in Eastman v. Philip Morris, an individual smoker case. The jury awarded compensatory but not punitive damages.
 
  •  On May 27, 2003, in Boerner v. Brown & Williamson Tobacco Corp., an Arkansas federal court jury returned a verdict against Brown & Williamson in another individual smoker action. On July 2, 2003, the trial judge dismissed the Boerner jury’s $15 million punitive damages award, but found in favor of the plaintiff on the design defect claim, which was not considered by the jury. The final judgment reflected the jury’s award of $4,025,000 in actual damages. On September 26, 2003, the judge denied Brown & Williamson’s motions for judgment as a matter of law and for a new trial. The judge also reinstated the jury’s original punitive damages award of $15 million. Brown & Williamson is appealing this case.
 
  •  On July 31, 2003, a California state court jury found in favor of Philip Morris in Reller v. Philip Morris USA Inc. on all counts except fraudulent concealment, on which the jury deadlocked. Mr. Reller has since died, and the fraudulent concealment claim will not be retried. On December 19, 2003, Mr. Reller’s estate filed an amended wrongful death complaint substituting the representative of the estate as the plaintiff.
 
  •  On August 15, 2003, a Pennsylvania state court jury found in favor of Brown & Williamson in Eiser v. Brown & Williamson Tobacco Corp., an individual “lights” case. Post-trial motions have been filed by the plaintiff, and a hearing took place on December 4, 2003.
 
  •  On September 25, 2003, in Henley v. Philip Morris, Inc., the California Court of Appeal affirmed the San Francisco County Superior Court’s final judgment with respect to the $1.5 million compensatory damages award to the plaintiff, but reduced the amount of punitive damages from $50 million to $9 million based on the United States Supreme Court’s opinion in State Farm v. Campbell. Philip Morris’s petition for rehearing was denied. On November 4, 2003, Philip Morris petitioned the California Supreme Court to review the case. On December 23, 2003, the California Supreme Court accepted Philip Morris’s appeal and remanded the case to the California Court of Appeal with directions that it vacate its September 25, 2003 ruling and issue a new ruling.
 
  •  On November 4, 2003, in Thompson v. Brown & Williamson Tobacco Corp., a Missouri state court jury returned a verdict against Philip Morris and Brown & Williamson, and awarded $2.1 million in compensatory damages. The jury found Brown & Williamson to be 10% at fault, Philip Morris to be 40% at fault, and plaintiff to be 50% at fault. On December 11, 2003, defendants filed a motion for judgment notwithstanding the verdict, or, in the alternative, motion for a new trial.
 
  •  On November 24, 2003, a New Hampshire state court jury returned a verdict in favor of Philip Morris in Longden v. Philip Morris, Inc.
 
  •  Most recently, on December 18, 2003, a New York state court jury returned a verdict against Brown & Williamson in Frankson v. Brown & Williamson Tobacco Corp. The jury awarded $350,000 in compensatory damages. The jury found the plaintiff to be 50% at fault, thereby causing the compensatory damages award to be reduced to $175,000. On January 8, 2004, the jury awarded $20 million in punitive damages, of which $6 million was assigned to Brown & Williamson, $2 million to a predecessor company and $12 million to two trade organizations. Defendants’ post-trial motions are to be filed by January 29, 2004.

      Finally, in Naegele v. Raybestos-Manhattan, Inc. and Myers v. Philip Morris, Inc., the California Supreme Court assessed the retroactive effect of California’s amended Civil Code Section 1714.45, which repealed a California statute that limited plaintiffs’ ability to sue manufacturers of tobacco products from 1988 through 1998. On August 5, 2002, the court ruled that the immunity repeal could not be applied retroactively and the immunity remains for the ten-year period the statute was in effect. In addition, the court found that the immunity applied to fraud claims but not to claims of adulteration. RJR Tobacco believes that these decisions should have a favorable impact on California cases currently on appeal, such as Whiteley v. Raybestos-Manhattan, Inc., and cases at the trial court level.

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Individual Smoking and Health Cases

      As of January 23, 2004, 1,499 individual cases, including approximately 1,061 individual smoker cases pending in West Virginia state court in a consolidated action, were pending in the United States against RJR Tobacco. This category of cases includes smoking and health cases alleging personal injury brought by or on behalf of individual plaintiffs, but does not include the Broin II cases discussed below. A total of 1,491 of the individual pending cases are brought by or on behalf of individual smokers or their survivors, while the remaining seven are brought by or on behalf of individuals or their survivors alleging personal injury as a result of exposure to ETS.

      Below is a description of the individual smoking and health cases against RJR Tobacco which went to trial or were decided or remained on appeal, since January 1, 2003.

      On March 20, 2000, a California state court jury found in favor of the plaintiff in Whiteley v. Raybestos-Manhattan, Inc. The jury awarded the plaintiff $1.72 million in compensatory damages and $20 million in punitive damages. RJR Tobacco and Philip Morris were each assigned $10 million of the punitive damages award. The defendants appealed the final judgment to the California Court of Appeal, First District, on May 30, 2000. Oral argument occurred on January 21, 2004.

      In Kenyon v. R. J. Reynolds Tobacco Co., an individual case in Florida, a jury awarded the plaintiff $165,000 in compensatory damages, but no punitive damages, on December 12, 2001. On May 30, 2003, Florida’s Second District Court of Appeal affirmed the final judgment without an opinion. RJR Tobacco sought rehearing or a written opinion, which was rejected on July 11, 2003. The court of appeal entered its mandate on August 28, 2003. In Florida, a supersedeas bond does not stay execution of a judgment once the court of appeal enters its mandate in favor of a plaintiff. Accordingly, RJR Tobacco deposited with the plaintiff’s counsel a check in the amount of the judgment plus accrued interest ($196,000) to avoid any possible business disruption during the remaining appeal. On September 5, 2003, RJR Tobacco filed a petition with the Florida Supreme Court, asking it to require the appeals court to issue a written opinion. That petition remains pending. On November 12, 2003, RJR Tobacco filed a petition for certiorari with the United States Supreme Court.

      On February 22, 2002, in Burton v. R. J. Reynolds Tobacco Co., a federal district court jury in Kansas found in favor of RJR Tobacco and Brown & Williamson on product defect and conspiracy claims, but found for the plaintiff on failure to warn, failure to test and fraudulent concealment claims. The jury apportioned 99% of the fault to RJR Tobacco and 1% to Brown & Williamson. It awarded the plaintiff $198,400 in compensatory damages, and determined that the plaintiff was entitled to punitive damages against RJR Tobacco but not Brown & Williamson. Brown & Williamson was voluntarily dismissed as a defendant by the plaintiffs on June 10, 2002. On June 21, 2002, the trial court awarded the plaintiff $15 million in punitive damages. RJR Tobacco appealed to the United States Court of Appeals for the Tenth Circuit. Oral argument was heard on January 12, 2004.

      In Figueroa-Cruz v. R. J. Reynolds Tobacco Co., a federal district court jury in San Juan, Puerto Rico, found in favor of one of two plaintiffs on September 25, 2002. On October 9, 2002, however, the trial judge granted RJR Tobacco’s motion for judgment on the pleadings. The plaintiffs appealed to the United States Court of Appeals for the First Circuit. On October 28, 2003, the appeals court affirmed the trial court’s decision. Plaintiffs filed a petition for rehearing; however, that petition was denied on December 12, 2003.

      On February 7, 2003, a Florida state court jury found in favor of RJR Tobacco and Philip Morris in Lucier v. Phillip Morris, Inc., an individual smoker case. Plaintiff appealed to the California Court of Appeal, Third Appellate District, on May 9, 2003. On December 4, 2003, the appellate court dismissed the appeal because of the plaintiffs’ failure to file the initial brief.

      On February 28, 2003, a Florida federal court jury found in favor of RJR Tobacco and Philip Morris in Allen v. R. J. Reynolds Tobacco Co., an individual smoker case. The plaintiff did not appeal.

      On May 8, 2003, the Mississippi Supreme Court, in Lane v. R. J. Reynolds Tobacco Co., ruled that the Mississippi Product Liability Act does not allow smoking and health cases based on products liability. RJR

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Tobacco believes that the effect of the Lane ruling will be to reduce the number, if not eliminate, smoking and health cases in Mississippi.

      On June 17, 2003, in Welch v. Brown & Williamson Tobacco Corp., a Missouri state court jury found in favor of RJR Tobacco and other cigarette manufacturers. The plaintiff’s new trial motion was denied on September 18, 2003. The plaintiff filed a notice of appeal to the Missouri Court of Appeals on September 23, 2003. No briefing schedule has been set.

      On December 10, 2003, in Hall v. R. J. Reynolds Tobacco Co., a state court jury in Florida returned a verdict in favor of RJR Tobacco and Brown & Williamson. The plaintiff filed a motion for a new trial on December 19, 2003, which was denied on January 6, 2004.

Broin II Cases

      As of January 23, 2004, approximately 2,737 lawsuits brought by individual flight attendants for personal injury as a result of illness allegedly caused by exposure to secondhand or environmental tobacco smoke in airplane cabins, referred to as the Broin II cases, were pending in Florida. In these lawsuits, filed pursuant to the terms of the settlement of the Broin v. Philip Morris, Inc. class action, discussed below under “— Class-Action Suits,” each individual flight attendant will be required to prove that he or she has a disease and that the individual’s exposure to secondhand smoke in airplane cabins caused the disease. Under the terms of the settlement of the original Broin case, punitive damages are not available in the Broin II cases.

      On October 5, 2000, Judge Robert Kaye entered an order applicable to all Broin II cases that the terms of the Broin settlement agreement do not require the individual Broin II plaintiffs to prove the elements of strict liability, breach of warranty or negligence. Under this order, there is a rebuttable presumption in the plaintiffs’ favor on those elements, and the plaintiffs bear the burden of proving that their alleged adverse health effects actually were caused by exposure to environmental tobacco smoke. Although the defendants still may prevail on causation and other theories, RJR Tobacco does not believe that the order is correct under Florida law or that it accurately reflects the intent of the Broin settlement agreement. RJR Tobacco, along with the other defendants, initially appealed this order in Jett v. Philip Morris, Inc. In October 2001, the intermediate appellate court dismissed the appeal as premature without addressing the Kaye order. The defendants asked the court to reconsider its ruling, but the court refused to do so. The defendants asked the Florida Supreme Court to review the order, but the court declined to accept jurisdiction on June 24, 2002.

      Below is a description of the Broin II cases against RJR Tobacco which went to trial or were decided or remain on appeal, since January 1, 2003.

      In French v. Philip Morris, Inc., a Florida state court jury found in favor of the plaintiff on June 18, 2002, and awarded $5.5 million in compensatory damages. On September 13, 2002, the trial judge reduced the damages award to $500,000, but denied the defendants’ remaining post-trial motions. The defendants’ appeal of the trial court’s final judgment is pending in the Third District Court of Appeal of Florida. Judge Kaye’s order in Jett v. Philip Morris, Inc., referred to above, was applied, and the defendants are appealing that order, as well as other matters. The appeal is in the briefing phase.

      In Janoff v. Philip Morris, Inc., a Florida state court jury found in favor of the defendants, including RJR Tobacco, on September 5, 2002. On September 12, 2002, the plaintiff filed a motion for a new trial, which the judge granted on January 8, 2003. The defendants appealed the new trial ruling to Florida’s Third District Court of Appeal on February 3, 2003. The appeal is in the briefing phase.

      In Tucker v. Philip Morris, Inc., a Florida state court jury found in favor of the defendants, including RJR Tobacco, on October 4, 2002. The plaintiff’s post-verdict motions were denied on January 28, 2003. The plaintiff noticed an appeal to Florida’s Third District Court of Appeal on February 28, 2003, but voluntarily dismissed the appeal on May 23, 2003.

      A Florida state court jury found in favor of RJR Tobacco and other cigarette manufacturers on February 7, 2003, in Seal v. Philip Morris, Inc. On February 14, 2003, the plaintiff filed a motion for a new trial, which was denied on April 24, 2003.

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      In Mittan v. Philip Morris, Inc., on July 16, 2003, the plaintiff accepted an $800 (eight hundred dollars) offer of judgment tendered by RJR Tobacco, Philip Morris, Brown & Williamson and Lorillard. RJR Tobacco’s share of the offer was $200.

      In Routh v. Philip Morris, Inc., the trial judge declared a mistrial on September 15, 2003. Retrial began on September 23, 2003. The jury returned a verdict in favor of the defendants, including RJR Tobacco, on October 14, 2003. The plaintiff filed a motion for a new trial on October 24, 2003; however, that motion was denied on December 16, 2003. The plaintiff will not appeal.

Class-Action Suits

      As of January 23, 2004, 18 class-action cases were pending in the United States against RJR Tobacco, and in some cases, RJR. In May 1996, in Castano v. American Tobacco Co., the Fifth Circuit Court of Appeals overturned the certification of a nationwide class of persons whose claims related to alleged addiction to tobacco products. Since this ruling by the Fifth Circuit, most class-action suits have sought certification of statewide, rather than nationwide, classes. Class-action suits based on claims similar to those asserted in Castano are pending against RJR Tobacco, and in some cases RJR, in state or federal courts in Alabama, California, Florida, Illinois, Louisiana, Minnesota, Missouri, New York, Oklahoma, Oregon, Utah and West Virginia. Twenty-five virtually identical class-action complaints were filed by one attorney in Nevada since July 2002. This same attorney also filed class action complaints in Kentucky, Massachusetts and Utah. As discussed below, a federal district court judge recently denied class certification in all 25 of the Nevada cases; a state court judge denied class certification in the Kentucky case; the Massachusetts case was voluntarily dismissed; and the Utah case remains pending.

      Class-action suits have been filed in a number of states against individual cigarette manufacturers and their parent corporations, alleging that the use of the terms “lights” and “ultralights” constitutes unfair and deceptive trade practices. In December 2000, a state court in Pennsylvania refused to certify one such class action, Oliver v. RJR Tobacco Co. That case was voluntarily dismissed. Five such suits are pending against RJR Tobacco and RJR in Florida, Illinois, Louisiana, Missouri and Minnesota. Classes have been certified in the Illinois case, Turner v. R. J. Reynolds Tobacco Co., and in the Missouri case, Collora v. R. J. Reynolds Tobacco Co. Each of these cases is discussed below. The Florida case, Rios v. R. J. Reynolds Tobacco Co., is in the class certification discovery phase. Most recently, in both the Louisiana and Minnesota actions, Harper v. R. J. Reynolds Tobacco Co. and Dahl v. R. J. Reynolds Tobacco Co., defendants removed the cases to federal court. On December 17, 2003, in Dahl, however, the case was remanded to state court.

      Other types of class-action suits also are pending in additional jurisdictions. Most of these suits assert claims on behalf of classes of individuals who claim to be addicted, injured or at greater risk of injury by the use of tobacco or exposure to environmental tobacco smoke, or the legal survivors of such persons. A number of unions and other third-party payers have filed health-care cost recovery actions in the form of class actions. These cases are discussed separately below. Class certification motions are pending in several state and federal courts.

      Few smoker class-action complaints have been certified or, if certified, have survived on appeal. Seventeen federal courts that have considered the issue, including two courts of appeals, and most state courts have rejected class certification in smoking and health cases. Only one federal district court has certified a smoker class action — In re Simon (II) Litigation — which was filed in the United States District Court for the Eastern District of New York before Judge Weinstein. In Simon (II), on September 19, 2002, Judge Weinstein certified a nationwide mandatory, non-opt-out punitive damages class. Defendants sought reconsideration of the certification ruling, which was denied by Judge Weinstein on October 25, 2002. On February 14, 2003, the United States Court of Appeals for the Second Circuit granted the defendants’ petition to review the class certification decision. Oral argument was heard on November 20, 2003. On February 10, 2003, in Sims v. Philip Morris, Inc., the United States District Court for the District of Columbia denied certification of a proposed nationwide class of smokers who purchased cigarettes while underage. On July 11, 2003, a federal district court judge in Nevada denied class certification in five separate cases, brought by the same attorney, which were consolidated for class certification purposes. On October 7, 2003, the same federal district court

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judge in Nevada denied class certification in 20 additional cases brought by the same attorney. On November 21, 2003, in Brown v. Philip Morris Inc., the Circuit Court of Campbell County, Kentucky, denied class certification; this case was voluntarily dismissed on December 12, 2003. Most recently, on December 8, 2003, in Jackson v. Philip Morris Inc., a federal district court judge in Utah dismissed the case due to plaintiffs’ failure to prosecute.

      Classes have been certified in several state court class-action cases in which RJR Tobacco is a defendant. On November 5, 1998, in Scott v. American Tobacco Co., a Louisiana state appeals court affirmed the certification of a medical monitoring and/or smoking cessation class of Louisiana residents who were smokers on or before May 24, 1996. On February 26, 1999, the Louisiana Supreme Court denied the defendants’ petition for writ of certiorari and/or review. Jury selection began on June 18, 2001. An initial jury was selected by July 16, 2001. However, the defendants, including RJR Tobacco, raised multiple challenges to the jury selection process. At various times, the Louisiana Court of Appeals and/or the Louisiana Supreme Court removed a number of jurors and alternate jurors that the trial court had allowed to be seated. The jury selection process was finally completed on September 23, 2002, and opening statements occurred on January 21, 2003. On July 28, 2003, the jury returned a verdict in favor of the defendants, including RJR Tobacco, on the plaintiffs’ claim for medical monitoring and found that cigarettes were not defectively designed. In addition, however, the jury made certain findings against the defendants, including RJR Tobacco, on claims relating to fraud, conspiracy, marketing to minors and smoking cessation. With respect to these findings, this portion of the trial did not determine liability as to any class member or class representative. What primarily remains in the case is a class-wide claim that the defendants, including RJR Tobacco, pay for a program to help people stop smoking. The trial judge has ordered that a phase two trial begin on March 29, 2004, to address the scope and cost of a statewide smoking cessation program. On October 23, 2003, the defendants, including RJR Tobacco, filed a challenge to the trial judge’s phase two trial order with the Louisiana Court of Appeals. The Court of Appeals declined to accept the appeal on December 5, 2003. On January 5, 2004, RJR Tobacco, Brown & Williamson and Lorillard filed a writ seeking review by the Louisiana Supreme Court.

      In Blankenship v. American Tobacco Co., the first tobacco-related medical monitoring class action to be certified and to reach trial, the West Virginia state court jury found in favor of RJR Tobacco and other cigarette manufacturers on November 14, 2001. On July 18, 2002, the plaintiffs petitioned the Supreme Court of West Virginia for leave to appeal, which was granted on February 25, 2003. Oral argument was heard on November 5, 2003.

      Trial began in July 1998 in Florida state court in Engle v. R. J. Reynolds Tobacco Co., in which a class consisting of Florida residents, or their survivors, alleges diseases or medical conditions caused by their alleged “addiction” to cigarettes. On July 7, 1999, the jury found against RJR Tobacco and the other cigarette-manufacturer defendants in the initial phase, which included common issues related to certain elements of liability, general causation and a potential award of, or entitlement to, punitive damages.

      The second phase of the trial, which consisted of the claims of three of the named class representatives, began on November 1, 1999. On April 7, 2000, the jury returned a verdict against all defendants. It awarded plaintiff Mary Farnan $2.85 million, the estate of plaintiff Angie Della Vecchia $4.023 million and plaintiff Frank Amodeo $5.831 million. The jury also found, however, that Frank Amodeo knew or should have known of his claim prior to May 5, 1990. RJR Tobacco believes that the legal effect of that finding should be to bar his claim based on the applicable statute of limitations.

      The trial court also ordered the jury in the second phase of the trial to determine punitive damages, if any, on a class-wide basis. On July 14, 2000, the jury returned a punitive damages verdict in favor of the “Florida class” of approximately $145 billion against all the defendants, with approximately $36.3 billion being assigned to RJR Tobacco.

      On July 24, 2000, the defendants, including RJR Tobacco, filed numerous post-verdict motions, including motions for a new trial and to reduce the amount of the punitive damages verdict. On November 6, 2000, the trial judge denied the post-trial motions and entered judgment. On November 7, 2000, RJR Tobacco posted an appeal bond in the amount of $100 million, the maximum amount required, pursuant to a Florida bond cap

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statute enacted on May 9, 2000, and intended to apply to the Engle case, and initiated the appeals process. On May 21, 2003, Florida’s Third District Court of Appeals reversed the trial court’s final judgment and remanded the case to the Dade County Circuit Court with instructions to decertify the class. The appellate court denied the class’s motion for rehearing on September 22, 2003. On October 23, 2003, the plaintiffs filed a notice asking the Florida Supreme Court to review the case. Briefing on whether the Florida Supreme Court should review the case is now complete. It is not known when the Florida Supreme Court will issue a decision. Although RJR Tobacco remains confident in its bases for appeal in this case, RJR Tobacco cannot predict the final outcome of the appellate process.

      On May 7, 2001, three of the non-RJR Tobacco defendants entered into agreements with the Engle class to deposit an additional $1.86 billion into separate escrow accounts to ensure that the stay of execution in effect pursuant to the Florida bond cap statute will remain in effect as to these three defendants throughout the appellate process, regardless of the results of a challenge, if any, to the Florida bond statute. Approximately $700 million of the total amount deposited by these three defendants is non-refundable and will go to the trial court to be distributed, regardless of the result of the appeal. RJR Tobacco has not entered into a similar agreement with the Engle class. Although RJR Tobacco cannot predict the outcome of any possible challenges to the Florida bond statute, RJR Tobacco remains confident of the applicability and validity of the statute in the Engle case.

      RJR Tobacco has been named as a defendant in several individual cases filed by members of the Engle class. One such case (in which RJR Tobacco was dismissed prior to trial), Lukacs v. Philip Morris, Inc., was tried against Philip Morris and Brown & Williamson, and resulted in a verdict for the plaintiffs on June 11, 2002. The Florida state court jury awarded the plaintiffs a total of $37.5 million in compensatory damages. On April 1, 2003, the Dade County Circuit Court granted in part the defendants’ motion for remittitur and reduced the jury’s award to plaintiff Yolanda Lukacs (on the loss of consortium claim) from $12.5 million to $0.125 million decreasing the total award to $25.125 million. These plaintiffs agreed to stay execution on the judgment pending the result of the Engle appeal.

      On November 30, 2000, in Daniels v. Philip Morris Cos., Inc., a San Diego Superior Court judge reversed a prior ruling and, based on a California unfair business practices statute, certified a class consisting of all persons who, as California resident minors, smoked one or more cigarettes in California between April 2, 1994 and December 1, 1999. Trial was scheduled for October 18, 2002, but the court granted the defendants’ motions for summary judgment on preemption and First Amendment grounds on September 12, 2002, and dismissed the action. At a hearing on October 21, 2002, the judge made final his original ruling. The plaintiffs are currently appealing the dismissal to the California Court of Appeal, Fourth Appellate District, Division One. Appellants’ opening brief was filed on July 30, 2003. Briefing is scheduled to be completed by March 29, 2004.

      On April 11, 2001, in Brown v. American Tobacco Co., Inc., the same judge in San Diego granted in part the plaintiffs’ motion for class certification. The class is composed of adult residents of California who smoked at least one of defendants’ cigarettes from 1993 through 2000, and who were exposed to the defendants’ marketing and advertising activities in California. Certification was granted as to the plaintiffs’ claims that the defendants violated §17200 of the California Business and Professions Code. The court, however, refused to certify the class under the California Legal Remedies Act. Class certification on the plaintiffs’ common law claims was denied on April 10, 2000. The defendants petitioned the California Supreme Court to review the trial court’s class certification ruling, but the Supreme Court denied the petition on January 16, 2002. The defendants, including RJR Tobacco, filed their motion for summary judgment on January 31, 2003. Briefing is complete, and the parties are awaiting the judge’s ruling.

      On November 14, 2001, in Turner v. R. J. Reynolds Tobacco Co., an Illinois state court judge (Madison County) certified a class defined as “[a]ll persons who purchased defendants’ Doral Lights, Winston Lights, Salem Lights and Camel Lights, in Illinois, for personal consumption, between the first date that defendants sold Doral Lights, Winston Lights, Salem Lights and Camel Lights through the date the court certifies this suit as a class action ....” On June 6, 2003, RJR Tobacco filed a motion to stay the case pending Philip Morris’s appeal of the Price v. Philip Morris case, which is discussed below. On July 11, 2003, the judge

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denied the motion, and RJR Tobacco appealed to the Illinois Fifth District Court of Appeals. The Court of Appeals denied this motion on October 17, 2003. On October 20, 2003, the trial judge ordered that the case be stayed for 90 days, or pending the result of the Price appeal, which is discussed below. The order stated that a hearing would be held at the end of the 90 days to determine if the stay should be continued. On November 5, 2003, the Illinois Supreme Court granted RJR Tobacco’s motion for a stay pending the court’s final appeal decision in Price v. Philip Morris. This case currently includes both RJR and RJR Tobacco as defendants.

      On December 31, 2003, in Collora v. R. J. Reynolds Tobacco Co., a Missouri state court judge in St. Louis certified a class defined as “[a]ll persons who purchased defendants’ Camel Lights, Camel Special Lights, Salem Lights and Winston Lights cigarettes in Missouri for personal consumption between the first date the defendants placed their Camel Lights, Camel Special Lights, Salem Lights and Winston Lights cigarettes into the stream of commerce through the date of this Order.” On January 14, 2004, RJR and RJR Tobacco, the only named defendants, removed this case to the United States District Court for the Eastern District of Missouri.

      A “lights” class-action case is pending in the same jurisdiction in Illinois against Philip Morris. Trial of the case against Philip Morris, Price v. Philip Morris, Inc. (formerly known as Miles v. Philip Morris, Inc.), began on January 21, 2003. On March 21, 2003, the trial judge entered judgment against Philip Morris in the amount of $7.1 billion in compensatory damages and $3 billion in punitive damages to the State of Illinois. Based on Illinois law, the bond required to stay execution of the judgment was set initially at $12 billion. Because of the difficulty of posting a bond of that magnitude, Philip Morris pursued various avenues of relief from the $12 billion bond requirement. On April 14, 2003, the trial judge reduced the amount of bond. He ordered the bond to be secured by $800 million, payable in four equal quarterly installments beginning in September 2003, and a pre-existing $6 billion long-term note to be placed in escrow pending resolution of the case. The plaintiffs appealed the judge’s decision to reduce the amount of the bond. On July 14, 2003, the appeals court ruled that the trial judge exceeded his authority in reducing the bond and ordered the trial judge to reinstate the original bond. On September 16, 2003, the Illinois Supreme Court ordered that the reduced bond be reinstated and agreed to hear Philip Morris’s appeal without need for intermediate appellate court review. The Price case remains in the Illinois Supreme Court. In the event RJR Tobacco tries and loses the Turner case, it could face similar bonding difficulties depending upon the amount of damages ordered, if any, which could have a material adverse effect on RJR Tobacco’s, and consequently RJR’s, results of operations, cash flows or financial condition.

      RJR Tobacco and other cigarette manufacturer defendants settled one class-action suit, Broin v. Phillip Morris, Inc., in October 1997. This case had been brought in Florida state court on behalf of all flight attendants of U.S. airlines alleged to be suffering from diseases or ailments caused by exposure to secondhand smoke in airplane cabins. The settlement agreement required the participating tobacco companies to pay a total of $300 million in three annual $100 million installments, allocated among the companies by market share, to fund research on the early detection and cure of diseases associated with tobacco smoke. It also required those companies to pay a total of $49 million for the plaintiffs’ counsel’s fees and expenses. RJR Tobacco’s portion of these payments was approximately $86 million. The settlement agreement bars class members from bringing aggregate claims or obtaining punitive or exemplary damages and also bars individual claims to the extent that they are based on fraud, misrepresentation, conspiracy to commit fraud or misrepresentation, RICO, suppression, concealment or any other alleged intentional or willful conduct. The defendants agreed that, in any individual case brought by a class member, the defendant will bear the burden of proof with respect to whether ETS can cause certain specifically enumerated diseases, referred to as “general causation.” With respect to all other issues relating to liability, including whether an individual plaintiff’s disease was caused by his or her exposure to ETS in aircraft cabins, referred to as “specific causation,” the individual plaintiff will have the burden of proof. Florida’s Third District Court of Appeal denied various challenges to this settlement on March 24, 1999, and subsequently denied motions to reconsider. On September 7, 1999, the Florida Supreme Court dismissed all proceedings, and the settlement and judgment became final. The Broin II cases, discussed above, arose out of the settlement of this case.

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Governmental Health-Care Cost Recovery Cases

      MSA and Other State Settlement Agreements. In June 1994, the Mississippi attorney general brought an action, Moore v. American Tobacco Co., against various industry members, including RJR Tobacco. This case was brought on behalf of the state to recover state funds paid for health-care and medical and other assistance to state citizens suffering from diseases and conditions allegedly related to tobacco use. Most other states, through their attorneys general or other state agencies, sued RJR Tobacco and other U.S. cigarette manufacturers based on similar theories. The cigarette manufacturer defendants, including RJR Tobacco, settled the first four of these cases scheduled for trial — Mississippi, Florida, Texas and Minnesota — by separate agreements between each state and those manufacturers in each case.

      On November 23, 1998, the major U.S. cigarette manufacturers, including RJR Tobacco, entered into the MSA with attorneys general representing the remaining 46 states, the District of Columbia, Puerto Rico, Guam, the Virgin Islands, American Samoa and the Northern Marianas. The MSA became effective on November 12, 1999, and settled all the health-care cost recovery actions brought by, or on behalf of, the settling jurisdictions and contained releases of various additional present and future claims.

      In the settling jurisdictions, the MSA released RJR Tobacco, its indemnitees and RJR from:

  •  all claims of the settling states and their respective political subdivisions and other recipients of state health-care funds, relating to past conduct arising out of the use, sale, distribution, manufacture, development, advertising, marketing or health effects of, the exposure to, or research, statements or warnings about, tobacco products; and
 
  •  all monetary claims relating to future conduct arising out of the use of, or exposure to, tobacco products that have been manufactured in the ordinary course of business.

      The cash payments made by RJR Tobacco under the MSA and the other state settlement agreements during the years 2003, 2002 and 2001 were $1.8 billion, $2.5 billion and $2.4 billion, respectively. RJR Tobacco records its allocation of ongoing settlement charges in cost of products sold as products are shipped. Set forth below is a table depicting the unadjusted tobacco industry settlement payment schedule under the MSA and the other state settlement agreements and related information.

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Unadjusted Original Participating Manufacturers’ Settlement Payment Schedule

                                                                             
2000 2001 2002 2003 2004 2005 2006 2007 2008+









(Dollars in Millions)
First Four States’ Settlements: (1)
                                                                       
 
Mississippi Annual Payment
  $ 85     $ 111     $ 111     $ 136     $ 136     $ 136     $ 136     $ 136     $ 136  
 
Florida Annual Payment
    275       358       358       440       440       440       440       440       440  
 
Texas Annual Payment
    363       471       471       580       580       580       580       580       580  
 
Minnesota Annual Payment
    128       166       166       204       204       204       204       204       204  
 
Minnesota Initial Payment
    243       243       243       122                                
 
Most Favored Nations Agmt (MS, FL, TX)
    1,215       1,215       1,215       609                                
Remaining States’ Settlement:
                                                                       
 
Initial Payments (1)
    2,472       2,546       2,623       2,701                                
 
Annual Payments (1)
    3,940       4,378       5,691       5,691       7,004       7,004       7,004       7,004       7,126  
 
Add’l Annual Payments (through 2017) (1)
                                                    861  
 
Base Foundation Funding (through 2008)
    25       25       25       25       25       25       25       25       25  
 
Additional Foundation Payments (2)
    300       300       300       300                                
 
Growers’ Trust ($295–2009 and 2010) (3)
    280       400       500       500       500       500       500       500       500  
 
Minnesota Blue Cross and Blue Shield
    57       57       57       57                                
     
     
     
     
     
     
     
     
     
 
   
Total
  $ 9,383     $ 10,270     $ 11,760     $ 11,365     $ 8,889     $ 8,889     $ 8,889     $ 8,889     $ 9,872  
     
     
     
     
     
     
     
     
     
 
RJR Tobacco’s settlement expenses
  $ 2,329     $ 2,584     $ 2,507     $ 1,925                                
RJR Tobacco’s cash payments
  $ 2,247     $ 2,393     $ 2,461     $ 1,812                                
RJR Tobacco’s expected settlement expenses
                          >$ 1,800     >$ 1,900     >$ 1,900     >$ 2,100     >$ 2,100  
RJR Tobacco’s expected cash payments
                          >$ 1,900     >$ 1,800     >$ 1,900     >$ 1,900     >$ 2,100  

(1)  Subject to adjustments for changes in sales volume, inflation and other factors. All payments are to be allocated among the companies on the basis of relative market share.
(2)  Subject to adjustments for changes in sales volume, inflation and other factors.
(3)  Subject to changes in total domestic cigarette volume of participating manufacturers and inflation. Generally, payment is based on each participating manufacturer’s relative market share.

      The MSA also contains provisions restricting the marketing of cigarettes. Among these provisions are restrictions or prohibitions on the use of cartoon characters, brand-name sponsorships, brand-name non-tobacco products, outdoor and transit brand advertising, payments for product placement, free sampling and lobbying. The MSA also required the dissolution of three industry-sponsored research and advocacy organizations.

      The MSA and the other state settlement agreements have materially adversely affected RJR Tobacco’s shipment volumes. RJR believes that they may materially adversely affect the results of operations, cash flows or financial position of RJR and RJR Tobacco in future periods. The degree of the adverse impact will depend, among other things, on the rate of decline in U.S. cigarette sales in the premium and discount categories, RJR Tobacco’s share of the domestic premium and discount cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the MSA and the other state settlement agreements.

      Department of Justice Case. On September 22, 1999, the U.S. Department of Justice brought an action in the United States District Court for the District of Columbia against various industry members, including RJR Tobacco. The government sought to recover federal funds expended in providing health care to smokers who have developed diseases and injuries alleged to be smoking-related, and, in addition, seeks, pursuant to the federal Racketeer Influenced and Corrupt Organizations Act, disgorgement of profits the government contends were earned as a consequence of a RICO racketeering “enterprise.” On December 27, 1999, the

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defendants filed a motion to dismiss, challenging all counts included in the action brought by the DOJ. On June 6, 2000, the trial court heard oral argument on the motion. On September 28, 2000, Judge Gladys Kessler of the United States District Court for the District of Columbia granted the non-Liggett defendants’ motion to dismiss the plaintiff’s Medical Care Recovery Act claim and Medicare Secondary Payer claim. The court denied the motion with respect to the RICO claims.

      In June 2001, the U.S. Attorney General assembled a team of three DOJ lawyers to work on a possible settlement of the federal lawsuit. The DOJ lawyers met with representatives of the tobacco industry, including RJR Tobacco, on July 18, 2001. No settlement was reached.

      On May 23, 2003, Judge Kessler denied the defendants’ first motion for partial summary judgment, which sought legal preclusion of many aspects of the DOJ’s lawsuit regarding advertising, marketing, promotion and warning claims. The court simultaneously granted partial summary judgment for the government on certain affirmative defenses. As of July 16, 2003, the parties had completed briefing on the defendants’ motion for partial reconsideration of the May 23, 2003 order striking certain affirmative defenses, or alternatively for certification for interlocutory appeal pursuant to 28 U.S.C. § 1292(b).

      Each side filed additional summary judgment motions in the fall of 2003. The defendants as a group have now filed nine summary judgment motions, with a request for additional motions pending with the court. The government has filed six summary judgment motions, including motions regarding various affirmative defenses, including those affirmative defenses addressing the standard for seeking disgorgement under RICO. On January 23, 2004, the court granted the government’s motion for partial summary judgment on certain of defendants’ equitable defenses, including waiver, equitable estoppel, laches and unclean hands. Although the order dismissed these particular affirmative defenses, it did not address or limit the evidence that may be introduced regarding the remaining RICO claims nor did it address the applicability of the legal doctrines to issues related to equitable relief should liability be established.

      Trial is scheduled for September 13, 2004.

      Local Government Cases. Some local government entities have filed lawsuits based largely on the same theories and seeking the same relief as the state attorneys general cases. Two such cases are pending against RJR Tobacco. On August 8, 2001, in County of Cook v. Philip Morris, Inc., the Circuit Court of Cook County, Illinois, granted the defendants’ motion for judgment on the pleadings based on remoteness grounds and dismissed the plaintiffs’ complaint in its entirety. The plaintiffs appealed the dismissal to the Illinois Appellate Court, First District, on September 5, 2001. The defendants noticed a cross-appeal on September 17, 2001, from the trial court’s adverse rulings on the defendants’ motions to dismiss on the grounds of MSA release and lack of standing. Briefing has been completed, although oral argument has not been scheduled. Most recently, on November 14, 2003, plaintiff voluntarily dismissed the complaint in St. Louis County v. American Tobacco Co.

      International Cases. A number of foreign countries have filed suit in state and federal courts in the United States against RJR Tobacco and other tobacco industry defendants to recover funds for health care, medical and other assistance paid by those foreign governments to their citizens. In Marshall Islands v. American Tobacco Co., the Republic of the Marshall Islands brought a health-care cost recovery suit against RJR Tobacco and other cigarette manufacturers. On May 9, 2002, the Supreme Court of the Marshall Islands affirmed the dismissal of all claims. In Venezuela v. Philip Morris Cos., Inc., Florida’s Third District Court of Appeal affirmed the trial court’s dismissal on October 1, 2002. On October 28, 2002, Venezuela filed a notice to invoke the discretionary jurisdiction of the Florida Supreme Court to review the decision of the Third District Court of Appeal. On June 10, 2003, the Florida Supreme Court declined Venezuela’s petition for review. The court further indicated that it would not entertain a motion for rehearing. In light of the Venezuela decision, on August 25, 2003, the Circuit Court of Miami-Dade County, Florida, granted the defendants’ motion for judgment on the pleadings in two additional cases brought by foreign sovereigns — Republic of Tajikistan v. Brooke Group Ltd., Inc. and State of Tocantins, Brazil v. Brooke Group Ltd., Inc. This most recent ruling led 22 other foreign nations to voluntarily dismiss their cases.

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      Of the four international cases currently pending in the United States, one is pending in state court and three are pending in federal court. Two of the three federal court cases are pending before the Judicial Panel on Multi-District Litigation in the United States District Court for the District of Columbia. Twenty other cases are pending outside the United States, two in Israel, three in Canada, and 15 in Puerto Rico. Other foreign governments and entities have stated that they are considering filing such actions in the United States.

      On November 12, 1998, the Canadian Province of British Columbia brought a case in British Columbia Provincial Court (federally appointed), similar to the state attorneys general cases discussed above, against RJR Tobacco and certain other Canadian and U.S. tobacco companies and their parent companies, including RJR. This lawsuit depended entirely on legislation enacted in British Columbia that was separately challenged by various Canadian tobacco companies. An agreement was reached with the government in British Columbia to litigate the separate constitutional challenges prior to the health-care cost recovery action. On February 21, 2000, the British Columbia Supreme Court declared the Cost Recovery Act unconstitutional and dismissed the action. This decision was not appealed by the government. On January 24, 2001, the Canadian Province of British Columbia enacted a second and revised statute and brought a second action in the same court. A trial of the constitutionality of the second statute and a claim that the second action be dismissed was heard from November 4 through November 29, 2002. On June 5, 2003, the trial court ruled in favor of the defendants, again finding that the legislation was unconstitutional. The Province appealed this ruling. The appeal was heard before the British Columbia Court of Appeal at a five-day hearing that commenced on November 24, 2003. Judgment was reserved. Although it could be announced at any time, a decision is expected to come down some time between mid-February and mid-March 2004.

      Pursuant to the terms of the 1999 sale of RJR’s international tobacco business, Japan Tobacco Inc. assumed RJR Tobacco’s liability, if any, in the health-care cost recovery cases brought by foreign countries.

Other Health-Care Cost Recovery and Aggregated Claims Cases

      Although the MSA settled some of the most potentially burdensome health-care cost recovery actions, many other such cases have been brought by other types of plaintiffs. Unions, groups of health-care insurers, a private entity that purported to self-insure its employee health-care programs, Native American tribes, hospitals, universities and taxpayers have advanced claims similar to those found in the governmental health-care cost recovery actions. These cases largely have been unsuccessful on remoteness grounds, which means that one who pays an injured person’s medical expenses is legally too remote to maintain an action against the person allegedly responsible for the injury.

      Union Cases. Numerous trial court judges have dismissed union trust fund cases on remoteness grounds. The first and only union case to go to trial to date was Iron Workers Local No. 17 v. Philip Morris, Inc., which was tried in federal court in Ohio. On March 18, 1999, the jury returned a unanimous verdict for the defendants, including RJR Tobacco. The plaintiffs dismissed their appeal of the verdict.

      Since March 1999, the United States Courts of Appeals for the Second, Third, Fifth, Seventh, Eighth, Ninth, Eleventh and District of Columbia Circuits all have ruled in favor of the tobacco industry in similar union cases. The United States Supreme Court has denied petitions for certiorari filed by unions in cases from the Second, Third, Ninth and District of Columbia Circuits.

      As of January 23, 2004, there were no pending lawsuits by union trust funds against cigarette manufacturers and others.

      Insurance-Related Cases. As of January 23, 2004, one insurance-related case was pending against RJR Tobacco.

      On June 6, 2001, in Blue Cross and Blue Shield of New Jersey, Inc. v. Philip Morris, Inc., a federal court jury in Brooklyn returned a verdict in favor of RJR Tobacco and other tobacco defendants on common law fraud and civil RICO claims, but found for the plaintiff, Empire Blue Cross and Blue Shield, on a claim under a New York state deceptive business practices statute. Empire pursued its claims against the defendants on behalf of itself directly, as well as on behalf of its insureds under a theory of subrogation. The jury verdict on the direct claim was approximately $17.8 million, and the verdict on the subrogated claim was approximately

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$11.8 million. RJR Tobacco’s portion of these amounts is $6.6 million and $4.4 million, respectively. The New York statute under which Empire recovered does not provide for punitive damages, but does allow for recovery of reasonable attorneys’ fees. On February 28, 2002, Judge Weinstein awarded plaintiffs’ counsel approximately $38 million in attorneys’ fees. On July 2, 2002, Judge Weinstein denied the defendants’ renewed motion to dismiss. He also refused to transfer the claims of non-New York plans to their respective states, and continued the stay of those claims, as well as all remaining claims of Blue Cross Blue Shield plans, until final resolution of the Empire Blue Cross case. The defendants, including RJR Tobacco, appealed to the United States Court of Appeals for the Second Circuit. On September 16, 2003, the Second Circuit:

  •  reversed the judgment for Empire on its subrogation claim, and
 
  •  reserved ruling on Empire’s direct claim pending resolution by the New York Court of Appeals of two certified questions:

  •  Are claims by a third party payer of health care costs seeking to recover costs of services provided to subscribers as a result of those subscribers being harmed by a defendant’s or defendants’ violation of N.Y. Gen. Bus. Law § 349 too remote to permit suit under that statute?
 
  •  If such an action is not too remote to permit suit, is individualized proof of harm to subscribers required when a third party payer of health care costs seeks to recover costs of services provided to subscribers as a result of those subscribers being harmed by a defendant’s or defendants’ violation of N.Y. Gen. Bus. Law § 349?

On October 30, 2003, the New York Court of Appeals agreed to review the two certified questions. The tobacco defendants, including RJR Tobacco, filed their initial brief on January 22, 2004.

      In Group Health Plan, Inc. v. Philip Morris, Inc. and Medica v. Philip Morris, Inc., a federal district judge in Minnesota dismissed all claims, except a state antitrust claim and a state conspiracy claim. The federal court certified to the Minnesota Supreme Court the question whether these two claims could be pursued under Minnesota law by Group Health Plan. On January 11, 2001, the Minnesota Supreme Court ruled that the plaintiff could pursue these claims. Certain defendants, including RJR Tobacco, filed motions for summary judgment based on the statutes of limitation and causation, injury and damages. On January 31, 2002, summary judgment was granted in favor of certain defendants, including RJR Tobacco. Plaintiffs appealed to the United States Court of Appeals for the Eighth Circuit. Argument occurred on May 15, 2003. On September 16, 2003, the United States Court of Appeals for the Eighth Circuit upheld the dismissal of the damages claims, but remanded the cases to the trial court to consider whether injunctive relief is available. Shortly after the appeals court ruling, the plaintiffs decided to dismiss the respective cases, and, on October 21, 2003, the judge entered an order dismissing the cases with prejudice.

      Native American Tribes. Two Native American Tribe cases remain pending against RJR Tobacco. On January 25, 2002, in Navajo Nation v. Philip Morris, Inc., the District Court of Navajo Nation granted the defendants’ motion to dismiss conspiracy, deceptive acts and restraint of trade claims. The court refused to dismiss the plaintiffs’ product liability claim. In response, the plaintiffs filed a motion to alter, amend and/or clarify the January 25, 2002 order. No decision has been made by the court. One other Native American tribe case remains pending before a tribal court in South Dakota.

      Hospitals. As of January 23, 2004, two cases brought by hospitals were pending against RJR Tobacco, City of St. Louis v. American Tobacco Co., Inc., pending in the Circuit Court of the City of St. Louis, Missouri, and County of McHenry v. Philip Morris, Inc., pending in the Circuit Court of Cook County, Illinois. In May 2000, in A.O. Fox Memorial Hospital v. American Tobacco Co., Inc., pending in state court in Nassau County, New York, a group of approximately 175 hospitals filed suit against the tobacco industry seeking at least $3.6 billion for costs expended to treat smoking-related illnesses. On December 14, 2001, the defendants’ motion to dismiss was granted. The Appellate Division of the Supreme Court, Second Judicial Department affirmed the trial court’s dismissal on February 10, 2003. In March 2003, the plaintiffs asked the Court of Appeals of New York, the highest state appellate court, for permission to appeal; their petition was denied on May 13, 2003.

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      Taxpayers. On October 2, 2003, in Mason v. American Tobacco Co., the United States Court of Appeals for the Second Circuit affirmed the United States District Court for the Eastern District of New York’s ruling that granted the defendants’ motion to dismiss and denied the plaintiffs’ motion for class certification. On October 16, 2003, the plaintiffs filed a motion for rehearing by the entire Court of Appeals. That motion was denied on December 8, 2003.

MSA-Enforcement and Validity

      As of January 23, 2004, two cases were pending against RJR Tobacco concerning the enforcement and validity of the MSA.

      The litigation challenging the validity of the MSA, including claims that the MSA violates antitrust laws, has not been successful. On February 12, 2003, in Forces Action Project, LLC v. California, a case in which a smokers’ rights organization challenged the propriety of the MSA on antitrust grounds, the United States Court of Appeals for the Ninth Circuit affirmed the United States District Court for the Northern District of California’s January 5, 2000 order that granted defendants’ motion to dismiss. On January 6, 2004, in Freedom Holdings, Inc. v. Spitzer, the United States Court of Appeals for the Second Circuit reversed the dismissal of a complaint asserting an antitrust challenge to legislation adopted by New York State in furtherance of the MSA and remanded the case for further proceedings.

      Arizona, California, New York and Washington have alleged that the posting of signage advertising RJR Tobacco’s former brand-name sponsorship of the NASCAR Winston Cup Series violates a provision of the MSA governing the times during which such signs may be posted. On February 1, 2002, a New York court ruled in favor of RJR Tobacco. On April 10, 2003, the New York Court of Appeals Appellate Division, First Department, of the New York Supreme Court affirmed this ruling. On September 2, 2003, the New York Court of Appeals denied the State’s petition for review. On November 27, 2001, the trial court in California ruled against RJR Tobacco. On March 27, 2003, the California Court of Appeal affirmed the trial court’s ruling against RJR Tobacco. On June 25, 2003, the California Supreme Court denied RJR Tobacco’s petition for review. On November 16, 2001, the Arizona trial court ruled against RJR Tobacco. On September 9, 2003, the Arizona Court of Appeals affirmed the trial court’s ruling. The Washington matter was rendered moot and was dismissed. RJR Tobacco ended its sponsorship of the NASCAR Winston Cup Series at the end of the 2003 season, so it will not pursue any further appeals of these cases.

      The State of Ohio alleged that RJR Tobacco’s purchase of advertising space on matchbooks distributed by an independent third party violates a provision of the MSA governing brand-name merchandise. On April 25, 2002, the Franklin County Common Pleas Court ruled in favor of RJR Tobacco. The state appealed the decision to the Ohio Court of Appeals, Tenth Appellate District, which, on March 31, 2003, reversed the trial court’s decision. RJR Tobacco appealed to the Ohio Supreme Court, which accepted RJR Tobacco’s petition on September 10, 2003. Briefing is ongoing and a date for oral argument has not been set.

      Finally, the State of California alleged, in the context of the placement of print advertising, that RJR Tobacco is in violation of the prohibition in the MSA against taking any action, “directly or indirectly, to target youth.” In a decision issued on July 12, 2002, the trial judge found that “although youth may not have been directly targeted ... RJR indirectly targeted youth, thereby violating the MSA.” In addition, the judge issued a $20 million fine. RJR Tobacco appealed this ruling to the California Court of Appeal, Fourth Appellate District. Oral argument was heard on December 9, 2003, and a decision is pending.

Asbestos Contribution Cases

      As of January 23, 2004, seven lawsuits were pending against RJR Tobacco in which asbestos companies and/or asbestos-related trust funds allege that they “overpaid” claims brought against them to the extent that tobacco use, not asbestos exposure, was the cause of the alleged personal injuries for which they paid compensation. On May 24, 2001, a Mississippi state court judge dismissed all such claims by Owens-Corning in Estate of Ezell Thomas v. RJR Tobacco Co. Owens-Corning appealed the dismissal to the Mississippi Supreme Court on August 15, 2001. Oral argument was heard on October 1, 2003. A decision is pending. A similar case, H.K. Porter Co., Inc. v. American Tobacco Co., was pending in the United States District Court

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for the Eastern District of New York before Judge Weinstein. However, on July 26, 2001, the parties stipulated to a dismissal of the action. In Fibreboard Corp. v. R. J. Reynolds Tobacco Co., a case pending in state court in California, Owens-Corning and Fibreboard asserted the same claims as those asserted in the Mississippi case. Motions to dismiss those claims have been held in abeyance pending the final determination of the Mississippi case.

Antitrust Cases

      A number of tobacco wholesalers, as well as indirect purchasers, have sued U.S. cigarette manufacturers, including RJR Tobacco, and its parent company, RJR, in federal and state courts, alleging that cigarette manufacturers combined and conspired to set the price of cigarettes, in violation of antitrust statutes and various state unfair business practices statutes. In these cases, the plaintiffs ask the court to certify the lawsuits as class actions on behalf of other persons who purchased cigarettes directly from one or more of the defendants. The federal cases against RJR Tobacco were consolidated and sent by the Judicial Panel on Multi-District Litigation for pretrial proceedings in the United States District Court for the Northern District of Georgia. The court certified a class of direct purchasers on January 27, 2001. The court granted the defendants’ motion for summary judgment in the consolidated federal cases on July 11, 2002, and the United States Court of Appeals for the Eleventh Circuit affirmed that decision on September 22, 2003. As of January 23, 2004, all state court cases on behalf of indirect purchasers have been dismissed, except for two which are pending in Kansas and New Mexico. The Kansas court granted class certification on November 15, 2001, while the New Mexico court granted class certification on April 11, 2003, and certified that decision for interlocutory appeal on June 24, 2003.

      On July 30, 1999, Cigarettes Cheaper!, a retailer, filed an antitrust counterclaim against RJR Tobacco in a gray market trademark suit originally brought by RJR Tobacco in the United States District Court for the Northern District of Illinois. Cigarettes Cheaper! alleges that it was denied promotional resources in violation of the Robinson-Patman Act. The District Court declined to dismiss the counterclaim. On January 23, 2001, the court granted Cigarettes Cheaper!’s motion to amend its counterclaim to include a violation of Section 1 of the Sherman Antitrust Act, claiming that RJR Tobacco conspired with other retailers to deny promotions to Cigarettes Cheaper!, an allegation that RJR Tobacco denies. On March 21, 2001, RJR Tobacco’s motion to add a trademark dilution claim against Cigarettes Cheaper! was granted. On June 28, 2001, the court granted RJR Tobacco’s motion to strike with prejudice several of Cigarettes Cheaper!’s affirmative defenses. These defenses related to:

  •  alleged misrepresentations caused by the packaging of cigarettes manufactured by RJR Tobacco for export;
 
  •  RJR Tobacco’s “No Bull” advertising campaign for its Winston cigarettes;
 
  •  antitrust trademark misuse;
 
  •  nominative fair use; and
 
  •  the first sale doctrine.

On June 25, 2003, the court granted RJR Tobacco’s motion for summary judgment on Cigarettes Cheaper!’s counterclaim alleging an illegal conspiracy under the Sherman Antitrust Act, but denied the motion with respect to the counterclaims alleging price discrimination under the Robinson-Patman Act. Trial on RJR Tobacco’s trademark claims and the remaining antitrust counterclaims began on January 12, 2004. The court declared a mistrial on January 13, 2004 because of inappropriate opening statements by Cigarettes Cheaper!’s counsel. The court has not set a new trial date.

      On February 16, 2000, a class-action complaint, Deloach v. Philip Morris Cos., Inc., was filed against RJR Tobacco, other cigarette manufacturers and others, in the United States District Court for the District of Columbia on behalf of a putative class of all tobacco growers and tobacco allotment holders. The plaintiffs assert that the defendants, Philip Morris, Inc., RJR Tobacco, Brown & Williamson Tobacco Corp. and Lorillard Tobacco Co., engaged in bid-rigging of American burley and flue-cured tobacco auctions beginning

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at least by 1996 and continuing to present. The defendants’ actions are alleged to have held the auction prices of tobacco at artificially low prices resulting in damage to tobacco growers and allotment holders. In addition, the plaintiffs allege that the defendants have engaged in a conspiracy to force the elimination or destruction of the federal government’s tobacco quota and price support program through an alleged illegal group boycott. On October 9, 2000, the defendants filed a motion to dismiss the second amended complaint and a motion to transfer venue to the United States District Court for the Middle District of North Carolina. On November 30, 2000, the court granted the motion to transfer the case. On December 20, 2000, the plaintiffs moved to amend the complaint to add the leaf-buying companies Dimon, Universal Leaf and Standard Commercial as the defendants, which motion was allowed. The plaintiffs’ motion to certify the class was granted on April 3, 2002. On April 16, 2002, RJR Tobacco and the other defendants petitioned the United States Court of Appeals for the Fourth Circuit to review the class certification ruling. On June 12, 2002, the Fourth Circuit declined to review the class certification ruling, and on July 8, 2002, the court denied a petition for rehearing. In May 2003, the plaintiffs and all defendants but RJR Tobacco entered into a class-wide settlement which was approved by Judge Osteen on October 1, 2003. The case continues against RJR Tobacco. Discovery has now been completed and dispositive motions have been filed by RJR Tobacco, but not yet argued. Trial has been set for April 19, 2004.

      On December 4, 2002, in Leslie H. Dial Ent., Inc. v. R. J. Reynolds Tobacco Co., Leslie H. Dial Enterprises, Inc. sued RJR Tobacco, Wal-Mart Stores, Inc. and Sam’s Club in the United States District Court for the District of South Carolina. The suit alleges that RJR Tobacco violated the Robinson-Patman Act by “refusing to allow” Dial, the operator of four small grocery stores, to participate in RJR Tobacco promotional programs and by not making RJR Tobacco promotional programs available to Dial on terms proportionately equal to those offered other retailers. The suit also alleges that RJR Tobacco conspired with Wal-Mart Stores and Sam’s Club to reduce competition in the sale of cigarettes in violation of Section 1 of the Sherman Antitrust Act and South Carolina civil conspiracy law. In addition, the complaint charges that RJR Tobacco has violated the South Carolina Unfair Trade Practices Act allegedly by denying promotional services and facilities to Dial that were offered to other retailers. The suit seeks unspecified damages. The plaintiff has requested a bench trial. RJR Tobacco has answered the complaint and asserted a number of defenses. On September 3, 2003, the court granted the plaintiff’s motion to file an amended complaint, the purpose of which is to name Sam’s East, Inc. as a defendant. Discovery is currently underway and, with the exception of expert discovery, must be completed by March 31, 2004. Trial is scheduled for November 1, 2004.

      On January 31, 2003, in Smith Wholesale Co., Inc. v. R. J. Reynolds Tobacco Co., Smith Wholesale Company, Inc. sued RJR Tobacco under the federal antitrust laws in the United States District Court for the Eastern District of Tennessee in connection with RJR Tobacco’s termination of Smith’s RJR Tobacco distribution agreement consistent with its terms. That same day, Smith moved for an order to prevent RJR Tobacco from terminating Smith’s agreement. The court granted Smith’s motion on February 7, 2003, and required RJR Tobacco to reinstate Smith’s contract. Prior to the court’s order that day, RJR Tobacco terminated its distribution agreement with Rice Wholesale Company, Inc. consistent with the terms of the distribution agreement. On February 18, 2003, Smith moved to amend its complaint to add Rice as a plaintiff and allege similar claims on behalf of Rice, a motion the court immediately granted, and Rice filed a motion for a preliminary injunction to prevent RJR Tobacco from terminating it. The court granted Rice’s motion on March 4, 2003. RJR Tobacco appealed the court’s February 7 order on February 11, 2003, and its March 4 order on March 6, 2003. On April 1, 2003, the United States Court of Appeals for the Sixth Circuit granted RJR Tobacco’s motion to consolidate the appeals and expedite oral argument. The parties have completed briefing the appeal and had oral argument on September 12, 2003. No decision on the appeal has been issued to date. In the meantime, on June 10, 2003, nine other wholesalers joined the lawsuit, and ten of the 11 plaintiffs filed another motion for a preliminary injunction, this time asking the federal district court to enjoin RJR from implementing amendments to its distribution agreements that were scheduled to become effective on June 30, 2003. A hearing on this motion was held on July 24, 2003, and the district court issued an order granting the motion on August 6, 2003. (Prior to issuing its decision, the district court granted the State of Tennessee’s motion to intervene as a plaintiff on July 3, 2003, and the State of Mississippi’s motion to intervene as a plaintiff on July 14, 2003.) RJR Tobacco appealed to the United States Court of Appeals for

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the Sixth Circuit on August 8, 2003. Briefing is complete. Oral argument has not been scheduled. On September 24, 2003, the district court granted RJR Tobacco’s emergency motion for a stay of the August 6, 2003 order, pending RJR Tobacco’s appeal. Plaintiffs subsequently filed a fourth amended complaint to add nine new plaintiffs, bringing the total of private plaintiffs to 20. Fact discovery is scheduled to close on August 13, 2004, with expert discovery to be completed by September 15, 2004. Trial is set to begin on November 30, 2004.

Other Litigation and Developments

      On December 10, 2003, the Attorney General of Vermont issued a civil subpoena to RJR Tobacco, asserting that he had “reason to believe that R. J. Reynolds Tobacco Company ha[d] engaged in unfair and deceptive acts and practices ... by publishing false or misleading claims about its product, Eclipse brand cigarettes, by failing to disclose material facts and/or by otherwise engaging in deceptive or unfair practices in marketing and selling Eclipse brand cigarettes.” The Vermont Attorney General indicated that his office was “working cooperatively with the offices of the attorneys general of California, Connecticut, Maine and New York ....” At this time, no lawsuit or enforcement action relating to Eclipse has been filed against RJR Tobacco in any of these five states. RJR Tobacco has obtained an extension of time for filing its response to the subpoena.

      On July 3, 2003, the Securities and Exchange Commission, referred to as the SEC, issued a subpoena to RJR pursuant to a formal order of investigation of potential violations of the securities laws. The subpoena, and discussions to date with the SEC staff, focus on whether the disclosure of specific amounts of certain expenses of RJR should have been quantified separately rather than aggregated with other expense items. RJR is endeavoring to cooperate with the SEC in a way that protects its rights. On August 14, 2003, the SEC filed, in the United States District Court for the District of Columbia, an Application for an order to show cause and an order requiring obedience to subpoena duces tecum. On August 29, 2003, RJR filed, in the same court, a motion for a protective order and its opposition to the SEC’s application for an order to show cause. As of October 11, 2003, both the SEC’s application and RJR’s motion for a protective order have been fully briefed and are pending before the court. Oral argument on these matters was heard on January 8, 2004. RJR is unable to predict the outcome of this investigation.

      On January 24, 2003, RJR and RJR Tobacco were each served with a subpoena issued by a federal grand jury sitting in the Southern District of New York. The subpoena seeks the production of documents relating to the sale and distribution of cigarettes in international markets. RJR and RJR Tobacco have been responding and will continue to respond appropriately to the subpoena and otherwise cooperate with this grand jury investigation.

      RJR Tobacco is aware of a grand jury investigation in North Carolina that is related to the cigarette business of certain of its former affiliates. In connection with this investigation, RJR Tobacco responded to document subpoenas dated July 7, 1999 and June 1, 2000, respectively. On January 20, 2004, RJR and RJR Tobacco were informed by the government that the investigation is now closed.

      On December 22, 1998, Northern Brands International, Inc., referred to as Northern Brands, entered into a plea agreement with the United States Attorney for the Northern District of New York. Northern Brands is a now-inactive RJR subsidiary that was part of the business of R. J. Reynolds International B.V., a former Netherlands subsidiary of RJR Tobacco, which was managed by a former affiliate, RJR-MacDonald, Inc., referred to as RJR-MI. On May 12, 1999, RJR-MI was sold to Japan Tobacco Inc. and subsequently changed its name to JT-MacDonald, Corp. Northern Brands was charged with aiding and abetting certain customers who brought merchandise into the United States “by means of false and fraudulent practices ....” It is understood that, at all relevant times over the past several years, JT-MacDonald, Corp., Japan Tobacco’s international operating company in Canada, cooperated with an investigation conducted by the Royal Canadian Mounted Police, referred to as RCMP, relating to the same events that gave rise to the Northern Brands investigation. On or about February 27, 2003, the RCMP filed criminal charges against and served summonses on JT-MacDonald, Corp., Northern Brands, R.J. Reynolds Tobacco International, Inc., referred to as RJR-TI, R. J. Reynolds Tobacco Co. (Puerto Rico), referred to as RJR-PR, and eight individuals

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associated with RJR-MI and/or RJR-TI during the period January 1, 1991 through December 31, 1996. The charges filed are for alleged fraud and conspiracy to defraud Canada and the Provinces of Ontario and Quebec in connection with the purchase, sale, export, import and/or re-export of cigarettes and/or fine cut tobacco. Although the international business was sold, RJR and RJR Tobacco retained certain liabilities relating to the Northern Brands guilty plea and the RCMP’s investigation of the activities that led to the plea. In October 2003, Northern Brands, RJR-TI and RJR-PR filed an application challenging both the propriety of the service of the summons on each of them as well as the jurisdiction of the Canadian court over each of them. A hearing on the application was held in December 2003 and the decision of the court is still pending, but is likely to be announced in early 2004.

      On September 18, 2003, RJR, RJR Tobacco, RJR-TI, RJR-PR, and Northern Brands were served with a statement of claim filed by the Attorney General of Canada in the Superior Court of Justice, Ontario, Canada. Also named as defendants are Japan Tobacco, Inc. and a number of its affiliates. The statement of claim seeks to recover under various legal theories taxes and duties allegedly not paid as a result of cigarette smuggling and related activities. The Attorney General is seeking to recover $1.5 billion in compensatory damages and $50 million in punitive damages, as well as equitable and other forms of relief.

      Over the past few years, several civil lawsuits have been filed against RJR Tobacco and its affiliates, along with other cigarette manufacturers, by the European Community and the following ten member states: Belgium, Finland, France, Greece, Germany, Italy, Luxembourg, the Netherlands, Portugal and Spain; as well as by Ecuador, Belize, and Honduras. These suits contend that RJR Tobacco and other tobacco companies in the United States may be held responsible variously under the federal RICO statute, the common law and other legal theories for taxes and duties allegedly unpaid as a result of cigarette smuggling. Each of these actions, which are discussed below, seeks compensatory, punitive and treble damages.

      On July 17, 2001, the action brought by the European Community was dismissed by the United States District Court for the Eastern District of New York. However, the European Community and its member states filed a similar complaint in the same jurisdiction on August 6, 2001. On October 25, 2001, the court denied the European Community’s request of August 10, 2001, to reinstate its original complaint. On November 9, 2001, the European Community and the ten member states amended their complaint filed on August 6, 2001, to change the name of defendant Nabisco Group Holdings Corp. to RJR Acquisition Corp. RJR Tobacco and the other defendants filed motions to dismiss that complaint on November 14, 2001, and the court heard oral argument on those motions on January 11, 2002. On February 25, 2002, the court granted the defendants’ motion to dismiss the complaint and, on March 25, 2002, the plaintiffs filed a notice of appeal with the United States Court of Appeals for the Second Circuit. On January 14, 2004, the Second Circuit affirmed the dismissal of the case.

      On October 30, 2002, the European Community and the following ten member states, Belgium, Finland, France, Greece, Germany, Italy, Luxembourg, the Netherlands, Portugal and Spain, filed a third complaint against RJR, RJR Tobacco and several currently and formerly related companies in the United States District Court for the Eastern District of New York. The complaint, which contains many of the same or similar allegations found in two earlier complaints that were previously dismissed by the same court, alleges that the defendants, together with certain identified and unidentified persons, including organized crime organizations and drug cartels, engaged in money laundering and other conduct for which they should be accountable to the plaintiffs under civil RICO and a variety of common law claims. The complaint also alleges that the defendants manufactured cigarettes, which were eventually sold in Iraq in violation of U.S. sanctions against such sales. The plaintiffs are seeking unspecified actual damages (to be trebled), costs, reasonable attorneys’ fees and injunctive relief under their RICO claims, and unspecified compensatory and punitive damages, and injunctive and equitable relief under their common law claims.

      On December 20, 2000, October 15, 2001, and January 9, 2003, applications for annulment were filed in the Court of First Instance in Luxembourg challenging the competency of the European Community to bring each of the foregoing actions and seeking an annulment of the decision to bring each of the actions, respectively. On January 15, 2003, the Court of First Instance entered a judgment denying the admissibility of the first two applications, principally on the grounds that the filing of the first two complaints did not impose

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binding legal effects on the applicants. On March 21, 2003, RJR and its affiliates appealed that judgment to the Court of Justice of the European Communities. The application for annulment filed in connection with the third action is still pending before the Court of First Instance. On September 18, 2003, however, the Court of First Instance stayed the proceedings in the third action, pending resolution of the appeals from the January 15, 2003 judgment denying the admissibility of the first two applications.

      RJR Tobacco and other defendants filed motions to dismiss the civil RICO actions seeking to recover taxes and revenues allegedly lost as a result of cigarette smuggling and related activities brought by Ecuador, Belize and Honduras in the United States District Court for the Southern District of Florida. These motions were granted on February 26, 2002, and the plaintiffs filed a notice of appeal with the United States Court of Appeals for the Eleventh Circuit on March 26, 2002. On August 14, 2003, the Eleventh Circuit announced its decision affirming the dismissal of the cases. On January 12, 2004, the Supreme Court of the United States announced that it had declined to review the decision of the Eleventh Circuit.

      RJR Tobacco has been served in two reparations actions brought by descendants of slaves. Plaintiffs in these actions claim that defendants, including RJR Tobacco, profited from the use of slave labor. These two actions have been transferred to Judge Norgle in the Northern District of Illinois by the Judicial Panel on Multi-District Litigation for coordinated or consolidated pretrial proceedings with other reparation actions. Seven additional cases were originally filed in California, Illinois and New York. RJR Tobacco is a named defendant in only one of these additional cases, but it has not been served. The action in which RJR Tobacco is named but has not been served was conditionally transferred to the Northern District of Illinois on January 7, 2003, but the plaintiffs contested that transfer, and the Judicial Panel on Multi-District Litigation has not yet issued a final ruling on the transfer. The plaintiffs filed a consolidated complaint on June 17, 2003. On July 18, 2003, the defendants moved to dismiss plaintiffs’ complaint. That motion was granted on January 26, 2004. The plaintiffs might seek to file an amended complaint or appeal the dismissal to the United States Court of Appeals for the Seventh Circuit.

      On June 8, 2001, the Attorney General of the State of California filed a lawsuit against RJR Tobacco in California state court alleging that RJR Tobacco violated California state law by distributing free cigarettes and free coupons for discounts on cigarettes on “public grounds,” even though the promotions occurred within an “adult-only facility” at a race track and certain festivals. RJR Tobacco answered the complaint on July 19, 2001, asserting that its promotions complied with all laws, including California state law and that this California state law is preempted by the Federal Cigarette Labeling and Advertising Act. On March 29, 2002, the court ruled that RJR Tobacco’s distribution of free cigarettes violated the law, but the distribution of free coupons for discounts on cigarettes did not. On April 29, 2002, the judge assessed a civil fine against RJR Tobacco of $14.8 million. On October 30, 2003, the California Court of Appeal, Second Appellate District, affirmed the trial court’s decision. On December 8, 2003, RJR Tobacco filed its petition for review with the California Supreme Court.

      On May 23, 2001, Star Scientific, Inc., referred to as Star, filed a patent infringement action against RJR Tobacco in the United States District Court for the District of Maryland. The suit alleges infringement of U.S. Patent No. 6,202,649 entitled “Method of Treating Tobacco to Reduce Nitrosamine Content, and Products Produced Thereby.” On July 30, 2002, Star filed another infringement action against RJR Tobacco in the United States District Court for the District of Maryland alleging infringement of a related patent, U.S. Patent No. 6,425,401 also entitled “Method of Treating Tobacco to Reduce Nitrosamine Content, and Products Produced Thereby.” RJR Tobacco has filed counterclaims seeking a declaration that the claims of the two Star patents in dispute are invalid, unenforceable and not infringed by RJR Tobacco. The Maryland court consolidated the two cases. No trial date has been set. Both sides have filed motions for summary judgment. On August 28, 2003, the court held a hearing on the pending motions, and heard oral arguments. On September 15, 2003, the court appointed a special master to issue a report and recommendation on certain of the pending motions by December 15, 2003. On December 4, 2003, the special master issued a report and recommendation regarding Star’s motion for claim construction and summary judgment on definiteness. On December 23, 2003, the special master issued a report and recommendation regarding RJR Tobacco’s motion for summary judgment that RJR Tobacco has not infringed the patents in the case. RJR Tobacco anticipates that the special master will issue reports and recommendations on the remaining four motions assigned to him,

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all of which are summary judgment motions filed by RJR Tobacco, in the near future. The order of reference to the special master includes a briefing schedule so that both sides have an opportunity to submit objections to each of the special master’s reports and recommendations.


      Although RJR’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates, when viewed on an individual basis, is not probable, the possibility of material losses related to tobacco litigation is more than remote. Litigation is subject to many uncertainties, and it is not possible to predict the outcome of the litigation pending against RJR Tobacco, or its affiliates, including RJR, or indemnitees.

      Unfavorable judgments awarding compensatory damages, punitive damages and/or fines have been returned against RJR Tobacco in the Engle class-action case, which was reversed by the intermediate appellate court on May 21, 2003, a small number of individual smoking and health cases, a Broin II flight attendant ETS case, an insurance-related action, an MSA enforcement action and a California state law enforcement action. Although RJR Tobacco believes that it has numerous bases for successful appeals in these cases, and both RJR Tobacco and RJR believe they have a number of valid defenses to all actions, and intend to defend all actions vigorously, it is possible that there could be further adverse developments in these cases, and that additional cases could be decided unfavorably against RJR Tobacco or its affiliates or indemnitees. Determinations of liability or adverse rulings in such cases or in similar cases involving other cigarette manufacturers as defendants, even if such judgments are not final, could materially adversely affect the litigation against RJR Tobacco or its affiliates or indemnitees, and could encourage the commencement of additional tobacco-related litigation. In addition, a number of political, legislative, regulatory and other developments relating to the tobacco industry and cigarette smoking have received wide media attention. These developments may negatively affect the outcomes of tobacco-related legal actions and encourage the commencement of additional similar litigation.

      Although it is impossible to predict the outcome of such events on pending litigation and the rate new lawsuits are filed against RJR Tobacco and RJR, a significant increase in litigation and/or in adverse outcomes for tobacco defendants could have a material adverse effect on either or both of these entities. Moreover, notwithstanding the quality of defenses available to it and its affiliates in litigation matters, it is possible that RJR’s results of operations, cash flows or financial condition could be materially adversely affected by the ultimate outcome of certain pending litigation matters.

ERISA Litigation

      On May 13, 2002, in Tatum v. The RJR Pension Investment Committee of the R. J. Reynolds Tobacco Company Capital Investment Plan, pending in the United States District Court for the Middle District of North Carolina, an employee of RJR Tobacco filed a class-action suit alleging that the defendants, RJR, RJR Tobacco, the RJR Employee Benefits Committee and the RJR Pension Investment Committee violated the Employee Retirement Income Security Act of 1974, referred to as ERISA. The actions about which the plaintiff complains stem from a decision made in 1999 by RJR Nabisco Holdings Corp., subsequently renamed Nabisco Group Holdings Corp., to spin off RJR, thereby separating NGH’s tobacco business and food business. As part of the spin-off, the 401(k) plan for the previously related entities had to be divided into two separate plans for the now separate tobacco and food businesses. The plaintiff contends that the defendants violated ERISA by not overriding an amendment to RJR’s 401(k) plan requiring that, prior to February 1, 2000, the stock funds of the companies involved in the food business — NGH and Nabisco Holdings Corp. — be eliminated as investment options from RJR’s 401(k) plan. In his complaint, the plaintiff requests, among other things, that the court issue an order requiring the defendants to pay as damages to the RJR 401(k) plan an amount equal to the subsequent appreciation that was purportedly lost as a result of the liquidation of the NGH and Nabisco Holdings Corp. funds. On July 29, 2002, defendants filed a motion to dismiss, which the court granted on December 10, 2003. On January 7, 2004, the plaintiff appealed to the United States Court of Appeals for the Fourth Circuit.

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Environmental Matters

      RJR and its subsidiaries are subject to federal, state and local environmental laws and regulations concerning the discharge, storage, handling and disposal of hazardous or toxic substances. Such laws and regulations provide for significant fines, penalties and liabilities, sometimes without regard to whether the owner or operator of the property knew of, or was responsible for, the release or presence of hazardous or toxic substances. In addition, third parties may make claims against owners or operators of properties for personal injuries and property damage associated with releases of hazardous or toxic substances. In the past, RJR Tobacco has been named a potentially responsible party, referred to as a PRP, with third parties under the Comprehensive Environmental Response, Compensation and Liability Act, with respect to several superfund sites.

      Regulations promulgated by the U.S. Environmental Protection Agency and other governmental agencies under various statutes have resulted in, and likely will continue to result in, substantial expenditures for pollution control, waste treatment, plant modification and similar activities. RJR and its subsidiaries monitor their environmental matters and, dependent upon the probability of occurrence and reasonable estimation of cost, accrue or disclose any material liability.

      Del Monte Corporation, a former subsidiary of RJR, is named a defendant in a lawsuit related to a superfund site in Hawaii, Akee v. The Dow Chemical Co., filed in the First Circuit Court of the State of Hawaii on October 7, 1999. The superfund site includes land on which Del Monte Corporation maintained fresh fruit operations at one time. In connection with litigation related to the superfund site, Del Monte Corporation also has received a demand for indemnity from an entity that was a chemical supplier to Del Monte Corporation. Del Monte Corporation has sought indemnity from RJR under the terms of the agreement by which RJR sold Del Monte Corporation in 1990. RJR, in turn, has provided notice of these claims to the buyers of the Del Monte fresh fruit business, asserting the right to be indemnified by the buyers of the fresh fruit business for any liability arising out of such claims under the terms of the agreement by which RJR sold the Del Monte fresh fruit business in 1989.

      Pursuant to an agreement dated June 12, 2001, among RJR, the buyers of the Del Monte fresh fruit business, Del Monte Corporation and others, the buyers of the Del Monte fresh fruit business agreed, from the date of the agreement forward, to indemnify RJR for any liabilities imposed in Akee and with respect to the environmental investigation and remediation of the superfund site required by the EPA.

      On June 1, 2001, RJR received notice from Del Monte Corporation of a claim made against it by a Hawaii landowner who has been sued by a lessee of its land, claiming injuries due to pesticide contamination of the soil, allegedly caused by Del Monte Corporation as a prior lessee of the land. The landowner-defendant has tendered the claim to Del Monte Corporation for defense and indemnity. Del Monte Corporation has in turn tendered the claim to RJR for defense and indemnity, claiming it is entitled to be indemnified under the terms of the agreement by which RJR sold Del Monte Corporation. Based on the plaintiff’s failure to provide any factual information in support of its claim that Del Monte Corporation was a prior lessee of the subject land, Del Monte Corporation has agreed to extend indefinitely the period during which RJR must respond to Del Monte Corporation’s tender of the claim to RJR for defense and indemnity, subject to the right to terminate the indefinite extension on 15 days’ notice to RJR.

      RJR Tobacco was notified by the EPA on June 11, 2000, of its potential liability under CERCLA for a superfund site in Greer, South Carolina. The notice and demand for reimbursement of costs incurred by the EPA were sent to a group of approximately 43 potentially responsible parties, including RJR Tobacco, and involve an aggregate exposure presently estimated to be approximately $5.1 million. Apportionment among the PRPs has not been completed, but RJR Tobacco believes that its apportionment will be immaterial to its results of operations, cash flows or financial condition. The PRPs are a group of companies previously involved as potentially responsible parties in another superfund site. The EPA alleges that some waste from the cleanup of the other site was transported to the site in question. RJR Tobacco has executed and extended a tolling agreement with the EPA. This tolling agreement provides for entry into good faith negotiations with the EPA, and is not an admission of fact or liability. The tolling agreement also should have no impact on any defense RJR Tobacco may assert, other than a defense based on the running of the statute of limitations. Information

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is being gathered from other potentially responsible parties notified by the EPA and an environmental consultant working on behalf of the PRP group, which includes RJR Tobacco.

      RJR Tobacco is a named defendant in a lawsuit related to an existing superfund site in North Carolina, United States v. AAF-McQuay, Inc., which was filed in United States District Court for the Western District of North Carolina on August 12, 2002. The “Jadco-Hughes” superfund site near Belmont, North Carolina, is land on which a solvent reclamation and disposal business was owned and operated in the 1970s. It was placed on the National Priorities List in 1986. RJR Tobacco, through its former packaging division (now a wholly owned subsidiary known as RJR Packaging, LLC), as a member of a group of 24 previously identified PRPs, executed a waiver of service of summons in this matter. A joint motion of plaintiff and all defendants for an extension of the stay of all proceedings and for an extension of time for all defendants to file answers or responses to the complaint was again granted on November 12, 2003. EPA filed the action as a result of the expiration of a then-existing tolling agreement that could not be timely renewed. The PRP group had requested information from the EPA regarding various EPA costs related to the Jadco-Hughes site. The parties are cooperating to seek a resolution of this matter. The aggregate exposure for the Jadco-Hughes site for all PRPs is presently approximately $9.2 million. Currently, RJR Tobacco’s apportionment among the PRPs of the costs associated with the remediation of the sites is approximately 32%.

      RJR and its subsidiaries have been engaged in a continuing program to comply with federal, state and local environmental laws and regulations. Although it is difficult to reasonably estimate the portion of capital expenditures or other costs attributable to compliance with environmental laws and regulations and to estimate the cost of resolving these CERCLA matters, RJR does not expect such expenditures or other costs to have a material adverse effect on the business, results of operations or financial condition of RJR or its subsidiaries.

Other Contingencies

      Until the acquisition by merger by Philip Morris Companies, Inc. of Nabisco from NGH on December 11, 2000, NGH and Nabisco were members of the consolidated group of NGH for U.S. federal income tax purposes. Each member of a consolidated group is jointly and severally liable for the U.S. federal income tax liability of other members of the group as well as for pension and funding liabilities of the other group members. NGH, now known as RJR Acquisition Corp., continues to be jointly and severally liable for these Nabisco liabilities prior to December 11, 2000.

      In connection with Philip Morris’s acquisition by merger of Nabisco and RJR’s subsequent acquisition by merger of NGH, Philip Morris, Nabisco and NGH entered into a voting and indemnity agreement that generally seeks to allocate tax liabilities ratably based upon NGH’s taxable income and that of Nabisco, had the parties been separate taxpayers. If Philip Morris and Nabisco are unable to satisfy their obligations under this agreement, NGH would be responsible for satisfying them.

      In connection with the sale of the international tobacco business to Japan Tobacco Inc. on May 12, 1999, RJR and RJR Tobacco agreed to indemnify Japan Tobacco against

  •  any liabilities, costs and expenses arising out of the imposition or assessment of any tax with respect to the international tobacco business arising prior to the sale, other than as reflected on the closing balance sheet;
 
  •  any liabilities, costs and expenses that Japan Tobacco or any of its affiliates, including the acquired entities, may incur after the sale in respect of any of RJR’s or RJR Tobacco’s employee benefit and welfare plans; and
 
  •  any liabilities, costs and expenses incurred by Japan Tobacco or any of its affiliates arising out of certain activities of Northern Brands.

Although it is impossible to predict the outcome of the Northern Brands litigation or the amount of liabilities, costs and expenses, a significant adverse outcome regarding any of these items could have an adverse effect on either or both of RJR and RJR Tobacco.

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      RJR Tobacco has entered into agreements to indemnify certain distributors and retailers from liability and related defense costs arising out of the sale or distribution of RJR Tobacco’s products. The cost of such defense indemnification has been, and is expected to be, insignificant. RJR Tobacco believes that the indemnified claims are substantially similar in nature and extent to the claims that RJR Tobacco is already exposed to by virtue of its having manufactured those products. For further information related to these guarantees, including probability and estimates of loss, see “— Litigation Affecting the Cigarette Industry — Accounting for Tobacco-Related Litigation Contingencies.”

      As long as RJR’s unsecured, unsubordinated debt rating remains either one level below BBB- by Standard & Poor’s or Baa3 by Moody’s, any fair value that results in a liability position of the interest rate swaps will require full collateralization with cash or securities.

Employees

      At December 31, 2003, RJR and its subsidiaries had approximately 6,600 full-time employees, 400 part-time employees and 1,100 employees receiving severance benefits as a result of the 2002 and 2003 restructuring plans. None of these employees are unionized. Employee relations are believed to be good.

 
Item 2.  Properties

      RJR’s executive offices are located in two buildings in downtown Winston-Salem, North Carolina, which are owned by RJR Tobacco. For information about RJR Tobacco’s operating facilities see “Business — Manufacturing” and “Business — Research and Development” in Item 1.

 
Item 3.  Legal Proceedings

      Various legal actions, proceedings and claims, including legal actions claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RJR’s operating subsidiaries’ products, are pending or may be instituted against RJR or its affiliates, including RJR Tobacco, or indemnitees. For a further discussion of these legal actions, proceedings and claims and other litigation and legal proceedings pending against RJR or its affiliates or indemnitees, see “Business — Litigation Affecting the Cigarette Industry,” “Business — ERISA Litigation” and “Business — Environmental Matters” in Item 1; “— Critical Accounting Policies and Recent Accounting Developments” and “— Governmental Activity” in “Management’s Discussion and Analysis of Financial Condition and Results of Operations”; note 14 to the consolidated financial statements; and Exhibit 99.1 to this report. You may request a copy of Exhibit 99.1, free of charge, by writing to the Corporate Secretary, R.J. Reynolds Tobacco Holdings, Inc., P.O. Box 2866, 401 N. Main Street, Winston-Salem, NC 27402-2866, or by phoning 336-741-5162.

 
Item 4.  Submission of Matters to a Vote of Security Holders

      None.

PART II

 
Item 5.  Market for Registrant’s Common Equity and Related Stockholder Matters

      RJR’s common stock, par value $.01 per share, is listed on the NYSE as RJR and began trading on June 15, 1999. On January 23, 2004, there were approximately 26,000 holders of record of RJR’s common stock. Stockholders whose shares are held of record by a broker or clearing agency are not included in this amount; however, each of those brokers or clearing agencies is included as one holder of record. The closing price of RJR’s common stock on February 6, 2004 was $59.49.

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      The high and low sales prices per share for RJR’s common stock on the NYSE Composite Tape, as reported by the NYSE, were:

                   
High Low


2003:
               
 
First Quarter
  $ 47.32     $ 31.13  
 
Second Quarter
    38.77       27.52  
 
Third Quarter
    40.54       31.10  
 
Fourth Quarter
    60.14       39.80  
 
2002:
               
 
First Quarter
  $ 67.15     $ 56.02  
 
Second Quarter
    71.90       50.38  
 
Third Quarter
    60.40       39.20  
 
Fourth Quarter
    44.60       34.83  

      From the third quarter of 1999 through the second quarter of 2001, RJR’s board of directors declared a quarterly cash dividend of $0.775 per common share, or $3.10 on an annualized basis. Beginning with the third quarter of 2001, the board of directors declared a quarterly cash dividend of $0.875 per common share, or $3.50 on an annualized basis, an increase of 12.9%. Beginning with the second quarter of 2002, the board of directors declared a quarterly cash dividend of $0.95 per common share, or $3.80 on an annualized basis, an increase of 8.6%.

      For equity compensation plan information, see note 16 to consolidated financial statements.

      RJR conducts its business through its subsidiaries and is dependent on the earnings and cash flow of its subsidiaries to satisfy its obligations and other cash needs. RJR’s credit facility limits the payment of dividends on its common stock in excess of specific amounts. For more information, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Financial Condition” in Item 7 and note 12 to the consolidated financial statements. RJR believes that the provisions of its revolving credit facility and the guarantees of its revolving credit facility, interest rate swaps and guaranteed, previously unsecured notes will not impair its payment of quarterly dividends.

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Item 6.  Selected Financial Data

      The selected historical consolidated financial data as of December 31, 2003 and 2002 and for each of the years in the three-year period ended December 31, 2003 are derived from the consolidated financial statements and accompanying notes, which have been audited by RJR’s independent auditors. The selected historical consolidated financial data as of December 31, 2001, 2000 and 1999 and for the years ended December 31, 2000 and 1999 are derived from audited consolidated financial statements not presented or incorporated by reference. Effective in 1999, the financial statements segregate the account balances and activities of the international tobacco business and Nabisco and report those account balances and activities as discontinued operations. For further information, including the impact of new accounting developments, acquisitions, restructuring and impairment charges, you should read this table in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 and the consolidated financial statements.

                                         
For the Years Ended December 31,

2003 2002 2001 2000 1999





(Dollars in Millions, Except Per Share Amounts)
Results of Operations:
                                       
Net sales (1)
  $ 5,267     $ 6,211     $ 6,269     $ 6,085     $ 5,898  
Income (loss) from continuing operations
    (3,689 )     418       444       299       195  
Income (loss) from discontinued operations
    122       40       (9 )     53       2,398  
Extraordinary items — gain (loss)
    121                   1,475       (250 )
Cumulative effect of accounting change
          (502 )                  
Net income (loss)
    (3,446 )     (44 )     435       1,827       2,343  
Per Share Data:
                                       
Basic income (loss) from continuing operations
    (44.08 )     4.71       4.57       2.96       1.80  
Diluted income (loss) from continuing operations
    (44.08 )     4.64       4.48       2.94       1.80  
Basic income (loss) from discontinued operations
    1.46       0.45       (0.09 )     0.52       22.10  
Diluted income (loss) from discontinued operations
    1.46       0.44       (0.09 )     0.52       22.08  
Basic income (loss) from extraordinary items
    1.45                   14.56       (2.30 )
Diluted income (loss) from extraordinary items
    1.45                   14.48       (2.30 )
Basic net loss from cumulative effect of accounting change
          (5.66 )                  
Diluted net loss from cumulative effect of accounting change
          (5.57 )                  
Basic net income (loss)
    (41.17 )     (0.50 )     4.48       18.04       21.60  
Diluted net income (loss)
    (41.17 )     (0.49 )     4.39       17.94       21.58  
Basic weighted average shares, in thousands
    83,697       88,733       97,043       101,264       108,495  
Diluted average shares, in thousands
    83,697       90,175       98,986       101,857       108,570  
Cash dividends declared per share of common stock (2)
  $ 3.80     $ 3.73     $ 3.30     $ 3.10     $ 1.55  
Balance Sheet Data (at end of periods):
                                       
Total assets
    9,677       14,651       15,122       15,554       14,377  
Long-term debt
    1,671       1,755       1,631       1,674       1,653  
Stockholders’ equity
    3,057       6,716       8,026       8,436       7,064  
Cash Flow Data:
                                       
Net cash from operating activities
    581       489       626       590       929  
Net cash from (used in) investing activities
    480       (820 )     (307 )     1,573       7,576  
Net cash used in financing activities
    (1,122 )     (105 )     (842 )     (881 )     (5,359 )
Other Data:
                                       
Ratio of earnings to fixed charges (3)
          5.2       6.4       5.1       2.8  
Deficiency in the coverage of fixed charges by earnings before fixed charges (3)
  $ (3,913 )   $     $     $     $  

(1)  Net sales and costs of products sold exclude excise taxes of $1.572 billion, $1.751 billion, $1.529 billion, $1.631 billion and $1.173 billion for the years ended December 31, 2003, 2002, 2001, 2000 and 1999, respectively.
(2)  RJR began trading as a separate company on June 15, 1999. From the third quarter of 1999 through the second quarter of 2001, RJR’s board of directors declared a quarterly cash dividend of $0.775 per common share, or $3.10 on an annualized basis. From the third quarter 2001 through the first quarter of 2002, the board of directors declared a quarterly cash dividend of $0.875 per common share or $3.50 on an annualized basis. Since the second quarter of 2002, the board of directors has declared a quarterly cash dividend of $0.95 per common share, or $3.80 on an annualized basis.
(3)  Earnings consist of income before income taxes and fixed charges. Fixed charges consist of interest on indebtedness, amortization of debt issuance costs and one-third of operating rental expense, representative of the interest factor.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

      The following is a discussion and analysis of RJR’s business, initiatives, critical accounting policies and its consolidated results of operations and financial condition. Following the overview and discussion of business initiatives, the critical accounting policies disclose certain accounting policies that are material to RJR’s results of operations and financial condition for the periods presented in this report. The discussion and analysis of RJR’s results of operations is presented in two comparative sections, 2003 compared with 2002 and 2002 compared with 2001. Disclosures related to liquidity and financial condition completes management’s discussion and analysis. You should read this discussion and analysis of RJR’s consolidated financial condition and results of operations in conjunction with the consolidated financial statements and the related notes as of December 31, 2003 and 2002 and for each of the years in the three-year period ended December 31, 2003.

Overview and Business Initiatives

      RJR’s operating subsidiaries include RJR Tobacco and Santa Fe. RJR’s single reportable operating segment, RJR Tobacco, is the second largest cigarette manufacturer in the United States. Santa Fe, acquired by RJR in 2002, manufactures and markets cigarettes and other tobacco products primarily in the United States.

      RJR’s operating subsidiaries primarily conduct business in the highly competitive U.S. cigarette market with a few large manufacturers and many smaller participants. The U.S. cigarette market is believed to be a mature market, and overall consumer demand is expected to decline over time. Trade inventory adjustments may result in short-term changes in demand for RJR Tobacco’s products if, and when, wholesale and retail tobacco distributors adjust the timing of their purchases of product to manage their inventory level. However, RJR Tobacco believes it is not appropriate for it to speculate on external factors that may impact the purchasing decision of the wholesale and retail tobacco distributors.

      Competition is primarily based on brand positioning and price, as well as product attributes and packaging, consumer loyalty, promotions, advertising and retail presence. Cigarette brands produced by the major manufacturers generally require competitive pricing, substantial marketing support, retail programs and other financial incentives to maintain or improve a brand’s market position or to introduce a new brand.

      RJR’s operating subsidiaries are committed to building and maintaining a portfolio of strong brands. RJR Tobacco’s marketing programs are designed to strengthen each brand’s image, build brand awareness and loyalty, and attract adult smokers of competing brands. RJR Tobacco has repositioned or introduced brand styles and line extensions designed to build each brand’s equity and attract adult smokers of competitive brands, but there can be no assurance that such efforts will be successful.

      In addition to building strong brand equity, RJR Tobacco’s marketing approach utilizes a retail pricing strategy, including discounting at retail, to defend its brands’ shares of market against competitive pricing pressure. Competitive discounting has increased significantly as a result of higher state excise taxes and the growth of deep-discount brands. Deep-discount brands are brands manufactured by manufacturers that are not original participants in the MSA, and accordingly, do not have cost structures burdened with MSA payments to the same extent as the original participating manufacturers.

      Starting in mid-2002, RJR Tobacco’s largest competitor significantly increased promotional spending. These increases, together with the continued strength of the deep-discount price tier of the market and the impact of substantially higher state excise taxes, have resulted in an adverse business environment. To maintain competitive prices, RJR Tobacco has increased its promotional spending since the second half of 2002. The increased promotional costs are expected to continue into the foreseeable future.

      During the fourth quarter of 2002, RJR implemented a restructuring plan in an effort to streamline its cost structure and improve long-term earnings. The restructuring plan included a workforce reduction, expected to be primarily completed in the first half of 2004, and the reclassification of certain non-tobacco businesses as held-for-sale.

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      In April 2003, in response to continuing challenges of an intensely competitive environment, RJR announced initiatives to fundamentally rethink RJR Tobacco’s approach to the marketplace and realign the cost structures of RJR Tobacco and RJR. These initiatives included a new brand-portfolio strategy focused on its two premium growth brands to optimize profitability and significant cost reductions, which resulted in restructuring and impairment charges. Certain of these initiatives resulted in restructuring and impairment charges in 2003, and are expected to result in additional charges through 2004. Additionally, during the fourth quarter of 2003, RJR Tobacco reevaluated its practices related to replacement of merchandising fixtures and transferred ownership to the cigarette retailers. For more information about these initiatives, related costs and savings, see “— Results of Operations.”

      During 2002, actual asset returns for RJR’s pension assets were adversely impacted by the continued deterioration of the equity markets and declining interest rates. Additionally, corporate bond yields, which are used in determining the discount rate for future pension obligations, continued to decline. The negative asset returns and declining discount rates unfavorably affected RJR’s pension plans’ funded status. Pension expense in 2003 was adversely impacted due to these factors and the lowering of the expected return on asset assumption from 9.5% per annum for 2002 to 9.0% per annum for 2003.

      During 2003, plan assets increased $391 million, as a result of the favorable 2003 equity market performance and contributions, partially offset by benefit payments. However, at December 31, 2003, the pension benefit obligation of RJR’s pension plans exceeded the fair value of plan assets by $750 million. The amount by which the projected benefit obligation exceeds the fair value of the plan assets could increase to the extent of a decline in the fair value of plan assets, as well as adverse changes in actuarial assumptions, including a reduction in the discount rate used to calculate the projected benefit obligation.

      Pension expense in 2004 is expected to be within a range of $70 million to $80 million, primarily due to an expected reduction in service cost as a result of the 2003 workforce reduction and a more favorable than expected return on plan assets during 2003. This decrease will be partially offset by the use of the lower discount rate of 6.15%. RJR contributed $110 million to its pension plan in January 2004. Additional cash funding may be made in the future.

Critical Accounting Policies

      Accounting principles generally accepted in the United States of America require estimates and assumptions to be made that affect the reported amounts in RJR’s consolidated financial statements and accompanying notes. Some of these estimates require difficult, subjective and/or complex judgments about matters that are inherently uncertain, and as a result, actual results could differ from those estimates. Due to the estimation processes involved, the following summarized accounting policies and their application are considered to be critical to understanding the business operations, financial condition and results of operations of RJR and its subsidiaries.

Tobacco–Related Litigation

      RJR and RJR Tobacco disclose information concerning tobacco-related litigation for which an unfavorable outcome is other than remote. RJR Tobacco and its affiliates record their legal expenses and other litigation costs and related administrative costs as selling, general and administrative expenses as those costs are incurred.

      As discussed in note 13 to the consolidated financial statements, RJR Tobacco and its affiliates have been named in a number of tobacco-related legal actions, proceedings or claims seeking damages in amounts ranging into the hundreds of millions or even billions of dollars. Unfavorable judgments awarding compensatory damages, punitive damages and/or fines have been returned against RJR Tobacco in the Engle class-action case, reversed by the intermediate appellate court on May 21, 2003, a small number of individual smoking and health cases, a Broin II flight attendant ETS case, a health-care cost recovery case, an MSA enforcement action and a California state law enforcement action. However, RJR Tobacco believes that it has numerous bases for successful appeals in these cases, and both RJR Tobacco and RJR believe they have a number of valid defenses to all actions and intend to defend all actions vigorously. Except for Kenyon v.

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R. J. Reynolds Tobacco Co., discussed in “Business — Litigation Affecting the Cigarette Industry” in Item 1 and note 13 to consolidated financial statements, for which RJR Tobacco expensed approximately $196,000 during the third quarter, RJR’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates, when viewed on an individual basis, is not probable. Accordingly, no liability for tobacco-related litigation currently is recorded in RJR’s consolidated financial statements. RJR and RJR Tobacco will record any loss related to tobacco litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated. When the reasonable estimate is a range, the recorded loss will be the best estimate within the range. If no amount in the range is a better estimate than any other amount, the minimum amount of the range will be recorded.

      Litigation is subject to many uncertainties, and it is possible that some of the tobacco-related legal actions, proceedings or claims could ultimately be decided against RJR Tobacco or its affiliates, including RJR. Any unfavorable outcome of such actions could have a material adverse effect on the financial condition, results of operations or cash flows of RJR or its subsidiaries.

Settlement Agreements

      As discussed in “Business — Litigation Affecting the Cigarette Industry” in Item 1 and note 13 to consolidated financial statements, RJR’s operating subsidiaries are participants in the MSA and other state settlement agreements related to governmental health–care cost recovery actions. Their obligations and the related expense charges under the MSA and other settlement agreements are subject to adjustments based upon, among other things, the volume of cigarettes sold by the operating subsidiaries, their relative market share and inflation. Since relative market share is based on cigarette shipments, the best estimate of the allocation of charges under these agreements is recorded in costs of products sold as the products are shipped. Settlement expenses under these MSA and other settlement agreements recorded in the accompanying consolidated statements of income were $1.9 billion in 2003, $2.5 billion in 2002 and $2.6 billion in 2001. RJR Tobacco estimates that its settlement charges will approximate $1.8 billion in 2004 and exceed $1.9 billion in 2005 and 2006, subject to adjustments, including those discussed above. Adjustments to these estimates, which historically have not been significant, are recorded in the period that the change becomes probable and the amount can be reasonably estimated.

Goodwill and Trademarks

      As of January 1, 2002, RJR adopted Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.” See note 1 to consolidated financial statements for a discussion of the impact of the initial adoption of SFAS No. 142 on goodwill and trademarks and for additional impairment charges in connection with RJR’s ongoing application of SFAS No. 142 in 2002 and 2003.

      RJR engaged an independent appraisal firm to assist it in determining the fair value of its reporting units and trademarks. The determination of fair value involves considerable estimates and judgment. In particular, the fair value of a reporting unit involves, among other things, developing forecasts of future cash flows, determining an appropriate discount rate, and when goodwill impairment is implied, the determination of the fair values of individual assets and liabilities, including unrecorded intangibles. Although RJR believes it has based its impairment testing and impairment charges on reasonable estimates and assumptions, the use of different estimates and assumptions could result in materially different results.

      As a result of the current competitive changes in the tobacco industry, RJR initiated comprehensive changes in its strategies and cost structure that resulted in a restructuring of its current business. Management can not predict the impact that the current competitive environment and RJR’s strategic initiatives may have on the fair value of RJR’s goodwill and RJR Tobacco’s trademarks in future periods.

Pension and Postretirement Benefits

      Pension expense is determined in accordance with the provisions of SFAS No. 87, “Employers’ Accounting for Pensions,” and SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits.” Postretirement benefit expense is determined in

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accordance with the provisions of SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions.” Because pension and post-retirement obligations will ultimately be settled in future periods, the determination of annual expense and liabilities is subject to estimates and assumptions. With the assistance of an independent actuarial firm, RJR reviews these assumptions annually and modifies them based on historic experience and expected future trends. The most critical assumptions and their sensitivity to change are presented below.

Assumptions:

                   
2003 2002


Weighted-average assumption used to determine benefit obligations at December 31:
               
 
Discount rate
    6.15%       6.40%  
 
Rate of compensation increase
    5.00%       5.00%  
Weighted-average assumptions used to determine net periodic benefit cost for years ended December 31:
               
 
Discount rate
    6.40%/6.50% (1)     7.40%  
 
Expected long-term return on plan assets
    9.00%       9.50%  
 
Rate of compensation increase
    5.00%       5.00%  

(1)  A discount rate of 6.40% was used for the period from January 1, 2003 to August 31, 2003, and adjusted to a discount rate of 6.50% for the period from August 31, 2003 to December 31, 2003 to reflect the impact of the 2003 restructuring plan.

      The overall expected long-term rate of return on assets assumption is based on: (1) the target asset allocation for plan assets, (2) long-term capital markets forecasts for asset classes employed, and (3) active management excess return expectations to the extent asset classes are actively managed.

Assumption Sensitivity:

      Assumed asset return and discount rates have a significant effect on the amounts reported for the benefit plans. A one-percentage-point change in assumed discount rate for the pension plans would have the following effects:

                 
1-Percentage 1-Percentage
Point Point
Increase Decrease


Effect on net periodic benefit cost
  $ (13 )   $ 11  
Effect on projected benefit obligation
    (249 )     271  

      A one-percentage-point change in assumed asset return for the pension plans would have the following effects:

                 
1-Percentage 1-Percentage
Point Point
Increase Decrease


Effect on net periodic benefit cost
  $ (21 )   $ 21  

      A one-percentage-point change in assumed discount rate for the other postretirement benefit plans would have the following effects:

                 
1-Percentage 1-Percentage
Point Point
Increase Decrease


Effect on net periodic benefit cost
  $ (6 )   $ 6  
Effect on postretirement benefit obligation
    (70 )     76  

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      On December 8, 2003, President Bush signed into law the Medicare Prescription Drug, Improvement and Modernization Act of 2003, referred to as the Act. The Act expanded Medicare to include, for the first time, coverage for prescription drugs. RJR sponsors retiree medical programs, which include coverage for prescription drugs

      RJR has elected to defer financial recognition of this legislation until the FASB issues final accounting guidance. When issued, that final guidance could require RJR to change previously reported information. This deferral election is permitted under FASB Staff Position FAS 106-1, “Accounting and Disclosure Requirements Related to the Medicare Prescription Drug Improvement and Modernization Act of 2003.”

      Differences between actual results and actuarial assumptions are accumulated and amortized over future periods. In recent years, actual results have varied significantly from actuarial assumptions. In particular, pension plan assets have declined due to the overall decline in the capital markets, and pension and postretirement liabilities have increased as a result of the decline in the discount rate. These changes have resulted in charges to comprehensive income and an increase in pension expense in 2003. Postretirement expense decreased in 2003 due to changes in plan benefits, partially offset by the decline in the discount rate.

      Pension expense in 2004 is expected to be within a range from $70 million to $80 million, primarily due to an expected reduction in service cost as a result of the 2003 workforce reduction and a more favorable than expected return on plan assets during 2003. This decrease will be partially offset by the use of the lower discount rate of 6.15%. RJR contributed $110 million to its pension plan in January 2004. Additional cash funding may be made in the future.

Restructuring and Asset Impairment Charges

      RJR and RJR Tobacco have recorded charges related to workforce reductions, asset impairments and associated exit costs during 2003 and 2002. The workforce reduction charges were recorded in accordance with SFAS No. 112, “Employers’ Accounting for Postemployment Benefits,” and SFAS No. 88. The calculation of severance pay requires management to estimate the population of employees to be terminated and the timing of their severance from employment. The calculation of benefits charges requires actuarial assumptions including determination of discount rates.

      The asset impairments were recorded in accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which requires management to estimate the fair value of assets to be disposed of.

      On January 1, 2003, RJR adopted SFAS No. 146, “Accounting for Costs Associated with Exit and Disposal Activities.” Charges related to restructuring activities initiated after this date were recorded when incurred. Prior to this date, charges were recorded at the date of an entity’s commitment to an exit plan, in accordance with EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).”

      These restructuring charges were based on management’s best estimate at the time of the restructuring. The status of the restructuring activities is reviewed on a quarterly basis and any adjustments to the reserve, which could differ materially from previous estimates, would be recorded as an adjustment to operating income.

Merchandising Fixtures

      Beginning in the fourth quarter of 2002, in response to changes in industry retail display, RJR Tobacco began replacing significant portions of its merchandising fixtures on an accelerated basis that resulted in accelerated amortization. During the second quarter of 2003, it became evident that the scope, extent and timing of competitors’ similar replacement actions were reduced significantly from RJR Tobacco’s original expectations. As a result, RJR Tobacco reevaluated its practices related to replacement of merchandising fixtures, and determined to reduce significantly any further replacement of its merchandising fixtures and to continue to utilize its current merchandising fixtures. Accordingly, the service lives of those fixtures targeted for near-term replacement, which were shortened in the fourth quarter of 2002, were extended to their original

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service lives. Additionally, the percentage salvageable became higher than previously estimated. As a result, there was no additional book value to amortize on an accelerated basis. Accordingly, RJR Tobacco ceased accelerated amortization. Amortization of merchandising fixtures during 2003 was $66 million, of which $21 million was accelerated amortization, compared with 2002 amortization expense of $96 million, of which $43 million was accelerated amortization. The change in estimate and resulting accelerated amortization adversely impacted net income $0.15 per basic and diluted share during the year ended December 31, 2003 and $0.29 per basic and diluted share during 2002. During the fourth quarter of 2003, RJR Tobacco reevaluated its strategy related to merchandising fixtures and transferred its ownership of these fixtures to the cigarette retailers, resulting in an impairment charge of $106 million.

Revenue Recognition

      Revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. For RJR’s operating subsidiaries, these criteria are met upon shipment, when title and risk of loss pass to the customer. Shipping and handling costs are classified as cost of products sold. Certain sales incentives, including coupons, buydowns and slotting allowances, are classified as reductions of net sales in accordance with Emerging Issues Task Force Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).” With respect to estimated amounts of consideration that will be claimed by customers, costs are recognized at the latter of the date at which the related revenue is recognized or the date at which the sales incentive is offered.

Accounting for Returned Goods

      During the second quarter of 2003, RJR Tobacco announced a revision of its policy related to returned goods. Previously, RJR Tobacco accepted all damaged and out-of-code-date products. Under its revised policy, RJR Tobacco will accept only returns of unintentionally damaged products. During the second quarter of 2003, all retail returns other than unintentionally damaged products were suspended. Returns other than unintentionally damaged products shipped from wholesalers under the previous return policy were last accepted during the third quarter of 2003.

      At June 30, 2003, the reserve for returned goods consisted of (1) an estimate of returns for unintentionally damaged product and (2) an estimate of returned goods from wholesalers under the previous policy. These estimates resulted in a $54 million reduction of the reserve for returned goods balance as of June 30, 2003, having the effect of increasing net sales $54 million. The change in the estimate of the reserve for returned goods was made in the second quarter, as that is the period that RJR Tobacco’s policy change was effected and announced to its customers. Reflecting the results of the revised returned goods policy, the returned goods reserve was reduced $42 million during the second half of 2003, for a total of $96 million during 2003. The change in the returned goods policy benefited net income $0.69 per basic and diluted share during the year ended December 31, 2003. The 2004 impact is expected to approximate the 2003 impact.

Recent Accounting Developments

Stock-Based Compensation

      RJR adopted the prospective method of transition of SFAS No. 148, “Accounting for Stock-Based Compensations — Transition and Disclosure — an Amendment of FASB Statement No. 123,” effective January 1, 2003. Accordingly, all compensation costs related to employee stock plans that were granted prior to January 1, 2003, will continue to be recognized using the intrinsic value-based method under the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. However, any compensation costs related to grants or modifications of existing grants subsequent to January 1, 2003 will be recognized under the fair value method of SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended. All compensation costs related to employee stock plans for all grant dates will be disclosed under the provisions of SFAS No. 123, as amended. Stock compensation is described more fully in note 16 to consolidated financial statements.

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Results of Operations

 
2003 Compared with 2002
                         
2003 2002 % Change



Net sales (1)
  $ 5,267     $ 6,211       (15.2 )%
Cost of products sold (1) (2)
    3,218       3,732       (13.8 )%
Selling, general and administrative expenses
    1,327       1,463       (9.3 )%
Fixture impairment
    106              
Restructuring and impairment charges
    368       224       64.3 %
Goodwill and trademark impairment charges
    4,089       13        
     
     
         
Operating Income
  $ (3,841 )   $ 779        
     
     
         

(1)  Excludes excise taxes of $1,572 million and $1,751 million for the years ended December 31, 2003 and 2002, respectively.
(2)  Includes settlement expense of $1,934 million and $2,514 million for the years ended December 31, 2003 and 2002, respectively.

      Net sales for the year ended December 31, 2003 decreased $944 million from the prior year due to $989 million lower overall volume and $113 million increased promotional spending, net of higher pricing, partially offset by a benefit of $96 million related to RJR Tobacco’s change in returned goods policy. RJR’s net sales are dependent upon its shipment volume in a declining market, full-price versus savings-brand mix, and list pricing, offset by promotional spending and trade incentives.

      Shipment volume in the domestic category for RJR’s operating segments, in billions of units, included:

                           
For the Twelve Months
Ended December 31,

%
2003 2002 Change



RJR Tobacco key brands:
                       
 
Camel excluding Regular
    20.0       22.1       (9.5 )%
 
Salem
    9.3       9.5       (1.6 )%
 
Base Winston
    15.5       17.9       (13.5 )%
 
Doral
    21.2       24.6       (13.7 )%
RJR Tobacco total full-price
    49.7       55.5       (10.3 )%
RJR Tobacco total savings
    30.3       35.1       (13.8 )%
     
     
         
RJR Tobacco total domestic (1)
    80.0       90.6       (11.7 )%
Santa Fe total domestic
    1.2       1.0       12.5  %
     
     
         
RJR total domestic (1)
    81.2       91.6       (11.4 )%
     
     
         
Industry (2):
                       
 
Full-price
    274.5       284.8       (3.6 )%
 
Savings
    96.9       106.6       (9.2 )%
     
     
         
Industry total domestic
    371.4       391.4       (5.1 )%
     
     
         

(1)  Excludes Puerto Rico and certain other U.S. territories’ volume.
(2)  The source of industry data is Management Science Associates, Inc. These data may not include all shipments of some manufacturers that MSAi is currently unable to monitor effectively. RJR Tobacco believes that the industry total domestic shipment volume may not fully include deep-discount volume.

      RJR Tobacco’s full-year total domestic shipment volume declined 11.7% due to underlying declines in consumption, or retail sales to consumers, and shifts in trade inventory levels.

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      Shipments in the full-priced tier increased to 62.2% of RJR Tobacco’s total domestic shipments during 2003 as compared with 61.2% in 2002. Industry full-price shipments as a percentage of total domestic shipments increased to 73.9% in 2003 from 72.8% in 2002.

      Retail share of market as a percentage of total retail sales of RJR’s operating segments according to data from Information Resources, Inc./Capstone(1) were:

                           
For the Twelve
Months Ended
December 31, Share

Point
2003 2002 Change



RJR Tobacco key brands:
                       
 
Camel excluding Regular
    5.94 %     5.69 %     0.25  
 
Salem
    2.54 %     2.41 %     0.13  
 
Base Winston
    4.42 %     4.57 %     (0.15 )
 
Doral
    5.54 %     5.86 %     (0.32 )
RJR Tobacco total domestic
    22.52 %     22.93 %     (0.41 )
Santa Fe total domestic
    0.29 %     0.26 %     0.03  

(1)  Retail share of market data is included in this document because it is used by RJR primarily as an indicator of the relative performance of industry participants and brands and market trends. You should not rely on the market share data reported by industry tracking organizations as being a precise measurement of actual market share because these organizations are not able to effectively track the volume of all deep-discount brands, which RJR believes represent approximately 13% to 15% of U.S. industry unit sales. Accordingly, the retail share of market of RJR Tobacco’s and Santa Fe’s brands as reported by Information Resources, Inc./ Capstone may overstate their actual market share. Moreover, in an industry experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes.

      In 2003, RJR Tobacco’s full-price share position of 14.24% of the market, was relatively level with 2002 at 14.20%. Full-price share performance was based on the growth of RJR Tobacco’s focus brands — CAMEL and SALEM, which posted a combined full-year gain of 0.38 share points — more than offsetting declines in other full-price brands.

      In 2003, CAMEL’s filtered styles posted a gain of 0.25 share points, on the strength of CAMEL’s Classic and Turkish families. SALEM has shown steady momentum since its “Stir the Senses” re-launch in April 2003, gaining 0.38 share points since the first quarter compared with the fourth quarter of 2003. SALEM has posted increases in both its Green Label and Black Label styles, with growth coming from competitive switching and increased franchise loyalty. Base WINSTON and DORAL retail share of market declined in 2003, reflecting competitive pricing pressures on their price-sensitive, adult, franchise smokers.

      Santa Fe’s NATURAL AMERICAN SPIRIT brand delivered higher volume, share and profits in 2003 compared to 2002.

      Cost of products sold decreased $514 million from 2002 primarily due to $580 million lower MSA costs, and to a much lesser extent, lower promotional product and volume-related manufacturing costs, partially offset by the adverse impact of higher costs of materials of $69 million. MSA expenses were $1.9 billion in 2003 and are expected to remain relatively level through 2006, subject to adjustment for changes in volume and other factors. For more information related to the MSA, see note 13 to consolidated financial statements.

      Selling, general and administrative expenses of $1,327 million during 2003 decreased $136 million, compared with 2002, primarily due to lower overall marketing expense. The decrease in marketing expense, net of an $80 million increase in advertising expense, was the result of the strategic marketing changes initiated during 2003. The decreases in SG&A were partially offset by $14 million fixed general expense, including higher special compensation and benefits and higher selling, general and administrative expenses of entities acquired in 2002, partially offset by lower legal expenses.

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      Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. During the first, second, third and fourth quarters of 2003, RJR Tobacco’s product liability defense costs were $37 million, $42 million, $29 million and $36 million, respectively, for a total of $144 million during 2003. During the first, second, third and fourth quarters of 2002, RJR Tobacco’s product liability defense costs were $43 million, $51 million, $51 million and $47 million, respectively, for a total $192 million during 2002.

      “Product liability” cases generally include smoking and health related cases. In particular, these cases include the following categories of cases listed in the table of cases set forth in “Business — Litigation Affecting the Cigarette Industry — Overview” in Item 1 and in note 13 to consolidated financial statements:

  •  Individual Smoking and Health;
 
  •  Flight Attendant — ETS (Broin II);
 
  •  Class Actions;
 
  •  Governmental Health-Care Cost Recovery;
 
  •  Other Health-Care Cost Recovery and Aggregated Claims; and
 
  •  Asbestos Contribution.

      “Product liability defense costs” include the following items:

  •  direct and indirect compensation, fees and related costs and expenses for internal legal and related administrative staff administering product liability claims;
 
  •  fees and cost reimbursements paid to outside attorneys;
 
  •  direct and indirect payments to third party vendors for litigation support activities;
 
  •  expert witness costs and fees; and
 
  •  payments to the Council for Tobacco Research — U.S.A., Inc. which funds are used primarily by the CTR to fund its legal defense costs.

      Numerous factors affect the amount of product liability defense costs. The most important factors are the number of cases pending and the number of cases in trial or in preparation for trial (i.e., with active discovery and motions practice). See “Business — Litigation Affecting the Cigarette Industry — Overview” in Item 1 and in note 13 to consolidated financial statements for detailed information regarding the number and type of cases pending, and “Litigation Affecting the Cigarette Industry — Scheduled Trials” in Item 1 and in note 13 to consolidated financial statements for detailed information regarding the number and nature of cases in trial and scheduled for trial through the end of 2004. The decrease in product liability defense costs in 2003 compared with 2002 was primarily due to a decrease in the level of activity in cases in preparation for trial, in trial and on appeal in 2003 compared with 2002.

      RJR Tobacco expects that the factors described above will continue to have the primary impact on its product liability defense costs in the future. Given the level of activity in cases in preparation for trial, in trial and on appeal and the amount of product liability defense costs incurred by RJR Tobacco over the past three years, RJR Tobacco’s recent experiences in defending its product liability cases and the reasonably anticipated level of activity in RJR Tobacco’s pending cases and possible new cases, RJR Tobacco does not expect that the variances in its product liability defense costs will be significantly different than they have been historically. However, it is possible that adverse developments in the factors discussed above, as well as other circumstances beyond the control of RJR Tobacco, could have a material adverse effect on the financial condition, results of operation or cash flows of RJR or its subsidiaries. Those other circumstances beyond the control of RJR Tobacco include the results of present and future trials and appeals, and the development of possible new theories of liability by plaintiffs and their counsel.

      Fixture impairment charges of $106 million in 2003 were recorded in the fourth quarter of 2003. These non-cash charges related to transfer of ownership of RJR Tobacco’s retail merchandising fixtures to cigarette

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retailers and reflect the elimination of the carrying value of the fixtures. As a result of this transfer, no further amortization is required. During 2003 and 2002, amortization related to the fixtures was $66 million and $96 million, respectively.

      Restructuring and asset impairment charges of $368 million, or $224 million after tax, and $224 million, or $135 million after tax, were recorded during the years ended December 31, 2003 and 2002, respectively. Restructuring charges for employee severance and benefits are based upon RJR’s ongoing benefit arrangement plan and are recognized when it becomes probable that a liability has been incurred and the amount of the liability can be estimated.

      The components of the 2003 restructuring and impairment charges, recorded and utilized through December 31, 2003, were:

                                   
Employee Contract
Severance Asset Termination/
and Benefits Impairment Exit Costs Total




Incurred during second quarter
  $     $ 18     $ 37     $ 55  
 
Utilized in second quarter
          (18 )     (22 )     (40 )
     
     
     
     
 
Balance, June 30, 2003
                15       15  
 
Incurred during third quarter
    292       10       9       311  
 
Utilized in third quarter
    (80 )     (10 )     (24 )     (114 )
     
     
     
     
 
Balance, September 30, 2003
    212                   212  
     
     
     
     
 
 
Incurred during fourth quarter
                7       7  
 
Utilized in fourth quarter
    (12 )           (6 )     (18 )
     
     
     
     
 
Balance, December 31, 2003
  $ 200     $     $ 1     $ 201  
     
     
     
     
 

      In April 2003, in response to continuing challenges of an intensely competitive environment, primarily pricing pressures, RJR announced initiatives to fundamentally rethink RJR Tobacco’s approach to the marketplace and realign the cost structures of RJR Tobacco and RJR. As a result, during the second quarter of 2003, RJR and RJR Tobacco incurred initial restructuring and impairment charges of $55 million. RJR Tobacco recorded a non-cash $18 million impairment charge to fully write off certain production equipment that it abandoned. RJR Tobacco also incurred contract termination expenses of $29 million related to the discontinuation of certain event-marketing programs, and RJR incurred other restructuring associated costs of $8 million during the second quarter of 2003.

      In September 2003, RJR announced a refocused brand portfolio strategy for RJR Tobacco and a significant cost reduction initiative. Marketing investments now focus on two growth brands, CAMEL and SALEM, with more limited investments in WINSTON and DORAL, to optimize profitability. Certain of these initiatives resulted in consolidated restructuring and impairment charges of $311 million, or $189 million after tax, in the third quarter of 2003. Of these charges, RJR Tobacco incurred $287 million related to severance and benefits, $10 million related to asset impairments and $1 million related to associated exit costs. RJR incurred $5 million severance and benefits and $8 million associated exit costs.

      Of the third quarter charges, the employee severance and benefits relate to an expected workforce reduction of approximately 2,600 full-time employees in operations and corporate functions. Approximately 1,400 reductions were completed as of December 31, 2003. The workforce reduction is expected to be completed during 2004. The asset impairment resulted from the abandonment of certain merchandising fixtures not yet shipped to retailers. The third quarter exit costs included professional fees for valuation and consulting services.

      In conjunction with the 2003 restructuring plan, during the fourth quarter, RJR incurred $3 million of consulting fees, and RJR Tobacco incurred $4 million of charges related primarily to aircraft lease termination and outplacement service fees.

      Additional charges of approximately $20 million are expected to be incurred during 2004 in connection with the 2003 restructuring plan. The cash portion of the 2003 restructuring and impairment charges is

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expected to be $265 million, of which $212 million relates to employee severance costs and $53 million relates to contract terminations and other exit costs. As of December 31, 2003, $64 million of this amount had been paid. Of the $108 million non-cash portion of the charges, $80 million related to benefit charges, and $28 million related to asset impairments. Cost savings related to the 2003 restructuring charges were $54 million during 2003, and are expected to be approximately $271 million during 2004 and $318 million on an annualized basis thereafter.

      The components of the 2002 restructuring and impairment charges, recorded and utilized through December 31, 2003, were:

                                   
Employee Contract
Severance Asset Termination/
and Benefits Impairment Exit Costs Total




Original charge
  $ 102     $ 115     $ 7     $ 224  
 
Utilized in 2002
    (44 )     (115 )     (2 )     (161 )
     
     
     
     
 
Balance, December 31, 2002
    58             5       63  
 
Utilized in 2003
    (27 )                 (27 )
 
Adjusted in 2003
    (2 )           (3 )     (5 )
     
     
     
     
 
Balance, December 31, 2003
  $ 29     $     $ 2     $ 31  
     
     
     
     
 

      In the fourth quarter of 2002, RJR Tobacco recorded a pre-tax restructuring charge of $224 million, $135 million after tax, in response to changing competitive practices within the tobacco industry during the second half of 2002.

      The employee severance and benefits relate to 572 full-time employee workforce reductions in operations support and corporate functions, of which 25 positions remained at December 31, 2003, and are expected to be eliminated in the first quarter of 2004.

      The asset impairment resulted from the remeasurement of the non-tobacco businesses at the lower of their carrying value or fair value less cost to sell. The non-tobacco businesses are classified as assets held for sale and liabilities related to assets held for sale in the consolidated balance sheets, in accordance with SFAS No. 144. As of December 31, 2003, the carrying amounts of the major classes of assets and liabilities in the disposal group included $13 million of accounts receivable, $31 million of inventories, $40 million of property, plant and equipment and other, and $10 million of accounts payable and accrued liabilities. As of December 31, 2002, the carrying amounts of the major classes of assets and liabilities in the disposal group included $15 million of accounts receivable, $52 million of inventories, $11 million of property, plant and equipment and other, and $8 million of accounts payable and accrued liabilities. RJR Tobacco completed the sale of one of the non-tobacco businesses in the second quarter of 2003, and expects to complete the sale of the remaining business during the first half of 2004.

      Contract termination and exit costs included certain contract terminations and lease terminations of 15 sales offices. Exit costs also included the separation of the non-tobacco businesses held for sale. During 2003, $5 million of the charge, concerning expected severance and related benefits and exit costs of field sales offices, was reversed, and was a reduction in restructuring and impairment charges in the consolidated statement of income for 2003.

      The cash portion of the 2002 restructuring and impairment charges is expected to be $58 million and primarily relates to employee severance costs. As of December 31, 2003, $27 million of this amount had been paid. The $161 million non-cash portion included $44 million related to employee benefits, $115 million related to asset impairments and $2 million related to the write-off of prepaid promotional rights that were terminated. Cost savings related to the 2002 restructuring charges were $39 million during 2003, and are expected to be $60 million in 2004.

      Goodwill and trademark impairment charges of $4,089 million were incurred during 2003. In response to competitive changes in the tobacco industry, RJR Tobacco initiated comprehensive changes in its strategies and cost structure that resulted in a restructuring primarily during the third quarter of 2003. The extent of the

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adverse impact of these competitive changes was not anticipated during the annual testing of trademarks and goodwill, performed in the fourth quarter of 2002. Accordingly, as provided in SFAS No. 142, RJR Tobacco tested its trademarks and goodwill for impairment, based on its revised forecast of expected sales and cash flows.

      The trademark impairment testing indicated that impairment occurred on certain of RJR Tobacco’s brands, primarily WINSTON and DORAL, reflecting RJR Tobacco’s decision in the third quarter of 2003 to limit investment in these brands in an effort to optimize profitability. Accordingly, RJR Tobacco recorded an impairment charge of $326 million, $197 million after tax, in the third quarter of 2003. This charge was based on the excess of the brands’ carrying values over their estimated fair values, determined using the present value of estimated future cash flows assuming a discount rate of 10.5%. The discount rate was determined by adjusting the RJR Tobacco enterprise discount rate by an appropriate risk premium to reflect an asset group risk. This impairment charge was included in goodwill and trademark impairment charges in the consolidated statements of income, as a decrease in the carrying value of trademarks in the consolidated balance sheet as of December 31, 2003, and had no impact on cash flows.

      For the purpose of testing goodwill, the fair value of RJR Tobacco was determined by an independent appraisal firm, based on the present value of the estimated future cash flows of the reporting unit assuming a discount rate of 10.0%. The determination of this discount rate is based on a weighted average cost of capital using a risk-free rate adjusted by a stock-beta adjusted risk premium. The valuation, in accordance with SFAS No. 142, indicated that the carrying value of RJR Tobacco exceeded its implied fair value. Preliminary estimated fair values were assigned to RJR Tobacco’s assets and liabilities to estimate the implied fair value of RJR Tobacco’s goodwill. As a result, the carrying amount of the goodwill of RJR Tobacco exceeded its implied fair value by $3.3 billion, and an impairment charge equal to that estimated excess was recognized in the third quarter of 2003. During the fourth quarter of 2003, RJR Tobacco completed its impairment measurement and recorded an additional $0.5 billion charge. These impairment charges were included in goodwill and trademark impairment charges in the consolidated income statements, as a decrease in the carrying value of goodwill in the consolidated balance sheet as of December 31, 2003, and had no impact on cash flows.

      Interest and debt expense was $111 million for the year ended December 31, 2003, a decrease of $36 million from 2002. This decrease is primarily due to the repayment of $550 million and $191 million in debt in the second and third quarters of 2003, respectively, and to a lesser extent, lower interest rates in 2003.

      Interest income decreased $33 million in 2003 compared with the prior year due to a lower average cash balance combined with lower interest rates.

      Other (income) expense, net included $5 million of income in 2003 compared with $11 million of expense in the prior-year period. The change was primarily due to $10 million in proceeds from a lease termination in the first quarter of 2003.

      Provision for (benefit from) income taxes was a benefit of $229 million, or an effective rate of 5.8%, for the year ended December 31, 2003, compared with a provision of $265 million, or an effective rate of 38.8%, in 2002. The 2003 effective tax rate included a benefit of $169 million from a favorable resolution of prior years’ tax matters, offset primarily by the effect of non-deductible goodwill impairment. The effective tax rate in 2002 exceeded the federal statutory rate of 35% primarily due to the impact of state taxes and, to a lesser extent, certain non-deductible items. RJR expects its effective tax rate to approximate 39.5% in 2004.

      Discontinued operations reflect transactions related to the 1999 sale of the international tobacco business to Japan Tobacco Inc. During 2003, these transactions included a $106 million favorable resolution of tax matters. During 2003 and 2002, these transactions included $16 million and $40 million, respectively, of after-tax reversals of indemnification accruals. Including these adjustments, the net after-tax gain on the sale of the international tobacco business was $2.5 billion.

      Extraordinary items included a gain of $121 million related to the favorable resolution of tax matters related to the acquisition of NGH in 2000. Including this adjustment, the net after-tax gain on the acquisition was $1.6 billion.

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2002 Compared with 2001

                         
2002 2001 % Change



Net sales (1)
  $ 6,211     $ 6,269       (0.9 )%
Cost of products sold (1) (2)
    3,732       3,560       4.8  %
Selling, general and administrative expenses
    1,463       1,429       2.4  %
Restructuring and impairment charges
    224              
Goodwill and trademark impairment charges
    13              
Amortization of trademarks & goodwill
          362        
     
     
         
Operating income
  $ 779     $ 918       (15.1 )%
     
     
         

(1)  Excludes excise taxes of $1,751 million and $1,529 million for the years ended December 31, 2002 and 2001, respectively.
(2)  Includes settlement expense of $2,514 million and $2,584 million for the years ended December 31, 2002 and 2001, respectively.

      Net sales for the year ended December 31, 2002 decreased $58 million from 2001. Of this decrease, $111 million was due to a less favorable, full-price/savings-brand mix and lower overall volume partially offset by $53 million of favorable pricing, net of higher promotional spending.

      Shipment volume in the domestic category for RJR’s operating segments, in billions of units, included:

                           
For the Twelve Months
Ended December 31,

%
2002 2001 Change



RJR Tobacco key brands:
                       
 
Camel excluding Regular
    22.1       20.9       5.7  %
 
Salem
    9.5       10.6       (11.1 )%
 
Base Winston
    17.9       19.0       (5.5 )%
 
Doral
    24.6       23.5       4.4  %
RJR Tobacco total full-price
    55.5       57.4       (3.4 )%
RJR Tobacco total savings
    35.1       33.3       5.4  %
     
     
         
RJR Tobacco total domestic (1)     90.6       90.7       (0.2 )%
Santa Fe total domestic
    1.0             100.0  %
     
     
         
RJR total domestic (1) (includes Santa Fe)
    91.6       90.7       1.0  %
     
     
         
Industry (2):
                       
 
Full-price
    284.8       300.1       (5.1 )%
 
Savings
    106.6       106.3       0.4  %
     
     
         
Industry total domestic
    391.4       406.4       (3.7 )%
     
     
         

(1)  Excludes Puerto Rico and certain other U.S. territories’ volume.
(2)  The source of industry data is Management Science Associates, Inc. These data may not include all shipments of some manufacturers that MSAi is currently unable to monitor effectively. RJR Tobacco believes that the industry total domestic shipment volume may not fully include deep-discount volume.

      The 0.2% decline from the prior-year period in RJR Tobacco’s total domestic shipment volume reflected an overall decline in retail sales to consumers, partially offset by the estimated slight building of inventories by wholesale and retail distributors.

      Shipments in the full-priced tier were 61.2% and 63.3% of RJR Tobacco’s total domestic shipments for the years ended December 31, 2002 and 2001, respectively. Industry full-price shipments were 72.8% and 73.9% of total domestic shipments for the years ended December 31, 2002 and 2001, respectively.

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      Retail share of market as a percentage of total retail sales of RJR’s operating segments according to data from Information Resources, Inc./Capstone(1) were:

                           
For the Twelve Months
Ended December 31,

Share
Point
2002 2001 Change



RJR Tobacco key brands:
                       
 
Camel excluding Regular
    5.69%       5.52%       0.17  
 
Salem
    2.41%       2.73%       (0.32 )
 
Base Winston
    4.57%       4.84%       (0.27 )
 
Doral
    5.86%       5.92%       (0.06 )
RJR Tobacco total domestic
    22.93%       23.42%       (0.49 )
Santa Fe total domestic
    0.26%              

(1)  Retail share of market data is included in this document because it is used by RJR primarily as an indicator of the relative performance of industry participants and brands and market trends. You should not rely on the market share data reported by industry tracking organizations as being a precise measurement of actual market share because these organizations are not able to effectively track the volume of all deep-discount brands, which RJR believes represent approximately 13% to 15% of U.S. industry unit sales. Accordingly, the retail share of market of RJR Tobacco’s and Santa Fe’s brands as reported by Information Resources, Inc./ Capstone may overstate their actual market share. Moreover, in an industry experiencing overall declining consumption, a particular product can experience increasing market share relative to competing products, yet still be subject to declining consumption volumes.

      CAMEL, RJR Tobacco’s largest full-price brand, continued its growth trend in 2002 based on the strength of the brand’s equity, its “Pleasure to Burn” positioning and initiatives to market CAMEL’s three distinct product families — the Classic, Turkish and Exotic families.

      Despite intense competitive price pressures, base WINSTON’s market share remained relatively stable for the last three quarters of 2002. During 2002, WINSTON’s S2 line extension, launched in 2001, was stable, but did not meet anticipated sales volumes.

      SALEM’s share declined in 2002, reflecting reduced levels of in-market support while the brand evaluated opportunities to strengthen its positioning.

      Although DORAL’s 2002 market share declined slightly compared with 2001, it’s trend showed improvement during 2002, due to increased promotional support, new tobacco blends on key styles, modernized packaging and the imaginative “Splendidly Blended” advertising campaign.

      Cost of products sold increased $172 million in 2002 from the prior year. The increase was due to higher promotional products, raw material costs and the inclusion of the cost of Santa Fe’s production operations, partially offset by $70 million of lower MSA costs.

      Selling, general and administrative expenses increased $34 million compared with 2001, due primarily to accelerated amortization of $43 million related to the replacement of merchandising fixtures. This increase was combined with higher product liability defense costs as discussed below, and the inclusion of Santa Fe’s selling, general and administrative expenses. These increases were partially offset by lower expenses related to stock-based benefit plans and advertising.

      Selling, general and administrative expenses include the costs of litigating and administering product liability claims, as well as other legal expenses. During the first, second, third and fourth quarters of 2002, RJR Tobacco’s product liability defense costs were $43 million, $51 million, $51 million and $47 million, respectively, for a total of $192 million during 2002. During the first, second, third and fourth quarters of 2001, RJR Tobacco’s product liability defense costs were $42 million, $42 million, $39 million and $42 million, respectively, for a total $165 million during 2001. The increase in product liability defense costs was primarily

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due to an increase in the level of activity in cases in preparation for trial, in trial and on appeal in 2002 compared with 2001.

      Restructuring and asset impairment charges of $224 million, or $135 million after tax, were recorded in the fourth quarter 2002, related to the 2002 restructuring plan, including the sale of certain non-tobacco businesses. The restructuring was implemented in an effort to streamline RJR’s cost structure and improve long-term earnings. Included in this charge is $102 million for employee severance and related benefits associated with workforce reductions of 572 full-time employees, or approximately 7% of RJR’s full-time employees.

      The non-tobacco businesses included in the restructuring plan were remeasured at the lower of their carrying value or fair value less cost to sell, and classified as assets held for sale and liabilities related to assets held for sale in the consolidated balance sheet at December 31, 2002, in accordance with SFAS No. 144. This remeasurement resulted in a $115 million charge in the fourth quarter of 2002.

      Contract termination and other exit costs consisted of $7 million related to contract and lease termination payments, and exit costs related to the segregation of the non-tobacco businesses held for sale.

      A trademark impairment charge of $13 million, $8 million after tax, was incurred in the fourth quarter of 2002, on two non-key brands, VANTAGE and CENTURY. The impairment was indicated during the annual valuation in accordance with SFAS No. 142, based on their estimated undiscounted net future cash flows. The impairment charge was measured as the excess of the brands’ carrying values over fair values, determined using the present value of estimated future cash flows assuming a discount rate of 10.5%. This impairment charge is reflected as a decrease in the carrying value of the trademarks in the consolidated balance sheets, as a trademark impairment charge in the 2002 consolidated income statement and had no impact on cash flows.

      Amortization expense was eliminated in 2002, reflecting the adoption of SFAS No. 142 on January 1, 2002. Amortization expense in 2001 was $362 million.

      Interest and debt expense decreased $3 million in the year ended December 31, 2002 from the prior year due to interest rate swaps acquired in the first and second quarters of 2002, mostly offset by the increased average debt balance resulting from the May 2002 issuance of the $750 million of notes.

      Interest income declined $75 million from 2001 primarily due to lower interest rates in 2002.

      Provision for (benefit from) income taxes was $265 million, or an effective rate of 38.8%, in 2002 compared with $448 million, or an effective rate of 50.2%, in 2001. The effective tax rate in 2002 exceeded the federal statutory rate of 35% primarily due to the impact of state taxes and, to a lesser extent, certain non-deductible items. The effective tax rate in 2001 exceeded the federal statutory rate of 35% primarily due to the impact of certain nondeductible items, including goodwill amortization, and to a lesser extent, state taxes.

      Discontinued operations in 2002 included a $40 million after-tax reversal of an indemnification accrual, reflecting a favorable settlement, and in 2001, included a $9 million after-tax, purchase-price adjustment. Both transactions relate to the 1999 sale of the international tobacco business to Japan Tobacco Inc.

Liquidity and Financial Condition

Liquidity

      At present, the principal sources of liquidity for RJR’s operating subsidiaries’ businesses and operating needs are internally generated funds from their operations and borrowings through RJR. Cash flows from operating activities are believed to be sufficient for the foreseeable future to enable the operating subsidiaries to meet their obligations under the MSA, to fund their capital expenditures and to make payments to RJR that, combined with RJR’s cash balance, will enable RJR to make its required debt-service payments and to pay dividends to RJR’s stockholders. The negative impact, if any, on the sources of liquidity that could result from a decrease in demand for products due to short-term inventory adjustments by wholesale and retail distributors, changes in competitive pricing, or accelerated declines in consumption, cannot be predicted. RJR cannot predict its cash requirements or those of its subsidiaries related to any future settlements or judgments,

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including cash required to be held in escrow or to bond any appeals, if necessary, and RJR makes no assurance that it or its subsidiaries will be able to meet all of those requirements.

      Contractual obligations as of December 31, 2003 were:

                                           
Payments Due by Period

Less than 1-3 4-5
Total 1 Year Years Years Thereafter





Long-term debt (1)
  $ 1,639     $ 56     $ 549     $ 329     $ 705  
Operating leases (2)
    22       13       6       2       1  
Non-qualified pension obligations (3)
    29       4       9       11       5  
Postretirement benefit obligations (3)
    643       58       130       132       323  
Joint venture funding (4)
    5       5                    
Service agreement (5)
    15       9       6              
Purchase obligations (6)
    214       190       24              
     
     
     
     
     
 
 
Total cash obligations
  $ 2,567     $ 335     $ 724     $ 474     $ 1,034  
     
     
     
     
     
 

(1)  For more information about RJR’s long-term debt, see “— Debt” below and note 12 to consolidated financial statements.
(2)  Operating lease obligations represent estimated lease payments primarily related to computer equipment, and to a lesser extent, aviation services and field sales offices.
(3)  For more information about RJR’s pension plans and postretirement benefits, see note 17 to consolidated financial statements. Postretirement benefit obligations captioned under “Thereafter” include obligations during the next five years only. Non-qualified pension obligations beyond five years are not estimable.
(4)  Joint venture funding is provided for each budget year, denominated in euros. For more information about the joint venture, see note 3 to consolidated financial statements.
(5)  A service agreement related to the joint venture with Gallaher Group Plc provides for annual payments denominated in Great British pounds. For more information about the related joint venture, see note 14 to consolidated financial statements.
(6)  Purchase obligations include commitments to acquire tobacco leaf, media services, aircraft and software maintenance.

      RJR Tobacco estimates that its settlement charges will exceed $1.8 billion in 2004 and each year thereafter. For more information about RJR Tobacco’s settlement payments, see “Business — Litigation Affecting the Cigarette Industry” in Item 1 and note 13 to consolidated financial statements.

      Commitments as of December 31, 2003 were:

                   
Commitment
Expiration Period

Less than
Total 1 Year


Standby letters of credit backed by revolving credit facility
  $ 20     $ 20  
     
     
 
 
Total commitments
  $ 20     $ 20  
     
     
 

Cash Flows

      Net cash flows from operating activities of $581 million in 2003 increased $92 million from 2002. This change primarily reflects benefits related to income taxes and lower MSA tobacco settlement expenses partially offset by decreased revenues due primarily to decreased volume, and to a lesser extent, increased promotional expenses. Net cash flows from operating activities decreased $137 million to $489 million in 2002, when compared with 2001. This decrease is primarily due to the decreased operating income as a result of increased promotional expenses in response to competitive promotions in the second half of 2002.

      Net cash flows from investing activities were $480 million in 2003 compared with a use of $820 million in 2002. Net cash flows from investing during 2003 included proceeds from the sale of short-term investments

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and the liquidation of a trust which effectively defeased subordinated debentures that were acquired with NGH in 2000. Net cash flows used in investing activities during 2002 included the purchase of $508 million of short-term investments, the 2002 acquisition of Santa Fe, net of cash acquired, and increased capital expenditures related to equipment replacements. Net cash flows used in investing activities in 2002 increased $513 million from $307 million in 2001. This change is primarily due to investments in short-term securities, utilizing the proceeds from the May 2002 issuance of notes; the cash payment for the acquisition of Santa Fe, net of cash acquired; and to a lesser extent, an increase in capital expenditures. These investments were partially offset by proceeds from the maturity of short-term securities in the fourth quarter, which were used to make required debt-service payments and to pay dividends to stockholders.

      Net cash flows used in financing activities were $1,122 million in 2003 compared with $105 million used in financing in 2002. This change is primarily due to the use of $741 million to repay notes that matured in 2003, compared with the $745 million cash proceeds provided from the issuance of notes in May 2002. This change is combined with decreased proceeds from the exercise of stock options and partially offset by the $436 million decrease in the repurchase of common stock. Net cash flows used in financing activities were $105 million in 2002 compared with a use of $842 million in 2001. This reduction is primarily due to the funds received from the May 2002 issuance of $750 million of public notes, partially offset by an increase in repurchases of common stock.

      In connection with the spin-off from NGH in 1999, RJR has assumed, subject to specified exceptions, all U.S. pension liabilities and related assets for current and former tobacco employees. In 2001, the additional cash required to fund these liabilities was $58 million. In January 2002, RJR contributed the expected additional cash requirement of $58 million for each of 2002 and 2003. As a result, the Pension Benefit Guaranty Corporation cancelled the related $116 million letter of credit, previously provided by RJR pursuant to an agreement with the PBGC. RJR contributed $110 million to its pension plan in January 2004.

Stock Repurchases

      The following tables summarize stock repurchases from November 1999 through February 6, 2004. These repurchases were made under programs authorized by RJR’s board of directors and funded through cash provided by operating activities and from RJR Acquisition Corp., utilizing the cash proceeds of the NGH acquisition. In April 2003, to increase financial flexibility, RJR indefinitely suspended repurchases under its $1.0 billion repurchase program authorized by the board of directors in February 2002.

      RJR continues to repurchase shares forfeited in respect of the tax liability associated with certain option exercises and restricted stock vesting under its 1999 Long Term Incentive Plan, referred to as the 1999 LTIP. Shares held by RJR through repurchase, in addition to shares forfeited pursuant to employee stock plans, are included in treasury stock in RJR’s consolidated balance sheets.

                   
Repurchases — 2003 and 2004 Shares Cost



(In millions)
$1 billion authorization
    1,441,460     $ 60  
1999 LTIP tax withholding
    348,414       15  
     
     
 
 
Total during 2003
    1,789,874       75  
1999 LTIP tax withholding in 2004
    99,091       6  
     
     
 
 
Total through February 6, 2004
    1,888,965     $ 81  
     
     
 
                     
Cumulative Period Completed Shares Cost




Programs completed
  November 1999 to February 2002     21,570,739     $ 875  
$1 billion approved February 6, 2002
  Ongoing — $530 million remaining     9,187,160       470  
1999 LTIP tax withholding
  Ongoing     566,579       27  
         
     
 
Total as of February 6, 2004     31,324,478     $ 1,372  
     
     
 

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Dividends

      On February 4, 2004, RJR’s board of directors declared a quarterly cash dividend of $0.95 per common share. The dividend will be paid on April 1, 2004 to stockholders of record as of March 10, 2004. On an annualized basis, the dividend rate is $3.80 per common share.

Capital Expenditures

      RJR Tobacco’s capital expenditures were $70 million, $111 million and $74 million in 2003, 2002 and 2001, respectively. RJR Tobacco’s capital expenditure program is expected to continue at a level sufficient to support its strategic and operating needs. RJR Tobacco plans to spend $55 million to $65 million for capital expenditures during 2004, funded primarily by cash flows from operations. The increase in 2002 was primarily due to increased equipment replacements. There were no material long-term commitments for capital expenditures as of December 31, 2003.

Debt

      RJR’s revolving credit facility with a syndicate of banks was amended and restated on May 10, 2002. Under the amendment and restatement, in May 2003 the committed amount was reduced from $622 million to $531 million through November 2004. The facility was further amended on September 25, 2003, primarily to modify certain definitions of terms related to negative covenants. RJR can use the full facility to obtain loans or letters of credit, at its option.

      Since prior to 2002, two of RJR’s material subsidiaries, RJR Tobacco and RJR Acquisition Corp., have guaranteed RJR’s obligations under the revolving credit facility. During 2003, Moody’s lowered its rating of RJR’s guaranteed, previously unsecured notes below investment grade, to Ba2, and Standard & Poor’s lowered its rating to BB+. These downgrades required RJR’s other material subsidiaries, including Santa Fe, to also guarantee the facility and to pledge all of their assets to secure their obligations under RJR’s revolving credit facility. These actions reflected the rating agencies’ concern over recent industry trends including heavy promotional activity, the growth of the deep-discount price tier, the volatility of tobacco litigation, and RJR’s competitive position. On October 28, 2003, Moody’s changed its ratings outlook from negative to stable, reflecting opportunities offered by the proposed combination of RJR and B&W’s U.S. tobacco operations. The outlook for Standard & Poor’s ratings remains negative. Concerns about, or further lowering of, the ratings of RJR’s guaranteed, previously unsecured unsubordinated debt notes by Standard & Poor’s or Moody’s could have an adverse impact on RJR’s ability to access the debt markets. However, given that RJR has significant cash balances and has no significant debt maturities prior to 2006, RJR’s management believes that such concerns about, or further lowering of, such ratings would not have a material adverse impact on RJR’s cash flows.

      RJR is not required to maintain compensating balances; however, RJR pays commitment fees of 1.5% per annum of the revolving credit facility committed amount. Borrowings under the revolving credit facility bear interest at rates that vary with the prime rate or LIBOR. The credit facility also limits RJR’s ability to pay dividends, repurchase stock, incur indebtedness, engage in transactions with affiliates, create liens, acquire, sell or dispose of specific assets and engage in specified mergers or consolidations. Under the credit facility, cumulative dividends and share repurchases generally may not exceed the sum of $500 million plus 50% of cumulative adjusted cash net income. Despite this general restriction, however, the credit facility further provides that up to an additional $500 million in dividends and share repurchases may be made. Stock repurchases also are limited to the extent that a stated minimum level of net worth must be maintained. At December 31, 2003, RJR had $20 million in letters of credit outstanding under the facility. No borrowings were outstanding, and the remaining $511 million of the facility was available for borrowing.

      RJR uses interest rate swaps to manage interest rate risk on a portion of its debt obligations. As long as RJR’s unsecured, unsubordinated debt rating remains either one level below BBB- by Standard & Poor’s or Baa3 by Moody’s, any fair value that results in a liability position of the interest rate swaps, will require full collateralization with cash or securities. In addition, because RJR and the guarantors have pledged their assets

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to secure their obligations under RJR’s revolving credit facility, as amended and restated, such pledge also has secured their obligations under these interest rate swap agreements.

      RJR has a $30 million uncommitted, unsecured line of credit with one bank. No borrowings were outstanding on this line of credit at December 31, 2003.

      In May 2003, RJR repaid $550 million of the guaranteed, previously unsecured notes. The remaining $1.45 billion guaranteed, previously unsecured notes, unlike RJR’s other non-bank debt, are guaranteed by RJR’s material subsidiaries, including RJR Tobacco and Santa Fe. Because RJR and the guarantors have pledged their assets to secure their obligations under the revolving credit facility, as amended and restated, certain of the guarantors, which are considered restricted subsidiaries under the guaranteed, previously unsecured notes, also have pledged certain of their assets to secure these notes. Excluded from the pledge to secure these notes are intellectual property, inventory, accounts receivable, cash and certain other assets. Generally, the terms of these notes restrict the issuance of guarantees by subsidiaries, the pledge of collateral, sale/leaseback transactions and the transfer of all or substantially all of the assets of RJR and its subsidiaries.

      On the mandatory redemption date of September 30, 2003, RJR used an associated irrevocable trust to repay the $98 million 9.5% junior subordinated debentures, due in 2047, acquired December 2000 in connection with the acquisition of NGH. Interest on these debentures was paid quarterly in arrears. These debentures were effectively defeased by an irrevocable trust, which was included in other current assets in the accompanying consolidated balance sheets as of December 31, 2002.

      On their due date of September 15, 2003, RJR repaid $93 million of unsecured public notes with a fixed interest rate of 7.625%. As of December 31, 2003, RJR had $195 million of unsecured public notes outstanding, at fixed interest rates of 8.25% through 9.25%, due in 2004 through 2013.

      The estimated fair value of RJR’s long-term debt was $1.7 billion, $2.5 billion and $1.8 billion, with an effective average interest rate of 4.31%, 5.44% and 7.89%, as of December 31, 2003, 2002 and 2001, respectively. The fair values are based on available market quotes and discounted cash flows, as appropriate.

Litigation and Settlements

      Various legal actions, proceedings and claims, including legal actions claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RJR’s operating subsidiaries’ products, are pending or may be instituted against RJR Tobacco or its affiliates, including RJR, or indemnitees. In July 2000, a jury in the Florida state court case Engle v. R. J. Reynolds Tobacco Co. rendered a punitive damages verdict in favor of the “Florida class” of plaintiffs of approximately $145 billion, with approximately $36.3 billion being assigned to RJR Tobacco. RJR Tobacco and the other defendants appealed the verdict. On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Dade County Circuit Court with instructions to decertify the class and dismiss the individual cases. Plaintiffs filed a motion for rehearing on July 16, 2003. The appellate court denied that motion on September 22, 2003, and issued its mandate on October 8, 2003 (which officially concluded proceedings before that court). The class filed its notice of intent to seek discretionary review by the Florida Supreme Court on October 22, 2003. Although RJR Tobacco remains confident in its bases for appeal in this case, RJR Tobacco cannot predict the final outcome of the appellate process. For further discussion of the Engle case and other litigation and legal proceedings pending against RJR or its affiliates or indemnitees, see “Business — Litigation Affecting the Cigarette Industry,” “Business — ERISA Litigation” and “Business — Environmental Matters” in Item 1; “— Governmental Activity”; note 13 to consolidated financial statements; and Exhibit 99.1 to this report.

      Even though RJR’s management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates, when viewed on an individual basis, is not probable, the possibility of material losses related to tobacco litigation is more than remote. However, RJR’s management is unable to predict the outcome of such litigation or to reasonably estimate the amount or range of any possible loss. Moreover, notwithstanding the quality of defenses available to it and its affiliates in tobacco-related litigation matters, it is possible that RJR’s financial condition, results of operations or cash

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flows could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters.

      In November 1998, RJR Tobacco and the other major U.S. cigarette manufacturers entered into the MSA with attorneys general representing most U.S. states, territories and possessions. As described under “Business — Litigation Affecting the Cigarette Industry” in Item 1 and note 13 to consolidated financial statements, the MSA imposes a stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers and places significant restrictions on their ability to market and sell cigarettes in the future. The cash payments made by RJR Tobacco under the MSA and the other state settlement agreements were $1.8 billion, $2.5 billion and $2.4 billion in 2003, 2002 and 2001, respectively. RJR Tobacco estimates these payments will be $1.9 billion in 2004 and will exceed $1.8 billion per year thereafter. However, these payments will be subject to adjustments for, among other things, the volume of cigarettes sold by RJR Tobacco, RJR Tobacco’s market share and inflation. RJR Tobacco cannot predict the impact on its business, competitive position or results of operations of the MSA and the other state settlement agreements, the business activity restrictions to which it is subject under these agreements or the price increases that it may be required to make as a result of these agreements.

Governmental Activity

      The marketing, sale, taxation and use of cigarettes have been subject to substantial regulation by government and health officials for many years. Various state governments have adopted or are considering, among other things, legislation and regulations that would:

  •  increase their excise taxes on cigarettes;
 
  •  restrict displays and advertising of tobacco products;
 
  •  establish fire safety standards for cigarettes;
 
  •  raise the minimum age to possess or purchase tobacco products;
 
  •  require the disclosure of ingredients used in the manufacture of tobacco products;
 
  •  impose restrictions on smoking in public and private areas; and
 
  •  restrict the sale of tobacco products directly to consumers or other unlicensed recipients, including over the Internet.

      In addition, in 2004, the U.S. Congress may consider legislation regarding:

  •  further increases in the federal excise tax;
 
  •  regulation of cigarette manufacturing and sale by the U.S. Food and Drug Administration;
 
  •  amendments to the Federal Cigarette Labeling and Advertising Act to require additional warnings;
 
  •  reduction or elimination of the tax deductibility of advertising expenses;
 
  •  implementation of a national standard for “fire-safe” cigarettes;
 
  •  regulation of the retail sale of cigarettes over the Internet; and
 
  •  changes to the tobacco price support program.

      Together with manufacturers’ price increases in recent years and substantial increases in state and federal excise taxes on cigarettes, these developments have had and will likely continue to have an adverse effect on cigarette sales.

      Cigarettes are subject to substantial excise taxes in the United States. The federal excise tax per pack of 20 cigarettes is $0.39. All states and the District of Columbia currently impose excise taxes at levels ranging from $.025 per pack in Virginia to $2.05 per pack in New Jersey. During 2003, 15 states increased their excise taxes. When fully implemented, these increases will raise the weighted average state cigarette excise tax per

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pack from $0.62 at the beginning of 2003 to $0.66. RJR Tobacco expects state excise taxes to increase even further in 2004 due to many states having budget shortfalls. Several states have pending legislation proposing further state excise tax increases.

      In 1964, the Report of the Advisory Committee to the Surgeon General of the U.S. Public Health Service concluded that cigarette smoking was a health hazard of sufficient importance to warrant appropriate remedial action. Since 1966, federal law has required a warning statement on cigarette packaging. Since 1971, television and radio advertising of cigarettes has been prohibited in the United States. Cigarette advertising in other media in the United States is required to include information with respect to the “tar” and nicotine yield of cigarettes, as well as a warning statement.

      During the past four decades, various laws affecting the cigarette industry have been enacted. In 1984, Congress enacted the Comprehensive Smoking Education Act. Among other things, the Smoking Education Act:

  •  establishes an interagency committee on smoking and health that is charged with carrying out a program to inform the public of any dangers to human health presented by cigarette smoking;
 
  •  requires a series of four health warnings to be printed on cigarette packages and advertising on a rotating basis;
 
  •  increases type size and area of the warning required in cigarette advertisements; and
 
  •  requires that cigarette manufacturers provide annually, on a confidential basis, a list of ingredients added to tobacco in the manufacture of cigarettes to the Secretary of Health and Human Services.

      The warnings currently required on cigarette packages and advertisements are:

  •  “SURGEON GENERAL’S WARNING: Smoking Causes Lung Cancer, Heart Disease, Emphysema, And May Complicate Pregnancy;”
 
  •  “SURGEON GENERAL’S WARNING: Quitting Smoking Now Greatly Reduces Serious Risks To Your Health;”
 
  •  “SURGEON GENERAL’S WARNING: Smoking By Pregnant Women May Result in Fetal Injury, Premature Birth, and Low Birth Weight;” and
 
  •  “SURGEON GENERAL’S WARNING: Cigarette Smoke Contains Carbon Monoxide.”

      Since the initial report in 1964, the Secretary of Health, Education and Welfare (now the Secretary of Health and Human Services) and the Surgeon General have issued a number of other reports which purport to find the nicotine in cigarettes addictive and to link cigarette smoking and exposure to cigarette smoke with certain health hazards, including various types of cancer, coronary heart disease and chronic obstructive lung disease. These reports have recommended various governmental measures to reduce the incidence of smoking. In 1992, the federal Alcohol, Drug Abuse and Mental Health Act was signed into law. This act requires states to adopt a minimum age of 18 for purchases of tobacco products and to establish a system to monitor, report and reduce the illegal sale of tobacco products to minors in order to continue receiving federal funding for mental health and drug abuse programs. In January 1996, the U.S. Department of Health and Human Services announced regulations implementing this legislation.

      Legislation imposing various restrictions on public smoking also has been enacted in 48 states and many local jurisdictions, and many employers have initiated programs restricting or eliminating smoking in the workplace. A number of states have enacted legislation designating a portion of increased cigarette excise taxes to fund either anti-smoking programs, health care programs or cancer research. In addition, educational and research programs addressing health care issues related to smoking are being funded from industry payments made or to be made under settlements with state attorneys general. Federal law prohibits smoking in scheduled passenger aircraft, and the U.S. Interstate Commerce Commission has banned smoking on buses transporting passengers interstate. Certain common carriers have imposed additional restrictions on passenger smoking.

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      In December 2003, the California Environmental Protection Agency Air Resources Board issued a “Proposed Identification of Environmental Tobacco Smoke as a Toxic Air Contaminant” for public review. If environmental tobacco smoke is identified as a “toxic air contaminant,” the Air Resources Board is required to prepare a report assessing the need and appropriate degree of control of environmental tobacco smoke. RJR Tobacco cannot predict the form any future California regulation may take.

      Several states have enacted or have proposed legislation or regulations that would require cigarette manufacturers to disclose the ingredients used in the manufacture of cigarettes. In September 2003, the Massachusetts Department of Public Health announced its intention to hold public hearings on amendments to its tobacco regulations. The proposed regulations would delete any ingredients-reporting requirement. (The U.S. Court of Appeals for the Second Circuit previously affirmed a ruling that the Massachusetts ingredient-reporting law was unconstitutional.) MDPH has proposed to inaugurate extensive changes to its regulations requiring tobacco companies to report nicotine yield ratings for cigarettes according to methods prescribed by MDPH. Because MDPH withdrew its notice for a public hearing in November 2003, it is impossible to predict the final form any new regulations will take or the effect they will have on the business or results of operations of RJR Tobacco.

      On May 21, 1999, RJR Tobacco, Lorillard Tobacco Company, Brown & Williamson Tobacco Corporation and Philip Morris, Inc. filed lawsuits in the United States District Court for the District of Massachusetts to enjoin implementation of certain Massachusetts attorney general regulations concerning the advertisement and display of tobacco products. The regulations went beyond those required by the MSA, and banned outdoor advertising of tobacco products within 1,000 feet of any school or playground, as well as any indoor tobacco advertising placed lower than five feet in stores within the 1,000-foot zone. The district court ruled against the industry on January 25, 2000, and the U.S. Court of Appeals for the First Circuit affirmed. The United States Supreme Court granted the industry’s petition for writ of certiorari on January 8, 2001, and ruled in favor of RJR Tobacco and the rest of the industry on June 28, 2001. The Supreme Court found that the regulations were preempted by the Federal Cigarette Labeling and Advertising Act, which precludes states from imposing any requirement or prohibition based on smoking and health with respect to the advertising or promotion of cigarettes labeled in conformity with federal law.

      In June 2000, the New York State legislature passed legislation charging the state’s Office of Fire Prevention and Control with developing standards for “fire-safe” or self-extinguishing cigarettes. On December 31, 2003, OFPC issued a final standard with accompanying regulations that will require all cigarettes offered for sale in New York State after June 28, 2004 to achieve specified test results when placed on ten layers of filter paper in controlled laboratory conditions. Certain design and manufacturing changes will be necessary for cigarettes manufactured for sale in New York to comply with the standard. There may be an adverse impact on the sale of cigarettes in New York due to reduced consumer acceptance of the changes in cigarettes made necessary to meet the standard. Inventories of cigarettes existing in the wholesale and retail trade as of June 28, 2004 that do not comply with the standard may continue to be sold, provided New York tax stamps have been affixed and such inventories have been purchased in comparable quantities in the same period in the previous year. Similar legislation is being considered in other states. Varying standards from state to state could have an adverse effect on the business or results of operations of RJR Tobacco.

      A price differential exists between cigarettes manufactured for sale abroad and cigarettes manufactured for U.S. sale. Consequently, a domestic “gray market” has developed in cigarettes manufactured for sale abroad. These cigarettes compete with the cigarettes RJR Tobacco manufactures for domestic sale. The U.S. federal government and all states, except Massachusetts, have enacted legislation prohibiting the sale and distribution of gray market cigarettes. In addition, RJR Tobacco has taken legal action against certain distributors and retailers who engage in such practices.

      Forty-four states have passed, and various states are considering, legislation to ensure nonparticipating manufacturers, referred to as NPMs, under the MSA are making required escrow payments. Under this legislation, a state would only permit distribution of brands by manufacturers who are deemed by the states to be MSA-compliant. Failure to make escrow payments could result in the loss of a nonparticipating manufacturer’s ability to sell tobacco products in a respective state. Early efforts to enact legislation, from

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2001 to early 2002, resulted in a range of NPM laws, some containing only minimal requirements. However, once the National Association of Attorneys General, referred to as NAAG, became involved in the legislative initiative, model “complementary” NPM language was developed and introduced in the states where either no NPM laws existed or where existing laws needed to be amended to bring them in line with the model language.

      Additionally, 20 states have approved legislation that closes a loophole in the MSA. The loophole allows nonparticipating manufacturers to recover most of the funds from their escrow accounts. To obtain the refunds, the manufacturers must establish that their escrow deposit was greater than the amount the state would have received had the manufacturer been a “subsequent participating manufacturer” under the MSA. NAAG has endorsed adoption of these legislative efforts.

      Finally, two states have enacted “equity assessments” on NPMs’ products, a legislative initiative that has not been endorsed by NAAG.

      Collectively, these forms of NPM legislation attempt to address some of the competitive inequities in the domestic cigarette market that benefit cigarette manufacturers that are not parties to the MSA.

      Twenty-six states have passed and several additional states are considering statutes limiting the amount of the bonds required to file an appeal of an adverse judgment in state court. The limitation on the amount of such bonds generally ranges from $25 million to $100 million. Such bonding statutes allow defendants that are subject to large adverse judgments, such as cigarette manufacturers, to reasonably bond such adverse judgments and pursue the appellate process.

      Tobacco leaf is an agricultural product subject to U.S. Government production controls and price supports that can affect market prices substantially. The tobacco leaf price support program is subject to congressional review and may be changed at any time. Post-MSA cigarette volume declines have dictated significant reductions in tobacco marketing quotas, which in turn have led many farmers to support legislation eliminating the current tobacco quota program with compensation for the lost value of their quotas. Such “quota buyout” legislation, funded by a tax on manufacturers and importers, has been introduced and could be considered during this session of Congress. Because of the importance of tobacco leaf as a raw material for RJR Tobacco’s products, substantial changes in the legislative or regulatory environment applicable to tobacco leaf could have a material effect on RJR Tobacco’s results of operations and cash flows.

      On May 21, 2003, the World Health Organization adopted a broad tobacco-control treaty. The treaty recommends and requires enactment of legislation establishing specific actions to prevent youth smoking, restrict and gradually eliminate tobacco products marketing, provide greater regulation and disclosure of ingredients, increase the size and scope of package warning labels to cover at least 30% of each package and include graphic pictures on packages. Although the United States delegate to the World Health Organization Assembly voted for the treaty, it is not known whether the treaty will be signed by the President and sent to the United States Senate for ratification. Ratification of the treaty by the United States Senate could lead to broader regulation of the industry.

      It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict the effect of new legislation or regulations on RJR Tobacco or the cigarette industry in general, but any new legislation or regulations could have an adverse effect on RJR Tobacco or the cigarette industry in general.

      For further discussion of litigation and legal proceedings pending against RJR, its affiliates, including RJR Tobacco, or indemnitees, see “Business — Litigation Affecting the Cigarette Industry,” “Business — ERISA Litigation” and “Business — Environmental Matters” in Item 1; note 13 to consolidated financial statements; and Exhibit 99.1 to this report.

Environmental Matters

      RJR and its subsidiaries are subject to federal, state and local environmental laws and regulations concerning the discharge, storage, handling and disposal of hazardous or toxic substances. RJR and its

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subsidiaries have been engaged in a continuing program to assure compliance with these environmental laws and regulations. Although it is difficult to identify precisely the portion of capital expenditures or other costs attributable to compliance with environmental laws and regulations, RJR does not expect such expenditures or other costs to have a material adverse effect on the business or financial condition of RJR or its subsidiaries.

      For further discussion of environmental matters, see “Business — Environmental Matters” in Item 1 and note 13 to consolidated financial statements.

Other Contingencies

      Until the acquisition by merger by Philip Morris Companies, Inc. of Nabisco from NGH on December 11, 2000, NGH and Nabisco were members of the consolidated group of NGH for U.S. federal income tax purposes. Each member of a consolidated group is jointly and severally liable for the U.S. federal income tax liability of other members of the group as well as for pension and funding liabilities of the other group members. NGH, now known as RJR Acquisition Corp., continues to be jointly and severally liable for these Nabisco liabilities prior to December 11, 2000.

      In connection with Philip Morris’s acquisition by merger of Nabisco and RJR’s subsequent acquisition by merger of NGH, Philip Morris, Nabisco and NGH entered into a voting and indemnity agreement that generally seeks to allocate tax liabilities ratably based upon NGH’s taxable income and that of Nabisco, had the parties been separate taxpayers. If Philip Morris and Nabisco are unable to satisfy their obligations under this agreement, NGH would be responsible for satisfying them.

      In connection with the sale of the international tobacco business to Japan Tobacco Inc. on May 12, 1999, RJR and RJR Tobacco agreed to indemnify Japan Tobacco against

  •  any liabilities, costs and expenses arising out of the imposition or assessment of any tax with respect to the international tobacco business arising prior to the sale, other than as reflected on the closing balance sheet;
 
  •  any liabilities, costs and expenses that Japan Tobacco or any of its affiliates, including the acquired entities, may incur after the sale with respect of any of RJR’s or RJR Tobacco’s employee benefit and welfare plans; and
 
  •  any liabilities, costs and expenses incurred by Japan Tobacco or any of its affiliates arising out of certain activities of Northern Brands.

Although it is impossible to predict the outcome of the Northern Brands litigation or the amount of liabilities, costs and expenses, a significant adverse outcome regarding any of these items could have an adverse effect on either or both of RJR and RJR Tobacco.

      RJR Tobacco has entered into agreements to indemnify certain distributors and retailers from liability and related defense costs arising out of the sale or distribution of RJR Tobacco’s products. The cost of such defense indemnification has been, and is expected to be, insignificant. RJR Tobacco believes that the indemnified claims are substantially similar in nature and extent to the claims that RJR Tobacco is already exposed to by virtue of its having manufactured those products. For further information related to these guarantees, including probability and estimates of loss, see “Business — Litigation Affecting the Cigarette Industry — Accounting for Tobacco — Related Litigation Contingencies” in Item 1.

      As long as RJR’s unsecured, unsubordinated debt rating remains either one level below BBB- by Standard & Poor’s or Baa3 by Moody’s, any fair value that results in a liability position of the interest rate swaps will require full collateralization with cash or securities.

Cautionary Information Regarding Forward-Looking Statements

      Statements included in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” that are not historical in nature are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements regarding RJR’s future

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performance and financial results inherently are subject to a variety of risks and uncertainties, described in the forward-looking statements. These risks include:

  •  The substantial and increasing regulation and taxation of the cigarette industry;
 
  •  various legal actions, proceedings and claims relating to the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of cigarettes that are pending or may be instituted against RJR or its subsidiaries;
 
  •  the substantial payment obligations and limitations on the advertising and marketing of cigarettes under various litigation settlement agreements;
 
  •  the continuing decline in volume in the domestic cigarette industry;
 
  •  competition from other cigarette manufacturers, including increased promotional activities and the growth of deep-discount brands;
 
  •  the success or failure of new product innovations and acquisitions;
 
  •  the effect of market conditions on the performance of pension assets, foreign currency exchange rate risk, interest rate risk and the return on corporate cash;
 
  •  any potential costs or savings associated with realigning the cost structure of RJR and its subsidiaries;
 
  •  the ability to achieve efficiencies in manufacturing and distribution operations without negatively affecting sales;
 
  •  the cost of tobacco leaf and other raw materials and other commodities used in products;
 
  •  the responsiveness of both the trade and consumers to new products and marketing and promotional programs; and
 
  •  the rating of RJR’s securities.

      In addition, RJR can give no assurance that the proposed formation of Reynolds American, the combination of RJR Tobacco and the U.S. assets, liabilities and operations of B&W, and the related combination transactions, will be consummated, or if consummated, that any expectations relating thereto will be realized. Factors that could affect whether these transactions are consummated include obtaining approvals from U.S. and European regulatory authorities and RJR stockholders, the receipt of satisfactory IRS rulings and the satisfaction or waiver of certain other conditions.

      Due to these uncertainties and risks, you are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. Except as provided by federal securities laws, RJR is not required to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise.

Item 7a. Quantitative and Qualitative Disclosures about Market Risk

      Market risk represents the risk of loss that may impact the consolidated financial position, results of operations and cash flows due to adverse changes in financial market prices and rates. RJR and its subsidiaries are exposed to interest rate risk directly related to their normal investing and funding activities. In addition, RJR and its subsidiaries have exposure to foreign currency exchange rate risk related to unrecognized firm commitments for the purchase of equipment, as well as obligations for, and service agreements related to, foreign operations denominated in euros and Great British pounds. RJR and its subsidiaries have established policies and procedures to manage their exposure to market risks and use major institutions that are creditworthy to minimize their investment and credit risk. Derivative financial instruments are not used for trading or speculative purposes. See note 14 to consolidated financial statements for further information regarding financial instruments entered into by RJR or its operating subsidiaries.

      The value-at-risk model is used to statistically measure the maximum fair value, cash flows and earnings loss over one year from adverse changes in interest rates and foreign currency rates. The computation assumes

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a 95% confidence level under normal market conditions. The actual observed correlation method is used for aggregating value at risk amounts across market risk exposure categories. This model indicates that near-term changes in interest rates and foreign currency rates will not have a material impact on the future earnings, fair values or cash flows, based on the historical movements in interest rates, foreign currency rates and the fair value of market-rate sensitive instruments at December 31, 2003.

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Item 8. Financial Statements and Supplementary Data

Independent Auditors’ Report

The Board of Directors

R.J. Reynolds Tobacco Holdings, Inc.:

We have audited the accompanying consolidated balance sheets of R.J. Reynolds Tobacco Holdings, Inc. and subsidiaries as of December 31, 2003 and 2002, and the related consolidated statements of income, stockholders’ equity and comprehensive income, and cash flows for each of the years in the three-year period ended December 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of R.J. Reynolds Tobacco Holdings, Inc. and subsidiaries as of December 31, 2003 and 2002, and the results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 to the consolidated financial statements, effective January 1, 2002, R.J. Reynolds Tobacco Holdings, Inc. and subsidiaries adopted the provisions of Statement of Financial Accounting Standards No. 142, “Goodwill and Other Intangible Assets.”

/s/ KPMG LLP

Greensboro, North Carolina

January 30, 2004

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Report of Management’s Responsibility for Financial Statements

      The financial statements presented in this report are the responsibility of management, and have been prepared in accordance with generally accepted accounting principles in the United States using, where appropriate, management’s best estimates and judgment. Management maintains a system of internal controls to provide reasonable assurance that RJR’s assets are safeguarded and transactions are executed as authorized and properly recorded. The system includes established policies and procedures, a program of internal audits, management reviews and careful selection and training of qualified personnel.

      The audit committee of RJR’s board of directors is composed solely of outside, independent directors. It meets periodically with management, the internal auditors and the independent auditors, to discuss and address internal accounting control, auditing and financial reporting matters. Both independent and internal auditors have unrestricted access to the audit committee.

/s/ Andrew J. Schindler  

 
Chairman of the Board, President and  
     Chief Executive Officer  
 
/s/ Dianne M. Neal  

 
Executive Vice President and  
     Chief Financial Officer  

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CONSOLIDATED STATEMENTS OF INCOME

(Dollars in Millions, Except Per Share Amounts)
                             
For the Years Ended December 31,

2003 2002 2001



Net sales (1)
  $ 5,267     $ 6,211     $ 6,269  
Costs and expenses:
                       
 
Cost of products sold (1) (2)
    3,218       3,732       3,560  
 
Selling, general and administrative expenses
    1,327       1,463       1,429  
 
Fixture impairment
    106              
 
Restructuring and asset impairment charges
    368       224        
 
Goodwill and trademark impairment charges
    4,089       13        
 
Amortization of trademarks and goodwill
                362  
     
     
     
 
   
Operating income (loss)
    (3,841 )     779       918  
Interest and debt expense
    111       147       150  
Interest income
    (29 )     (62 )     (137 )
Other (income) expense, net
    (5 )     11       13  
     
     
     
 
   
Income (loss) from continuing operations before income taxes
    (3,918 )     683       892  
Provision for (benefit from) income taxes
    (229 )     265       448  
     
     
     
 
   
Income (loss) from continuing operations
    (3,689 )     418       444  
Discontinued operations:
                       
 
Gain (loss) on sale of discontinued businesses, net of income taxes (2003 — $97; 2002 — $22; 2001 — $(5))
    122       40       (9 )
     
     
     
 
   
Income (loss) before extraordinary item and cumulative effect of accounting change
    (3,567 )     458       435  
Extraordinary item — gain on acquisition
    121              
Cumulative effect of accounting change, net of $328 income taxes
          (502 )      
     
     
     
 
   
Net income (loss)
  $ (3,446 )   $ (44 )   $ 435  
     
     
     
 
Basic income (loss) per share:
                       
 
Income (loss) from continuing operations
  $ (44.08 )   $ 4.71     $ 4.57  
 
Gain (loss) on sale of discontinued businesses
    1.46       0.45       (0.09 )
 
Extraordinary item
    1.45              
 
Cumulative effect of accounting change
          (5.66 )      
     
     
     
 
   
Net income (loss)
  $ (41.17 )   $ (0.50 )   $ 4.48  
     
     
     
 
Diluted income (loss) per share:
                       
 
Income (loss) from continuing operations
  $ (44.08 )   $ 4.64     $ 4.48  
 
Gain (loss) on sale of discontinued businesses
    1.46       0.44       (0.09 )
 
Extraordinary item
    1.45              
 
Cumulative effect of accounting change
          (5.57 )      
     
     
     
 
   
Net income (loss)
  $ (41.17 )   $ (0.49 )   $ 4.39  
     
     
     
 
Dividends declared per share
  $ 3.80     $ 3.73     $ 3.30  
     
     
     
 

  (1)  Excludes excise taxes of $1,572 million, $1,751 million and $1,529 million for the years 2003, 2002 and 2001 respectively.
  (2)  Includes settlement expense of $1,934 million, $2,514 million and $2,584 million for the years 2003, 2002 and 2001, respectively.

See Notes to Consolidated Financial Statements

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CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in Millions)
                               
For the Years Ended December 31,

2003 2002 2001



Cash flows from (used in) operating activities:
                       
 
Net income (loss)
  $ (3,446 )   $ (44 )   $ 435  
 
Less (gain) loss from discontinued operations
    (122 )     (40 )     9  
 
Adjustments to reconcile to net cash flows from (used in) continuing operating activities:
                       
   
Cumulative effect of accounting change, net of income taxes
          502        
   
Fixture impairment
    106                  
   
Restructuring and asset impairment charges
    277       224        
   
Goodwill and trademark impairment charges
    4,089       13        
   
Depreciation and amortization
    151       184       491  
   
Deferred income tax expense (benefit)
    (470 )     18       (43 )
   
Extraordinary gain on acquisition
    (121 )            
   
Other changes, net of acquisition effects, that provided (used) cash:
                       
     
Accounts and notes receivable
    29       5       (6 )
     
Inventories
    79       (56 )     (141 )
     
Accounts payable and accrued liabilities including income taxes and other working capital
    (49 )     (88 )     (109 )
   
Litigation bonds
    (10 )     (55 )      
   
Tobacco settlement and related expenses
    83       17       123  
   
Pension and postretirement
    (18 )     (194 )     (102 )
   
Other, net
    3       3       (31 )
     
     
     
 
   
Net cash flows from operating activities
    581       489       626  
     
     
     
 
Cash flows from (used in) investing activities:
                       
 
Purchases of short-term investments
    (4 )     (508 )     (207 )
 
Proceeds from short-term investments
    492       120        
 
Capital expenditures
    (70 )     (111 )     (74 )
 
Increases in equity investments
    (36 )            
 
Acquisitions, net of cash acquired
    (9 )     (339 )      
 
Net proceeds from (used in) the sale of businesses
    6             (14 )
 
Proceeds from liquidation of trusts
    99              
 
Other, net
    2       18       (12 )
     
     
     
 
   
Net cash flows from (used in) investing activities
    480       (820 )     (307 )
     
     
     
 
Cash flows from (used in) financing activities:
                       
 
Repurchase of common stock
    (75 )     (511 )     (494 )
 
Dividends paid on common stock
    (323 )     (335 )     (320 )
 
Repayments of long-term debt
    (741 )     (43 )     (73 )
 
Proceeds from exercise of stock options
    17       39       45  
 
Proceeds from issuance of long-term debt
          745        
     
     
     
 
   
Net cash flows used in financing activities
    (1,122 )     (105 )     (842 )
     
     
     
 
Net change in cash and cash equivalents
    (61 )     (436 )     (523 )
Cash and cash equivalents at beginning of year
    1,584       2,020       2,543  
     
     
     
 
Cash and cash equivalents at end of year
  $ 1,523     $ 1,584     $ 2,020  
     
     
     
 
Income taxes paid, net of refunds
  $ 231     $ 203     $ 457  
Interest paid
  $ 99     $ 135     $ 141  
Tobacco settlement and related expense payments
  $ 1,819     $ 2,464     $ 2,393  

See Notes to Consolidated Financial Statements

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CONSOLIDATED BALANCE SHEETS

(Dollars in Millions)
                         
December 31,

2003 2002


Assets
               
Current assets:
               
 
Cash and cash equivalents
  $ 1,523     $ 1,584  
 
Short-term investments
    107       595  
 
Accounts and notes receivable, net of allowance (2003 — $3; 2002 — $3)
    67       96  
 
Inventories
    684       762  
 
Deferred income taxes
    713       588  
 
Other current assets
    153       289  
 
Assets held for sale
    84       78  
     
     
 
   
Total current assets
    3,331       3,992  
Property, plant and equipment, at cost:
               
 
Land and land improvements
    92       89  
 
Buildings and leasehold improvements
    636       636  
 
Machinery and equipment
    1,416       1,359  
 
Construction-in-process
    39       77  
     
     
 
   
Total property, plant and equipment
    2,183       2,161  
     
Less accumulated depreciation
    1,289       1,221  
     
     
 
       
Property, plant and equipment, net
    894       940  
Trademarks, net of accumulated amortization (2003 — $481; 2002 — $481)
    1,759       2,085  
Goodwill, net of accumulated amortization (2003 — $0; 2002 — $3,359)
    3,292       7,090  
Other assets and deferred charges
    401       544  
     
     
 
    $ 9,677     $ 14,651  
     
     
 
Liabilities and stockholders’ equity
               
Current liabilities:
               
 
Accounts payable
  $ 36     $ 60  
 
Tobacco settlement and related accruals
    1,629       1,543  
 
Accrued liabilities and other
    1,134       1,075  
 
Current maturities of long-term debt
    56       741  
 
Liabilities related to assets held for sale
    10       8  
     
     
 
   
Total current liabilities
    2,865       3,427  
Long-term debt (less current maturities)
    1,671       1,755  
Deferred income taxes
    806       1,236  
Long-term retirement benefits
    1,034       1,176  
Other noncurrent liabilities
    244       341  
Commitments and contingencies:
               
Stockholders’ equity:
               
 
Common stock (shares issued: 2003 — 116,430,211; 2002 — 115,413,501)
    1       1  
 
Paid-in capital
    7,377       7,401  
 
Retained earnings (accumulated deficit)
    (2,469 )     1,217  
 
Accumulated other comprehensive loss — (cumulative minimum pension liability: 2003 — $(462); 2002 — $(599))
    (462 )     (598 )
 
Unamortized restricted stock
    (23 )     (19 )
     
     
 
      4,424       8,002  
 
Less treasury stock (shares: 2003 — 31,326,603; 2002 — 29,365,197), at cost
    (1,367 )     (1,286 )
     
     
 
   
Total stockholders’ equity
    3,057       6,716  
     
     
 
    $ 9,677     $ 14,651  
     
     
 

See Notes to Consolidated Financial Statements

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CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

AND COMPREHENSIVE INCOME (LOSS)
(Dollars in Millions)
                                                                 
Retained Accumulated
Earnings Other Unamortized Total
Common Paid-In (Accumulated Comprehensive Restricted Treasury Stockholders’ Comprehensive
Stock Capital Deficit) Income (Loss) Stock Stock Equity Income (Loss)








Balance at December 31, 2000
  $ 1     $ 7,291     $ 1,481     $ (8 )   $ (41 )   $ (288 )   $ 8,436          
Net income
                435                         435     $ 435  
Minimum pension liability, net of $61 tax expense
                      (113 )                 (113 )     (113 )
                                                             
 
Total comprehensive income
                                            $ 322  
                                                             
 
Dividends
                (324 )                       (324 )        
Stock options exercised
          42                               42          
Tax benefit on stock options exercised
          20                               20          
Restricted stock awarded
          18                   (26 )     8                
Restricted stock amortization
                            23             23          
Restricted stock forfeited
                1             2       (2 )     1          
Common stock repurchased
                                  (494 )     (494 )        
     
     
     
     
     
     
     
         
Balance at December 31, 2001
    1       7,371       1,593       (121 )     (42 )     (776 )     8,026          
Net income
                (44 )                       (44 )   $ (44 )
Minimum pension liability, net of $258 tax expense
                      (478 )                 (478 )     (478 )
Other
                      1                   1       1  
                                                             
 
Total comprehensive income
                                              $ (521 )
                                                             
 
Dividends
                (332 )                       (332 )        
Stock options exercised
          40                               40          
Tax benefit on stock options exercised
          14                               14          
Restricted stock awarded
          (28 )                 14       14                
Restricted stock forfeited
          4                   9       (13 )              
Common stock repurchased
                                  (511 )     (511 )        
     
     
     
     
     
     
     
         
Balance at December 31, 2002
    1       7,401       1,217       (598 )     (19 )     (1,286 )     6,716          
Net income
                (3,446 )                       (3,446 )   $ (3,446 )
Minimum pension liability, net of $76 tax expense
                      137                   137       137  
Other
                      (1 )                 (1 )     (1 )
                                                             
 
Total comprehensive income
                                            $ (3,310 )
                                                             
 
Dividends
          (81 )     (240 )                       (321 )        
Stock options exercised
          17                               17          
Tax benefit on equity awards
          14                               14          
Restricted stock awarded
          23                   (23 )                    
Restricted stock amortization
                            16             16          
Restricted stock forfeited
          3                   3       (6 )              
Common stock repurchased
                                  (75 )     (75 )        
     
     
     
     
     
     
     
         
Balance at December 31, 2003
  $ 1     $ 7,377     $ (2,469 )   $ (462 )   $ (23 )   $ (1,367 )   $ 3,057          
     
     
     
     
     
     
     
         

See Notes to Consolidated Financial Statements

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Summary of Significant Accounting Policies

Basis of Presentation

      The consolidated financial statements include the accounts of R.J. Reynolds Tobacco Holdings, Inc., referred to as RJR, and its wholly owned subsidiaries. RJR’s wholly owned subsidiaries include its operating subsidiaries, R. J. Reynolds Tobacco Company, referred to as RJR Tobacco, and Santa Fe Natural Tobacco Company, Inc., referred to as Santa Fe.

      The equity method is used to account for investments in businesses that RJR does not control, but has the ability to significantly influence operating and financial policies. The cost method is used to account for investments in which RJR does not have the ability to significantly influence operating and financial policies. RJR has no investments in entities greater than 20% for which it accounts by the cost method, and has no investments in entities greater than 50% for which it accounts by the equity method. All material intercompany balances have been eliminated.

      The preparation of the consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires estimates and assumptions to be made that affect the reported amounts in the consolidated financial statements and accompanying notes. Actual results could differ from those estimates. Certain reclassifications were made to conform prior years’ financial statements to the current presentation.

      All dollar amounts are presented in millions unless otherwise noted.

Cash Equivalents and Short-Term Investments

      Cash equivalents include money market funds, commercial paper and time deposits in major institutions with high credit ratings to minimize investment risk. As short-term, highly liquid investments readily convertible to known amounts of cash, with remaining maturities of three months or less at the time of purchase, cash equivalents have carrying values that approximate fair values. Debt securities included in cash equivalents are classified and accounted for as held-to-maturity or, in certain instances, available-for-sale securities. The appropriate classification of cash equivalents and short-term investments is determined at the time of purchase and the classification is reassessed at each reporting date. Short-term investments include investment pools that are classified and accounted for as available-for-sale securities.

      Investment securities classified as available-for-sale are reported at fair value based on current market quotes with unrealized gains and losses, net of any tax effect, recorded as a separate component of comprehensive income in stockholders’ equity until realized. Interest income and amortization of premiums and discounts are included in interest income. Gains and losses on investment securities sold are determined based on the specific identification method and are included in other (income) expense, net. Unrealized losses that are other than temporary are recognized in net income. No securities are held for speculative or trading purposes.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Accounts Receivable

      Accounts receivable are reported net of allowance for doubtful accounts. A summary of activity in the allowance for doubtful accounts is summarized as follows:

           
Balance at December 31, 2000
  $ 11  
 
Bad debt expense
    2  
     
 
Balance at December 31, 2001
    13  
 
Reduction in allowance
    (10 )
     
 
Balance at December 31, 2002
    3  
 
Bad debt expense
    2  
 
Write-off of bad debt
    (2 )
     
 
Balance at December 31, 2003
  $ 3  
     
 

Inventories

      Inventories are stated at the lower of cost or market. The cost of tobacco inventories is determined principally under the last-in, first-out, or LIFO, method. The cost of work in process and finished goods includes materials, direct labor, and variable costs and overhead and full absorption of fixed manufacturing overhead. Stocks of tobacco, which have an operating cycle that exceeds 12 months due to curing requirements, are classified as current assets, consistent with recognized industry practice.

Property, Plant and Equipment

      Property, plant and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets. Useful lives range from 20 to 50 years for buildings and improvements and from 3 to 30 years for machinery and equipment. The cost and related accumulated depreciation of assets sold or retired are removed from the accounts and the gain or loss on disposition is recognized in income.

Long-lived Assets

      Long-lived assets, such as property, plant and equipment, and purchased intangibles with definite lives, are reviewed for impairment whenever events or changes in circumstances indicate that the book value of the asset may not be recoverable. The carrying value of long-lived assets would be impaired if the best estimate of future undiscounted cash flows expected to be generated by the asset is less than the carrying value. If an asset is impaired, the loss is measured as the difference between estimated fair value and carrying value.

      On January 1, 2002, RJR adopted Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which supersedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,” and certain portions of Accounting Principles Board Opinion No. 30, “Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions.” SFAS No. 144 provides updated guidance concerning the recognition and measurement of an impairment loss for certain types of long-lived assets and requires that long-lived assets to be disposed of be reported separately in the asset and liabilities sections of the consolidated balance sheet. SFAS No. 144 also expands the reporting of discontinued operations to include components of an entity that have been or will be disposed of. The scope of SFAS No. 144 excludes goodwill and other intangibles that are accounted for in accordance with SFAS No. 142, “Goodwill and Other Intangible Assets.” The adoption of SFAS No. 144 did not have a material impact on RJR’s consolidated results of operations, financial position or cash flows. Prior to the adoption of SFAS No. 144, long-lived assets were accounted for in accordance with SFAS No. 121.

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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

Accounting for Returned Goods

      During the second quarter of 2003, RJR Tobacco announced a revision of its policy related to returned goods. Previously, RJR Tobacco accepted all damaged and out-of-code-date products. Under its revised policy, RJR Tobacco will accept only returns of unintentionally damaged products. During the second quarter of 2003, all retail returns other than unintentionally damaged products were suspended. Returns other than unintentionally damaged products shipped from wholesalers under the previous return policy were last accepted during the third quarter of 2003.

      At June 30, 2003, the reserve for returned goods consisted of (1) an estimate of returns for unintentionally damaged product and (2) an estimate of goods to be returned from wholesalers under the previous policy. These estimates resulted in a $54 million reduction of the reserve for returned goods balance as of June 30, 2003, having the effect of increasing net sales $54 million. The change in the estimate of the reserve for returned goods was made in the second quarter, as that is the period that RJR Tobacco’s policy change was effected and announced to its customers. Reflecting the results of the revised returned good policy, the returned goods reserve was reduced $42 million during the second half of 2003, for a total of $96 million during 2003. The change in the returned goods policy benefited net income $0.69 per basic and diluted share during the year ended December 31, 2003.

Merchandising Fixtures

      Beginning in the fourth quarter of 2002, in response to changes in industry retail display, RJR Tobacco began replacing significant portions of its merchandising fixtures on an accelerated basis that resulted in accelerated amortization. During the second quarter of 2003, it became evident that the scope, extent and timing of competitors’ similar replacement actions were reduced significantly from RJR Tobacco’s original expectations. As a result, RJR Tobacco significantly reduced further replacement of its merchandising fixtures. Accordingly, the service lives of those fixtures targeted for near-term replacement, which were shortened in the fourth quarter of 2002, were extended to their original service life. Additionally, the percentage salvageable became higher than previously estimated. As a result, there was no additional book value to amortize on an accelerated basis. Accordingly, RJR Tobacco ceased accelerated amortization. Amortization of merchandising fixtures during 2003 was $66 million, of which $21 million was accelerated amortization, compared with amortization expense of $96 million, of which $43 million was accelerated amortization, for 2002. The change in estimate and resulting accelerated amortization adversely impacted net income $0.15 per basic and diluted share during 2003 and $0.29 per basic and diluted share during 2002.

      In response to marketplace activity, during the fourth quarter of 2003, RJR Tobacco reevaluated its strategy related to merchandising fixtures and transferred its ownership of these fixtures to the cigarette retailers, resulting in an impairment charge of $106 million.

Goodwill and Trademarks

      Intangibles include primarily goodwill and trademarks that have indefinite lives. Trademarks are capitalized when acquired. During 2001, these intangibles were amortized using the straight-line method, principally over 40 years, and tested for impairment, by comparison of their carrying value with estimated future undiscounted cash flows expected to be generated by the asset, when events and circumstances indicated that the asset might be impaired.

      On January 1, 2002, RJR adopted SFAS No. 141, “Business Combinations,” and SFAS No. 142. As a result, RJR Tobacco’s trademarks and goodwill are no longer amortized but rather are tested annually for impairment or more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.

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      The following table presents net income and income per share as if the provisions of SFAS No. 142 had been applied as of January 1, 2001:

         
Year Ended
December 31,
2001

Reported income before extraordinary item
  $ 435  
Add back: goodwill amortization
    260  
                  trademark amortization, net of tax
    62  
     
 
Adjusted income before extraordinary item
  $ 757  
     
 
Adjusted net income
  $ 757  
     
 
Basic income per share:
       
Reported income before extraordinary item
  $ 4.48  
Add back: goodwill amortization
    2.68  
                  trademark amortization, net of tax
    0.64  
     
 
Adjusted income before extraordinary item
  $ 7.80  
     
 
Adjusted net income
  $ 7.80  
     
 
Diluted income per share:
       
Reported income before extraordinary item
  $ 4.39  
Add back: goodwill amortization
    2.63  
                  trademark amortization, net of tax
    0.63  
     
 
Adjusted income before extraordinary item
  $ 7.65  
     
 
Adjusted net income
  $ 7.65  
     
 

      For the initial application of SFAS No. 142, an independent appraisal firm was engaged to value RJR’s goodwill and trademarks as of January 1, 2002. RJR’s goodwill as of January 1, 2002 was attributable to one reporting unit, RJR Tobacco, which comprises substantially all of RJR’s consolidated results of operations and financial condition. No goodwill impairment was indicated, since the fair value of RJR was determined to be greater than its carrying value using several valuation techniques, including discounted cash flow analysis. However, the fair values of WINSTON, SALEM, VANTAGE, NOW and MORE, using an income approach, were less than their carrying values, which resulted in an $830 million, or $502 million after tax, impairment charge, reported as a cumulative effect of a change in accounting during the quarter ended March 31, 2002.

      The following impairment charges were based on the results of appraisals performed by an independent appraisal firm. In connection with the annual impairment testing in the fourth quarter of 2002, impairment occurred on two of RJR Tobacco’s non-key brands, VANTAGE and CENTURY. The related impairment testing indicated that the carrying amounts of these brands would not be recoverable through future undiscounted cash flows. Accordingly, RJR Tobacco recorded impairment charges of $13 million, $8 million after tax, based on the excess of the brands’ carrying values over their fair values, determined using the present value of estimated future cash flows assuming a discount rate of 10.5%. The discount rate was determined by adjusting the RJR Tobacco enterprise discount rate by an appropriate risk premium to reflect an asset group risk. These impairment charges are reflected as decreases in the carrying value of the trademarks in the consolidated balance sheets and as trademark impairment charges in the 2002 consolidated income statement and had no impact on cash flows.

      In response to competitive changes in the tobacco industry, RJR Tobacco initiated comprehensive changes in its strategies and cost structure that resulted in a restructuring primarily during the third quarter of 2003. The extent of the adverse impact of these competitive changes was not anticipated during the annual testing of trademarks and goodwill, performed in the fourth quarter of 2002. Accordingly, as provided by

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SFAS No. 142, RJR Tobacco tested its trademarks and goodwill for impairment based on its revised forecast of expected sales and cash flows. The trademark impairment testing indicated that impairment occurred on certain of RJR Tobacco’s brands, primarily WINSTON and DORAL, reflecting RJR Tobacco’s decision in the third quarter of 2003 to limit investment in these brands in an effort to optimize profitability. Accordingly, RJR Tobacco recorded an impairment charge of $326 million, $197 million after tax, in the third quarter of 2003. This charge was based on the excess of the brands’ carrying values over their fair values, determined using the present value of estimated future cash flows assuming a discount rate of 10.5%. This impairment charge was included in goodwill and trademark impairment charges in the 2003 consolidated statement of income, as a decrease in the carrying value of trademarks in the consolidated balance sheet as of December 31, 2003, and had no impact on cash flows.

      For the purpose of testing goodwill, the fair value of RJR Tobacco was based on the present value of the estimated future cash flows of the reporting unit assuming a discount rate of 10.0%. The determination of this discount rate is based on a weighted average cost of capital using a risk-free rate adjusted by a stock-beta adjusted risk premium. The valuation indicated that the carrying value of RJR Tobacco exceeded its implied fair value. Preliminary estimated fair values were assigned to RJR Tobacco’s assets and liabilities to estimate the implied fair value of RJR Tobacco’s goodwill. As a result, the carrying amount of the goodwill of RJR Tobacco exceeded its implied fair value by $3.3 billion, and an impairment charge equal to that estimated excess was recognized in the third quarter of 2003. During the fourth quarter of 2003, RJR Tobacco completed its impairment measurement and recorded an additional $0.5 billion charge, primarily due to finalized appraisal values of property, plant and equipment. These impairment charges were included in goodwill and trademark impairment charges in the 2003 consolidated income statement and as a decrease in the carrying value of goodwill in the consolidated balance sheet as of December 31, 2003, and had no impact on cash flows.

      The $9 million goodwill acquired by Santa Fe is attributable to its acquisition of the externally owned portion of a joint venture, Santa Fe Natural Tobacco Company: Europe GmbH, in April 2003.

      The changes in the carrying amount of trademarks during the years ended December 31, 2002 and 2003, respectively, were:

                           
RJR Tobacco Santa Fe Consolidated



Balance as of January 1, 2002
  $ 2,773     $     $ 2,773  
 
Trademarks acquired
          155       155  
 
Impairment due to accounting change
    (830 )           (830 )
 
Impairment included in operating income
    (13 )           (13 )
     
     
     
 
Balance as of December 31, 2002
    1,930       155       2,085  
 
Impairment included in operating income
    (326 )           (326 )
     
     
     
 
Balance as of December 31, 2003
  $ 1,604     $ 155     $ 1,759  
     
     
     
 

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      The changes in the carrying amount of goodwill during the years ended December 31, 2002 and 2003, respectively, were:

                           
RJR Tobacco Santa Fe Consolidated



Balance as of January 1, 2002
  $ 6,875     $     $ 6,875  
 
Goodwill acquired
          215       215  
     
     
     
 
Balance as of December 31, 2002
    6,875       215       7,090  
 
Goodwill acquired
          9       9  
 
Impairment included in operating income
    (3,763 )           (3,763 )
 
Adjustment due to resolution of pre-LBO tax exposure accrual
    (44 )           (44 )
     
     
     
 
Balance as of December 31, 2003
  $ 3,068     $ 224     $ 3,292  
     
     
     
 

Accounting for Derivative Instruments and Hedging Activities

      SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended, requires RJR to measure every derivative instrument, including certain derivative instruments embedded in other contracts, at fair value and record them in the balance sheet as either an asset or liability. Changes in fair value of derivatives are recorded currently in earnings unless special hedge accounting criteria are met. For derivatives designated as fair value hedges, the changes in fair value of both the derivative instrument and the hedged item are recorded in earnings. For derivatives designated as cash flow hedges, the effective portions of changes in the fair value of the derivative are reported in other comprehensive income. The ineffective portions of hedges are recognized in earnings in the current period.

      RJR formally assesses both at inception of the hedge and on an ongoing basis, whether each derivative is highly effective in offsetting changes in fair values or cash flows of the hedged item. If it is determined that a derivative is not highly effective as a hedge or if a derivative ceases to be a highly effective hedge, RJR will discontinue hedge accounting prospectively.

Software Costs

      In accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” certain computer software and software development costs incurred in connection with developing or obtaining computer software for internal use that has a useful life of greater than one year are capitalized. These costs are amortized over five years or less. During 2003 and 2002, costs of $12 million and $20 million, respectively, were capitalized, and at December 31, 2003 and December 31, 2002, the unamortized balance was $33 million and $36 million, respectively. Related amortization expense was $15 million, $11 million and $8 million for the years ended December 31, 2003, 2002 and 2001, respectively.

Revenue Recognition

      Revenue from product sales is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the seller’s price to the buyer is fixed or determinable, and collectibility is reasonably assured. For RJR’s operating subsidiaries, these criteria are met upon shipment, when title and risk of loss pass to the customer. Shipping and handling costs are classified as cost of products sold. Certain sales incentives, including coupons, buydowns and slotting allowances, are classified as reductions of net sales in accordance with Emerging Issues Task Force Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products).”

      Effective January 1, 2002, EITF No. 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products,” requires that consideration paid to a distributor or retailer to promote the vendor’s products, such as slotting fees or buydowns, generally be characterized as a reduction of

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revenue when recognized in the vendor’s income statement. EITF No. 01-9 became effective in November 2001, codifying and reconciling certain issues in EITF No. 00-25. As of January 1, 2002, the operating subsidiaries have characterized the applicable costs as reductions of net sales rather than as selling, general and administrative expenses. For the year ended December 31, 2001, $2.3 billion was reclassified from selling, general and administrative expenses to a reduction of net sales. The adoption of EITF No. 00-25, as codified by EITF No. 01-9, did not impact RJR’s consolidated financial position, operating income or net income.

Advertising and Research and Development

      Advertising costs, which are expensed as incurred, were $135 million, $55 million and $73 million in the years ended December 31, 2003, 2002 and 2001, respectively. The increased advertising expense during 2003 reflects RJR Tobacco’s refocused marketing strategy on CAMEL and SALEM. Research and development costs, which are expensed as incurred, were $54 million, $63 million and $64 million in the years ended December 31, 2003, 2002 and 2001, respectively.

Income Taxes

      Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Income taxes for RJR and RJR Tobacco are calculated on a separate return basis.

Stock-Based Compensation

      Effective January 1, 2003, RJR adopted the prospective method of transition of SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure, an amendment of SFAS No. 123.” SFAS No. 148 amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to that statement’s fair value method of accounting for stock-based employee compensation. SFAS No. 148 also amends the disclosure provisions of SFAS No. 123 and APB No. 28, “Interim Financial Reporting,” to require disclosure in the summary of significant accounting policies, or its equivalent, of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income and earnings per share for all periods presented in the financial statements. The transition and disclosure provisions of this statement are effective for financial statements for fiscal years ending after December 15, 2002.

      All of RJR’s compensation costs related to employee stock plans that were granted prior to January 1, 2003, will continue to be recognized using the intrinsic value-based method under the provisions of APB No. 25, “Accounting for Stock Issued to Employees,” and related Interpretations. However, any compensation costs related to grants or modifications of existing grants subsequent to January 1, 2003, will be recognized under the fair value method of SFAS No. 123, as amended. All compensation costs related to employee stock plans for all grant dates will be disclosed under the provisions of SFAS No. 123, as amended. Stock compensation is described more fully in note 16 to the consolidated financial statements.

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      The following table illustrates the effect on net income and income per share if RJR had applied the fair value recognition provisions of SFAS No. 123 for all awards for the years ended December 31:

                           
2003 2002 2001



Net income (loss), as reported
  $ (3,446 )   $ (44 )   $ 435  
 
Add: Stock-based employee compensation expense included in reported net income, net of tax
    10             11  
 
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of tax
    9       8       10  
     
     
     
 
Pro forma net income (loss)
  $ (3,445 )   $ (52 )   $ 436  
     
     
     
 
Income (loss) per share:
                       
 
Basic — as reported
  $ (41.17 )   $ (0.50 )   $ 4.48  
 
Basic — pro forma
    (41.16 )     (0.59 )     4.49  
 
Diluted — as reported
    (41.17 )     (0.49 )     4.39  
 
Diluted — pro forma
    (41.16 )     (0.58 )     4.40  

Pension and Postretirement

      Gains or losses are annual changes in the amount of either the benefit obligation or the market-related value of plan assets resulting from experience different from that assumed or from changes in assumptions. The minimum amortization of unrecognized gains or losses, as described in SFAS No. 87, “Employers’ Accounting for Pensions,” is included in pension expense. Prior service costs, which are changes in benefit obligations due to plan amendments, are amortized on a straight-line basis over the average remaining service period for active employees. The market-related value of plan assets recognizes changes in fair value in a systematic and rational manner over five years. For further information and detailed disclosure in accordance with SFAS No. 132(R), “Employers’ Disclosures about Pensions and Other Postretirement Benefits,” see note 17 to consolidated financial statements.

Tobacco-Related Litigation Contingencies

      In accordance with SFAS No. 5, “Accounting for Contingencies,” RJR and RJR Tobacco will record any loss related to tobacco litigation at such time that an unfavorable outcome becomes probable and the amount can be reasonably estimated. When the reasonable estimate is a range, the recorded loss will be the best estimate within the range. If no amount in the range is a better estimate than any other amount, the minimum amount of the range would be recorded. See note 13, “Commitments and Contingencies,” to consolidated financial statements, concerning tobacco-related litigation for which an unfavorable outcome is other than remote.

Recently Adopted Accounting Pronouncements

      The adoption of the following accounting pronouncements has not had, or is not expected to have, a material effect on RJR’s financial position, results of operations or cash flows.

  •  On January 1, 2003, the provisions of SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” became effective and nullified EITF No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for costs associated with an exit or disposal activity be recognized when those costs are incurred, and that the total amount expected to be incurred in connection with the activity be disclosed. Under EITF No. 94-3, a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan.
 
  •  In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities.” This Interpretation, as amended by FIN No. 46(R), clarifies the application of Accounting Research

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  Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties.
 
  •  In April 2003, the FASB issued SFAS No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” This statement amends SFAS No. 133, for implementation issues related to the definition of a derivative and other FASB projects related to financial instruments. SFAS No. 149 requires that contracts with comparable characteristics be accounted for in a similar fashion.
 
  •  In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that financial instruments within the scope of SFAS No. 150 be classified as a liability or an asset.
 
  •  In December 2003, the FASB issued SFAS No. 132(R), which replaces SFAS No. 132, “Employers’ Disclosures about Pensions and Other Postretirement Benefits.” SFAS No. 132(R) does not change the measurement and recognition provisions of SFAS No. 87, SFAS No. 88, “Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits,” and SFAS No. 106, “Employers’ Accounting for Postretirement Benefits Other Than Pensions,” however, it includes additional disclosure provisions for annual reporting, including detailed plan asset information by category, expanded benefit obligation disclosure and key assumptions. In addition, interim disclosures related to the individual elements of plan costs and employer’s current year contributions are required. See note 17 to consolidated financial statements for further information regarding RJR’s pension and postretirement plans.

Note 2 — Pending Business Combination Transactions

      On October 27, 2003, RJR announced the signing of a definitive agreement with Brown & Williamson Tobacco Corporation, referred to as B&W, a subsidiary of British American Tobacco p.l.c., referred to as BAT, to combine RJR Tobacco and the U.S. assets, liabilities and operations of B&W, subject to specified exceptions.

      The agreement provides for establishing a new publicly traded holding company, Reynolds American Inc., referred to as Reynolds American, with approximately 150 million shares outstanding. Reynolds American will issue common shares to B&W in exchange for the U.S. assets, liabilities and operations of B&W, subject to specified exceptions, and will issue common shares to existing RJR stockholders in exchange for their existing RJR shares on a one-for-one basis. Upon completion of the combination, B&W will own approximately 42% of Reynolds American, and existing RJR stockholders will own approximately 58%. No indebtedness for borrowed money of B&W will be assumed by Reynolds American. The transaction is expected to be tax-free to RJR stockholders, and will be treated as a purchase for financial accounting purposes.

      The agreement provides for B&W to transfer with its U.S. operations cash in an amount equal to accrued expenses under the Master Settlement Agreement, referred to as the MSA. The cash balance is contingent on the timing of closing the transaction, but averages approximately $750 million during the year. The RJR Tobacco and B&W U.S. tobacco operations will be combined in an indirect subsidiary of Reynolds American, and that subsidiary will indemnify B&W for its historical and current litigation liabilities.

      Under a separate agreement, RJR will pay a subsidiary of BAT $400 million in cash to acquire the stock of Lane Limited, a subsidiary that manufactures or distributes cigar, roll-your-own and pipe tobacco brands and other tobacco products, including DUNHILL and CAPTAIN BLACK tobacco products. BAT will retain

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the rights to use the BAT trademarks outside the United States. Santa Fe and Lane will operate as independent subsidiaries of Reynolds American.

      The combination transactions are expected to be completed during mid-2004, pending the necessary approvals from U.S. and European regulatory authorities and RJR stockholders, as well as satisfactory IRS rulings and other conditions. The headquarters and operations of Reynolds American are expected to be consolidated in Winston-Salem, North Carolina.

Note 3 — Acquisitions and Joint Venture

      On July 16, 2002, RJR acquired a 50% interest in R.J. Reynolds-Gallaher International Sarl, a joint venture created with Gallaher Group Plc, to manufacture and market a limited portfolio of American-blend cigarette brands. The joint venture, headquartered in Switzerland, has initially marketed its products in France, Spain, the Canary Islands and Italy, and in 2003, expanded into Andorra and Belgium. RJR’s financial contribution during the first five years is expected to be $75 million to $100 million. RJR Tobacco has licensed REYNOLDS, a new American-blend brand in a unique Slide Box pack, to the joint venture. This investment is accounted for using the equity method.

      On January 16, 2002, RJR acquired all of the voting stock of privately held Santa Fe. The acquisition was accounted for as a purchase, with its cost of $354 million allocated on the basis of the estimated fair market value of the assets acquired and liabilities assumed. The results of operations of Santa Fe have been included in the accompanying consolidated statements of income since January 16, 2002. Although Santa Fe is an operating segment of RJR, its financial condition and results of operations do not meet the materiality criteria to be separately reportable.

      In April 2003, Santa Fe, through a wholly owned subsidiary, acquired with cash, the externally owned portion of a joint venture, Santa Fe Natural Tobacco Company: Europe GmbH. The cost of the acquisition, net of cash acquired, was $9 million.

Note 4 — Restructuring and Impairment Charges

2003 Restructuring and Asset Impairment Charges

      The components of the 2003 restructuring and asset impairment charges, recorded and utilized through December 31, 2003, were:

                                   
Employee
Severance Contract
and Asset Termination/
Benefits Impairment Exit Costs Total




Incurred during second quarter
  $     $ 18     $ 37     $ 55  
 
Utilized in second quarter
          (18 )     (22 )     (40 )
     
     
     
     
 
Balance, June 30, 2003
                15       15  
 
Incurred during third quarter
    292       10       9       311  
 
Utilized in third quarter
    (80 )     (10 )     (24 )     (114 )
     
     
     
     
 
Balance, September 30, 2003
    212                   212  
     
     
     
     
 
 
Incurred during fourth quarter
                7       7  
 
Utilized in fourth quarter
    (12 )           (6 )     (18 )
     
     
     
     
 
Balance, December 31, 2003
  $ 200     $     $ 1     $ 201  
     
     
     
     
 

      In April 2003, in response to continuing challenges of an intensely competitive environment, primarily pricing pressures, RJR announced initiatives to fundamentally rethink RJR Tobacco’s approach to the marketplace and realign the cost structures of RJR Tobacco and RJR. As a result, during the second quarter of 2003, RJR and RJR Tobacco incurred initial restructuring and impairment charges of $55 million. RJR

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Tobacco recorded a non-cash $18 million impairment charge to fully write off certain production equipment that it abandoned. RJR Tobacco also incurred contract termination expenses of $29 million related to the discontinuation of certain event-marketing programs, and RJR incurred other restructuring associated costs of $8 million during the second quarter of 2003.

      In September 2003, RJR announced a refocused brand portfolio strategy for RJR Tobacco and a significant cost reduction initiative. Marketing investments now focus on two growth brands, CAMEL and SALEM, with more limited investments in WINSTON and DORAL, to optimize profitability. Certain of these initiatives resulted in consolidated restructuring and impairment charges of $311 million, or $189 million after tax, in the third quarter of 2003. Of these charges, RJR Tobacco incurred $287 million related to severance and benefits, $10 million related to asset impairments and $1 million related to associated exit costs. The remaining $13 million was incurred by RJR.

      Of the third quarter charges, the employee severance and benefits relate to a workforce reduction of 40%, or approximately 2,600 full-time employees, in operations and corporate functions. Approximately 1,400 reductions were completed as of December 31, 2003. The workforce reduction is expected to be materially completed during 2004. The asset impairment resulted from the abandonment of certain merchandising fixtures. The third quarter exit costs included professional fees for valuation and consulting services.

      In conjunction with the 2003 restructuring plan, during the fourth quarter, RJR incurred $3 million of consulting fees and RJR Tobacco incurred $4 million of charges related primarily to aircraft lease termination and outplacement service fees related to restructuring.

      Additional charges of approximately $20 million are expected to be incurred during 2004 in connection with the 2003 restructuring plans. The cash portion of the 2003 restructuring and impairment charges is expected to be $265 million, of which $212 million relates to employee severance costs and $53 million relates to exit costs. As of December 31, 2003, $64 million of this amount had been paid. Of the $108 million non-cash portion of the charges, $80 million related to benefit charges, and $28 million related to asset impairments. In the consolidated balance sheet as of December 31, 2003, $132 million is included in accrued liabilities and other and $69 million is included in other noncurrent liabilities.

2002 Restructuring and Asset Impairment Charges

      The components of the 2002 restructuring and asset impairment charges, recorded and utilized through December 31, 2003, were:

                                   
Employee
Severance Contract
and Asset Termination/
Benefits Impairment Exit Costs Total




Original charge
  $ 102     $ 115     $ 7     $ 224  
 
Utilized in 2002
    (44 )     (115 )     (2 )     (161 )
     
     
     
     
 
Balance, December 31, 2002
    58             5       63  
 
Utilized in 2003
    (27 )                 (27 )
 
Adjusted in 2003
    (2 )           (3 )     (5 )
     
     
     
     
 
Balance, December 31, 2003
  $ 29     $     $ 2     $ 31  
     
     
     
     
 

      In the fourth quarter of 2002, RJR Tobacco recorded a pre-tax restructuring charge of $224 million, $135 million after tax, in response to changing competitive practices within the tobacco industry during the second half of 2002.

      The employee severance and benefits relate to 572 full-time employee workforce reductions in operations support and corporate functions, of which 25 positions remained at December 31, 2003. These remaining positions are expected to be eliminated in the first quarter of 2004.

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      The asset impairment resulted from the remeasurement of the non-tobacco businesses at the lower of their carrying value or fair value less cost to sell. The non-tobacco businesses are classified as assets held for sale and liabilities related to assets held for sale in the consolidated balance sheets, in accordance with SFAS No. 144. As of December 31, 2003, the carrying amounts of the major classes of assets and liabilities in the disposal group included $13 million of accounts receivable, $31 million of inventories, $40 million of property, plant and equipment and other, and $10 million of accounts payable and accrued liabilities. As of December 31, 2002, the carrying amounts of the major classes of assets and liabilities in the disposal group included $15 million of accounts receivable, $52 million of inventories, $11 million of property, plant and equipment and other, and $8 million of accounts payable and accrued liabilities. RJR Tobacco completed the sale of one of the non-tobacco businesses in the second quarter of 2003, and expects to complete the sale of the remaining business, currently in negotiation, during the first half of 2004.

      Contract termination and exit costs included certain contract terminations and lease terminations of 15 sales offices. Exit costs also included the separation of the non-tobacco businesses held for sale. During 2003, $5 million of the charge, concerning expected severance and related benefits and exit costs of field sales offices, was reversed, and was included as a reduction in restructuring and asset impairment charges in the consolidated statement of income for 2003.

      The cash portion of the 2002 restructuring and impairment charges is expected to be $58 million and primarily relates to employee severance costs. As of December 31, 2003, $27 million of this amount had been paid. The $161 million non-cash portion included $44 million related to employee benefits, $115 million related to asset impairments and $2 million related to the write-off of prepaid promotional rights that were terminated. In the consolidated balance sheet as of December 31, 2003, $25 million is included in accrued liabilities and other and $6 million is included in other noncurrent liabilities.

Note 5 — Discontinued Operations

      Discontinued operations reflect transactions related to the 1999 sale of the international tobacco business to Japan Tobacco Inc. During 2003, these transactions included a $106 million favorable resolution of tax matters and a $16 million after-tax reversal of an indemnification accrual. Transactions during 2002 and 2001 included a $40 million after-tax reversal of an indemnification accrual and a $9 million after-tax, purchase-price adjustment, respectively. Including these adjustments, the net after-tax gain on the sale of the international tobacco business was $2.5 billion.

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Note 6 — Income Per Share

      The components of the calculation of income per share were:

                             
For the Years Ended
December 31,

2003 2002 2001



Income (loss) from continuing operations
  $ (3,689 )   $ 418     $ 444  
Gain (loss) from discontinued operations
    122       40       (9 )
Extraordinary item — gain on acquisition
    121              
Cumulative effect of accounting change
          (502 )      
     
     
     
 
 
Net income (loss)
  $ (3,446 )   $ (44 )   $ 435  
     
     
     
 
Basic weighted average shares, in thousands(1)
    83,697       88,733       97,043  
 
Effect of dilutive potential shares:
                       
   
Options
          897       1,472  
   
Restricted stock
          545       471  
     
     
     
 
Diluted weighted average shares, in thousands(2)
    83,697       90,175       98,986  
     
     
     
 

(1)  Outstanding contingently issuable restricted stock of 1.0 million shares, 1.6 million shares and 1.7 million shares were excluded from the basic share calculation for the years ended December 31, 2003, 2002 and 2001, respectively, as the related vesting provisions had not been met.
(2)  Potentially dilutive shares of 0.4 million options and 0.3 million restricted shares were excluded from diluted amounts for 2003 and 0.3 million common stock equivalents were excluded from diluted per share amounts for 2002, as they would have been anti-dilutive. No anti-dilution existed in 2001.

Note 7 — Short-Term Investments

      Short-term investments classified as available-for-sale as of December 31 were:

                   
2003 2002


Commercial paper and asset-backed securities
  $ 83     $ 263  
Money market funds and certificates of deposit
          151  
Federal agency securities
    3       126  
Master notes
          25  
U.S. government treasury bills
          6  
Other investments
    21       24  
     
     
 
 
Total short-term investments
  $ 107     $ 595  
     
     
 

      The contractual maturities of these securities averaged less than one year. Realized and unrealized gains and losses on available-for-sale securities for the years ended December 31, 2003 and 2002 were not significant, and accordingly, the amortized cost of these securities approximated fair value.

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Note 8 — Inventories

      The major components of inventories at December 31 were:

                   
2003 2002


Leaf tobacco
  $ 605     $ 599  
Raw materials
    19       18  
Work in process
    36       35  
Finished products
    86       110  
Other
    19       26  
     
     
 
 
Total
    765       788  
Less LIFO allowance
    81       26  
     
     
 
    $ 684     $ 762  
     
     
 

      Inventories valued under the LIFO method were approximately $639 million and $736 million at December 31, 2003 and 2002, respectively. The LIFO allowance reflects the excess of the current cost of LIFO inventories at December 31, 2003 and 2002, over the amount at which these inventories were carried on the consolidated balance sheets. During 2003 net income increased by $4 million due to LIFO inventory liquidations. During 2002 and 2001, there was no impact on net income from LIFO inventory liquidations.

Note 9 — Short-Term Borrowings and Borrowing Arrangements

      RJR’s revolving credit facility with a syndicate of banks was amended and restated on May 10, 2002. Under the amendment and restatement, in May 2003 the committed amount was reduced from $622 million to $531 million through November 2004. The facility was further amended on September 25, 2003, primarily to modify certain definitions of terms related to negative covenants. RJR can use the full facility to obtain loans or letters of credit, at its option.

      Since prior to 2002, two of RJR’s material subsidiaries, RJR Tobacco and RJR Acquisition Corp., have guaranteed RJR’s obligations under the revolving credit facility. During 2003, Moody’s lowered its rating of RJR’s guaranteed, previously unsecured notes below investment grade, to Ba2, and Standard & Poor’s lowered its rating to BB+. These downgrades required RJR’s other material subsidiaries, including Santa Fe, to also guarantee the facility and to pledge all of their assets to secure their obligations under RJR’s revolving credit facility. These actions reflected the rating agencies’ concern over recent industry trends including heavy promotional activity, the growth of the deep-discount price tier, the volatility of tobacco litigation and RJR’s competitive position. On October 28, 2003, Moody’s changed its ratings outlook from negative to stable, reflecting opportunities offered by the proposed combination of RJR and B&W’s U.S. tobacco operations. The outlook for Standard & Poor’s ratings remains negative. Concerns about, or further lowering of, the ratings of RJR’s guaranteed, previously unsecured unsubordinated debt notes by Standard & Poor’s or Moody’s could have an adverse impact on RJR’s ability to access the debt markets. However, given that RJR has significant cash balances and does not anticipate a need to issue additional public debt prior to 2006, RJR’s management believes that such concerns about, or further lowering of, such ratings would not have a material adverse impact on RJR’s cash flows.

      RJR is not required to maintain compensating balances; however, RJR pays commitment fees of 1.5% per annum of the revolving credit facility committed amount. Borrowings under the revolving credit facility bear interest at rates that vary with the prime rate or LIBOR. The credit facility also limits RJR’s ability to pay dividends, repurchase stock, incur indebtedness, engage in transactions with affiliates, create liens, acquire, sell or dispose of specific assets and engage in specified mergers or consolidations. Under the credit facility, cumulative dividends and share repurchases generally may not exceed the sum of $500 million plus 50% of cumulative adjusted cash net income. Despite this general restriction, however, the credit facility further provides that up to an additional $500 million in dividends and share repurchases may be made. Stock

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repurchases also are limited to the extent that a stated minimum level of net worth must be maintained. At December 31, 2003, RJR had $20 million in letters of credit outstanding under the facility. No borrowings were outstanding, and the remaining $511 million of the facility was available for borrowing.

      RJR has a $30 million uncommitted, unsecured line of credit with one bank. No borrowings were outstanding on this line of credit at December 31, 2003.

Note 10 — Accrued Liabilities and Other

      Accrued liabilities at December 31 included:

                 
2003 2002


Payroll and employee benefits
  $ 325     $ 310  
Marketing and advertising
    383       345  
Accrued interest
    21       28  
Accrued restructuring charges
    163       41  
Other
    242       351  
     
     
 
    $ 1,134     $ 1,075  
     
     
 

Note 11 — Income Taxes

      The components of the provision for (benefit from) income taxes from continuing operations were:

                           
For the Years Ended
December 31,

2003 2002 2001



Current:
                       
 
Federal
  $ 200     $ 202     $ 426  
 
State and other
    41       45       65  
     
     
     
 
      241       247       491  
     
     
     
 
Deferred:
                       
 
Federal
    (413 )     30       (36 )
 
State and other
    (57 )     (12 )     (7 )
     
     
     
 
      (470 )     18       (43 )
     
     
     
 
Provision for (benefit from) income taxes
  $ (229 )   $ 265     $ 448  
     
     
     
 

      The current deferred income tax asset shown on the consolidated balance sheets at December 31 included:

                   
2003 2002


Deferred tax assets (liabilities):
               
 
LIFO inventories
  $ (184 )   $ (237 )
 
Pension and other postretirement liabilities
    62       71  
 
Tobacco settlement related accruals and other accrued liabilities
    644       608  
 
Other accrued liabilities
    191       146  
     
     
 
    $ 713     $ 588  
     
     
 

      No valuation allowance has been provided, as RJR believes it is more likely than not that all of the deferred tax assets will be realized.

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      The non-current deferred income tax liability shown on the consolidated balance sheets at December 31 included:

                   
2003 2002


Deferred tax assets:
               
 
Pension and other postretirement liabilities
  $ (368 )   $ (413 )
 
Other accrued liabilities
    (62 )     (92 )
     
     
 
      (430 )     (505 )
     
     
 
Deferred tax liabilities:
               
 
Property and equipment
    266       284  
 
Trademarks
    695       823  
 
Other
    275       634  
     
     
 
      1,236       1,741  
     
     
 
    $ 806     $ 1,236