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THE DECADE AHEAD: CHALLENGES AND OPPORTUNITIES FOR R.J. REYNOLDS TOBACCO COMPANY APRIL 1982 a, 14- Arthur D Little, Inc~

THE DECADE AHEAD: CHALLENGES AND OPPORTUNITIES FOR R.7. REYNOLDS TOBACCO COMPANY Project Director Ellen I. Metcalf Gary A. Marple Anne J. Neilson APRIL 1982 J %D . 0 N Arthur D Litth Inc .

TABLE OF CONTENTS l_: PaRe I. EXECUTIVE SUMMARY 1 II. OBJECTIVES 2 III. APPROACH 2 VI. THE PRESENT SITUATION 4 V. FACTORS COMMON TO ALL SCENARIOS 27 VI. MAJOR DRIVING FORCES 40 VII. IMPACTS: THREATS AND OPPORTUNITIES 41 VIII. ALTERNATE SCENARIOS OF THE FUTURE TO 1992 43 IX. MONITORING CHANGE 93 APPENDIX A 97 a, i Arthur D Litth Inc

TABLE OF TABLES AND FIGURES Table Pa e 1 Production Trade of Unmanufactured Tobacco 7 2 Preliminary 1981 Allotment and Tobacco Farm Figures, 10 by Tobacco Type 3 Tobacco Farms 12 4 All Tobacco, Three-Year Average 13 5 Resident Population of the U.S. by Selected Age Groups 29 6 Female Civilian Labor Force Participation Rates by Age Group 30 7 Real GNP Growth 31 8 Total Per Capita and Per Household Disposable Personal Income 32 Fi ure 1 Cross Impacts of Driving Forces 42 2 Scenario Continuim 45 3 Historic and Projected Number of Farmers: Under Most 49 Likely Environment and Slow Evolutionary Growth •4 Implications for the Industry 55 5 Impacts of the Most Likely Scenario on R.J. Reynolds 56 6 Historic and Projected Number of Farms 66 7 Implications for the Industry 74 8 Impacts of the Most Change Scenario on R.J. Reynolds 76 9 Impacts of the Least Change Scenario on R.J. Reynolds 89 10 Alternate Scenarios and Triggering Events 94 11 Judged Influence of Various Factors on Scenarios 96 r ii Arthur D Litth Inc ,

I. EXECU"I1VE SUMMARY In October 1981, Arthur D. Little, lnc. was authorized to assist R.J. Reynolds in looking at the challenges and opportunities in the decade ahead. This report summarizes the results of our work. We have posed three likely scenarios for the decade ahead: slow evolutionary change, a more rapid consolidation of supply, and rapidly declining demand. Of these three, we believe consolidation of supply is most likely. The events which will have the greatest effect on R.J. Reynolds in.the next decade are those outside the company's control (but not outside its influence). The two key areas are: public attitudes and policy concerning ' assive) smoking; and the price support and f ( t ff i p s o ec ve e the negat allotment system. These two areas should be monitored by Reynolds, and°:- Reynolds may wish to try to influence events in these areas. Reynolds can take action in four areas, however, which will position the company to maximize opportunities and minimize threats posed by any of these scenarios. which is efficient for short runs anufacturin t i g m t cos l. Low-un as well as long production runs. This ~will ' require R.J.` ` and 'instrumentation; Reynolds undertaking its own machine he ke" ' ' t ta unlikely to. design, as machine manufacturers are lead. It will also "require capital investment in new plant and equipment. • highly 2. Focused R&D ef forts ' on new products, which are " processed, ultra low in tar, and highly flavored. ;t_ _ Segmented market and distribution which maximize sales per 3 . promotional dollar. This requires understanding the cigarette' purchasing and media use patterns of various market segments1~~ advisin loser relationship with tobacco growers, from A 4 _ r c . them on tobacco needs to contract growing to assure supply, o ~' ' the appropriate quality. ;,t+srf~~ ~ -1-

11. OBJECTIVES There were two major objectives for the study: 1. To develop three scenarios (most likely, most change, and least change) for the U.S. cigarette industry over the next 10 years encompassing four areas: resource availability economic conditions government regulation technological change 2. To estimate the impacts of those scenarios on R.J. Reynolds. III. APPROACH A task force was assembled at R.J. Reynolds to work with the Arthur D. Little core team. The task force met with the Arthur D. Little core team to refine the scope of the study. Consensus as to the most important areas of investigation was not reached in that meeting, but was subsequently refined, based on the task force's assessment of 28 _items. The bases of assessment were: importance to Reynolds, and degree of knowledge about the item. Of the 28, items half were judged to be of high-to-medium importance, with low-to-medium knowledge. These were considered by the R.J. Reynold's task force to be top priority. * ingredient labeling requirements * potential FDA regulation * opportunities for microencapsulation * breakthroughs which would alter the desire to smoke * potential for genetic engineering in the growing of tobacco or other ingredients * the use of electronics * the impact of economic conditions on consumers, farmers, and processor R&D and marketing activities * alternate uses of labor now growing/harvesting tobacco * alternate uses of land now growing tobacco * stability of foreign ingredients * stAbility of flax supply -2 Arthur D little Inc

Although the study encompassed the remaining 14 of the 28 items raised in our first meeting, they were given a low priority, either because they were considered to be of low importance or because the level of knowledge was high. Appendix A indicates perceived importance and level of knowledge of each of the 28 items. The Arthur D. Little core team then identified and interviewed about 20 staff specialists. From these interviews we developed a going-in position in four areas: * tobacco growing ~ other ingredients * manufacturing and processing ~ marketing and social issues These position papers included a brief overview of the current situation, an assessment of the issues and driving forces which could alter the current situation, and expectations for likely change. These going-in positions were outlined on flip charts and served as the starting point for four brainstorming sessions with Arthur D. Little staff specialists. The four sessions were held in a two-day period and were attended by the R.J. Reynolds task force. The sessions were designed to encourage creative synergy among specialists in considering likely future events and their impacts and cross-impacts. Including the core team, 16 Arthur D. Little staff members participated in the two-day sessions. Biographies of staff members were sent to R.J. Reynolds after the sessions for reference. During the sessions we refined the issues list and generated a list of possible events which could alter the current situation. We also achieved consensus as to when the events might occur or, in the case of manufacturing/processing, established a list of high-priority items for R.J. Reynolds to address. r -3- Arthur D little lnc

The core team drafted three scenarios using the inputs from the brainstorming sessions. These were labeled: * Most Likely: Consolidated Supply * Most Change: Rapidly Declining Demand * Least Change: Slow Evolution The three scenarios encompass the driving forces which are expected to have a major impact on the industry over the next decade. These drafts, along with write-ups of the current situation, were submitted to the R.J. Reynolds task force for review. A workshop meeting was held with the R.J. Reynolds task force to review the materials, to present and refine an impact assessment for each scenario, and to plan the presentation. A draft of our slide presentation was submitted to R.J. Reynolds. Substantial revisions were made and the draft was rewritten and resubmitted. R.J. Reynolds subsequently elected to incorporate materials generated internally and make the presentation. IV. THE PRESENT SITUATION A. Growing Tobacco Two major kinds of tobacco are grown in the United States: flue-cured (60% of all tobacco grown in the United States) and burley (about 30% of all tobacco). Both are grown on relatively small farms, although there are some major differences, as noted below. In 1979, tobacco was the nation's sixth largest cash crop, worth more than $2.2 billion. V -4- Arthur D Litth Inc

r 1 Flue-Cured A recent studyl of the primary flue-cured tobacco farming areas in the United States (where 75% of all U.S. flue-cured tobacco is grown) indicates that the average size of flue-cured tobacco management units in this study area was 13.8 acres of tobacco in 1979. Because of the larger management unit on which flue-cured tobacco is grown (compared to burley tobacco) and because flue-cured tobacco is harvested as individual leaves rather than as a whole plant, the mechanization of flue-cured tobacco has been more rapid than that of burley tobacco. Flue-cured tobacco harvesting has three stages. First, the leaves are removed from the plants in the field; second, the leaves are prepared for curing; and last, the leaves are cured. The leaves can be pulled by F1and or by machine. Leaves can be prepared for curing by tying on sticks either manually or mechanically, by placing them in bulk racks, or by putting them in big boxes. Bulk racks are steel frames about 50 inches long and 15 inches high. Big boxes are steel containers which hold the equivalent of eight to 20 bulk racks of tobacco. Tobacco tied on sticks is generally cured in conventional barns, and racks or boxes of tobacco are cured in so-called bulk barns. Conventional barn harvest systems were used for about 39% of U.S. flue-cured tobacco acreage in 1979, down from 92% in 1972. Bulk barn systems were the principal harvest systems used by 37% of the flue-cured tobacco growers in 1979; 61 % of the flue-cured acreage was cured in bulk barns, compared with 8% in 1972. "Trends in Flue-Cured Tobacco Farming" by Verner N. Grise Ag. Ec. Report No. 470, Economics and Statistics Service, USDA, Washington, D.C., June 1981. -5- Arthur D little Inc

The majority of the farms and of the acres of tobacco which are bulk cured are still harvested manually. About 10% of the tobacco farms use mostly mechanical harvesting, and these produced about 20% of the acres of tobacco grown in 1979. Only 1% of U.S. tobacco was harvested by these methods in 1972. The farm operators who used mechanical harvesters, according to the Grise study, averaged 29 acres of tobacco. About 90% of the growers with less than nine acres of tobacco use conventional barn harvest systems to cure all or most of their tobacco. In 1981, about 529 metric tons of flue-cured tobacco were produced in the United States.• In 1980, about 177 metric tons of unmanufactured flue-cured tobacco was exported. (See Table 1.) Flue-cured tobacco is grown on the Piedmont and Alluvial plains. Flue-cured tobacco is also grown in many other countries, principally China, Brazil, Zimbabwe, India, Japan, and South Korea. The principal exporters of flue-cured tobacco are the United States, Zimbabwe, Brazil, and India. The United States accounts for about 20% of world production and 29% of exports. (See Table 1.). Burley Burley tobacco farms average only about two acres of tobacco. About 70% of these farms grew two or fewer acres; less than 1% have 15 or more acres in tobacco. Harvesting is a manual operation. A study of burley-growing areas in Kentucky and Tennesee2, where about one-half of the burley tobacco grown in the United States is produced, found that farms where burley tobacco is grown are generally small. 2 "Burley Tobacco Farming Characteristics and Potential for Change" by Verner N. Grise and Owen K. Shugars, Agricultural Economic Report No. 460, Econopics Statistics and Cooperative Service, USDA, Washington, D.C., September, 1980. -6- Arthur D Little Inc