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I I I I I I I CONF'IDENTIAL ~ U.S.A. ~ I I I I I I I I I I 1988-1992 FIVE YEAR PLAN BUSINESS PLANNING & ANALYSIS MARCH 1988 NC71'E Discussion and analysis of competitors is based on public information and internal modeling of competition developed by the Planning Departnent. Projections and discussions of future actions by competitors are primarily based on extension of historical trends withinn the context of PM-USA's forecasted U.S. cigarette industry environment. _ #36 - O. Dudley

N.liqVr" :,qs,.a i. I,, . i: q:1q]l EXECUTIVE SUMMARY 2055014031

I I I I I I I I I I I I I I I I PLAN OVERVIEW Philip Norris U.S.A.'s 1988-1992 Five Year Plan sets forth the business strategies which will be enployed to accelerate our momentum in the cigarette industry. To respond to the current and expected industry/competitive envirorunent, PM-USA has sociopolitical, marketing and operations strategies which have as an objective continued unit volume, market share and profit gz'owth. While the cigarette industry as a whole continues to be impacted by anti-tobacco forces, PM-USA possesses strong internal assets -- a young smoker base, a leading position in most industry segments, superior product quality, modern infrastructure and substantial financial resources - to prosper despite this threat. These assets enable PM-USA to exploit energing industry trends and position the company to achieve its voltmoe and profit objectives unless the industry is significantly changed by external events such as large excise tax increases, a radical acceleration in smoking restrictions or unfavorable product liability rulings. Our Five Year Plan objectives include: • Domstic volu-e growth of 17.9 billion units. • Market share growth of 9.4 sharepoints. • Operating income increases averaging 13.4 percent per year. • Cutraalative after-tax cash flow of $11.6 billion. As seen on the next page, PM-USA's five year objectives exceed those in last year's Plan and reflect our basic strategy for the future -- to enhance our current mamentum by aggressively investing in the cigarette business while maintaining our profitability and cash flow. To achieve these objectives, we have in place sociopolitical, marketing and operations strategies to: • Maximize industry volume potential by protecting the rights of smokers and manufacturers. • Enhance the strong brand imagery of our products through increased media support while taking advantage of brand development opportunities with targeted consumer programs and line extensions. At the sam time we will actively work to increase our penetration of the price/value category. • Improve PM-USA's retail presence, particularly in the supermarket and convenience trade classes. • Pursue technological innovation both in terms of developing new products and refining manufacturing processes. • Neet growing production requirenents within existing facilities ~ while maintaining manufacturing flexibility, continuing to improve O ~ our superior product quality and ensuring a_stable supply of Cs' quality leaf tobacco. ~ ~ C A-1 C~ ~ ~

CCI~lPARISON OF PLAN ASSUNPTIONS AIID PM-USA CBJD,.^'n7F,S Industry 1988-1992 1987-1991 Five Year Plan Five Year Plan • Avg. Annual Industry Voltane Decliie -2.8% -1.7% • Federal Excise Tax Per Zhousand $8.00 $8.00 • Price/Value Category Share 21.9% (1992) 13.8% (1991) in Last Year of Plan PM-USA • Total Marke t Share Growth 9.4 share points 4.5 sharepoints • Total Volum e Growth (Billions) 17.4(1) 6.3 • PM-USA Pric e/Value Penetration 35% (1992) 19% (1991) • Total Full Margin Price Increases $20.50 per 1000 $13.05 per 1000 • Annual Oper ating Incane Growth 13.4$(1) 12.0% • Total After Tax Cash Flow $11.6(1) $10.0 fran Operations (Billions) (1) Post-Spinoff. Pre-Spinoff volume growth =•17.9 billion, operating income growth = 13.4%, after-tax cash flow = $11.8 billion. ATTAINMIINT OF PROFITABILITY OBJECTIVES An outgrowth of our business'strategies will be a significant expansion of PM-USA's market share along with increases in profitability and cash flow. To achieve these objectives, PM-USA must balance four components - pricing, volume growth, marketing spending and productivity improvements. Meeting our objectives is vitally important given shareholder expectations and the impact PM-USA has on Philip Morris Companies' results. Pricing The pricing actions of other manufacturers led to an acceleration of PM-USA's price increases in 1987 beyond the levels forecasted in last year's Plan. The December increase of $2.00 per thousand on top of the $1.50 increase in June represents a significant departure fran the $1.00-1.25 level of semi-annual increases the industry had instituted beginning in June 1984. This acceleration is partially the result of competitive attempts to maintain profit growth in the face of declining unit volume and a growing proportion of price/value products in their sales mix. Manufacturer pricing appears to have reached a new level which is expected to remain essentially stable during the Plan. However, this pricing is considerably higher than in last year's Plan and creates a number of industry risks. • Full margin retail prices are forecasted to increase 8.8 percent annually during the Plan. This compares to expected yearly growth in the consumer price index and disposable income per capita of 4.4 percent and 5.2 percent over the same period. Against this broader econom.ic background, and in conjunction with growing pressure from anti-smoking forces, excessive price increases may reinforce smokers' societal/perceived health concerns and provide an economic justification to reduce or stop consumption of cigarettes, or switch to lower priced alternatives. I I I I I I I I I I I I I I I I A-2

I I I I I I I I i I I I I I I I I • The issue of cigarette affordability may becane particularly acute for young adult sawkers, who typically have lower disposable incames than the general population. As seen below, despite expected increases in the minimum wage, the minutes of work required to purchase a pack of cigarettes is projected to increase for minimum wage;.workers (which rnay include a significant number of young adult smokers) at a faster rate than for other employment groups. • The increased per unit profitability of cigarettes due to higher pricing could lead to greater full margin and price/value couponing and the emergence of products priced at sub-generic levels. • The enhanced industry profitability resulting fran these price increases could lead to the entry of new participants into the U.S. cigarette industry -- participants who would be mpre willing to dramatically change the industry's pricing structure in hopes of building share. A continued weak dollar further heightens the risk of foreign intervention through the acquisition of a danestic competitor. PM-USA and the industry are responding to the issue of cigarette affordability by offering consumers a variety of lower priced and value enhanced alternatives. These alternatives include numerous price/value options, full margin and price/value couponing and, for PM-USA in particular, a broad menu of product incentives to reinforce the premium image and value of our brands. We will continue to explore new ways to improve cigarette affordability, especially for young adults, where PM-USA has a dcminant share. Volume Growth The second component of PM-USA's long-term profitability strategy is volume growth, which will total 17.9 billion units during the Plan, substantially above the 6.3 billion conanitment in last year's Plan. This will occur despite an accelerated decline in industry volume and will result in a market share increase of 9.4 sharepoints to 47.2 percent in 1992. Volume growth will occur principally from Marlboro, new products and our price/value entries. At the same time, PM-USA will strive to slow the volume declines of our other brands. A-3

As mentioned earlier, one of the risks of the industry's aggressive~4icing will be increased price/value development -- perhaps led by the advent of a new tier of products priced at sub-generic levels. Should this segment emerge, PM-USA will become an active participant and this new category would accelerate the decline of both the industry's and PM-USA's full margin business. We have projected a third price tier into our financial forecast and have estimated that by 1992 it would result.zn an additional shift of nine billion units (versus the top chart on the next page) frcan. PM-USA's full margin business to our price/value entries. Marketing Strategy PM-USA intends to invest the additional resources generated by anticipated industry price increases to accelerate our long-term volume and share momentum. During the plan period, total marketing expenditures are projected to increase at a rate of 18.1 percent annually to nearly $2.5 billion by 1992. This ccxnpares to a nine percent rate in last year's Plan. An important element of this increase will be to enhance the flexibility of our marketing expenditures so that a portion of these resources can be reallocated as necessary to respond to external factors. PM-USA's level of marketing spending reflects our planned response to current and expected industry trends, including the possibility of an advertising ban. Additional image support can leverage the recent competitive trend away from advertising and provide a more forceful mssage for our brands. We anticipate that higher industry pricing will require a more aggressive defense of our brands, including Marlboro, to izProve their affordability. This defense will include high quality incentives, continuity programs and targeted couponing. Sales support will be increased, in part to accorrmodate a planned redeployment beginning in 1988. Finally, msrchandising spending will accelerate as we continue to expand our retail presence to a point where it is co=ensurate with our market share., This will be particularly important if an advertising ban occurs. Productivity A key component of our long-term profitability strategy is to increase manufacturing productivity. During the plan period, PM-USA will benefit from the modernization of the Manufacturing Center and Cabarrus, increased utilization of Cabarrus, labor savings and improved economi.es of scale. Our efficient use of production facilities, raw materials and human resources will ~enable PM-USA to realize constant dollar variable and fixed cost savings of $0.26 and $0.08 per thousand, providing our donmstic and export sales targets are achieved. This translates into a cumulative productivity savings of $350 million -- a substantial increase over last year's $250 million conan.i.tment. PLAN OU7.'LINE The remainder of this Plan will review PM-USA's 1987 performance, our forecast of the industry's future direction and the strategies which will be implemented by Marketing, Corporate Affairs and Operations to achieve our unit volume, market share and profitability objectives. Projected financial statements for 1988 through 1992 are also included. These statements reflect the spin-off impact on PM-USA. Major assunptions in the statements include a continuance of the $8.00 per thousand federal excise tax on cigarettes, no additional restrictions on the manner in which we market our products and the emergence of a third price tier of sub-generic products. A-4 20550t4035

I I I I I I I I I I I I I I PM-USA FORECASTED VOLUME AND NARKET SHARE Unit Volture (Billions) Market Share 1987 1992 Change 1987 1992 Change Marlboro 134.6 136.8 2.2 23.6% 27.7% 4.1% Benson & Hedges 24.1 20.1 (4.0) 4.2 4.1 (0.1) Merit 22.2 19.8 (2.4) 3.9 4.0 0.1 Virginia Slims 17.5 16.4 (1.1) 3.1 3.3 0.2 Parliament 5.1 4.0 (1.1) 0.9 0.8 (0.1) Cambridge 6.4 16.9 10.5 1.1 3.4 2.3 Famous Brands 0.9 3.2 2.3 0.2 0.7 0.5 Other 4.8 2.7 (2.1) 0.8 0.5 (0.3) New Products - 13.6 13.6 - 2.7 2.7 TOTAL Domestic 215.6 233.5 17.9 37.8% 47.2% 9.4% Overseas Military 2.8 2.3 (0.5) TOTAL PM-USA 218.4 235.8 17.4 PM-USA FORECASTED MARKE'TING SPENDING (Millions) 1987 1992 Advertising/POS/Events $ 407 $ 643 Consuner Spending 201 812 Sales Support 237 434 Merchandising 195 451 Other 35 130 TOTAL $1,075 $2,470 CONSTANT DOLLAR MANUFACTURZNG COST PER THOUSAND 1987 Actual 1992 Estimate Change ~ Variable Cost Leaf $3.60 $3.58 $0.02 Conversion 1.36 1.06 0.30 ~ Other Direct Materials 1.97 2.03 (0.06) ~ © Total Variable Costs $6.93 $6.67 $0.26 ~ ~ Fixed Costs 1.85 1.77 0.08 (:P TOTAL MANUFACTURING COSTS $8.78 $8.44 $0.34 ~ ~ L tz n I A-5

1987 Performance During 1987, the industry experienced a number of events which are impacting PM-USA's strategies. Most notably, manufacturers' pricing reached an unprecedented level in a year without an FET hike. RJR announced that they are developing an alternative smoking product -- a product which has the potential to dramatically change the industry's status quo, especially for smaller competitors who have limited R&D resources. The envirorumental tobacco smoke issue has come to the forefront in the minds of smokers and non-smokers, resulting in an increase in smoking restrictions and growing pressure on smokers. Finally, the price/value category continued to expand, fueled by branded generic products. This occurred despite a narrowing of the price gap with full margin products. Nevertheless, in 1987 PM-USA continued to build upon the momentum generated in earlier years to achieve a share gain of 0.9 share points to 37.8 percent. Domestic volume growth totaled one billion units to 215.6 billion and PM-USA's year-end wholesale inventory was reduced. Operating income of $2.7 billion was 13;,4 percent above 1986 and after tax cash flow totaled nearly $1.7 billion. The chart below cornpares our 1987 performance versus the objectives in last year's Plan. 1987 PERFOPMANt3; VERSUS OaTECTIVES (1) 1987 Actual 1987 Objective Unit Voltme • Volume (Billions) 215.6 216.0 • Market Share 37.8% 37.8% Profitability • Operating Revenues +7.4% +7.2% • Operating Income Growth +13.4% +13.4% • Return on Assets 55.1% 41.1% • After-Tax Cash Flow (Millions) $1,658 $1,513 Operations(2) • Constant Dollar Productivity $28 $39 Sm,ings (Millions) • Reduction in Constant Dollar 10C 15t Manufacturing Cost Per 1,000 • People Savings from Capital 93 66 Expenditures • Coitwosite Cigarettes Per 16,000 16,300 Labor Hour • Efficiency 72.7% 71.3% • Critical Quality Defects Lawest in Industry Lowest in Industry (1) Compxzrisons do not reflect spin-off impact. (2) Constant Dollar Savings and Cigarettes Per Labor. Hour were impacted by the growth of export sales beyond forecasted levels. I I I I I A I I I I i I I A-6

41 INDtTST,RY VOLUME The U.S. cigarette industry has been impacted by several factors which have lowered__smoking incidence andd reducedd daily consumption. Excessive taxation, restrictions on smoking in public and at work as well as adverse publicity on perceived health issues -- particularly environmental tobacco snoke (ETS) -- have have largely been responsible for these trends. In recent years anti-smoking ini tiatives have grown znore vis ib le __ an.d threateni.ng, whi 1e __ at the same_ time _ declining voltme has made cc~npetitors increasingly reliant on pricing to achieve profit _`growth. Maximizing long-term industry volume appears dependent on maintaiping the social acceptability of smoking and rrmoderating the impact of J 1 price increases on smokers. U.S~ cigarette shipments decreased 2.0 percent in 1987 from 581.9 billion units to 570.0 billion. This performance is a continuation of a downward trend in industry volune which began in mid-1985. Over-this period, the industry has faced a growing number of threats in the political, business and social arenas. Excise taxes have increased at the state and local levels. Legislation to restrict_ smokin.g has been more prevalent at all levels of goverrnrent and businesses continue to seek to segregate snokers or ban smking entirely. The ambient 'smoke issue, fueled by the 1986 Surgeon` GeneY=al's Report, has intensified the anti-smoking mavement despite a lack of definitive scientific evidence. Anti-snoking advocates have successfully created a negative public perception of ETS and recent studies proclaiming the effects of ETS on snakers' families, particularly young children,'have hardened this perception. 1987 IDIDUSTRY VOLUI IE INDUSTRY UNIT VOLUME CALENDAR ADJUSTED TWELVE MONTH CEIMULATIVE SALES ~„ BILLIOtJS OF UJITS ~ 630f 650t 57p{. ~ M J S D M J S D M J S D M J S D M J S D M J S D 1982 1983 1984 1985 1986 1987 650 A-7

1988-1992 IDIDUSTRY FORECAST Given the current political _and social environment, -coupled with the projected acceleration of industry pricing, it -appears likely that industry volume will erode at a faster rate_over the next five years. During this period, PM-USA projects industry voluma to decline about 2.8 percent per year, reaching _ 494.5 billion units in 1992. This compares to an average annual decline rate of 1.7 percent since 1984. The Plan decline rate is greater than the 1.7 percent rate in last yearYs Plan, reflecting a deterioration of political and social attitudes toward smoking and higher industry pricing along with the adverse demographic trends discussed in last year's Plan_-- lower start rates and incidence, a drop in daily consumption and an.-aging population. INDUSTRY VDLIW FOFlECAST THIS YEAA'S LAST YEAR'S PLAN PLAN 70 BILLIONS OF UNITS &50H 6M 550~ 5W 4504 40W- 1980 1982 1984 i986 1988 1990 1992 `Start rates for young adults are expected to remain relatively flat over the Plan period, although at a level considerably less than overall smoking incidence. I?uring the last three years, start rates have remained fairly constant at 14 to 15 percent based on an annual study conducted by the University of Michigan. (See graph ° on next page.) •-Smoking incidence declines are projected to continue. Based on current industry volimie and trends exhibited over the past five years, incidence among adults is estimated to be approximately 31 percent, down from 34 percent in 1982. PM-USA's industry forecast a.ssiunes that future incidence declines will approximate those exhibited over the last five years, which would result in a 28 percent incidence level in 1992. • Average daily consunption is forecasted to decline about 2.5 ,-cigarettes per smoker due to increased smoking restrictions, C growing concern over envirorurental tobacco smoke and a larger share ~-.. of females in the smoking population. This is down fran the two Cigarettes per day drop forecasted in last year's Plan. ~ ~ A-~$