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Beer `liller 13rewin g Company's operatin,r reNcnues were up 4.8% and uperating income was up 16.7% in 1986. Shipments of 38.7 million barrels were up 4.4%, the first significaut gain in four years, and our barrelage increase resulted in a gain in market slfare. Miller Lite, the second best- selling brand in the United States, increased volume and continued to lead the low calorie segment. New Miller Genuine Draft was successfully intro- duced nationally and very sig- nificantly slowed the volume docline of the Miller High Life brand family. Lowenbrau had a declitfe in volume but held its share of the super-premium segrnent. Meister Brau and U.S. Beer Industry Barrel Shipments Federal Tax Paid Withdrawals ; U.S. Beerlndustry Barrel Shipments . Miller Share of U.S. Industry (%) Milwaukee's Best, our entries in the popular-price category, both strongly increased their volume with resulting share gains. During 1986, we introduced new products into test market in the United States and suc- cessfully began selling Miller Lite under license in the United Kingdom. Financial Services and Real Estate Operations In 1986, Philip Morris Credit Corporation's (PMCC) financ- ing revenues rose 74% to $162 million, and net earnings rose over 100% to $70.9 million. These results include the equity income since July 1986 of Mis- sion Viejo Realty Group Inc. (MVRG), PMCC's real estate subsidiary. Our after-tax return on invested capital was 25% in 1986, up from 16% in the prior year. PMCC's growth resulted pri- marily from customer financing operations and leveraged lease investments. In addition, cumu- lative gains on PMCC's lever- aged lease portfolio, resulting principally from the Tax Reform Act of 1986, and the inclusion of General Foods Credit Corporation and MVRG, also contributed to increased earnings. In 1986, we invested $343 million in leveraged leases, bringing the total equipment value of our portfolio to over $3 billion. We also continued to provide financing services to customers of Philip Morris' subsidiaries. Operating revenues for MVRG rose significantly in 1986, and net earnings were 45% higher than in the prior year. MVRG's performance was based on strong demand for land from builders and a good residential housing market that reacted to lower mortgage interest rates. We continued to fund PMCC's operations through the issuance of commercial paper and long- term debt in domestic and international capital markets. In sum, Ph4 Morris Compa- nies Inc.'s progress in 1986 ggives us conj'idence that we can con- tinue to build upon our strong base to achieve superior results in the future. 9

Purchasing... only the highest quality agricultural products. ur purchasing systems assure the acquisition of adequate supplies of the finest raw materials. Quality control personnel, using the most advanced testing equipment and stringent control procedures, are an integral part of our manufacturing processes. The highest standards are maintained from raw materials to finished goods. Philip Morris begins with quality to deliver quality.

1VJ..eeting or exceeding standards for speed and costs while increasing quality levels is efficient manufactur- ing. To keep costs down, we design or acquire the most advanced process technologies. Combined with effec- tive systems engineering and a posi- tive personnel environment, these factors are key to Philip Morris' success- ful manufacturing operations. At Philip Morris, machinery counts but more important are the people who run it.

Pacliapng,•• Serviceable package design is f h k' d e A6thou h e t assuring esthetic appeal with real consumer benefits. designers are engaged to assure visual appeal. At Philip Morris, p. g ar more an s sn appearance is of paramount impor- tance to effective marketing, the design must guarantee the delivery of quality to the consumer. Cartons and cans, cases and packages must meet the rigorous tests of transit, storage, and shelf life. The most modern and exhaustive testing is applied to insure ~ consumer satisfaction while the finest a package design begins with the consumer in mind.

Distribution. in depth, mar•ket- bY-market, store-bY-stoY°e • he distribution process begins as goods move out of our plants. Our shipment of products is carefully managed in order to eliminate exces- sive inventories or, worse yet, out-of- stock conditions. The flow of our products is overseen through every stage of the system-from ware- house to retail, from the back room to the shelf. Philip Morris people work to guarantee a fair share of exposure, thus assuring availability and visibility in every retail outlet. At Philip Morris, distribution is the delivery of consumer satisfaction.

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Promotion... effective advertising, compelling promotion. Successful marketing is the effective use of every element of the marketing mix in order to induce consumer awareness, comprehension, trial, and repeat sales. The tools are varied and conditions differ froan product to product, but one rule is an imperative at Philip Morris: only the best... advertising that's compelling and promotions that fit the interests of our consumers. At Philip Morris, ~,effective marketing balanced ;with quality products leads to our ultimate goal-consumer satisfaction.

Management's Discussion and Analysis of Financltal Condition and Results of Operations Financial Review General Net earnings for 1986 increased 17. 7% to ti1.5 billion. The 1986 results include the first full year of operating results of General Foods Corporation ("Gerieral Foods") which was acquired in November 1985. The capital structure of the company reflects the two-for-one common stock split-up distributed in Apri11986. Except as otherwise noted, all per-share amounts have been restated to reflect the split-up. Earnings per share reached $6.20 in 1986, up 18.3% from 1985. Dividends declared in 1986 increased 23.8% to $2.475 per share ($590 million) from $2.00 per share ($479 million) in 1985. The quarterly dividend declared in November 1986 was at an annual rate of $3.00 per share, an increase of 50% over November 1985. Return on average stockholders' equity was 28.4% in both 1986 and 1985. The company's return on average assets was 10.6% in 1986, down from 12.8% in 1985 due principally to the inclusion of General Foods for a full year. In 1986, 1.9 million shares of common stock were repur- chased after the common stock split-up at an average cost of $72.53 per share. In 1985 and 1984, the company repurchased 6.6 million shares of its common stock at a pre-split average cost of $79.35 per share (13.2 million shares at $39.68 per share after giving effect to the common stock split-up). Sub- stantially all of the shares repurchased in 1985 and 1984 were retired prior to the common stock split-up. ® Stockholders' Equity (Year•End) . Net Return on Average Stockholders' Equity (%) Biliions of Dollars 5.6 28 4.8 ' 24 4.0 20 3.2 16 2.4 12 1.6 .1111111118 .a 4 0 1111111111D 77 78 79 80 81 82 83 84 85 86 % ® Total Assets (Year•End) ~ Net Return (Before Net Interest) on Average Total Assets (%) Bitlions of Dollars % 17.5 ~ 14 2.5 0 1111111111. 77 78 79 80 81 82 83 84 85 86 Debt and Interest At December 31, 1986, the company's debt-to-equity ratio was 1.22 to 1.00, down from 1.69 to 1.00 at December 31, 1985. In 1986, the company reduced total debt by $1.1 billion to $6.9 billion with funds generated from operations and from the sale of The Seven-Up Company ("Seven-Up"). At December 31, 1986, approximately $1.2 billion (17%) of the company's total debt was sensitive to interest rate fluctua- tions, compared with 39% at December 31, 1985. The com- pany's average interest rate on total debt during 1986 was 9.3% versus 9.9% during 1985. At year-end 1986, the average interest rate on total debt was 8.8%. Credit facilities totaling $7.8 billion are maintained with var- ious lenders to support commercial paper borrowings for sea- sonal and other needs of the company's operations. Substantially all of these facilities have maturities beyond one year. Of these facilities, $6.8 billion were unused at December 31, 1986. Interest expense more than doubled in 1986 to $779 million. The increase was due primarily to the first full year of interest on the General Foods acquisition debt. Interest coverage (earnings before interest and taxes divided by interest) was 4.61 in 1986 compared with 7.76 in 1985. The company maintains an "A-1/P-1" rating in the commer- cial paper market and a strong "A" credit rating for long-term obligations. Total debt increased by $5.4 billion in 1985 due principally to financing of the General Foods acquisition and $1.0 billion of outstanding General Foods debt. The acquisition financing consisted principally of a $3.6 billion borrowing under a  Total Debt (Year•End) ~ Ratio of Total Debt to Stockholders' Equity (vear•End) Billions of Dollars . Ratio 8.4 3.5 7.2 ' 3.0 6.0 ' ' 2.5 4,8 ~ ' 2.0 3.6 . .  1.5 2.4 . 1.0 1.2 .I 1 115 ', 0120 .'rIt11111.5 IllIlIIlli0 ~o IIIIIIIIt10 77 78 79 80 81 82 83 84 85 86 ~J 77 78 79 80 81 82 83 84 85 86  Interest Expense ~ Interest Coverage (Earnings Before Interest and Taxes D'mded by Interest) Millions of Dollars 840 10.5 720 1 9.0 ~ 240 . 3.0 Coverage 20

revolving credit facility and $1.4 billion in other short-term debt. Prior to the end of 1985, the company refinanced $1.5 billion of the debt by issuing long-term fixed rate debt and also entered into $700 million of interest rate swap and cap agreements. During 1986, the company issued $1.8 billion of long-term debt, of which $1.1 billion was to refinance acquisition debt, 5372 million was to refinance short-term debt underlying the 1985 interest rate swap and cap agreements, and $250 million was to refinance high-coupon debt. Long-term debt issued in 1986 included $885 million in the United States, $500 million in the Eurodollar market and the equivalent of $403 million of foreign currency denominated borrowings. The company entered into forward exchange agreements to hedge its exposure on the 1986 foreign currency denominated borrowings. Funds Provided and Used In addition to funds related to capital and debt activities previously discussed, other funds provided and used were as follows. Funds Provided Consolidated funds from operations increased $442 million (24.9%) to $2.2 billion in 1986 due primarily to increased earnings and noncash charges for depreciation and amortiza- tion. The increase in noncash charges for depreciation and amortization was due principally to the inclusion of the first full year of operating results of General Foods. In 1985, funds from operations increased 14.6% over 1984 due primarily to increased earnings. Total funds provided in 1986 included $487 million of work- ing capital generated principally from the sale of substantially all of Seven-Up. In 1985, total funds provided included $169 million of working capital generated from the sale of the Philip Morris Industrial operations. Since the company is a holding company, one of its principal sources of funds is dividends from its subsidiaries. Philip Morris Incorporated ("PMI"), comprising the company's tobacco operations, has certain debt agreements that restrict its ability to pay cash dividends and to make other distribu- tions with respect to its common stock. At December 31, Foreign Currency Translation The company's consolidated international operations account for 26% of its operating revenues, 10% of its operating profit and 20% of its identifiable assets. The principal consolidated foreign operations are in Europe and use local currency as the functional currency. Currency translation adjustments increased stockholders' equity by $139 million in currency gains for 1986 as the dollar continued a weakening trend that began in 1985. Currency translation adjustinents resulted in a $54 million increase to stockholders' equity in 1985 and a decrease of $120 million during 1984 when the dollar was very strong. The company continually monitors its foreign currency exposure and acts to minimize such exposure, when deemed prudent, through various hedging transactions. 1986, approximately $1.5 billion of PMI's consolidated earn- ings reinvested in its business was free of such restrictions. None of the company's other subsidiaries' long-term debt agreements limit their ability to pay cash dividends or to make other distributions with respect to their common stock. The company expects that funds from operations and avail- able credit facilities will be sufficient to meet the needs of the business. Funds Used Capital expenditures increased $331 million to $678 million in 1986 due primarily to the inclusion of the first full year of General Foods. Similarly, the 16% increase in capital expenditures for 1985 was attributable to capital expenditures of General Foods from the date of its acquisition. Capital expenditures are estimated to be $900 million in 1987 and $3.1 billion for the years 1988-1991, of which approximately $500 million and $2.0 billion, respectively, relate to General Foods. In 1986, the company elected pursuant to Section 338 of the Internal Revenue Code to "step up" the tax bases of General Foods' assets and paid the resulting tax. The most signifi= cant effect of the election was to increase the carrying value of domestic property, plant and equipment by $508 mil- lion. In addition, certain intangibles became deductible for tax purposes. The principal use of funds in 1985 was the payment of $5.6 billion to acquire General Foods, $718 million of which was working capital acquired. 21

Operating Results 1986 Compared with 1985 Operating revenues for 1986 increased $9.4 billion (59.2%) and operating profit, as definedfor segment reporting, increased $938 million (34.9%). The increases reflect the inclusion of the first full year of operating results of General Foods and growth in the tobacco and beer operations, partially offset by the exclusion of Seven-Up and Philip Morris Industrial. Net earnings increased by $223 million (17.7%) over 1985, due principally to increased operating profit, partially offset by interest expense associated with the acquisition of General Foods as well as a higher effective income tax rate. Earnings in 1986 included $106 million of goodwill amorti- zation, substantially all of which related to the acquisition of General Foods. Goodwill amortization of $28 million in 1985 included $16 million amortization of General Foods goodwill from the date of its acquisition. Interest expense, net increased by $443 million in 1986 due principally to General Foods acquisition borrowings. In 1986, other deductions, net increased by $39 million. In 1985, this line item included a $77 million gain on the sale of the Philip Morris Industrial operations and a $50 million write-down in anticipation of the sale of Seven-Up. The company's effective tax rate in 1986 was 47.5% com- pared with 46.1% in 1985. The increase resulted from the non- deductibility of certain intangibles and other items relating to the acquisition of General Foods and from the impact of cer- tain provisions of the Tax Reform Act of 1986 (the 'Act"). The Act repealed investment tax credits retroactive to January 1, 1986. Accordingly, the company's 1986 effective tax rate reflects only investment tax credits for capital additions con- tractually committed at December 31, 1985. Other provisions of the Act that will affect the company in future years include changes in the calculation of depreciation for tax purposes, changes in the foreign tax credit provisions and reduction of corporate income tax rates. The impact of the Act on 1986 net earnings was not significant. Based on preliminary analy- sis, it is anticipated that changes in the tax law will have a positive impact on both earnings and cash flows for 1987 and future years. In 1986, the company changed its method of determining expense for domestic pension plans to conform to the require. ments of Statement of Financial Accounting Standards No. 87 ("SFAS 87"). The change increased earnings before income taxes, net earnings and earnings per share by $76 million, $39 million and $.16, respectively. The decrease in pension costs reflects changes in certain actuarial assumptions and the amortization of the unrecognized net gain of $429 million at the date of adoption, January 1, 1986. Future pension costs are expected to be more volatile due to certain requirements of SFAS 87. Changes in pension costs resulting from that volatility are not, however, expected to be as great as the initial decrease in pension costs resulting from the adoption of SFAS 87. Based on the current overfunded status of the plans, the company anticipates that no significant contributions will be required for the next several years. Management believes that inflation has not had a significant impact on the company's results of operations as reported in the accompanying financial statements. 1985 Compared with 1984 In 1985, operating revenues increased $2.2 billion (15.6%) and operating profit, as defined for segment reporting, increased $406 million (17.8%). The increases were due primarily to growth in tobacco operations and to the inclusion of the operating results of General Foods from its date of acquisition. In 1985, net earnings increased by $366 million (41.3%) over 1984 due to increases in operating profit and a write-down in 1984 of the brewery in Trenton, Ohio, which reduced net earn- ings by $146 million. In 1985, interest expense, net was $38 million (14.3%) higher than 1984 due principally to borrowings to finance the acquisition of General Foods. The company's effective income tax rate in 1985 was 46.1% compared with 44.7% in 1984. The increase was due primarily to higher non- deductible expenses. 22