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Double Danger For Big Tobacco


The claim is breathtaking. On Sept. 21 the U.S. Justice Dept. is scheduled to make opening arguments in a civil Racketeer-Influenced & Corrupt Organizations Act (RICO) lawsuit asserting that the nation's biggest cigarette companies have engaged in an illegal conspiracy since 1953. The government is seeking disgorgement of a brow-raising $280 billion -- almost the six defendant companies' entire profits during the five-decade period.

Big Tobacco has faced many legal challenges through the years but never one this daunting. And it comes at the exact same moment as a bill now in Congress proposing to give the Food & Drug Administration the power to regulate the manufacturing and contents of cigarettes -- something the industry has energetically tried to avoid for most of its recent history. The measure passed the Senate by a wide margin in July. Although it faces skeptics in the House, it could very well reach a vote by October.

In the old days, the companies could at least draw strength from one another. Cigarette makers stood shoulder to shoulder against all attacks. But the old fortress mentality has dissipated. While the Justice suit could be devastating for big players such as Altria, Reynolds American, and Liggett, it may be a blessing for upstarts that aren't named in the suit, including Commonwealth Brands Inc. and General Tobacco. FDA regulation, meanwhile, is backed by No.1 cigarette maker Altria Group Inc. (MO) -- but opposed by nearly every other company in the business. "This is not only controversial because it's about tobacco," says Merrill Lynch & Co. (MER) tobacco analyst Martin Feldman. "It's controversial because you have the industry split."

As the heat builds for tobacco companies, the market itself has never been tougher. Because of a steady climb in state and local excise taxes and the high cost of the Master Settlement Agreement (MSA) signed by the largest companies in 1998 to end lawsuits filed by 46 states, the price of cigarettes has soared -- yet profits are eroding. Feldman notes that the average price of a pack of Marlboros at the time the MSA was signed was $1.88. Today, it's $3.41. Although key brand Marlboro has actually increased its market share, to 39.5%, Altria's earnings are down. Its U.S. tobacco business, Philip Morris USA Inc., had an EBITA operating profit of $5.76 billion three years ago, Feldman notes. By last year, that had dropped to $4.2 billion. R.J. Reynolds, now part of Reynolds American Inc., saw an even sharper drop from $1.3 billion to $722 million, and others are down too.

LOW-COST UPSTARTS

Meanwhile, the traditional industry leaders are under attack by a host of fast-growing low-cost manufacturers like Star Tobacco and Dosal Tobacco Corp. These companies aren't part of the MSA, which adds up to 50 cents for each pack of cigarettes. Ronald J. Bernstein, president and CEO of Liggett Group (VGR), calls the overall level of competition "almost frantic."

Altria, Reynolds, and the other major tobacco manufacturers could hardly stand a Justice victory. The feds argue that the industry operated as an illegal enterprise starting with a December, 1953, meeting in the Plaza Hotel in New York. During this get-together, the government claims, five tobacco CEOs hatched a plan to fund scientific research and a publicity campaign to battle rising concerns about cancer.

In its 1,000-page finding of fact, Justice outlines 50 years of industry attempts to cloud the true harm of smoking. The industry's alleged goal: to "preserve and enhance...profits by maximizing the numbers of smokers." The government contends, too, that while the industry was arguing that there was no proof that cigarettes cause cancer, it had already documented known carcinogens in its products. Prosecutors are asking for profit disgorgement and a new regulatory scheme that would bring many of the restrictions the companies agreed to under the MSA to a national level.

Tobacco companies have denied any conspiracy and argue that the government's aggressive application of the RICO statute in this case won't hold up. To win its case, Justice has to prove that the past behavior it describes is likely to continue. Yet since the MSA, industry lawyers say, company behavior has improved. "Cigarettes today are sold very differently than they were in the past," says Altria general counsel William Ohlemeyer.

While some of the industry's legal arguments appear to be strong, ordinary rules do not apply to such an unpopular defendant. Justice has won several, though not all, pretrial motions, and investors have reacted badly. On May 24, when the judge hearing the suit refused to limit the massive disgorgement sought, Altria stock dropped to a six-month low of $44.95 a share.

It may be a sign of how out of favor the industry is that even the free-market Bush Administration has failed to slow the case -- despite the fact that it was started by the Clinton White House and has cost $135 million to prepare. Why didn't W's troops kill the lawsuit? Some tobacco execs and analysts speculate that the political costs of dropping the suit would have been too high.

GOOD PUBLICITY?

Indeed, although Altria executives deny it, some observers think one reason the company is backing FDA regulation to defuse future judicial and juror anger against the industry. The legislation would give the FDA oversight of the manufacturing of cigarettes and would enlarge the health warnings they carry. It would also provide FDA regulation of any new products that claim to lower the harm of cigarette smoking. And the new standards would apply to all manufacturers, small and large.

Altria's rivals worry the proposed marketing restrictions would hinder them from gaining market share against the dominant leader. They also fear that the fine print of the bill's provisions for FDA review of safer cigarettes would specifically help Philip Morris' ongoing efforts to make a product aimed at reducing exposure to harmful substances in cigarettes. "If you can partner with government to kill your competition off, then that's a good deal," says Tommy J. Payne, rival Reynolds American's executive vice-president of external relations.

Supporting the bill is certainly a big shift for Altria, which spearheaded the industry's rigid opposition to FDA oversight in the late 1990s. Now the company hopes an FDA regime might help usher in an era of better public relations. "One of the basic things we've been trying to say for the last seven to eight years is it doesn't always have to be us against everybody else," says Steven C. Parrish, Altria's senior vice-president of corporate affairs. So far, though, it looks as if the cigarette manufacturer and its rivals are more embattled than ever.

By Nanette Byrnes in New York, with John Carey in Washington


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