Tobacco Takes A New Road
By Barbara Rudolph
A stranger coming upon Tobaccoville, N.C., twelve miles north of Winston-Salem, might not be prepared for the sight. In the foothills of the Blue Ridge Mountains stands a sleek, Bauhaus-style building. This is R.J. Reynolds' new $1 billion plant, which covers some 614 acres and 2 million sq. ft. of floor space. Still under construction, it will soon be the world's largest cigarette factory. The plant will have the capacity to roll out more than 5 billion packs a year.
"It's our vote of confidence in the tobacco industry," says Donald Nanney, a factory manager of R.J. Reynolds'. Only a few years ago, such a vote would have seemed unnecessary. Economic recessions came and went, prices continually climbed, but Americans always kept buying more and more cigarettes. Today, though, while the $18 billion tobacco industry remains very profitable, the element of predictability is gone. The industry is facing a spate of product-liability suits and, for the first time in its history, a period of declining consumption. Unit sales peaked in 1981, when Americans puffed on 640 billion cigarettes. By the end of this year, consumption is expected to be down 7% from that level.
Recent laws requiring harsher health warnings on cigarette packages, a popular preoccupation with physical fitness and restrictions on smoking in many restaurants and offices do not make business easy for industry executives. It comes as no surprise, then, that tobacco makers are aggressively diversifying. Philip Morris and R.J. Reynolds, which together account for 67% of total industry sales, have recently made major nontobacco takeovers. In June Reynolds agreed to buy Nabisco Brands, which makes scores of food products, including Oreo cookies and Ritz crackers. Three months later, Philip Morris announced that it would acquire General Foods, one of the largest U.S. food companies and a producer of such goods as Maxwell House coffee and Jell-O.
The most visible trouble for the industry comes from about 40 product-liability suits in which cigarette manufacturers are charged with causing disease and, in some cases, death. Similar lawsuits have been around since the 1950s, and tobacco firms have always defeated any claims. This week in Santa Barbara County, Calif., Superior Court, a case comes to trial. R.J. Reynolds is the sole cigarette manufacturer named in the lawsuit, but tobacco makers are closely following the case. Says Robert Rukeyser, vice president of American Brands, maker of Lucky Strike and Pall Mall: "We take these suits very seriously. We're not complacent." Echoes Aaron Twerski, a law professor at Hofstra University: "The whole world is watching."
The Santa Barbara trial is certain to be a courtroom drama. The case involves John Galbraith, a former insurance company administrator who for 50 years smoked two to three packs of cigarettes a day. In 1982 Galbraith died, at 69. The official cause of death was heart disease and emphysema. He spent the last years of his life hooked up to an oxygen machine. According to his family's lawyers, Galbraith was once found removing the mask in order to take a quick puff. Galbraith's widow and three children are suing R.J. Reynolds for making a defective product.
The plaintiffs lawyer is Melvin Belli, 78, who is renowned for his personal-injury liability work. Belli thinks his case has been strengthened by court rulings in somewhat similar suits outside the tobacco industry. In the past, plaintiffs had to prove that a manufacturer was negligent in making its products. Recently, though, courts have allowed plaintiffs to collect damages without such proof. They need only establish that a manufacturer has made a defective product.
"The industry has never paid a cent" in the similar cases that have been filed over the years, declares John Strauch, the lead attorney for Reynolds. The company's lawyers are expected to argue that Galbraith freely chose to smoke and thus cannot hold the company responsible for his illness. Nor will they concede that smoking can cause cancer. It "is still an open scientific question," Strauch says.
For investors, the lawsuits represent a cloud hanging over the industry. Philip Morris shares closed the week at 74 5/8, down 21% from their March high. R.J. Reynolds was at 25 1/2, off 27% from its April peak. Admits Reynolds Chairman J. Tylee Wilson: "I believe that the product-liability issue is probably depressing the price of our stock."
Some Wall Street analysts argue that the legal threat is not that serious. They consider cigarette stocks to be sharply undervalued. Says Marc Cohen, who follows the industry for Sanford C. Bernstein, a New York brokerage firm: "The financial community is overreacting. It is understating the strength of the manufacturers' defense, and it is overstating the financial consequences." Concurs John Maxwell of Furman Selz Mager Dietz & Birney: "This is still a healthy business financially."
Tobacco companies have not been standing by doing nothing as their stocks go down. Philip Morris, in buying General Foods, and R.J. Reynolds, in taking over Nabisco, have made dramatic moves that will change the structure of those companies. Philip Morris, which had earlier acquired Miller Brewing and Seven-Up, will now become the largest U.S. consumer-products manufacturer, with sales of more than $23 billion. Reynolds, owner of Kentucky Fried Chicken and Del Monte foods, will be close behind. Its revenues will exceed $19 billion. Since both cigarettes and food are sold in grocery stores and supermarkets and both depend heavily on strong consumer marketing, the businesses seem compatible.
Tobacco manufacturers insist that liability lawsuits had no bearing on their corporate strategies. Says Rukeyser of American Brands, which has made an average of two acquisitions a year during the past 20 years: "We're not being frightened away from tobacco."
Indeed, diversification is nothing new for most cigarette companies. In the 1960s Reynolds bought the company that made Hawaiian Punch. Philip Morris acquired Miller Brewing in 1970. But the level of diversification is now much higher. While tobacco contributed 77% of Reynolds' operating profits five years ago, it will drop to some 55% next year. Similarly, tobacco next year will account for about 73% of Philip Morris' operating income, down from 92% just last year. Wrote Chairman Hamish Maxwell in a letter to Philip Morris stockholders: "While the company does not share a concern about the future of tobacco, we believe the best step that we can take is to ... broaden our earnings base." More acquisitions may follow, since both Philip Morris and R.J. Reynolds still have lots of cash on hand.
Nonetheless, cigarette companies continue to promote their primary business. Recently, in fact, they have been openly defending smoking against its outspoken critics. In advertisement-essays that appear in newspapers and magazines, Reynolds attacks what it considers unfair criticism. Four months ago, Philip Morris began publishing a quarterly magazine that is sent free to tobacco users.
The industry has also been busy creating new brands. Philip Morris is test marketing Concord, which has an adjustable filter that allows a smoker to control the amount of tar inhaled. New economy labels have been strong sellers. Market share of these cigarettes jumped from 3.3% in 1983 to an estimated 7% this year. The group includes generic cigarettes, which cost about $2 less for each carton than brand names. They are sold in plain black or white packages and are supported by little advertising. Other economy brands are the so-called value packs in which 25 cigarettes are sold for the same price as a 20-pack. Example: R.J. Reynolds' Century, which claims about 1% of the total cigarette market. Still, new brands often fail. Philip Morris this year withdrew Rio, a new menthol product, because of low sales.
Several economic factors now benefit cigarette producers. The price of the most commonly used tobacco leaf has fallen by about 10% so far this year. In addition, consumers are willing to pay higher prices. A pack typically costs $1.04, up 9.5% from 1983. Some of that hike reflects the doubling of the federal cigarette excise tax, to 16-c-, in 1983. The tax is due to return to 8-c- on Nov. 14, but Congress may keep the higher level because it generated $4.7 billion in revenues for the fiscal year that ended Sept. 30.
Cigarette company profits are good and likely to stay that way. Industry operating earnings this year are expected to increase 15% from 1984, to $4.6 billion. That gain is even more impressive since revenues rose by just 6%, to $18.4 billion. Profits for the next few years should also be strong.
Such gains, though, are not being enjoyed equally. Market leaders R.J. Reynolds and Philip Morris have been winning sales at the expense of smaller firms, and that trend will probably continue. Reynolds' hold on the market is up 1.2% since 1983, to 32%, while Philip Morris' is up 3.2%, to 35%. Meanwhile Lorillard, maker of Kent and Newport, and American Brands have been losing ground.
These days tobacco manufacturers are most encouraged by business abroad. Sales in Third World countries are increasing by nearly 2% a year. In Kenya, consumption rises by 8% annually. No market is more tempting than China, where people smoke about 1 trillion cigarettes a year. R.J. Reynolds has a joint venture to produce cigarettes in Xiamen, located on China's southeast coast. Production is expected to begin next year. For the foreseeable future, though, the U.S. is likely to remain the single largest market for domestic cigarette makers. Some 55 million Americans call themselves smokers, and tobacco manufacturers are not about to leave them empty-handed. --By Barbara Rudolph. Reported by B. Russell Leavitt/Winston-Salem and Thomas McCarroll/New York
[This article contains a table. Please see hardcopy of magazine or PDF.]
Philip Morris
35%
R.J. Reynolds
32%
Brown & Williamson
11%
Lorillard
8%
American Brands
8%
Ligget Group
6%
Source: John C. Maxwell Jr.
With reporting by Reported by B. Russell Leavitt/Winston-Salem, Thomas McCarroll/New York