Roy Den Hollander

1. Roy Den Hollander Economics 97IA
Coffin Nails
Decision If Philip Morriss cigarette business was spun-off, would it provide investors with higher
returns than long-term U.S. Government bonds after taking into account the additional risk.
Industry Chart & Date
Competitors: There are six major competitors in the global market that manufacture, distribute
and sell American blend cigarettes. While all six are large operations, the industry concentrates in
two firms: Philip Morris, usually with a market share of over 40%, and RJR Nabisco, with about
a 30% market share.
1. American Brands (AM) sold its domestic operations, American Tobacco Co. to B.A.T.
Industries in December 1994 but retained ownership of its United Kingdom operations. Prior to
the sale, AM was the fourth largest producer by market share worldwide. Brands included Lucky
Strikes, Pall Mall and Tareyton.
2. B.A.T. Industries owns Brown & Williamson (BW) into which it merged the American
Tobacco Co. in 1995. B.A.T. was and still is the second largest producer by market share
worldwide. Brands include Kool and Kent.
3. Brooke Group, which was Liggett & Myers Tobacco, has the smallest market share and the
most financial troubles. After some initial success at winning market share through discount
cigarettes in the 80’s and early 90’s, Philip Morris retaliated with its own discount cigarettes and
in 1993 a 20% price cut on its brand name cigarettes. As other producers followed suit, Brooke’s
market share shrunk and it is now verging on backruptcy. Brands include Chesterfield, L&M and
Lark.
4. Loews, which acquired America’s oldest tobacco company, Lorillard, ranks fifth and has
Newport, Kent and True among its brands.

2. 5. Philip Morris (PM) is the largest cigarette producer in the world with 44.8% of cigarette
shipments in 1994. Premium brands include Marlboro, Merit, Virginia Slims and Parliament.
Discount brands: Basic and Cambridge.
6. RJR Nabisco, parent of R.J. Reynolds Tobacco, formerly the largest cigarette company but
now a distant number three pushes Winston, Salem and “Joe” Camel.
Product Segments: The two key products and industry battlegrounds during price war are
Premium and Discount cigarettes. Discounts include low price brand names and price/value
cigarettes that are marketed with no frills packaging (generics) or sold under private or store
brand labels. Premiums are essentially the same as Discounts but with an image attached, created
by intense advertising to the tune of 8.3% of the industry’s total value of input.
Vertical Structure: All the major cigarette producers purchase American tobacco at auction and
some oriental tobacco outside the U.S. The companies clean, stem, grade and dry the tobacco
and age it for three years. Large amounts of leaf tobacco are kept in inventory. The companies
mix and roll the tobacco into cigarettes in large, efficiently computer-run plants. Cigarettes are
primarily sold to chain stores, large retail outlets and distributors to smaller retail and other
wholesale outlets, then on in to mouths of millions of addicts the world over.

3. Cigarette Industry Chart
Product Segments
Vertical Structure Premium Discount
Tobacco Growers
Cigarette Producers American Brands American Brands
B.A.T. B.A.T.
Brooke Brooke
Loews Loews
Numerous Distributors P.M. P.M.
Numerous Retailers
Millions of Addicts

4. Revenues From Cigarettes
1989 1990 1991 1992 1993 1994
AM 4,286.35 4,796.60 4,859.82 4,950.40 4,475.52 4,419.10
B.A.T. 8,251.70 11,714.64 12,383.51 11,930.88 13,885.20 11,956.14
Brooke 231.61 479.50 529.47 480.00 210.00 114.51
Loews 1,772.74 1,895.55 2,015.76 2,190.56 2,053.02 1,916.00
P.M. 15,604.40 18,172.43 20,186.88 21,540.85 21,260.82 23,661.44
RJR 7,403.12 8,049.82 8,543.73 8,968.38 8,005.12 7,683.00
Total 37,549.92 45,108.54 48,519.17 50,061.10 49,889.70 49,750.19
Market Share(%)
1989 1990 1991 1992 1993 1994
AM Premium 5.8 5.3
Discount 10.7 10.0
Total 11.4 10.6 10.0 9.9 9.0 8.9
B.A.T. Premium 7.8 7.6
Discount 21.2 21.9
Total 21.98 25.97 25.6 23.8 27.8 24.0
Brooke Premium 1.2 1.4
Discount 14.4 12.5 9.9 6.9 4.7 5.4
Total 0.62 1.06 1.1 1.0 0.4 0.23
Loews Premium 9.6 9.9
Discount 0.2 0.9
Total 4.7 4.2 4.2 4.4 4.1 3.9
P.M. Premium 48.0 48.8
Discount 29.6 27.1 29.4 26.5
Total 41.6 40.29 41.6 43.0 42.6 47.6
RJR Premium 27.6 27.0
Discount 28.4 33.2
Total 19.7 17.85 17.6 17.9 16.0 15.4
1) I have used revenues from all tobacco products to approximate revenues from just cigarettes.
Revenues include domestic and international.
Discount Segments as % of Cigarette Market
1989 1990 1991 1992 1993 1994
25.0 30.2 36.8 32.5
Return on Equity(%)
All of the major cigarette producers are conglomerates, which makes it difficult to attribute the
exact amount of common stock equity to the cigarette portion of the business. I have assumed

5. the percentage of common equity that generates cigarette sales equals the cigarette percentage of
sales.
ROE from Cigarettes = % Profits from Cigarettes x Total Profits
% Sales from Cigarettes x
Total Common Stock Equity at Beginning of Period
2) Revenue from Cigarettes table was used to calculate Total Cigarette Market Share.
Return on Equity
1989 1990 1991 1992 1993 1994
A.M. 27.9 24.1 25.2 24.0 12.7 20.5
B.A.T. 28.0 13.0 18.8 25.1 26.0 21.1
Brooke 30.1 14.6 14.0
Loews 81.4 54.7 57.7 58.0 63.9 67.1
P.M. 69.0 61.3 56.3 60.6 37.9 54.5
RJR 5 6 19.4 12.1 6 13.0
RJR 5 416.0 210.0 49.7 47.3 63.0
(Operating
Income)
Brooke’s problems since 1991 were due largely to loss of market share in the discount and brand
segments as a result of price competition by the other producers to meet Brooke’s efforts to
undermine product differentiation with discount cigarettes. RJR’s problems, however, were a
result of paying down its takeover debt. I have, therefore, also calculated RJR’s return on equity
using operating income figures, which is the second of figures for RJR.
4) From 1996 through 1994, Brooke has had a network deficit, therefore, a return on equity
would not be meaningful.
5) Figures not available because RJR was taken private.
6) RJR suffered a deficit; therefore, return on equity was negative.
Return on Sales(%)
1989 1990 1991 1992 1993 1994
A.M. 9.6 8.6 10.9 11.3 6.6 11.6
B.A.T. 11.9 4.8 5.0 7.5 7.1 8.2
Brooke 5.7 14.5 18.7 11.0 8 8
Loews 28.7 20.8 21.3 24.0 25.8 30.5

6. P.M. 13.6 13.2 14.0 15.1 9.4 11.8
RJR NA 37.0 35.0 26.3 25.8 31.8
Barriers to Entry
The revenues for the six major cigarette producers grew from 1989 through 1992 by 30%. 1993
and 1994 resulted in a revenue decline primarily because the industry leader, P.M., dramatically
cut prices to win back market share from its brand name premium cigarettes that was lost to
discount cigarettes.
7) Since RJR profits were skewed due to takeover debt payments. I have used operating income
from cigarettes for RJR instead of net income.
8) Net income negative.
The discount portion of the cigarette market had grown from virtually zero in the early eighties to
41% in early 1993. Until “Marlboro Friday” on April 2, 1993, revenues had increased steadily
since 1984, although demand in the U.S. continually declined. But for the price cut in 1993,
revenues would have continued to increase. The overseas market, however, especially in Eastern
Europe and the former Soviet Union continues to grow since the early nineties. The market
shares for the individual firms since 1984, other than Brooke’s flirtation with backruptcy, did not
change significantly, even with the market share battle between premium and discount cigarettes.
In addition, no new companies entered or tried to enter the industry. Rather some consolidation
occurred when B.A.T. purchased American Brands U.S. operations. As such, the American blend
cigarette manufacturing industry has barriers of entry.
Behind those barriers, all the companies, except Brooke, are making economic profits.
Even factoring in the risk of Clinton and the Food & Drug Administration’s efforts to regulate the
industry and the numerous lawsuits the risk of investing in the cigarette industry as compared to
its returns still produces risk/return yields above long-term government bonds. The Republican

7. controlled Congress will temper any federal legislation, a number of states’ laws eliminating the
proof of causation in court appears unconstitutional, and, so far, no significant lawsuits have been
won against the industry. While cigarettes will not be banned and the industry driven into
bankruptcy by legislation, there does exist uncertainty, which is reflected in the rider.
Types of Barriers: The ranking of the six cigarette producers from highest to lowest sales is
P.M., B.A.T., RJR, A.M., Loews and Brooke. The ranking from high to low for return on sales
is Loews, RJR, P.M., A.M., B.A.T. and Brooke. Since the largest in sales do not also have the
highest return on sales, there does not appear to be an economies of scale barrier where the higher
the output per period, the lower the average cost per unit.
The key although tenuous barrier to entry is product differentiation. One cigarette, like
one spoon of heroin, is just as addicting and satisfying as the next. Cigarettes are essentially
commodities, which compete on price and engender very little customer loyalty in any one
producer’s product. Cigarette producers, however, have combined an addictive commodity with
a lifestyle image to win customer loyalty through extensive marketing and advertising. Marketing
and advertising for premium (full-price) brands build brand awareness and add value for the
custome by subtley connecting the satisfaction of a fix with the illusion of living a certain lifestyle.
A consumer is not going to switch when both the relief and high are international with now they
wish to be. The carefull cultured image is illustrated by the names of some of RJR’s marketing
programs. Camel Insider, Winston Winners, Winston Select Weekends and Salem Preferred.
While producers’ sales forces design individual in-store programs to fit the neighborhood
demographics, advertising costs the industry over $2 billion a year.
The barrier of customer loyalty, however, is a tenuous one. At some point the price can
become so high that it reduces the customer’s ability to satisfy her cravings, so she seeks out
quantity at a lower price. As the price on premium brands surpassed a dollar, Brooke began to

8. increase marke share through price competition by selling discount cigarettes to satisfy those
customers who could not afford a sufficient number of fixes via premium brands. A new market
segment resulted, which presented producers with a dilemma: then compete by introducing their
own discounts or stand idly by while their premium market and profits shrank. Since some profit
from discounts was better than a continuing profit decline in premiums, all the producers
introduced discount cigarettes. The market share and larger profits from premium brands
declined as the discounts share of the market grew from 25% in 1990 to 41% in early 1993.
Advertising and marketing costs increase the average cost from premiums but not to such an
extent as to offset the increased profits from higher prices. In fact, premiums are 10 times more
profitable than discounts because of the higher price that product differentiation allows the
producers to charge. The growth of the discount cigarette segment undercut the barrier of
customer brand loyalty and threatened to push the market somewhat towards a competitive one
of commodities. If this key entry barrier were lowered, firms that otherwise would remain out
might be tempted to enter, even in the face of other barriers such as government regulations.
Additional entrants, even with the growth in overseas demand, would shift each firm’s demand
curve inward towards a tangential point its average cost curve; thereby reducing Price - Average
cost; i.e. economic profits.
The industry’s leader, P.M., strengthened the weaker barrier in 1993 and 1994 by using its
remaining customer brand loyalty and a dramatic reduction in price for premiums so they were
price competitive with discounts to regain market share from the discounts. Coupled with P.M.’s
increased brand advertising and marketing, the market share for discounts fell to around 30%, and
P.M. gained market share from the other producers, especially Brooke and RJR. The other
producers eventually followed P.M.’s strategy in order to stem their loss of market share. But
more importantly for the industry, as P.M.’s chairman said, “Brands didn’t die in April of ‘93

9. (time of P.M. price cut). They were reborn.” Although Brooke lost a large percentage of its
share and was nearly driven into bankruptcy, the discount segment continues to pose a threat to
the industry’s barrier of customer brand loyalty.
Federal and state government actions and threatened actions and lawsuits ironically create
another barrier behind which the industry can reap economic profits. The executive branch of the
Federal Government wants a ban on the sale of cigarettes to minors, elimination of sales through
vending machines (which accounts for $2.2 billion in revenues), stricter limits on advertising,
elimination of free samples as marketing promotions, FDA regulation of cigarettes and will
interfere with advertising campaigns such as RJR’s effort to market a brand to black smokers.
Four states and 100 cities ban smoking in public spaces and some states have passed legislation
aimed at making at easier to find cigarette producers liable for the harms of smoking. Lawsuits by
individuals and class actions persist. The U.S. Supreme Court ruled that federal labeling did not
absolve producers from liability for conspiracy to conceal or misrepresent the effects of smoking.
Florida is trying to recover $1.4 billion in smoking related healthcare costs and 50 law firms
intend to file a class action suit on behalf of every American who has ever smoked. Even though
the Congress is now trying to reduce business regulations in general and all of the 800 lawsuits
brought against the cigarette producers so far have failed, the stigma attached to tobacco sales
and the threat of government restrictions have ensured immense profits for those few companies
still in the cigarette business, as no new potential competitors are both willing and able to venture
into such a troubled market.
Nature Competitive Rivalry
Since premium cigarettes face an inelastic demand curve, producers can increase revenues by
raising prices because the percentage of decrease in output is less than the percentage increase in
price. Since the early 80’s prices rose an average 10% per year until 1993. With the introduction

10. of discount cigaretttes the premium demand curve shifted inward becoming less inelastic because
consumers now had a choice to substitute discounts for premiums. As a result, an increase in
premium prices in order to make up for lost revenues from reduced demand did not bring
insufficient greater revenue because a percentage change in price now caused a greater percentage
change in output.
The growth in the discount market threatened the very foundation of economic profits in
the industry: product differentiation. Extensive advertising and product promotions had enabled
the producers to create a myth among consumers that cigarette brands were different. Each
premium brand had an image so producers were able to act as mini-monopolists within a
particular premium brand segment, which gave them the marekt power to restrict output and raise
prices as compared to a competitive market of undifferentiated goods (which is what cigarettes
really are). Product differentiation allows for lower output but at a higher price and economic
profits results because the price is greater than the average cost, which remains so because of the
entry barrier of customer loyalty (product differentiation). But the escalating high prices of
premiums caused customers to try the lower price discounts which began breaking down the
myths of differentiation and reducing economic profits as customers shifted to discounts. In a
sense the cigarette market today could be classified as almost competitive in the discount segment
and oligopolistic in the premium segment. P.M.’s dominance of the industry enabled it to impose
discipline and play a coordinated role in price leadership. By slashing 40 cents off of its premium
brands, coupled with intense advertising and promotions, P.M. won back many of its former
premium customers while forcing the other producers to follow suit or lose more market share to
P.M. Initially, the decline in profits cause Brooke and RJR to cut advertising and both lose
share. The industry’s profits fell by 43% in 1993 but rose in 1994 as demand and the price for
premims increased, unit volume grew and costs fell. Marlboro’s market share increased from

11. 22% to 30%. The increased advertising, especially by P.M. and later on by RJR, continues to
increase demand for premiums, allow for price increases and strengthen product differentiation.
The discount market, however, still remains a threat at over 30% and there are indications RJR
may try to regain some of the market share it lost to P.M. through further price cuts or pushing
discounts.
In order to preserve economic profits and prepare for possible additional price cuts, the
industry began engaging in aggressive cost cutting in late 1993. The industry however, especially
P.M., has pursued increase efficiency for years. Since 1982 the input of labor in number of hours
has steadily decreased while value added by manufacturing increased as a result of capital
investement in efficient ciagarette producing equipment.
For example, P.M. recently entered into a labor contract where employees receive stock instead
of wage or benefit increases. The number of shares provided the employees will not be significant
enough to cause dilution.
The mature cigarette industry may avoid market competition via further price cuts by
exploiting the growing overseas market. Since the fall of the Soviet Unionin 1991, the unit
volume growth has been especially strong in Eastern Europe and the former Soviet Union.
Worldwide markets are expected to expand, and with price increases, cigarette profits should
grow. The combined overseas sales of P.M. and RJR made up 46 % of their revenues in 1991,
but only 25% of their combined profit. In 1994, overseas combined sales increased to 57% of
revenues and 43% of combined profits. Although operating profit margins overseas are between
50% and 75% of U.S. margins, they are rapidly rising.
Following P.M.’s retaliations against discount cigarette producers in 1993, the industry
appears to be managing cooperation once again. B.A.T.’s purchase of American Tobacco from

12. A.M. and its decision to produce mainly premium cigarettes with American Tobacco rather than
continue A.M. discounts will eliminate on other large manufacture of discounts. Brooke, the
instigator and for a time leader in discounts, has only a 5.4% share of the discount market.
Further, all the producers are expected to increase prices in 1995 by consistent 3% with profits
growing by 10%. Chosen by “Marlboro Friday” and the discount price wars, the producers are
back to pursuing economic profits by strengthening.
The wild card in the industry rivalry is government. Government regulation can affect
rivalry by influencing growth and producers cost structure. Additional U.S. restrictions on
advertising will hinder product differentiation and further government findings on the health
effects of smoking will reduce demand and increase costs via lawsuits. ?? taxes per unit of output
will shift the supply curve upward because producers will want to receive the same net price as
before. The industry supply curve, which is the sume of the producers’ marginal cost curves, is
probably more elastic than the industry demand curve. As a result, a tax will be shifted forward to
the consumers, so consumer demand for discounts will increase causing ruinous price
competition.
Eliminating sales through vending machines will increase the inconvenience and difficulty of
obtaining cigarettes largely for the youth market, thereby reducing sales. In 1993, producers sold
11 million packs through vending machines. The Newtonian Congress, however, will mitigate the
executive branch’s impact on cigarette producers, provided the Republicans maintain control after
the 1996 elections. There are also government problems overseas. Restrictions on advertising
are growining in some Asian countries and anti-smoking sentiment is on the rise in Europe, but in
the lawless former Soviet Union, the addiction to cigarettes face no legal threat. Considering the
length of time it took to negatively impact cigarette sales in the U.S. (an enlightened nation), the

13. overseas market should grow substantially over the long term customer brand loyalty, increasing
efficiency and focusing on growth in the overseas market rather than fighting over existing market
share in the shrinking but relatively stable U.S. market.
Buyer Power The producers will sell to a large number of retailers and wholesalers, whom
include convenience stores, supermarkets, wholesale clubs, drugstores and mass merchandisers.
When supermarkets and drugstores started to reduce their promotions and sales in response to the
politically correct tyranny sweeping the land, convenience stores picked up the slack. In 1994,
tobacco as a percent of convenience store sales reached 27.9%. Beer was second at 13.2% so the
supermarket and drugstore loss became the convenience stores gain. Buyes from the producers
do not exert significant power because they are too numerous, unlikely to enter into production,
majority of cigarettes are significantly differentiated and any individual buyer, except for RJR’s
McLane Co., does not purchase a significant percentage of the producers outputs.
Supplier’s Power Two key suppliers are the tobacco growers and labor. Labor has very litle
influence on the producers. Labor is largely unskilled; therefore, there exists a large labor pool.
Over the years producers have replaced laborers with technology, minimized labor costs and not
all the producers are unionized.
Tobacco growers are more numerous than producers and their product is not
differentiated. Growers sell the bulk of their product to the producers, which can be stored for
years allowing inventories to build, so growers do not exert significant influence on producers.
Conclusion P.M. is acting to protect its market share, enhance barriers and increase efficiency.
The industry has apparently stabilized after the price competition caused by discounts and the
overseas market should grow signficantly over the long term. The politically correct fanatics in
the White House, however, pose a significant threat to the domestic market. Their efforts may
only be campaign tactics, but if not, and Clinton wins reelection, he may pursue a final solution

14. strategy against the cigarette industry since there is no subsequent election to mitigate his actions.
I would wait until after the 1996 election, if Clinton loses or his interest in cigarettes wanes, then
invest.