Authors: Richard Kluger
But in 1992, RJR, determined if not desperate to pay off its leveraged buyout debt before it ruined the new owners, decided to heavily mine the low end of the volatile cigarette market. The new management had no stockholders to satisfy, no lofty return-on-equity rate to sustain; its priority was to generate sales dollars, at however slender a profit margin, in order to get out of debt as quickly as possible. Thus, RJR set up a dummy subsidiary called Forsyth Tobacco, named for the North Carolina county where the company was based, in order to mask the provenance of new brands priced radically low—Monarch at ninety-nine cents and private labels like Austin, sold at eighty-nine cents by the Circle K convenience stores in the Southwest, and America’s Highway, offered at only sixty-nine cents by British Petroleum’s filling stations. RJR also heavily couponed its premium-priced brands, especially Camel, to try to check severe hemorrhaging of its market share in that besieged sector. Mostly, though, the executives at Winston-Salem hoped to run away with the discount sector, where Brown & Williamson was offering its GPC Approved brand for a dollar, and American Tobacco and Liggett were placing almost all their bets
as well. With a whole new breed of superdiscount brands selling at one-half to as low as one-third the cost of the full-priced brands, the sector Philip Morris so thoroughly dominated, sales in the premium market could move only at an accelerated downward pace. For its part, Philip Morris did all it could to stave off a massive switchover to the cheap brands; why should it grab a nickel-a-pack profit, which the Monarch and other deep-discount brands averaged, when it could earn ten to eleven times as much on every pack of Marlboro it sold?
In what amounted to a full-fledged price war led by RJR, some 30 percent of all cigarette sales in 1992 were registered in the discount sector, where Reynolds had retaken the lead with a 36 percent share. The lower prices seemed to be encouraging Americans to keep smoking, or at least to slow their quitting rate. Per capita cigarette consumption, which had dropped by 4 percent in each of the two previous years, was off now by only 1 percent. Philip Morris brands dropped 3 percent overall in unit sales, but Marlboro was off almost twice that percentage and the other full-priced brands were similarly hurting; its deep-discount Basic brand had become PM’s second best seller. Reynolds, on the other hand, showed a 3 percent increase overall; even full-priced Camel was up a few points; and the other companies had recorded still higher gains, all of them in the discount sector. But there was some solace for Philip Morris in its 9 percent net income rise on U.S. cigarette sales, which, while well under its usual pace of advance, contrasted with RJR’s 19 percent drop in net income due to sharply reduced margins on its rising discount sales. On the strength of the performance of its food and international tobacco units, PM was able to declare a 23 percent increase in its annual dividend rate, almost as if nothing had changed.
There was real trouble, though, lurking in the fourth-quarter U.S. cigarette sales trend for 1992. PM brands were off 9 percent in units while its competitors had all posted gains of that magnitude or more. And the downward spin continued into the new year. By March of 1993, Marlboro units were off an additional 8 percent as the discbunt sector for the industry approached a 40 percent market share, and some tobacco analysts were predicting that it would command fully half the industry sales before long. It was beginning to look as if RJR’s strategy had been correct. PM-USA President Campbell admitted “surprise” at the swiftness of the discount sector’s growth, but neither he nor anyone else at the industry leader’s headquarters was willing to acknowledge that he had contributed to the trend by having pushed up prices too high for too long.
Michael Miles understood and approved of the PM pricing game, which had amounted to a calculated decision to hold margins as high as possible for as long as possible and then retrench when and if necessary—as the company had in effect done after holding aloof from the discount sector because a leap
into the price-cutting fray would have succeeded only in cutting profitability. Now, though, Miles saw that the company, relying on the domestic tobacco division for nearly half its profits, risked irreparable losses to its market share if it kept on playing a strictly bottom-line game. Averse as they all were to tampering with the price of Marlboro, the fuel that generated about half of PM’s $60-billion-a-year gross, Miles felt he had no choice but to approve an experimental cut of forty cents a pack in the Portland, Oregon, market—a slash of nearly 20 percent. The results were encouraging: defectors began drifting back to the No. 1 brand, for which many would pay a premium so long as it was not exorbitant.
Without warning to the financial community or tobacco wholesalers, who might have made a run on the company by trade-unloading
(i.e.
, returning portions of their heavy Marlboro inventories for what they had paid instead of absorbing the loss in value due to the impending price cut), Philip Morris announced on April 2, 1993, that it was temporarily dropping the nationwide price on Marlboro by forty cents, or its equivalent through coupons or other incentives, and freezing the price on all its other top brands. The company conceded that the income lost by the big price slash would come almost entirely out of profits, which it expected to fall by a huge $2 billion for 1993 as a result.
Coming in the wake of mounting public hostility toward smoking being stirred up by the new Clinton White House, which had indicated it would seek a major increase in the federal tax levy on cigarettes to help pay for the administration’s proposed health-care reform package, the news from 120 Park Avenue sent Wall Street reeling. In stock trading that April day, soon dubbed “Marlboro Friday” by the financial community, Philip Morris dropped 14¾ points, or 23 percent of its value—an astounding $13 billion paper loss to its 100,000 stunned shareholders. Big “MO,” as Philip Morris was designated on the New York Stock Exchange trading tape, fell below $50 a share after having sold as high as $85 the year before.
As often happened, investors were overreacting to an unanticipated event. Wall Street brokers and analysts, however, did little better. Spoiled for so long by PM’s unbroken skein of spectacular profitability, some of them turned now into doomsayers and blamed the company for acting in a panicky fashion after having clung too long to its high-pricing policy in a down economy with consumers on a bargain-hunting bent. Few saw it as simply and pithily as the company’s former chief executive in Europe, Ronald Thomson, who remarked privately of the big Marlboro price cut, “They just got a bit too greedy, and now they have to pay some of it back.” In truth, Wall Street may have expected Philip Morris to keep scoring unstoppable gains, but the company’s top marketers knew they were playing a temporizing hand at best by defying the economic laws of pricing. Their aggressive policy had indeed been instrumental in transforming the company, but in hindsight its executives had waited too long
to ease off in premium-brand pricing, inviting rivals to undercut PM’s share dominance while still allowing them to turn a decent profit in a greatly expanded discount sector. The result was that when the erosion of full-priced brands reached the point where Philip Morris management could no longer tolerate it, the corrective action seemed traumatic.
There was one large side benefit to the PM price slash, even if its abruptness had unsettled investors far too severely for the good of the company stock. The price cut dealt a deft and punishing blow to RJR for having plunged so deeply into discounting and forgetting the lesson that earlier generations of tobacco executives had come to recognize: a price war would hurt them all; there was no need for rash measures in their oligopolistic industry, where the pie was large enough and the clientele sufficiently captive that all could prosper, more or less, if the pricing line held. But Reynolds, unable to halt the Philip Morris juggernaut, had chosen to wage war on the industry leader and settle for thinner per-unit profits from what it hoped would become a good deal larger slice of the market. Such thinking assumed PM would hew to its ever upward full-price policy, no matter what. The simple fact, though, was that Philip Morris was far better able to absorb the reduced margins of a pricing war than Reynolds, which had to give up nine cents of every sales dollar to meet the interest charges on its LBO debt, against only three cents that PM had to allot to debt service. Similarly, the price-slashing left RJR with fewer profits to shelter at the effective 8 percent income tax rate it was paying, thanks to its huge debt charges, while PM, at a 32 percent tax rate, was giving up less proportionately since it had to hand over a much larger piece of its profits to the government. All that aside, the Marlboro price cut seemed likely to have a negative impact on RJR’s gross tobacco revenues, reducing the capacity of Henry Kravis and his partners to replace draining junk-bond yields, some with interest accruing at a potentially disastrous rate, with equity instruments. Stock warrants that RJR Holdings, the KKR-run parent company, had issued at 11¼ as a debt-retiring device dropped to half that value in the wake of the PM move. Little wonder that Kravis, in remarks at Harvard Business School a few weeks after Philip Morris announced the Marlboro cut, called it “the dumbest decision in corporate history … . They have ruined one of the best names in the world and created permanent damage.” What PM had ruined was RJR’s attempt to waylay it. Michael Miles, seeking to reassure his stockholders at the annual meeting held at about the same time that Kravis made his disparaging comment, promised to make further cuts if required to stem PM’s loss of market share.
To implement the new pricing program, Miles made a pair of fateful personnel moves. Hard-driving Geoffrey Bible, veteran of cigarette price wars in Australia and Germany, where PM had allowed itself to be undersold too long before striking back, was advanced to worldwide czar of the company’s tobacco operations, effectively moving past his titular overseer, William Murray,
while James Morgan was restored to the post of senior vice president for marketing at PM-USA, the key job he had held at the time he left the company a decade before. The feisty Bible denied charges that the company had been too greedy in its pricing policy, calling the Marlboro cuts merely “an acknowledgment of our current economic conditions.” In reality, they were an acknowledgment that Philip Morris could not exercise absolute pricing power in a time of economic duress for many of its customers.
Morgan, who had played a useful role during the heyday of Marlboro’s growth, gave the brand a bigger advertising push and made sure there was no suggestion in its always spare copy that its price had been slashed, lest the brand’s gold-plated image be cheapened. He also helped revamp PM’s discount strategy. Its Basic brand, the former low-priced supermarket entry, was pushed up by a dime to $1.40 a pack, or forty cents below the average price now for Marlboro; Alpine and Cambridge, which had been pegged in between, were cut to the same price as Basic and given some small promotional support while Buck and Bristol were left to wither. In short, there were now just two PM cigarette price levels, and the company elected to put virtually all of its discount-sector effort into Basic, investing it with what Morgan liked to call “brand equity”. The Basic line was extended to the full range of “packings,” dressed in a smarter yet still quite basic-looking package, and advertised with what Morgan called “a bit of twinkle”—spartan layouts showing, for example, a pack inside a baseball mitt and headlined “Your Basic catch” or with a Walkman mini-CD player clamped on it and headlined “Your Basic conceit”—and promoted with what the industry called “trinkets,” T-shirts and flashlights bearing the brand logo, for example. All of this was to see if the old Philip Morris brand-image magic could work for a product with a sales twist no more unique than a variant of the old Miller Lite pitch, “Tastes good, costs less.”
While the company waited to learn if these collective measures would correct its tailspin, management made a number of economy moves in anticipation of the expected drop in net from the deep cigarette price cut. Some 14,000 jobs were to be slashed, about an 8 percent reduction in the payroll, and forty food plants closed. A stock buyback program aimed at enhancing per-share equity value was suspended as well, and, most shockingly, for the first time in twenty-five years there was to be no increase in the dividend during 1993. The stock price, accordingly, stayed in the doldrums.
III
N
o subject more thoroughly arrested the attention of the tobacco manufacturers than the trend to sharply higher cigarette taxes, with their dampening effect on sales. To raise prices aggressively in the hope of richer profits
was the prerogative of risk-taking entrepreneurs, but to be forced to do so for the benefit of government was to serve as a revenue collector with no hope of gain and plenty to lose.
Yet the nonsmoking public, even in the antitax Reagan-Bush era, had seemed only too glad to punish self-indulgent smokers whose habit jacked up the insurance costs for the rest of society and stood accused of disproportionate use of health-care services, 43 percent of which were paid for by federal and state tax-derived funds. The combined federal-state levy on American cigarettes, which had averaged twenty cents a pack in 1980, had risen to forty-six cents by 1992, the highest for any product relative to its selling price and three times as high as the tax on gasoline. Even so, the U.S. cigarette tax was among the lowest in the industrial world; the equivalent levy in 1992 stood at $4.07 a pack in Denmark, $3.25 in Canada, $3.24 in Great Britain, $2.23 in Germany, $1.52 in France, $1.49 in Italy, and $1.08 in Japan. The trend line in the U.S., though, was cause for alarm in the industry camp. In 1993, right after the Environmental Protection Agency officially ruled that secondhand smoke was capable of killing, fifteen states raised their cigarette tax, and in 1994 several imposed quantum leaps in the tobacco excise—Washington State by twenty-five cents, Arizona by forty cents, and Michigan by fifty cents for a total cigarette levy in that state of ninety-nine cents, then the highest in the nation.