Legacy Funding to End in 2003

Per the following WSJ article, and due to Section IX(e) of the 1998 Master Settlement Agreement (MSA) between tobacco companies and State Attorneys General, it appears almost certain that Participating Manufacturers will not be required to fund the American Legacy Foundation after March 31, 2003. In drafting the MSA, the tobacco industry correctly anticipated that competing Nonparticipating Manufacturers could easily possess .05% of the US cigarette market share by 2003, a level that exempts Participating Manufacturers from making future payments to the American Legacy Foundation. This is another reason why it is critical for State Legislatures to appropriate significantly more settlement funds for tobacco control programs.

Source: Bill Godshall

Tobacco Settlement Causes a Rise In Makers of Low-Price Cigarettes
Page One Feature
by Gordon Fairclough / gordon.fairclough@wsj.com5
The Wall Street Journal Interactive Edition, Tuesday, 5/1/01

DENTON, Texas -- No sign hangs outside Alex Hemani's small factory across from an auto-body shop in this Dallas suburb. "We're not doing anything illegal," Mr. Hemani says. "But we like to keep a low profile."

Mr. Hemani makes cigarettes. Behind the doors of his beige, metal-clad building, clanking 1960s-era machinery churns out packs of discount smokes for customers around Texas.

A 34-year-old Pakistani immigrant, Mr. Hemani once ran a convenience store and later a supply business serving other mom-and-pop retailers. Since last year, he has poured more than $1 million in savings into Patriot Tobacco Co.

Despite the tobacco industry's blackened reputation and the lawsuits that have pummeled the big cigarette makers, Mr. Hemani sees gold in Patriot's red-white-and-blue packs. "If I can make the cigarettes," he says, "I know that I can sell them."

Premium cigarette prices are up, making room for new discount brands such as these.

The rise of Patriot and other small makers of low-price cigarettes is an unintended consequence of the legal settlement reached between the major manufacturers and 46 state governments in November 1998. In that landmark deal, the states sought to recoup the cost of caring for sick smokers. The states and public-health advocates also expected the sheer size of the settlement -- a combined $206 billion over 25 years -- to discourage smoking by forcing the large tobacco companies to raise prices. The big manufacturers have done just that: Wholesale list prices, excluding taxes, have risen nearly 80% since the settlement.

A New Swarm
In response, upstart cigarette makers have swarmed into the market, reversing a century-long trend of industry consolidation. They are selling cigarettes at or below prices available before the settlement. Some cut-rate smokes are selling for as little as $1 a pack, compared with an average retail price of more than $3 for big-name brands, such as Marlboro. That's a powerful draw for penny-pinching smokers.

To feed the market for inexpensive cigarettes, tiny factories with antiquated second-hand equipment are popping up across the country. S&M Brands Inc. makes Bailey's and Tahoe cigarettes in a brick former school house in rural southern Virginia, while Smokin Joes pumps out bargain-basement smokes in a factory near Lewiston, N.Y. Other companies are contracting to have discount cigarettes manufactured abroad. New Cigarette Brands Scores of new brands, with names such as GT One, Money and Ol' Smoothie, have hit the shelves of gas stations and convenience stores. Small companies have grabbed nearly 4% of the U.S. retail cigarette market, up from just 1% in 1997. Four percent represents roughly 16.8 billion cigarettes a year.

"I am disturbed by the proliferation of little companies," says Oklahoma Attorney General W.A. Drew Edmondson, who heads a panel of state legal officials overseeing the settlement with the industry. "They are able to sell a cheaper product, and all of the data show that the price of cigarettes particularly impacts youth smoking." The upstarts counter that their no-frills brands aren't intended to appeal to status-conscious teenagers.

After the initial postsettlement spike in prices, cigarette consumption dropped 7% in 1999. Since then, the annual decrease has settled back to the 1%-to-2% rate that has been the norm for decades, although that pattern can't be attributed to the recent success of discount manufacturers.

Another Twist
In another twist, the rise in small-company sales has already triggered provisions of the 1998 settlement that reduce the payments states receive from the major manufacturers -- by amounts that could reach into the billions.

And in a maneuver that state officials complain subverts the settlement, one big manufacturer, Brown & Williamson Tobacco Corp., is making cigarettes that are sold under the label of one of the upstarts. B&W denies it is doing anything wrong.

Although most public attention to the settlement was focused on the four biggest manufacturers, provisions were made for the upstarts to sign the deal, too. Those that did so promptly are effectively allowed to make payments to the states at lower rates than their bigger competitors.

Small companies that decline to sign the settlement are required under state laws to pay money into escrow accounts to cover any future state claims against them. But state officials say that some companies are failing to make escrow payments. At least six states -- Missouri, Nevada, New Jersey, South Dakota, Utah and Washington -- have gone to court to try to force these companies to pay.

The settlement pegs cigarette-company payments to sales. As smaller companies that didn't sign the pact gain market share, the agreement allows major manufacturers to pay less. The states have already felt the sting of this arrangement. For 1999, states say their settlement receipts fell by a combined $190 million because of the increase in sales by nonsigning companies. So far there has been no comparable reduction for 2000, but that could change as industry statistics are updated.

"If these market shifts continue, the losses to the states could easily run into the billions and billions of dollars," says William Sorrell, the attorney general of Vermont. States have been using the settlement money for a wide range of purposes, from health education to road paving.

A separate provision of the settlement threatens funding for the American Legacy Foundation, formed under the pact to wage a national antismoking crusade. The Washington, D.C.-based foundation has received about $270 million a year since 1999 from cigarette makers to pay for health education. One foundation television advertisement depicts body bags piling up in the streets around the New York headquarters of industry titan Philip Morris Cos.

Cushioning the Bottom Line
Starting in 2003, however, if sales by nonsigning manufacturers in any year amount to more than just 0.95% of the market -- a level that has already been exceeded -- industry payments for the education campaign for that year would cease. Thus, while the new competition is taking revenue away from major manufacturers, the settlement cushions the effect on their bottom line and embarrassing anticigarette messages could be stifled.

Such provisions were included in the settlement to protect the major manufacturers' sales and profits and their ability to pay the states. Tobacco foes now say they simply failed to anticipate the magnitude of the surge in discount competition. "It didn't occur to us" that newcomers could gain as much market share as they have, says Washington state Attorney General Christine Gregoire, who helped draft the settlement. "It was a surprise to me that it really doesn't take a lot of capital to start a cigarette company."

The big manufacturers express ambivalence about their tiny rivals. "We've really been hit," says Susan Ivey, chairman and CEO of Brown & Williamson, which is a unit of British American Tobacco PLC and the country's third-largest cigarette maker. "We've certainly had consumers trade down to those lower-priced options."

B&W has fared the worst among the major companies since the 1998 settlement. Its sales in the fourth quarter of last year, the latest period for which figures are available, were 35% lower than in the third quarter of 1998, just before the settlement was signed.

But B&W has found a way to soften the low-price threat by establishing an unusual alliance with Star Scientific Inc., the largest company that hasn't signed the settlement. B&W now makes two- thirds of the off-price cigarettes sold as Star brands. Thus, while B&W profits on its contract manufacturing for Star, it helps the smaller company activate provisions that lower industry settlement payments.

The states object strongly to "Brown & Williamson essentially aiding and abetting" a nonsigning company "in subverting the agreement," says Dennis Eckhart, California's senior assistant attorney general in charge of tobacco enforcement. California and several other states are contemplating legal action against Brown & Williamson, he says. B&W denies trying to undermine the state settlement. Mark Smith, a B&W spokesman, says the company is manufacturing cigarettes for Star to earn extra money. "We're a business, and we've been hurt," he says.

Mr. Smith points out that B&W is also working with Star to support the smaller company's efforts to develop potentially less-hazardous cigarettes. B&W has helped Star to develop and test-market a product called Advance, which the companies say contains lower levels of cancer-causing chemicals than regular cigarettes. B&W also has lent Star about $29.2 million, mostly for the construction of special barns to cure purportedly less-dangerous tobacco.

Star got its start in 1991, but the business didn't really take off until after the state settlement in November 1998. Soon, the company's factory in Petersburg, Va., was running practically 24 hours a day, seven days a week, struggling to keep up with orders. Star's discount- cigarette sales grew more than eight-fold, jumping from $20.7 million in 1997 to $176.8 million last year. The leap in demand prompted Star to turn to Brown & Williamson.

Paul L. Perito, Star's chairman, says the company aims to leave the traditional cigarette business entirely in about five years. In the meantime, he says, revenue from cheap cigarettes funds a significant part of the company's research on reducing carcinogens in tobacco. Star says that this fall it intends to test-market mint-flavored lozenges made from less-toxic tobacco that give users a nicotine fix when they can't smoke.

Other small tobacco companies don't boast such grand ambitions. Patriot's Mr. Hemani says he will stick to making "something cheap -- that's what people are looking for." Less-expensive cigarettes don't taste worse, he adds, "unless it's really bad tobacco."

The hardest part of getting into the inexpensive-cigarette business often is obtaining the equipment at a reasonable price. CigTec LLC, in Charles City, Va., found its first production lines last year in a factory in Nicaragua that was being shut down by British American Tobacco. The 30-year-old machinery now hums around the clock in an industrial-park factory. Monthly production has grown to 69 million cigarettes, compared with about 7 million last June, the company's first month in operation.

That still isn't much compared with the big manufacturers. At its Richmond, Va., plant, Philip Morris can crank out 672 million cigarettes a day. The country's largest tobacco company, Philip Morris, makes a profit of about $4.66 a carton, according to Martin Feldman, a tobacco analyst at Salomon Smith Barney. Discounters make 50 cents to 70 cents a carton.

Even though the national settlement led to higher prices and helped expand the market for discount cigarettes, small companies still complain that it unfairly penalizes them. Star has challenged the pact on U.S. constitutional grounds in a lawsuit filed in federal court in Richmond. The company contended that the escrow payments it has had to make as a nonsigning company -- $13.1 million for 2000 -- amount to an "unlawful taking of private property" in violation of the Fifth Amendment. A federal judge dismissed Star's complaint in March, but the company has appealed.

Avoiding Payments
In the meantime, Star is looking for legal ways to avoid making escrow payments. For example, the company says it has shifted to selling primarily in the four states that aren't part of the national settlement agreement and, therefore, have no escrow-payment requirements. Those states -- Florida, Texas, Mississippi and Minnesota -- forged separate settlements and together account for about 15% of the U.S. cigarette market. Some state attorneys general object, however, that many of the cigarettes Star and other small companies sell in the four states end up being resold elsewhere.

If, after 25 years, the states don't file new legal claims against the industry, all escrow payments are supposed to be returned to the companies. But Star and other small companies say they are being unjustly punished now. "Why should I pay for something the big companies did 40 or 50 years ago?" asks Malcolm L. Bailey, chief executive of S&M Brands, in Keysville, Va.

The little companies typically don't advertise and have lower overhead. They are too small and haven't been around long enough to attract smoking-related lawsuits.

What's more, companies that haven't signed the agreement aren't bound by its marketing restrictions. S&M, for example, promotes its Bailey's brand on T-shirts, baseball caps and camping equipment. Tobacco companies that have signed the settlement pact are barred from putting their logos on any merchandise.

Says Mr. Bailey: "We're selling the cigarettes as fast as we can make them."

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