| Risk Factors RAI and its subsidiaries operate with certain known risks and uncertainties that could have a material adverse effect on their operations, some of which are beyond their control |
| The following is a description of the most significant risks and uncertainties: A dlra36dtta3 billion judgment was entered against RJR Tobacco and a dlra17dtta6 billion judgment was entered against B&W in Engle v |
| Although this judgment was reversed by an intermediate appellate court, RJR Tobacco cannot predict the final outcome of the appellate process |
| If RJR Tobacco is unsuccessful in the appeal of these judgments, or the stay of the judgment is terminated or the Florida bonding cap statute is overturned, the Engle judgment would have a material adverse effect on the results of operations, cash flows 10 _________________________________________________________________ [62]Table of Contents and financial condition of RJR Tobacco, RJR and RAI and the ability of these entities to continue to operate |
| On November 6, 2000, the Circuit Court of Miami-Dade County, Florida, entered a judgment in favor of the plaintiffs against RJR Tobacco, B&W and the other cigarette manufacturer defendants in Engle |
| Engle is a class-action case on behalf of Florida residents and citizens and their survivors alleging personal injury or death due to their addiction to cigarettes containing nicotine |
| Under the court’s judgment, approximately dlra145 billion in punitive damages was awarded to the “Florida class” against all defendants, with approximately dlra36dtta3 billion being assigned to RJR Tobacco and approximately dlra17dtta6 billion being assigned to B&W In addition, approximately dlra12dtta7 million in compensatory damages was awarded to the three named class representatives |
| The judgment also provides that the awards bear interest at the rate of 10prca per year |
| The defendants, including RJR Tobacco and its indemnitee, B&W, each posted the statutorily required bond of dlra100 million in order to stay the judgment and filed a notice of appeal |
| Three of the defendants in Engle, other than RJR Tobacco and B&W, entered into agreements with the Engle class to deposit an additional dlra1dtta86 billion into separate escrow accounts to ensure that the stay of execution in effect pursuant to the Florida bond statute will remain in effect as to these three defendants throughout the appellate process, regardless of the results of a challenge, if any, to the Florida bonding cap statute |
| RJR Tobacco and B&W did not enter into a similar agreement with the Engle class |
| The Engle trial court did not consider compensatory damages for the estimated remaining 500cmam000 to 700cmam000 individual members of the Engle class, and there are significant legal and procedural issues related to the compensatory damages consideration |
| Any compensatory damages awarded would be in addition to the damages previously awarded |
| On May 21, 2003, Florida’s Third District Court of Appeal reversed the trial court’s final judgment and remanded the case to the Miami-Dade County Circuit Court with instructions to decertify the class |
| On October 23, 2003, the plaintiffs filed a notice seeking review by the Florida Supreme Court |
| On May 12, 2004, the Florida Supreme Court agreed to review the case |
| Oral argument occurred on November 3, 2004 |
| Although RJR Tobacco believes it has substantial grounds to prevail on appeal, RJR Tobacco may not prevail on appeal |
| In addition, a court could strike down the Florida bonding cap statute, and the stay of the judgment could be lifted |
| Any requirement that RJR Tobacco pay all or a substantial portion of the punitive damages award would have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI RJR Tobacco, RJR and RAI could be subject to substantial liabilities from tobacco-related cases |
| As of February 3, 2006, 1cmam280 tobacco-related cases were pending against RJR Tobacco or its affiliates, including RAI and RJR and its indemnitees, including B&W: 1cmam270 in the United States; five in Puerto Rico; four in Canada and one in Israel |
| Of the 1cmam280 total cases, 35 cases are pending against B&W that are not also pending against RJR Tobacco, and 964 have been consolidated for trial on some common related issues in West Virginia |
| In addition, 2cmam626 cases filed by flight attendants alleging injury as a result of exposure to secondhand smoke in airline cabins are pending in Florida against RJR Tobacco or its affiliates or indemnitees |
| RJR Tobacco and B&W have prevailed in five of the first six flight attendant cases to be tried to verdict |
| Punitive damages are not recoverable in these cases, and the majority of the secondhand smoke cases do not allege injuries of the same magnitude as alleged in other tobacco-related litigation |
| It is likely that similar legal actions, proceedings and claims arising out of the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of cigarettes will continue to be filed against RJR Tobacco or its affiliates and indemnitees and other tobacco companies for the foreseeable future |
| During the fourth quarter of 2005, four tobacco-related cases were served against RJR Tobacco or its affiliates or indemnitees |
| Victories by plaintiffs in highly publicized cases against RJR Tobacco and other tobacco companies regarding the health effects of smoking may stimulate further claims |
| A material increase in the number of pending claims could significantly increase defense costs and have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and consequently, of RAI In 11 _________________________________________________________________ [63]Table of Contents addition, adverse outcomes in pending cases could have adverse effects on the ability of RJR Tobacco and its indemnitees, including B&W, to prevail in smoking and health litigation |
| Punitive damages, often in amounts ranging into the billions of dollars, are specifically pled in a number of the pending cases in addition to compensatory and other damages |
| An unfavorable resolution of certain of these actions could have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI In accordance with accounting principles generally accepted in the United States of America, referred to as GAAP, RAI and RJR Tobacco record any loss related to tobacco litigation at such time as an unfavorable outcome becomes probable and the amount can be reasonably estimated |
| RAI’s management continues to conclude that the loss of any particular pending smoking and health tobacco litigation claim against RJR Tobacco or its affiliates or indemnitees, including B&W, when viewed on an individual basis, is not probable |
| RJR Tobacco and its affiliates believe that they have a number of valid defenses to the tobacco-related litigation claims against them, as well as valid bases for appeal of adverse verdicts against them |
| RAI, RJR Tobacco and their respective affiliates and indemnitees, have, through their counsel, filed pleadings and memoranda in pending tobacco-related litigation that set forth and discuss a number of grounds and defenses that they and their counsel believe have a valid basis in law and fact |
| Based on their experience in the tobacco-related litigation against them and the strength of the defenses available to them in such litigation, RJR Tobacco and its affiliates believe that their successful defense of tobacco-related litigation in the past will continue in the future |
| Therefore, no liability for pending smoking and health tobacco litigation currently is recorded in RAI’s consolidated financial statements |
| You should not infer from the absence of any such reserve in RAI’s financial statements that RAI will not be subject to significant tobacco-related liabilities in the future |
| In addition, RJR has liabilities totaling dlra94 million that were recorded in 1999 in connection with certain indemnification claims asserted by Japan Tobacco Inc, referred to as JTI, against RJR and RJR Tobacco, relating to the activities of Northern Brands International, Inc |
| (an inactive, indirect subsidiary of RAI involved in the international tobacco business that was sold to JTI in 1999) and related litigation |
| RJR Tobacco could be subject to substantial liabilities from claims asserted by the US Department of Justice |
| On September 22, 1999, the US Department of Justice brought an action against RJR Tobacco, B&W and other tobacco companies in the United States District Court for the District of Columbia |
| The government initially sought to recover funds expended by the federal government in providing health care to smokers who have developed diseases and injuries alleged to be smoking-related |
| In addition, the government sought, pursuant to the federal Racketeer Influenced and Corrupt Organization Act, referred to as RICO, disgorgement of profits the government contends were earned as a consequence of a RICO racketeering “enterprise |
| ” In September 2000, the court dismissed the government’s claims asserted under the Medical Care Recovery Act as well as those under the Medicare as Secondary Payer provisions of the Social Security Act, but did not dismiss the RICO claims |
| In February 2005, the United States Court of Appeals for the District of Columbia ruled that disgorgement is not an available remedy in this case |
| This ruling limits the government’s potential remedies principally to forward-looking relief, including measures such as those already included in the MSA The government’s petition for panel rehearing and for rehearing en banc was denied in April 2005 |
| On July 18, 2005, the government filed a petition for writ of certiorari with the United States Supreme Court, which was denied on October 17, 2005 |
| The bench (non-jury) trial began in September 2004, and closing arguments concluded June 10, 2005 |
| Also on June 10, 2005, the judge ordered that the parties file a variety of post-trial submissions |
| On July 22, 2005, Judge Kessler granted a motion to intervene filed by six organizations, including the American Cancer Society, to allow them to “contribute their perspective on what appropriate and legally permissible remedies may be imposed should liability be found |
| ” On August 15, 2005, the parties filed their proposed findings of fact |
| An adverse outcome in this case could have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and consequently, of RAI 12 _________________________________________________________________ [64]Table of Contents RJR Tobacco could be subject to substantial liabilities from lawsuits based on claims that smokers were misled through its marketing of “light,” “ultra light” and “low-tar” cigarettes |
| Class-action suits have been filed in a number of states against individual cigarette manufacturers and their parent corporations, alleging that the use of the terms “lights” and “ultra lights” constitutes unfair and deceptive trade practices |
| Eleven such suits are pending against RJR Tobacco or its affiliates, including RAI and RJR, and indemnitees, including B&W, in state or federal courts in Florida, Illinois, Louisiana, Minnesota, Missouri, New York and Washington |
| A “lights” class-action case is pending in Madison County, Illinois against RJR Tobacco’s competitor, Philip Morris, Inc |
| Trial of the case against Philip Morris, Price v |
| Philip Morris, Inc, formerly known as Miles v |
| Philip Morris, Inc, began in January 2003 |
| In March 2003, the trial judge entered judgment against Philip Morris in the amount of dlra7dtta1 billion in compensatory damages and dlra3 billion in punitive damages to the State of Illinois |
| Because of the difficulty of posting a bond of that magnitude, Philip Morris pursued various avenues of relief from the dlra12 billion bond requirement |
| In April 2003, the trial judge reduced the amount of bond |
| The plaintiffs appealed the judge’s decision to reduce the amount of the bond |
| In July 2003, the appeals court ruled that the trial judge exceeded his authority in reducing the bond and ordered the trial judge to reinstate the original bond |
| In September 2003, the Illinois Supreme Court ordered that the reduced bond be reinstated and agreed to hear Philip Morris’ appeal without need for intermediate appellate court review |
| On December 15, 2005, the Illinois Supreme Court reversed the lower state court’s decision and sent the case back to the lower court with instructions to dismiss the case |
| On January 5, 2006, the plaintiffs filed a petition for rehearing |
| Although RJR Tobacco and RJR are not defendants in the Price case, they are defendants in a similar class-action case, Turner v |
| R J Reynolds Tobacco Co, also brought in Madison County, Illinois |
| The class certified in this case consists of persons who purchased certain brands of “light” cigarettes manufactured and sold by RJR Tobacco during a specified time period |
| On October 24, 2003, a justice on the Illinois Supreme Court ordered an emergency stay of all proceedings pending review by the entire Illinois Supreme Court of RJR Tobacco’s emergency stay/supremacy order request filed on October 15, 2003 |
| On November 5, 2003, the Illinois Supreme Court granted RJR Tobacco’s motion for a stay pending the court’s final appeal decision in Price |
| B&W is a defendant in a similar class-action case, Howard v |
| Brown & Williamson Tobacco Corporation, also brought in Madison County, Illinois |
| On June 6, 2003, the trial judge issued an order staying all proceedings pending resolution of the Price case |
| The plaintiffs appealed this stay order to the Illinois Fifth District Court of Appeals, which heard oral argument on October 7, 2003 |
| The Court of Appeals affirmed the Circuit Court’s stay order on August 19, 2005 |
| In the event RJR Tobacco and its affiliates and indemnitees lose the Turner or Howard cases, or one or more of the other pending “lights” class-action suits, RJR Tobacco could face bonding difficulties similar to the difficulties faced by Philip Morris in Price depending upon the amount of damages ordered, if any, which could have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and consequently, of RAI RJR Tobacco could be subject to substantial liabilities from tobacco-related antitrust lawsuits |
| RJR Tobacco and its indemnitees, including B&W, and certain of their subsidiaries are defendants in multiple actions alleging violations of federal and state antitrust laws, including allegations that the major US cigarette manufacturers, including RJR Tobacco and B&W, conspired to fix cigarette prices |
| An adverse outcome in any of these cases could have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and consequently, of RAI RJR Tobacco’s retail market share has declined in recent years and is expected to continue to decline for the medium term; any continuation in the decline beyond the medium term could adversely affect the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI According to data from IRI, the combined share of RJR Tobacco and B&W of the US cigarette retail market declined to 29dtta98prca in 2005 from 30dtta82prca in 2004 and 32dtta09prca in 2003, continuing a trend in effect for 13 _________________________________________________________________ [65]Table of Contents several years |
| While RJR Tobacco expects this trend to continue for the medium term, at the beginning of 2005, RJR Tobacco implemented a new brand portfolio marketing strategy, which RJR Tobacco expects, over a four to six-year time frame, will result in growth in total RJR Tobacco market share |
| If this new marketing strategy is unsuccessful and the decline in RJR Tobacco’s market share continues beyond the medium term, this could adversely affect the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI You should not rely on this market share data as being a precise measurement of actual market share because IRI is not able to effectively track the volume of all deep-discount brands, gray market imports and sales through alternative channels |
| Accordingly, the retail share of market of RJR Tobacco as reported above may overstate its actual market share |
| RAI believes deep-discount brands made by small manufacturers in recent years have proliferated and have increased their combined market share of 13prca to 15prca of US industry unit sales |
| Because these small manufacturers generally do not make payments under the MSA and other state settlement agreements to the same extent as the original participating manufacturers, these manufacturers have a substantial cost advantage over RJR Tobacco |
| In response to deep-discount pricing and other pricing pressures in the marketplace, such as increased cigarette state excise taxes, the major manufacturers have increased promotional spending significantly and, in some cases, lowered their wholesale list prices |
| These factors have had and could continue to have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and consequently, of RAI RJR Tobacco has substantial payment obligations under the MSA and other litigation settlement agreements, which materially adversely affects its ability to compete against manufacturers of deep-discount cigarettes that are not subject to these obligations |
| On November 23, 1998, the major US manufacturers of tobacco products, including RJR Tobacco and B&W, entered into the MSA with 46 states and other US territories to settle the asserted and unasserted health care cost recovery and certain other claims of those states and territories |
| RJR Tobacco, B&W and the other major US tobacco manufacturers previously had settled similar claims brought by four other states |
| The aggregate cash payments made by RJR Tobacco under the MSA and other state settlement agreements were dlra2dtta7 billion, dlra2dtta0 billion and dlra1dtta8 billion in 2005, 2004 and 2003, respectively |
| These amounts do not include payments made in connection with B&W’s US brands prior to July 30, 2004 |
| RJR Tobacco estimates its payments will be approximately dlra2dtta6 billion in each of 2006 and 2007 and will exceed dlra2dtta7 billion thereafter, subject to adjustment as discussed elsewhere herein |
| These payments make it difficult for RJR Tobacco to compete with certain manufacturers of deep-discount cigarettes |
| The manufacturers of deep discount brands are either subsequent participating manufacturers or non-participating manufacturers to the MSA As such, they have lower payment obligations than do the original participating manufacturers, allowing them to price their products lower than the original participating manufacturers |
| This pricing, in turn, may require higher levels of discounting and promotional support by RJR Tobacco as part of its efforts to defend its existing brands, attract adult smokers of competitive brands and launch new brands |
| RAI believes that these settlement obligations may materially adversely affect the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI The degree of the adverse impact will depend, among other things, on the rate of decline in US cigarette sales in the premium and discount categories, RJR Tobacco’s share of the domestic premium and discount cigarette categories, and the effect of any resulting cost advantage of manufacturers not subject to the MSA and other state settlement agreements |
| RAI’s operating subsidiaries have substantial payment obligations under the Fair and Equitable Tobacco Reform Act |
| On October 22, 2004, the President signed the Fair and Equitable Tobacco Reform Act of 2004, referred to as FETRA, eliminating the US government’s tobacco production controls and price support program |
| The buyout of tobacco quota holders provided for in FETRA is funded by a direct quarterly assessment on every tobacco product manufacturer and importer, on a market-share basis measured on volume to which federal excise tax is applied |
| The aggregate cost of the buyout to the industry is approximately dlra9dtta9 billion, including approximately dlra9dtta6 billion payable to quota tobacco holders and growers through industry assessments over ten years and approximately dlra290 million for the liquidation of quota tobacco stock |
| 14 _________________________________________________________________ [66]Table of Contents The MSA provided for the establishment of a dlra5dtta15 billion trust fund to be divided among the states that produce cigarette tobacco to compensate tobacco growers and quota holders for any negative effects that the MSA might have on them — MSA participants’ payment obligations with respect to this fund are referred to as “Phase II” obligations |
| As a result of the tobacco buyout legislation, the MSA Phase II obligations established in 1999 will be continued as scheduled through the end of 2010, but will be offset against the tobacco quota buyout obligations |
| RAI’s operating subsidiaries’ annual expense under FETRA, excluding the tobacco stock liquidation assessment, is estimated to be approximately dlra260 million |
| RAI’s operating subsidiaries have incurred dlra81 million in 2005 related to assessments from quota tobacco stock liquidation |
| Of this amount, approximately dlra25 million has been paid through the fourth quarter of 2005, and the remaining amount is scheduled to be paid, quarterly, by December 31, 2006 |
| RAI’s operating subsidiaries estimate that their overall share of the buyout will approximate dlra2dtta4 billion to dlra2dtta9 billion prior to the deduction of permitted offsets under the MSA FETRA’s substantial buyout payment obligations could negatively affect the profits and cash flows of RJR Tobacco and RAI’s other operating subsidiaries and could adversely affect sales if price increases are required to offset the obligations |
| The assumption of certain of B&W’s historical and future liabilities has exposed RJR Tobacco and its subsidiaries to significant additional potential liabilities associated with the cigarette and tobacco industry |
| In connection with the combination of RJR Tobacco and the US assets, liabilities and operations of B&W on July 30, 2004, RJR Tobacco agreed to indemnify B&W and its affiliates for B&W’s historic and future liabilities related to the contributed business, including all tobacco-related litigation and all post-closing liabilities under the MSA and other state settlement agreements with respect to B&W’s US cigarette and tobacco business |
| These liabilities could expose RJR Tobacco to material losses, which would materially adversely affect the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI RJR Tobacco is dependent on the US cigarette business, which it expects to continue to decline |
| The international rights to substantially all of RJR Tobacco’s brands were sold in 1999 to JTI In connection with this sale, RJR Tobacco also agreed that, prior to its use or license outside the United States of any trademarks or other intellectual property relating to its manufacture or sale of tobacco products, RJR Tobacco would first negotiate in good faith with JTI with respect to JTI’s acquisition or licensing of such trademarks or intellectual property |
| In addition, in connection with the business combination, RAI entered into a non-competition agreement with BAT under which RAI’s operating subsidiaries generally are prohibited, subject to certain exceptions, from manufacturing and marketing certain tobacco products outside the United States until July 2009 |
| Consequently, RJR Tobacco is dependent on the US cigarette market |
| As a result of price increases, restrictions on advertising and promotions, funding by US manufacturers, including RJR Tobacco, of smoking prevention campaigns, increases in regulation and excise taxes, health concerns, a decline in the social acceptability of smoking, increased pressure from anti-tobacco groups and other factors, US cigarette consumption has generally been declining, and it is expected to continue to decline, which could adversely affect the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI US cigarette shipments as tracked by MSAi decreased at a compound annual rate of 1dtta6prca from 1987 through 1997 |
| After declining 4dtta6prca in 1998 and 9prca in 1999, shipments remained relatively stable in 2000, declined 3dtta2prca in 2001, 3dtta7prca in 2002, 5dtta1prca in 2003 and 1dtta8prca in 2004 |
| RAI’s operating subsidiaries are subject to significant limitations on advertising and marketing cigarettes that could harm the value of their existing brands or their ability to launch new brands |
| Television and radio advertisements of tobacco products have been prohibited in the United States since 1971 |
| Under the MSA, RAI’s operating subsidiaries, including RJR Tobacco, cannot use billboard advertising, cartoon characters, sponsorship of certain events, non-tobacco merchandise bearing their brand names and various other advertising and marketing techniques |
| In addition, the MSA prohibits the targeting of youth in advertising, promotion or marketing of tobacco products |
| Although these restrictions were intended to 15 _________________________________________________________________ [67]Table of Contents ensure that tobacco advertising was not aimed at young people, some of the restrictions also may limit the ability of RAI’s operating subsidiaries to communicate with adult smokers |
| For example, RAI’s operating subsidiaries only advertise their cigarettes in magazines in which the vast majority of readers are adults 18 years of age or older |
| Additional restrictions may be imposed legislatively or agreed to in the future |
| Recent proposals have included limiting tobacco advertising to black-and-white, text-only advertisements |
| These limitations may make it difficult to maintain the value of existing brands |
| Moreover, these limitations could significantly impair the ability of RAI’s operating subsidiaries to launch new premium brands |
| The cigarette industry is subject to substantial and increasing regulation and taxation, which has a negative effect on sales volume and profitability |
| A wide variety of federal, state and local laws limit the advertising, sale and use of cigarettes, and these laws have proliferated in recent years |
| For example, many local laws prohibit smoking in restaurants and other public places |
| Private businesses also have adopted regulations that prohibit or restrict, or are intended to discourage, smoking |
| This trend has had, and is likely to continue to have, a material adverse effect on the sales, volumes, operating income and cash flows of RJR Tobacco and, consequently, of RAI Cigarettes are subject to substantial and increasing excise taxes in the United States |
| The federal excise tax per pack of 20 cigarettes is dlra0dtta39 |
| All states and the District of Columbia currently impose excise taxes at levels ranging from dlra0dtta07 per pack in South Carolina to dlra2dtta46 in Rhode Island |
| During 2005, seven states increased their excise taxes |
| After consideration of these actions, the weighted average state cigarette excise tax per pack, calculated on a 12-month rolling average, is dlra0dtta783 |
| Several states have pending legislation proposing excise tax increases |
| In 2006, increased excise taxes are likely to result in declines in overall sales volume and shifts by consumers to less expensive brands |
| Both of these results could have a material adverse effect on the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI In 1996, the US Food and Drug Administration, referred to as the FDA, published regulations that would have severely restricted cigarette advertising and promotion, and limited the manner in which tobacco products could be sold |
| On March 21, 2000, the US Supreme Court held that Congress did not give the FDA authority to regulate tobacco products under the Federal Food, Drug, and Cosmetic Act and, accordingly, the FDA’s assertion of jurisdiction over tobacco products was impermissible under that act |
| Since the Supreme Court decision, various proposals have been made for federal and state legislation to regulate cigarettes |
| A presidential commission appointed by former President Clinton issued a final report on May 14, 2001, recommending that the FDA be given authority by Congress to regulate the manufacture, sale, distribution and labeling of tobacco products to protect public health |
| In addition, congressional advocates of FDA regulation have introduced legislation for consideration by Congress |
| Additional federal or state regulation relating to the manufacture, sale, distribution, advertising, labeling and mandatory ingredients disclosure of tobacco products could reduce sales, increase costs and have a material adverse effect on the business of the operating subsidiaries of RAI Extensive and inconsistent regulation by multiple states could prove to be particularly disruptive to the business of RJR Tobacco |
| These factors could have a material adverse effect on RAI’s results of operations, cash flows and financial condition |
| Various state governments have adopted or are considering adopting legislation establishing fire safety standards for cigarettes |
| Compliance with this legislation could be burdensome |
| In June 2000, the New York State legislature passed legislation charging the state’s Office of Fire Prevention and Control, referred to as the OFPC, with developing standards for “fire-safe” or self-extinguishing cigarettes |
| On December 31, 2003, OFPC issued a final standard with accompanying regulations that requires all cigarettes offered for sale in New York State after June 28, 2004, to achieve specified test results when placed on ten layers of filter paper in controlled laboratory conditions |
| The cigarettes that RAI’s operating companies sell in New York State comply with this standard |
| In 2005, California and Vermont each enacted fire-safe legislation of its own, adopting the same testing standard set forth in the OFPC regulations described above |
| This requirement will take effect in Vermont on May 1, 2006, and in California on January 1, 2007 |
| Similar legislation is being considered in a number of other states |
| Varying standards from state to state could have an adverse effect on the business or results of operations of RJR Tobacco |
| 16 _________________________________________________________________ [68]Table of Contents RJR Tobacco’s volumes, market share and profitability may be adversely affected by competitive actions and pricing pressures in the marketplace |
| The cigarette industry is highly competitive |
| Among the major manufacturers, brands primarily compete on such elements as product quality, price, brand recognition, brand imagery and packaging |
| Substantial marketing support, merchandising display, competitive pricing and other financial incentives generally are required to maintain or improve a brand’s market position or introduce a new brand |
| Increased selling prices from higher cigarette taxes and settlement costs have resulted in increased competitive discounting and the proliferation of deep-discount brands |
| If RJR Tobacco is not able to develop, produce or commercialize new products and technologies required by regulatory changes or changes in adult consumer preferences, sales and profitability could be adversely affected |
| Consumer health concerns and changes in regulations are likely to require RJR Tobacco to introduce new products or make substantial changes to existing products |
| If RJR Tobacco is not able to develop, produce or commercialize new products and technologies required by regulatory changes or changes in adult consumer preferences, sales and profitability could be adversely affected |
| Similarly, RAI believes that there may be increasing pressure from public health authorities and consumers to develop a conventional cigarette or an alternative cigarette that provides a demonstrable reduced risk of adverse health effects |
| RJR Tobacco may not be able to develop a reduced risk product that is broadly acceptable to adult consumers in a cost-effective manner, or at all |
| The costs associated with developing new products and technologies, as well as the inability to develop acceptable products in response to competitive conditions or regulatory requirements, may have a material adverse effect on RAI’s results of operations, cash flows and financial condition |
| Fire, violent weather conditions and other disasters may adversely affect the operations of RAI’s operating subsidiaries |
| A major fire, violent weather conditions or other disasters that affect the manufacturing facilities of RAI’s operating subsidiaries could have a material adverse effect on the operations of RAI’s operating subsidiaries |
| Although RAI has insurance coverage for some of these events, a prolonged interruption in the manufacturing operations of RAI’s operating subsidiaries could have a material adverse effect on the ability of its operating subsidiaries to effectively operate their businesses |
| The integration of RJR Tobacco and B&W’s US cigarette and tobacco business may not result in RAI’s realization of all of the anticipated benefits of the business combination |
| The business combination of RJR Tobacco and B&W’s US cigarette and tobacco business, which occurred in July 2004, involves the integration of two businesses that previously operated independently, each with its own business, products, customers, employees, culture and systems |
| The ultimate success of the business combination will depend, in part, on the successful integration of the two businesses and realization of the anticipated synergies and cost savings from the integration |
| The integration is not fully complete, and there is no assurance that RAI will realize all of the anticipated benefits or achieve these benefits within the anticipated time frame |
| The failure to timely and efficiently complete the integration of RJR Tobacco and B&W’s US cigarette and tobacco businesses could have a material adverse effect on the business, financial condition and operating results of RJR Tobacco and, consequently, of RAI RJR Tobacco now depends on third-party suppliers for its tobacco packaging materials requirements; if the supply of tobacco packaging materials from the suppliers is interrupted, or the quality of the packaging declines, RJR Tobacco’s packaging costs and sales could be negatively affected |
| On May 2, 2005, RJR Tobacco and RJR Packaging, LLC, a wholly owned subsidiary of RJR Tobacco, referred to as RJR Packaging, sold the assets and business of RJR Packaging to five packaging companies |
| In 17 _________________________________________________________________ [69]Table of Contents connection with this sale, RJR Tobacco entered into agreements with four of the purchasers, pursuant to which those companies will supply RJR Tobacco with certain of its tobacco packaging materials requirements |
| As a result of the sale of RJR Packaging’s operations and the supply agreements, RJR Tobacco is now dependent upon third parties for its packaging requirements |
| Now that RJR Tobacco no longer controls the supply of its packaging materials, the risks of an interruption in that supply, or a decline in the quality of the packaging materials, may have increased |
| If the supply of packaging materials is interrupted, RJR Tobacco’s own shipments of tobacco products could be materially slowed, which could decrease sales |
| A decline in the quality of the packaging materials could also negatively affect sales |
| If RJR Tobacco had to seek alternate suppliers, particularly on an urgent basis, there is no guarantee that RJR Tobacco could find alternate suppliers willing or able to supply packaging materials at the same cost or quality as RJR Tobacco could obtain from the purchasers of the RJR Packaging business on a timely basis, if at all |
| If, as a result of securing an alternate supply of packaging materials, RJR Tobacco’s packaging costs increased, its profits could consequently decrease, or if RJR Tobacco were obliged to increase the price of its products to compensate for increased packaging costs, its sales could decrease |
| Sales could also be negatively affected if the quality of packaging from the alternate suppliers is inferior to the quality available from the purchasers of RJR Packaging’s operations |
| Any increase in RJR Tobacco’s packaging costs or decrease in its sales could materially adversely affect the results of operations, cash flows and financial condition of RJR Tobacco and, consequently, of RAI The ability of RJR to access the debt capital markets could be impaired because of its credit rating |
| In 2003, Moody’s and S&P downgraded their ratings of RJR’s long-term debt below investment grade |
| Because of these ratings, in the future RJR may not be able to sell its debt securities or borrow money in such amounts, at the times, at the lower interest rates or upon the more favorable terms and conditions that might otherwise be available to RJR if its debt was rated investment grade |
| The downgrading of RJR’s debt in 2003 obligated RAI and certain of RJR’s subsidiaries to guarantee RJR’s obligations under RJR’s revolving credit facility and debt securities issued under RJR’s 1999 and 2002 indentures, and obligated RJR, RAI and these subsidiaries to pledge certain of their assets, including RJR’s stock in RJR Tobacco, to secure their obligations under RJR’s revolving credit facility and these debt securities |
| RJR’s below-investment grade credit rating may make it more difficult for RJR to obtain future debt financing on an unsecured basis |
| In addition, future debt security issuances or other borrowings may be subject to further negative terms, including limitations on indebtedness or similar restrictive covenants, particularly if RJR’s ratings decline further |
| RJR’s credit ratings are influenced by some important factors not entirely within the control of RJR or its affiliates, such as tobacco litigation and the regulatory environment |
| Moreover, because the kinds of events and contingencies that impair RJR’s credit ratings and the ability of RJR and its affiliates to access the debt capital markets are often the same kinds of events and contingencies that could cause RJR and its affiliates to seek to raise additional capital on an urgent basis, RJR and its affiliates may not be able to issue debt securities or borrow money upon acceptable terms, or at all, at the times at which they may most need additional capital |
| RJR’s revolving credit facility contains restrictive covenants that may limit the flexibility of RAI and of RJR and its subsidiaries, and breach of those covenants may result in a default under the agreements relating to the facility |
| RJR’s revolving credit facility limits, and in some circumstances prohibits, the ability of RAI and of RJR and its subsidiaries to, among other things: • incur additional debt; • pay dividends; • make capital expenditures, investments or other restricted payments; • engage in sale-leaseback transactions; • guarantee debt; 18 _________________________________________________________________ [70]Table of Contents • engage in transactions with shareholders and affiliates; • create liens; • sell assets; • issue or sell capital stock of subsidiaries; and • engage in mergers and acquisitions |
| These restrictions could limit the ability of RJR and its subsidiaries to obtain future financing, make acquisitions or needed capital expenditures, withstand a future downturn in its business or the economy in general, conduct operations or otherwise take advantage of business opportunities that may arise |
| In addition, if RJR does not comply with these covenants and with financial covenants in its revolving credit facility that require it to maintain certain minimum financial ratios, any indebtedness outstanding under the facility could become immediately due and payable |
| In addition, the lenders under RJR’s revolving credit facility could refuse to lend funds if RJR is not in compliance with the covenants or could terminate the facility |
| If RJR were unable to repay accelerated amounts, the lenders under RJR’s revolving credit facility could initiate a bankruptcy proceeding or liquidation proceeding, or proceed against any collateral securing that indebtedness |