FROM THE OFFICE OF PUBLIC AFFAIRS

Chairman Conrad, and distinguished members of the Task Force, I am pleased to appear before you today. I joined the Treasury Department last year, after working for 18 years on Wall Street. As a partner of the Goldman Sachs Group, L.P., I was fortunate to have a variety of experiences that help inform my understanding of bankruptcy issues in the tobacco industry. During the 1980's and early 1990's, I was a senior professional in the firm's merger effort. In that capacity, I valued companies and advised clients on how to assess businesses. That is what I hope to do here with you today. After I left the merger department, I gained both trading and international experience as the head of Goldman Sachs' debt and currency trading efforts in Japan. As a bond trader, I assessed how world and market events affected the valuation of bonds and their underlying credits. That experience also bears upon the views that we will be presenting today.

Jon Gruber, Deputy Assistant Secretary for Economic Policy, is here with me to help address any of your questions. Mr. Gruber has been with the Treasury Department for the last year, and is also a professor of economics at the Massachusetts Institute of Technology.

My testimony will consider the effect of comprehensive tobacco legislation on the risk of insolvency in the tobacco industry. To best understand such effects, I will begin by providing the Task Force with a brief overview of the tobacco industry and its business characteristics. I think that you will share our conclusion that the industry is currently financially strong and viable, but not without risk. This financial risk, which has been endemic to the industry for many years, arises from uncertainties related to litigation concerning the companies' business practices. Subsequently, I will turn to proposed legislation and its implications for the tobacco industry's overall financial health. Finally, I will make some observations about how bond investors assess the tobacco industry's credit risk.

1. Industry Characteristics

The U. S. tobacco industry is financially strong. It is comprised of four major companies: B.A.T. Industries, Loews, Philip Morris, and RJR Nabisco. (A fifth company, Liggett Group, has a market share of just over one percent.) As presented in Figure A, these companies had combined revenues approaching $150 billion last year. They had operating earnings in excess of $23 billion. Their combined stock market value is $145 billion. By all of these measures, this is a large and viable industry. It also is concentrated as an oligopoly among only a handful of players.

These companies also are well-diversified. As presented in Figure B, only one-third of the industry's operating earnings is derived from domestic tobacco. International tobacco sales accounted for 27 percent of operating earnings. Moreover, each of the companies in the industry has diversified holdings in other businesses. With interests in food, beer, financial services, and hotels, the industry owns such familiar companies as Kraft Foods, Miller Brewing, Nabisco, CNA, and Loews Hotels. These non-tobacco interests accounted for 39 percent of earnings last year. As can be seen, the industry does not, by any means, rely solely on domestic cigarette sales to stay profitable.

2. Business Characteristics

The tobacco companies share several business characteristics.

First, they enjoy significant brand loyalty from their customers. With such strong consumer franchises, the companies benefit from significant barriers to entry. Moreover, the industry's limited potential for technological innovation helps to maintain these barriers. In addition, potential marketing restrictions are likely to raise these barriers and strengthen their franchises.

Second, cigarette sales are highly concentrated among the top brands. The leading product, Marlboro, accounts for approximately one-third of all domestic cigarette sales. The top dozen brands together account for 80 percent of domestic cigarette sales.

Third, the tobacco business has very high operating margins. Loews, Philip Morris and RJR had combined operating earnings of 38 cents on every dollar of domestic tobacco sales last year. Even the smallest among them, Loews, earned 32 cents on every dollar of tobacco sales. These generous industry margins are over three times the average profits enjoyed by American industry as a whole.

The industry benefits from advantages on both the revenue side and the cost side of its business. The strength of brand names and the industry's oligopolistic nature give tobacco companies substantial pricing flexibility. At the same time, the industry's cost structure is largely variable (i.e., directly related to output), allowing the industry to more readily adapt to changing environments. Approximately two-thirds of costs are selling, general and administrative costs. Dominated by distribution, marketing, and advertising costs, these are largely variable. Manufacturing costs, which make up the remaining one-third of costs, also are dominated by variable costs, such as the purchase of raw materials and packaging.

Fourth, the industry has provided smooth returns over many years. Contrasted to many industries, the tobacco industry has had relatively modest volatility in revenues or earnings. This is especially relevant in analyzing insolvency risk.

Fifth, the tobacco companies recently have experienced growth in international sales. The companies are profitable in many countries, despite having lower market shares in foreign markets. More importantly, they are profitable even in countries where cigarette prices are significantly higher than in the U.S. For example, they profitably compete for sales in the U.K., Denmark and Norway, where the average price for a package of cigarettes is more than twice as high as the price in the domestic market. Under most estimates of price increases under the proposed legislation, prices in the United States are not expected to reach the current levels in many foreign countries.

On the other hand, however, the companies have been confronted with declining demand in the U.S. Over the last five years, domestic demand has dropped by more than one percent per year.

3. Potential Legal Liabilities

As we have reviewed, the industry is currently financially strong and viable. It is not, however, without risk. The tobacco companies face one major business uncertainty: the potential for incurring substantial legal liabilities. This financial risk, which has been a characteristic of the industry for years, emanates from uncertainties related to litigation concerning the companies' business practices. Although the industry has lost only one lawsuit in its history, the risk of a major damages award creates uncertainty that must be factored into any assessment of financial prospects. The various expenses associated with settling and defending lawsuits also affect the profitability of the tobacco companies.

As stated earlier, the risks associated with potential legal liability have confronted this industry for many years. Litigation risks were endemic to the industry before any comprehensive tobacco legislation was ever contemplated, and they remain an independent source of business uncertainty notwithstanding the proposed legislation. Even in this environment, however, the combined stock market value of the tobacco companies has risen almost 50 percent in the last three years.

4. Proposed Legislation

I would like to now turn to the subject of comprehensive tobacco legislation and discuss some of the key features as contemplated.

Price Provisions

The central goal of proposed legislation is to lower youth smoking and the volume of cigarette sales in the United States. This goal is to be achieved in a variety of manners, including increasing the price of tobacco products. S. 1415, as reported out of the Commerce Committee, requires cigarette manufacturers to make substantial payments to the Government, and mandates that the costs of such payments be passed through to consumers. As Deputy Secretary Summers has testified, the Administration estimates that the provisions will raise the price of cigarettes by $1.10 per pack, in constant dollars, by the year 2003, using pricing assumptions that ensure youth smoking targets will be met. Given other underlying trends in cigarette pricing, it is anticipated that the real price of cigarettes will rise to approximately $3.20.

Despite the size of the required payments, the proposed legislation contains three classes of provisions that protect the industry against a sharp drop in profitability. First, as noted, the legislation provides for consumers, not manufacturers, to finance the industry's payments. The pass-through provisions in the legislation ensure that the payment costs do not come directly out of tobacco company profits.

Second, industry payments are allocated by market share, and adjusted for sales volumes declines after the fifth year. By taking into account individual companies' ability to pay, these mechanisms further ameliorate the effects on industry profitability. In addition, a number of proposals phase in the industry payments over five years. This allows the industry to adjust over time.

Third, both the original Attorney Generals' proposed settlement and S. 1415 contain a number of features that tend to maintain the market share of existing industry participants. For example, the legislation imposes costs not only on current market participants, but also on new entrants and importers.

Further Provisions

The Commerce Committee bill further attempts to reduce youth smoking through other means, such as restricting the access of youth to tobacco products, and restricting marketing to youth. It also imposes surcharges if the industry does not meet the youth-smoking reduction targets that the companies agreed to with the Attorneys General.

Legal Liability Provisions

Another central feature of comprehensive legislation is the legal liability protections that it provides to the industry. The comprehensive legislation would settle the 41 outstanding state suits against the industry, as well as a handful of local suits. The terms of the legislation also would apply to new entrants to the industry, and to international competitors. It thus resolves significant legal uncertainty, and provides broader coverage than merely settling currently outstanding legal claims. National legislation that covers all potential participants in the industry ensures that the industry is able to pass settlement costs on to consumers.

Comprehensive legislation also provides for limits on the industry's liability. Such limits further reduce the legal uncertainty facing this industry. The extent of the reduction in risk, however, depends on the details of the limits themselves.

5. Implications of Legislation for Bankruptcy Risk

I will now turn to the question of how comprehensive tobacco legislation will affect the tobacco industry's financial health. In summary, we do not believe that the proposed legislation will materially affect the tobacco companies' risk of insolvency. Even under conservative assumptions with respect to price, domestic sales volume and operating margin, the tobacco industry will remain very profitable. The companies will continue to have earnings that are more than sufficient to cover interest payments. In short, comprehensive tobacco legislation poses less risk of bankruptcy for this industry than pending and future litigation, or simply the vicissitudes of the market.

The Effect of Price Increases on Sales Volume

Our analysis of the proposed legislation focuses on its effects on pricing, sales volume, and operating margins in the tobacco industry. As previously outlined, the proposed legislation contains several provisions that provide for the pass-through of payments to prices. The attendant price increases will lead to a decline in sales volume. We estimate that for every 10 percent increase in price, there is a 4.5 percent reduction in product demand. As a result, a $1.10 price increase, for example, would lower sales volumes by about 22 percent.

Some research analysts from Wall Street have predicted that the price increases caused by the proposed legislation will be greater than this analysis, and other legislation that has been proposed has contemplated greater price increases as well. If the price increase were higher, say $1.50, there would be a projected 30 percent decline in domestic cigarette volumes.

The Effect on Operating Earnings

Operating earnings are affected not only by reductions in sales volume, but also by declines in operating margins. As previously noted, the tobacco industry's cost structure is largely variable, allowing it to more readily adapt to changing environments. Thus, it is likely that the proposed legislation would cause the industry's margins to decline only modestly. Based upon the relationship between sales volume and operating margin that currently exists within the industry, we estimate that a 22 percent decline in sales volume will lead to a decline in operating margins of approximately 15 percent. Under those circumstances, the combined effect of declining domestic sales and operating margins would lead to only a 12 percent decline in the total operating earnings of the industry. Accordingly, the tobacco companies would remain more profitable than American industry as a whole.

As noted earlier, some Wall Street research analysts project larger volume declines than 22 percent, and some proposed legislation contemplates larger volume declines as well. Even if that were the case, the domestic tobacco businesses of the various companies would remain profitable. Using margin assumptions more conservative than above, a 30 percent decline in volumes would lead to only a 15 percent decline in industry operating earnings. The industry would still have over $4 billion in domestic tobacco operating earnings and approximately $20 billion in overall operating earnings.

Corporate Debt Levels

The tobacco companies paid approximately $3 billion of interest payments last year on their outstanding debt. As noted, the industry had operating earnings of over $23 billion. Thus, the industry earned enough to cover its interest more than seven times. Indeed, all of the major participants in the tobacco industry have operating earnings from sources other than domestic tobacco -- such as international sales and non-tobacco products -- that far exceed annual interest payments. Thus, even with significant reductions in domestic tobacco earnings, these firms should be able to meet their interest obligations. Moreover, the asset values of the non-tobacco businesses of Phillip Morris, RJR Nabisco, and Loews, are greater than the companies' outstanding debt. For instance, in the case of RJR Nabisco, the company's 80 percent stake in Nabisco is worth approximately $10 billion, while the company's outstanding debt (excluding Nabisco) is just over $5 billion.

6. Bond Market Investors

I now will discuss how bond investors assess the industry's credit risk. Bond investors are an important barometer, as they risk their money based on their assessment of potential risks and rewards. In addition, they are not easily swayed by politics, rhetoric or theory.

By way of background, corporate bonds trade at yields that are higher than the Treasury's borrowing rate. This interest rate differential is due to many factors, but is primarily associated with the risk of corporate default. Investors refer to this interest rate differential as a "credit spread." The greater the "spread" above Treasuries, the greater the credit risk associated with the company.

In addition to assessing the risk of companies in relation to the Treasury, investors also make judgments about the risk of companies in relation to each other. Investors assess the relative risks of corporate bonds in terms of maturities and company-specific risks. The yield that investors demand on a particular firm's bonds reflects what investors believe to be the credit risk of the firm. Investors generally demand a higher yield if they perceive that the credit risk is more significant. Conversely, they will accept a lower yield if they believe that the credit is safer. Thus, the yield demanded by investors for a particular bond will change as perceptions about the company's creditworthiness change.

Figure C illustrates how bond investors assessed the credit risk of the tobacco companies at three points in time. We looked at trading levels (I) prior to the Attorney Generals' proposed settlement, (ii) just after the Attorney Generals' proposed settlement, and (iii) during the several days after the Commerce Committee voted S. 1415 out of committee. The numbers in the columns represent the additional yield that investors required to buy the tobacco companies' bonds (relative to an index of other relevant corporate bonds). Where investors demanded higher yields, they perceived higher levels of risk.

A number of important observations can be made from this information. First, investors viewed the credit risk for all of the companies in early April 1998 as about the same as they did one year earlier. This is evidenced by the fact that the additional yield required by investors did not changed materially. In fact, investors were willing to purchase the industry's bonds at modestly lower yields than prior to the Attorney Generals' proposed settlement. Accordingly, S. 1415 does not appear to have had any negative effect on investor perceptions of the tobacco companies' credit risk. If anything, these firms are now viewed by investors as slightly safer than they were one year ago.

Second, after the Attorney Generals' proposed settlement, the bonds of one of the companies, RJR, improved significantly. This suggests that investors saw the Attorney Generals' proposed settlement as lowering the credit risk for this company. That yield advantage was reversed as the enactment of the June 20 settlement became less likely. But, to reemphasize, in the wake of the Commerce Committee vote, the market's assessment of the bankruptcy risk of RJR, as well as the other tobacco companies, was no different than it was before discussions of comprehensive tobacco legislation were made public. The risk was, and remains, low.

Third, the interest rates required on the debt of all but one firm in this industry are very close to those required on the most financially secure businesses in America. The one company for which investors require an additional premium, RJR, has greater levels of debt. This is primarily due to the debt left over from RJR's leveraged buy-out completed in 1989. To give you some context, however, even RJR, which is the riskiest of the tobacco companies, has a yield that is similar to well-known companies such as Westinghouse and K-Mart.

7. Conclusion

In conclusion, the tobacco industry is financially strong and viable. Comprehensive tobacco legislation includes mechanisms to protect that financial condition. The legislation assures that payments are made by consumers rather than the tobacco manufacturers, and makes adjustments according to individual companies' ability to pay. The industry has substantial operating earnings to bear any decline in earnings due to price increases caused by the legislation. The industry also has significant non-tobacco assets that are currently valued well in excess of their debt. As previously noted, tobacco companies for years have faced substantial legal uncertainties related to their business practices. Comprehensive tobacco legislation does not increase these existing risks. Lastly, S. 1415 does not appear to have any material effect on bond investors' perceptions of the tobacco companies' credit risk.

While there are commercial risks facing the tobacco companies, as there are facing all companies, we do not see any reason to expect that the pricing effects of comprehensive tobacco legislation would materially affect these companies' risk of insolvency. They should be able to continue to operate profitably in the United States and abroad.