Authors: Richard Kluger
To complaints—raised in hushed tones that rarely reached Maxwell’s ears—that he had surrounded himself with too many organization men and not enough freethinkers, the chairman might have pointed to his chief financial officer. German-born, American-educated Hans Storr had been with the company almost as long as Maxwell but had never been a favorite of his
and was widely expected to be replaced as CFO. But Maxwell soon saw that Storr was, in the words of Shep Pollack, his predecessor as CFO, “smart as hell and worked like a dog.” He was also astute at anticipating changes in interest and currency exchange rates and exploiting them. Having convinced Maxwell that the growing U.S. trade deficit had to soften the dollar on international exchanges, Storr deposited $2 billion of Philip Morris funds in overseas banks and thus earned some $400 million for the company in the mid’ Eighties while cementing links with foreign bankers that would shortly prove of great value.
To secure the corporate profit base in U.S. cigarette sales before launching his diversification program, Maxwell mandated as PM-USA’s marketing target an annual share gain of no less than 1 percent of the domestic pie—and the use of whatever means were needed to achieve it. This included a modified version of the trade-loading that RJR was now living off, but Philip Morris faced a far smaller risk of inventory pileup since its brands continued to defy the sales slippage affecting the rest of the industry. Marlboro stayed strong, accounting for three out of every five packs of Philip Morris brands sold and sprinting ahead in the vital eighteen-to-twenty-four-year-old sector, where its customer share rose from about 40 percent in the early ’Eighties to nearly 70 percent by the end of the decade. PM’s main problem now was to obtain retail shelf exposure in proportion to its sales in order to avoid running out of stock all the time. Such an allocation of selling space, desirable on its face to the retail outlets as well, was greatly complicated by Reynolds’s dominance at the store level, where its big sales force patrolled constantly and its regional sales directors had long cultivated supermarket and other chain-store executives. The RJR-provided carton racks were still accepted as a convenience by store managers, thus assuring that its own brands, if no one else’s, would be fully stocked, even though they were not moving off the shelves nearly as fast as the Philip Morris makes. Reynolds was also now discounting feverishly, through price-off coupons and stickers, to prevent further erosion of its market share.
Philip Morris, then, had a great deal of catching up to do organizationally if it hoped to rout Reynolds. But it also had a compelling story to tell the chains. Cigarettes were perhaps the most profitable item in their stores, and 90 percent of those profits flowed from sales and only 10 percent from “push money” (placement and display fees) from rivals who paid for their space on the Reynolds racks. In the biggest stores, this ancillary income could reach $1,000 a month, but by grabbing it, Philip Morris’s sales force now argued, store managers were sacrificing a far larger take from lost sales of hot PM brands, which kept running out because they were not given enough shelf space.
To push this argument, sales vice president Vincent Buccellato urged top management to spend for a larger and more persuasive field force and to offer retailers Philip Morris racks to break Reynolds’s lock on the concept. But
stores willing to make the switch soon learned that RJR would not do what all of its rivals had been compelled to do when Reynolds had been king of the hill—pay up for assured space and position on their arch foe’s racks. This response blunted the PM challenge, since it meant that stores would reap less push money from a Philip Morris rack; throughout the ’Eighties, RJR clung to more than 70 percent of the store racks and its preferred positioning. But Philip Morris’s aggressive pricing was cutting into carton sales, the staple of supermarket cigarette activity, and single-pack sales rose at the front of the store, where PM was investing heavily in displays and neutralizing RJR’s rack advantage. All-out war was waged now at retail outlets between the two industry leaders for cigarette signage, ranging from door and window decals to newspaper racks bearing cigarette logos—usually either Marlboro or Winston—to elaborate, fluorescent-lighted clock fixtures mounted over the checkout register. Most daunting to Reynolds hopes was the growth of cigarette sales in the convenience-store market. The proliferation of the 7-Eleven chain and its imitators, helped by the oil companies, which were funding the expansion of their filling stations into the convenience grocery and sundries business, was good news for Philip Morris, since the typical convenience outlet customer was a young male, earning good pay, who bought one pack of cigarettes at a time—and it was Marlboro, in one of its dozen versions (or “packings,” to use the industry term), more often than not. And because the new convenience chains did not invite the sort of long-running institutional ties that RJR had enjoyed with supermarkets, Philip Morris was able to use its money for strong signage and displays without having to worry about Reynolds racks.
As a result of these trends, so favorable to Philip Morris’s full-priced brands, the rest of the industry, Reynolds included, turned more and more to the discount sector, especially in the convenience-store market. Brands like RJR’s Doral, Brown & Williamson’s Richland, and American Tobacco’s Capri were selling well, even if at reduced margins, allowing Reynolds to sustain its unit sales through the mid-’Eighties, but Philip Morris continued to post fractional gains in units, enough to satisfy Hamish Maxwell’s command to gain a point a year in overall market share.
Abetting this effort was a Philip Morris innovation aimed at fixing the company’s out-of-stock woes at the nation’s 250,000 retail outlets, where clerks with marginal literacy and a notoriously high turnover rate lacked the skills and incentive to keep PM’s forty-five to fifty packings fully stocked, costing the company tens of millions in lost sales. Philip Morris also understood that wholesalers, already losing ground to chains that bought directly from the cigarette makers, were being pinched further by heavier carrying charges on their inventories, often swollen by trade-loading, and by the whipsaw tactics of retailers, who made as much as 20 percent on their cigarette markups (compared
with the 1 percent or less that the jobbers eked out) but continually pushed for longer discounts. To help rescue wholesalers, many hanging by a thread, and advance their own cause, Philip Morris in the late ’Eighties conceived its “Masters” sales program, which paid wholesalers a cash bonus for, first, putting their operations on a more systematic basis—PM offered guidance in computerized inventory control and financial record-keeping—and, second, making sure that the distribution and retail pipeline was always fully stocked with all packings of Philip Morris brands, not just the leading sellers, and that these were well displayed. The PM sales force was assigned to keep constant check on how well the wholesalers were performing and whether they were really earning the eight- or nine-cents-per-carton bonus payment. Sweepstakes prizes, including fancy paid vacations, were awarded to the best performers in the Masters program, which netted the largest and most efficient jobbers as much as half a million dollars a year in bonus money. RJR aped the effort with its “Winners” version, but it was less ambitious and amounted to little more than an added volume discount.
For a time, its Masters program helped keep Philip Morris’s full-priced brands moving relatively well—and much better than its rivals’—but a sizable downturn in the economy finally forced the industry leader to quit holding itself aloof from the discount sector. By the end of the ’Eighties, RJR held one-third of the discount cigarette business, and the PM-USA managers knew they would have to yield a portion of their sensational profit margins on full-price brands (approaching 50 percent) to keep Reynolds from running wild in the off-price sector, by then accounting for about 15 percent of cigarette sales and about to double that—and more—in the early 1990s. PM began pushing hard into the discount market with a pair of its retired failures, Alpine and Cambridge, retrofitted as off-price brands, and brought out a new “branded generic” called Buck, an even lower-priced “sub-generic,” Bristol, and black-and-white Basic as a supermarket house brand. By 1989 Philip Morris had gained about a quarter of the discount sector, and while this quick incursion was a mixed blessing (because every pack it sold at discount might result in one less full-priced pack sold), it served, as Maxwell would later acknowledge, “to take the curse off of our aggressive pricing of the top-name brands.” By the end of the ’Eighties, PM held a historically huge 42 percent overall share of the cigarette business, while Reynolds, finally abandoning trade-loading as a ruinously expensive and artificial device, dropped to just under 29 percent. This growing dominance provided Philip Morris with the wherewithal to transform its corporate profile.
III
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o transform Philip Morris truly—and not simply to recostume it as a nicotine-stained trollop masquerading in finery to gain respectability—would take a change in the corporate mind-set, used to fat tobacco profits compared to which earnings from almost all other businesses looked anemic. And cigarette making was a delightfully simple form of enterprise, measured against other consumer goods. “It’s a lovely business, because it’s so relatively easy,” Hamish Maxwell reflected in his retirement years. “Cigarettes have tremendous brand loyalty, you don’t have to bring out new products every five minutes, new advertising campaigns can actually hurt you,” and there was scant technological innovation required after the manufacturing speed reached nearly 10,000 units per minute. In short, cigarettes had spoiled the company’s managers who, by 1984, were contemplating massive entry into some other field.
Ehud Houminer, as Maxwell’s designated brainstormer, had been given a few basic guidelines as he scanned the economic terrain from Philip Morris’s Park Avenue aerie. First, no more turnaround situations. The company had more or less succeeded, at an extravagant price, with Miller Brewing, but it had failed in a string of other attempts, among them ASR, Clark Gum, and, most distressingly, Seven-Up, even then bleeding badly despite multiple cash transfusions. What was wanted now was a company already a major factor in its field, and the field ought to be a vast one, with plenty of growing room. The beer business, by comparison, was too limited, and Miller, having gained more than one-fifth of the market, had finally aroused industry leader Anheuser-Busch sufficiently to halt further penetration of its dominion. The idea now was “to buy the biggest business we could afford,” Houminer recounted, and the move was supposed to command a strong consensus within Philip Morris in contrast to the contentious Seven-Up purchase.
But what industry, and which company? “I studied zillions of industries,” said Houminer, and the one he kept coming back to was food. Not just little corners of it, like the beer or soft-drink business—the whole larder. He reasoned that Philip Morris ought to stick to what it knew and did best—consumer products in general and the processing of agricultural products in particular. The manufacturing, packaging, and marketing of food were cousins of the cigarette business, and it was a huge industry with sales running into the hundreds of billions of dollars annually. While it was hard to gain entry to it, the food business offered many opportunities for maneuver and growth—and whatever acquisition PM now made would be only a start, for Maxwell was determined that, given the resources at his disposal, Philip Morris should become
a principal player, and preferably the share leader, in whatever field the company entered. “It didn’t matter which company,” Houminer recounted, so long as it was profitable and had a pedigree in the form of famous trademarks and a global potential far from fully realized; more dynamic management could always be enlisted, if need be.
Food offered advantages to Philip Morris investors as well as to its executives. Even though profit margins in the food business were, at 10 percent or so, far below those in tobacco, Wall Street valued the former’s earnings at almost twice the P/E ratio of the cigarette companies; food was a stable, socially essential, and wholesome form of commerce, rarely drawing liability suits. And here was a way for the No. 1 cigarette purveyor to plant high and benign hedges of respectability around its fortresslike headquarters, where a siege mentality prevailed; it would no longer be classified as a rogue operation. Through food, it would also gain influence with the media, especially the broadcasting industry, where food advertising was a prime contributor to profits, and as manufacturers of indisputably healthful and legitimate products, the company would gain political strength as well by acquiring some outfit with a big payroll outside the Tobacco Belt and in the mainstream of the economy.
The problem was how to achieve all of that without a major dilution of per-share earnings. The answer, hardly invented by Philip Morris but strongly embraced now by Houminer and resident financial chief Hans Storr, was maximum use of leveraging—buying earnings that were higher than what it cost to acquire them. Equity would not be diluted if the great expedition into food was funded not by the sale of new stock or the exchange of PM shares for those of the targeted company—both steps that would broaden the equity base and require a greater payout of dividends—but with borrowed funds that could be readily obtained at favorable rates, given Philip Morris’s cascading cash flow and increasing dominance in the cigarette business. The company could safely afford to depart from the fiscally sound 50/50 debt/equity ratio it had hewed to, running it up at least temporarily as high as 75/25 without imperiling its pristine credit standing. Thus, once PM settled on its takeover candidate, it could put down a relatively small portion of the purchase price in the form of cash from surplus and borrow the rest on a short-term payback schedule, not likely to prove burdensome in view of what Storr foresaw as dropping interest rates. The newly acquired company’s earnings could then be used to cover interest charges, entirely tax-deductible and thus relieving downward pressure on overall earnings, and PM’s cash flow, mounting by the year, would be applied to pay down a big piece of the loan principal, which could be entirely repaid within three or four years. As the debt service then shrank, more and more of the acquired company’s earnings could be brought to the bottom line. And even if, after the purchase price was entirely paid off, the return on equity capital was not as great as that from the tobacco operations, Wall Street would reward
Philip Morris investors by boosting the price of its stock, because the company by then would be heavily into the food business and would no longer be viewed as primarily a hot but suspect tobacco operator. The stockholders’ total return—dividends plus stock price enhancement in the market—would be at least as high as if the company had stuck with tobacco exclusively and paid out more and more of the profits as dividends until the goose died and there were no more golden eggs.