Management's Discussion and Analysis of Financial Condition and Results of Operations

(Continued)

Discussion and Analysis > Financial Review

• Net Cash Provided by Operating Activities, Continuing Operations: During 2007, net cash provided by operating activities on a continuing operations basis was $10.2 billion, compared with $9.9 billion during 2006. The increase in cash provided by operating activities was due primarily to higher earnings from continuing operations (after excluding the non-cash reversal of income tax reserves in 2006), the return of $1.3 billion of escrow bond deposits in December 2007 related to the Engle U.S. tobacco case and lower pension plan contributions, partially offset by the return in 2006 of approximately $2 billion of escrow bond deposits related to the Price U.S. tobacco case and a higher use of cash to fund working capital. The change in working capital was due primarily to higher receivables at PMI from additional trade purchases in anticipation of 2008 tax-driven price increases in many markets and higher finished goods inventories at PMI in anticipation of further trade purchases prior to excise tax increases.
  
  During 2006, net cash provided by operating activities on a continuing operations basis was $9.9 billion, compared with $7.6 billion during 2005. The increase in cash provided by operating activities was due primarily to the return of the escrow bond deposit related to the Price U.S. tobacco case, lower pension plan contributions and higher earnings from continuing operations, partially offset by the reimbursement of Kraft’s portion of income tax benefits related to the RAR and a higher use of cash to fund working capital. The increase in working capital reflects PMI’s increase in inventories in anticipation of 2007 excise tax-driven increases in many markets. 
• Net Cash Used in Investing Activities, Continuing Operations: One element of PMI’s growth strategy is to strengthen its brand portfolio and/or expand its geographic reach through active programs of selective acquisitions. ALG and PM USA from time to time consider acquisitions as part of their adjacency strategy, as evidenced by ALG’s 2007 acquisition of John Middleton, Inc.
  
  During 2007, 2006 and 2005, net cash used in investing activities on a continuing operations basis was $5.3 billion, $0.5 billion and $5.4 billion, respectively. In 2007, the net cash used primarily reflects the purchases of John Middleton, Inc., and Lakson Tobacco in Pakistan, as well as PMI’s increased investment in its Mexican tobacco business. In 2006, proceeds from sales of businesses of $520 million were primarily from the sale of PMI’s interest in a beer business in the Dominican Republic. The net cash used in 2005 reflects the purchase of 98% of the outstanding shares of Sampoerna.
  
  On December 11, 2007, in conjunction with PM USA’s adjacency strategy, Altria Group, Inc. acquired 100% of John Middleton, Inc., a leading manufacturer of machine-made large cigars, for $2.9 billion in cash. The acquisition was financed with existing cash. In November 2007, PMI acquired an additional 30% stake in its Mexican tobacco business from Grupo Carso, which increased PMI’s ownership interest to 80%, for $1.1 billion. During the first quarter of 2007, PMI acquired an additional 50.2% stake in a Pakistan cigarette manufacturer, Lakson Tobacco, and completed a mandatory tender offer for the remaining shares, which increased PMI’s total ownership interest in Lakson Tobacco from 40% to approximately 98%, for $388 million.
  
  In November 2006, a subsidiary of PMI exchanged its 47.5% interest in E. León Jimenes, C. por. A. (“ELJ”), which included a 40% indirect interest in ELJ’s beer subsidiary, Cerveceria Nacional Dominicana, C. por. A., for 100% ownership of ELJ’s cigarette subsidiary, Industria de Tabaco León Jimenes, S.A. (“ITLJ”) and $427 million of cash, which was contributed to ITLJ prior to the transaction. As a result of the transaction, PMI now owns 100% of the cigarette business and no longer holds an interest in ELJ’s beer business.
  
  Capital expenditures for 2007 increased 13.5% to $1.5 billion (of which $1.1 billion related to PMI). The expenditures were primarily for modernization and consolidation of manufacturing facilities, expansion of research and development, and expansion of certain production capacity. Excluding PMI, 2008 capital expenditures are expected to be slightly below 2007 expenditures, and are expected to be funded by operating cash flows.
• Net Cash Used in Financing Activities, Continuing Operations: During 2007, 2006 and 2005 net cash used in financing activities on a continuing operations basis was $3.5 billion, $10.6 billion and $1.2 billion, respectively. The decrease of $7.1 billion from 2006 was due primarily to the issuance of debt in 2007 as opposed to the repayment of debt in 2006. The increase of $9.4 billion from 2005 to 2006 was due primarily to the repayment of short and long-term debt in 2006 ($5.6 billion) and the issuance of debt for the Sampoerna acquisition in 2005 ($4.1 billion).
• Debt and Liquidity:
  
  Credit Ratings: At December 31, 2007, ALG’s debt ratings by major credit rating agencies were as follows:
  
  
                                                           
  
  On January 30, 2008, the major credit rating agencies listed in the table above affirmed ALG’s debt ratings following the announcement of the PMI spin-off, and Fitch upgraded ALG’s outlook to positive.
  
  ALG’s credit quality, measured by 5 year credit default swaps, has improved dramatically over the past two years with levels that approximate those of Single-A rated issuers.
  
  Moody’s expects that, should PMI be spun-off from Altria Group, Inc. as expected, PMI’s long-term and short-term ratings could be as high as A2 and Prime-1, respectively. Standard & Poor’s believes that the potential corporate credit rating for PMI could be as high as A+ based solely on its business risk assessment. Fitch expects that, should PMI be spun-off from Altria Group, Inc., PMI’s long-term and short-term ratings could be A+ and F1, respectively.
  
  Credit Lines: ALG and PMI maintain separate revolving credit facilities. ALG intends to use its revolving credit facilities to support the issuance of commercial paper.
  
  As discussed in Note 9. Short-Term Borrowings and Borrowing Arrangements, the purchase price of the Sampoerna acquisition was primarily financed through euro 4.5 billion of bank credit facilities arranged for PMI and its subsidiaries in May 2005, consisting of a euro 2.5 billion three-year term loan facility (which, through repayments had been reduced to euro 1.5 billion) and a euro 2.0 billion five-year revolving credit facility. On December 4, 2007, PMI entered into new credit agreements consisting of a $3.0 billion five-year revolving credit facility, a $1.0 billion three-year revolving credit facility and a euro 1.5 billion 364-day term loan facility. On December 4, 2007, PMI borrowed euro 1.5 billion under the new term loan facility to repay the debt outstanding under its 2005 term loan facility. These facilities, which are not guaranteed by ALG, require PMI to maintain an earnings before interest, taxes, depreciation and amortization (“EBITDA”) to interest ratio of not less than 3.5 to 1.0. At December 31, 2007, PMI’s ratio calculated in accordance with the agreements was 44.6 to 1.0.
  
  ALG has a 364-day revolving credit facility in the amount of $1.0 billion, which expires on March 27, 2008. In addition, ALG maintains a multi-year credit facility in the amount of $4.0 billion, which expires April 15, 2010. The ALG facilities require the maintenance of an earnings to fixed charges ratio, as defined by the agreements, of not less than 2.5 to 1.0. At December 31, 2007, the ratio calculated in accordance with the agreements was 19.6 to 1.0. After the effectiveness of the spin-off of PMI, ALG’s multi-year credit facility will be reduced from $4.0 billion to $3.5 billion and the earnings to fixed charges ratio will be replaced with a ratio of EBITDA to interest expense of not less than 4.0 to 1.0. In addition, the facility will then require the maintenance of a ratio of debt to EBITDA of not more than 2.5 to 1.0. If the PMI spin-off had occurred as of December 31, 2007, the ratio of EBITDA to interest expense would have been 15.6 to 1.0, and the ratio of debt to EBITDA would have been 0.9 to 1.0. On January 28, 2008, Altria Group, Inc. entered into a $4.0 billion, 364-day bridge loan agreement to finance a tender offer and consent solicitation expenses related to its outstanding consumer products debt prior to the spin-off of PMI. The agreement contains the same covenants mentioned above, and is required to be prepaid or reduced by the net amount of any capital markets transactions.
  
  ALG and PMI expect to continue to meet their respective covenants. These facilities do not include any credit rating triggers or any provisions that could require the posting of collateral. The multi-year facilities enable the respective companies to reclassify short-term debt on a long-term basis. At December 31, 2007, $2,205 million of short-term borrowings that PMI expects to remain outstanding at December 31, 2008 were reclassified as long-term debt.
  
  

  At December 31, 2007, credit lines for ALG and PMI, and the related activity, were as follows:
  
  
                                                           
  
  
                                                            
  
  In addition to the above, certain international subsidiaries of PMI maintain credit lines to meet their respective working capital needs. These credit lines, which amounted to approximately $2.6 billion are for the sole use of these international businesses. Borrowings on these lines amounted to approximately $0.6 billion and $0.4 billion at December 31, 2007 and 2006, respectively.
  
  Debt: Altria Group, Inc.’s total debt (consumer products and financial services) was $11.0 billion and $8.5 billion at December 31, 2007 and 2006, respectively. Total consumer products debt was $10.5 billion and $7.4 billion at December 31, 2007 and 2006, respectively. Total consumer products debt includes PMI’s third-party debt of $6.3 billion and $2.8 billion at December 31, 2007 and 2006, respectively. At December 31, 2007 and 2006 (after giving effect to the Kraft spin-off), Altria Group, Inc.’s ratio of consumer products debt to total equity was 0.57 and 0.58, respectively. The ratio of total debt to total equity was 0.60 and 0.67 at December 31, 2007 and 2006 (after giving effect to the Kraft spin-off), respectively. Fixed-rate debt constituted approximately 44% and 65% of total consumer products debt at December 31, 2007 and 2006, respectively. The weighted average interest rate on total consumer products debt, including the impact of swap agreements, was approximately 5.6% and 5.8% at December 31, 2007 and 2006, respectively.
  
  At December 31, 2007, ALG had approximately $2.8 billion of capacity remaining under its existing shelf registration statement.
  
  ALG does not guarantee the debt of PMI.
  
  On January 31, 2008, Altria Group, Inc. and its subsidiary, Altria Finance (Cayman Islands) Ltd. commenced tender offers to purchase for cash $2.6 billion of notes and debentures denominated in U.S. dollars and approximately €1.0 billion in euro-denominated bonds. Altria Group, Inc. expects to record a charge of approximately $400 million upon completion of the tender offer. In order to finance the tender offer, Altria Group, Inc. has arranged a $4.0 billion, 364-day bridge loan. Subsequent to the spin-off, Altria Group, Inc. intends to access the public debt market to refinance debt incurred in connection with the tender offer.
  
  Taxes: The IRS concluded its examination of Altria Group, Inc.’s consolidated tax returns for the years 1996 through 1999, and issued a final RAR on March 15, 2006. Altria Group, Inc. agreed with the RAR, with the exception of certain leasing matters discussed below. Consequently, in March 2006, Altria Group, Inc. recorded non-cash tax benefits of $1.0 billion, which principally represented the reversal of tax reserves following the issuance of and agreement with the RAR. Altria Group, Inc. reimbursed $337 million in cash to Kraft for its portion of the $1.0 billion in tax benefits, as well as pre-tax interest of $46 million. The amounts related to Kraft were reclassified to earnings from discontinued operations. The tax reversal resulted in an increase to earnings from continuing operations of $631 million for the year ended December 31, 2006.
  
  Altria Group, Inc. has agreed with all conclusions of the RAR, with the exception of the disallowance of benefits pertaining to several PMCC leveraged lease transactions for the years 1996 through 1999. PMCC will continue to assert its position regarding these leveraged lease transactions and contest approximately $150 million of tax and net interest assessed and paid with regard to them. The IRS may in the future challenge and disallow more of PMCC’s leveraged leases based on Revenue Rulings, an IRS Notice and subsequent case law addressing specific types of leveraged leases (lease-in/lease-out (“LILO”) and sale-in/lease-out (“SILO”) transactions). PMCC believes that the position and supporting case law described in the RAR, Revenue Rulings and the IRS Notice are incorrectly applied to PMCC’s transactions and that its leveraged leases are factually and legally distinguishable in material respects from the IRS’s position. PMCC and ALG intend to vigorously defend against any challenges based on that position through litigation. In this regard, on October 16, 2006, PMCC filed a complaint in the U.S. District Court for the Southern District of New York to claim refunds for a portion of these tax payments and associated interest. However, should PMCC’s position not be upheld, PMCC may have to accelerate the payment of significant amounts of federal income tax and significantly lower its earnings to reflect the recalculation of the income from the affected leveraged leases, which could have a material effect on the earnings and cash flows of Altria Group, Inc. in a particular fiscal quarter or fiscal year. PMCC considered this matter in its adoption of FIN 48 and FASB Staff Position No. FAS 13-2.