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    Tobacco Industry Faces Cloudy Future

    Fitch report says litigation and excise taxes are leading companies down a path to lower profitability.

    CHICAGO -- While the U.S. tobacco industry remains highly profitable, declining domestic cigarette consumption and pricing pressure related to discount cigarettes have resulted in lower profits for the major tobacco firms, according to a new report by Fitch Ratings.

    The credit outlook for the major tobacco firms in the United States has been supported by substantial cash flow generation relative to debt levels, high levels of liquidity and financial flexibility. These factors allow the firms to finance sizeable dividends and share repurchases out of cash flow.

    However, the uncertainties of litigation risk, declining domestic cigarette consumption and pricing pressure related to discount cigarettes are key issues the industry is currently facing, according to the Fitch report titled "U.S. Tobacco Industry -- litigation, excise taxes and lower profitability cloud future."

    "While current litigation remains manageable, continued litigation losses in California is a concern. A Rating Watch Negative would result if any of the major firms lost in any stage of an appeal, which would increase the probability of a substantial payout for punitive damages," said Wesley Moultrie, senior director of Fitch Ratings.

    In addition to concerns about litigation risks, a near-term concern for these firms is pricing pressure. Recent wholesale price increases, along with federal and state excise tax increases and a weak economy, have begun to result in declining market share for some of the premium brands as consumers look for discount brands.

    Although heightened promotional activity has hurt profits for the major tobacco firms, Fitch does not view the reduced profitability due to additional promotional spending itself as a substantial threat to the leading firms. Weaker players will face a credit review should they lose a material amount of market share that negatively affects their cash flow and operating earnings, despite substantial liquidity.

    Cigarette prices have been steadily rising as a result of the Master Settlement Agreement (MSA) as well as excise tax and wholesale prices increases. Due to the recent price increases, leading industry players have increased promotional spending, intensifying the competitive atmosphere. Although the spending increases will result in reduced operating income, the major tobacco firms believe the short-term decrease in profitability is necessary to defend volume and market share and maintain long-term expansion of business.

    Looking out to the intermediate to longer term, prolonged periods of heightened competitive activity would result in lower profitability for the major firms, says Fitch. In addition, continued acceleration of promotional spending levels and attempts by competitors to match those levels could have a significant negative effect on credit measures and credit ratings.

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