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TMCNet:  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

[May 02, 2014]

MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) Description of Our Company We are a holding company whose subsidiaries and affiliates, and their licensees, are engaged in the manufacture and sale of cigarettes and other tobacco products in markets outside the United States of America. We manage our business in four segments: • European Union; • Eastern Europe, Middle East & Africa ("EEMA"); • Asia; and • Latin America & Canada.


Our products are sold in more than 180 markets and, in many of these markets, they hold the number one or number two market share position. We have a wide range of premium, mid-price and low-price brands. Our portfolio comprises both international and local brands.

We use the term net revenues to refer to our operating revenues from the sale of our products, net of sales and promotion incentives. Our net revenues and operating income are affected by various factors, including the volume of products we sell, the price of our products, changes in currency exchange rates and the mix of products we sell. Mix is a term used to refer to the proportionate value of premium-price brands to mid-price or low-price brands in any given market (product mix). Mix can also refer to the proportion of shipment volume in more profitable markets versus shipment volume in less profitable markets (geographic mix). We often collect excise taxes from our customers and then remit them to governments, and, in those circumstances, we include the excise taxes in our net revenues and in excise taxes on products. Our cost of sales consists principally of tobacco leaf, non-tobacco raw materials, labor and manufacturing costs.

Our marketing, administration and research costs include the costs of marketing and selling our products, other costs generally not related to the manufacture of our products (including general corporate expenses), and costs incurred to develop new products. The most significant components of our marketing, administration and research costs are marketing and sales expenses and general and administrative expenses.

Philip Morris International Inc. is a legal entity separate and distinct from our direct and indirect subsidiaries. Accordingly, our right, and thus the right of our creditors and stockholders, to participate in any distribution of the assets or earnings of any subsidiary is subject to the prior rights of creditors of such subsidiary, except to the extent that claims of our company itself as a creditor may be recognized. As a holding company, our principal sources of funds, including funds to make payment on our debt securities, are from the receipt of dividends and repayment of debt from our subsidiaries. Our principal wholly owned and majority-owned subsidiaries currently are not limited by long-term debt or other agreements in their ability to pay cash dividends or to make other distributions with respect to their common stock.

- 34--------------------------------------------------------------------------------- Table of Contents Executive Summary The following executive summary provides significant highlights from the "Discussion and Analysis" that follows.

Consolidated Operating Results for the Three Months Ended March 31, 2014 - The changes in our reported diluted earnings per share ("diluted EPS") for the three months ended March 31, 2014, from the comparable 2013 amounts, were as follows: Diluted EPS % Growth For the three months ended March 31, 2013 $ 1.28 2013 Asset impairment and exit costs - 2013 Tax items 0.01 Subtotal of 2013 items 0.01 2014 Asset impairment and exit costs (0.01 ) 2014 Tax items - Subtotal of 2014 items (0.01 ) Currency (0.16 ) Interest (0.01 ) Change in tax rate -Impact of lower shares outstanding and share-based payments 0.05 Operations 0.02 For the three months ended March 31, 2014 $ 1.18 (7.8 )% Asset Impairment and Exit Costs - During the first quarter of 2014, we decided to cease cigarette production in Australia by the end of 2014 and transition all Australian cigarette production to our affiliate in South Korea. As a result, we recorded pre-tax asset impairment and exit costs of $23 million ($16 million after tax or $0.01 per share) related to severance costs for the factory closure in Australia. During the three months ended March 31, 2013, we recorded pre-tax asset impairment and exit costs of $3 million (less than one cent impact on diluted EPS) related to the termination of distribution agreements in Asia.

On April 4, 2014, we announced the initiation by our affiliate, Philip Morris Holland B.V. ("PMH"), of consultations with employee representatives on a proposal to discontinue cigarette production at its factory located in Bergen op Zoom, the Netherlands. Subject to the final outcome of the consultations and fulfillment of certain other conditions, PMH would anticipate implementing the contemplated decision by October 2014.

Income Taxes - Our effective income tax rate for the three months ended March 31, 2014 decreased by 0.7 percentage points to 28.9%. The effective tax rate for the three months ended March 31, 2013, was unfavorably impacted by the additional expense associated with the enactment of the American Taxpayer Relief Act of 2012 ($17 million). The special tax item discussed in this paragraph decreased our diluted EPS by $0.01 per share in 2013. Excluding the impact of this special tax item, the change in tax rate was primarily due to earnings mix and repatriation cost differences.

Currency - The unfavorable currency impact during the reporting period was due primarily to the Argentine peso, Australian dollar, Indonesian rupiah, Japanese yen, Russian ruble, Swiss franc and Turkish lira.

Interest - The unfavorable impact of interest was due primarily to higher average debt levels, partially offset by lower average interest rates on debt.

Lower Shares Outstanding and Share-Based Payments - The favorable diluted EPS impact was due to the repurchase of our common stock pursuant to our share repurchase program.

Operations - The increase in diluted EPS of $0.02 from our operations was due primarily to the following segments: • EEMA: Higher pricing and lower marketing, administration and research costs, partially offset by unfavorable volume/mix and higher manufacturing costs; and - 35--------------------------------------------------------------------------------- Table of Contents • European Union: Higher pricing and lower marketing, administration and research costs, partially offset by unfavorable volume/mix; partially offset by: • Asia: Unfavorable volume/mix and higher manufacturing costs, partially offset by higher pricing and lower marketing, administration and research costs.

For further details, see the "Consolidated Operating Results" and "Operating Results by Business Segment" sections of the following "Discussion and Analysis." 2014 Forecasted Results - On April 17, 2014, we revised our 2014 full-year reported diluted EPS forecast to be in a range of $5.09 to $5.19, versus $5.26 in 2013. Excluding an unfavorable currency impact, at then prevailing exchange rates, of approximately $0.61 for the full-year 2014, and an estimated $0.03 per share restructuring charge in Australia, reported diluted earnings per share are projected to increase by approximately 6% to 8% versus adjusted diluted earnings per share of $5.40 in 2013. This forecast includes a productivity and cost savings target of $300 million and a share repurchase target of $4.0 billion.

We calculated 2013 adjusted diluted EPS as reported diluted EPS of $5.26, plus the $0.02 per share charge related to discrete tax items, and the $0.12 per share charge related to asset impairment and exit costs.

Adjusted diluted EPS is not a measure under the accounting principles generally accepted in the United States of America ("U.S. GAAP"). We define adjusted diluted EPS as reported diluted EPS adjusted for asset impairment and exit costs, discrete tax items and unusual items. We believe it is appropriate to disclose this measure as it represents core earnings, improves comparability and helps investors analyze business performance and trends. Adjusted diluted EPS should be considered neither in isolation nor as a substitute for reported diluted EPS prepared in accordance with U.S. GAAP.

This 2014 guidance excludes the impact of any future acquisitions, unanticipated asset impairment and exit cost charges, future changes in currency exchange rates and any unusual events. This forecast also excludes the proposal to discontinue cigarette production in Bergen op Zoom in the Netherlands. The factors described in the "Cautionary Factors That May Affect Future Results" section of the following "Discussion and Analysis" represent continuing risks to this forecast.

- 36--------------------------------------------------------------------------------- Table of Contents Discussion and Analysis Consolidated Operating Results See pages 55-58 for a discussion of our "Cautionary Factors That May Affect Future Results." Our cigarette volume, net revenues, excise taxes on products and operating companies income by segment were as follows: For the Three Months Ended March 31, (in millions) 2014 2013 Cigarette volume: European Union 41,705 42,967 Eastern Europe, Middle East & Africa 62,006 66,834 Asia 70,801 72,619 Latin America & Canada 21,449 22,527 Total cigarette volume 195,961 204,947 Net revenues: European Union $ 6,619 $ 6,523 Eastern Europe, Middle East & Africa 4,562 4,423 Asia 4,475 5,251 Latin America & Canada 2,123 2,330 Net revenues $ 17,779 $ 18,527 Excise taxes on products: European Union $ 4,606 $ 4,553 Eastern Europe, Middle East & Africa 2,553 2,380 Asia 2,293 2,461 Latin America & Canada 1,410 1,549 Excise taxes on products $ 10,862 $ 10,943 Operating income: Operating companies income: European Union $ 978 $ 938 Eastern Europe, Middle East & Africa 927 935 Asia 915 1,342 Latin America & Canada 202 254 Amortization of intangibles (22 ) (24 ) General corporate expenses (40 ) (58 ) Less: Equity (income)/loss in unconsolidated subsidiaries, net (9 ) 4 Operating income $ 2,951 $ 3,391 As discussed in Note 9. Segment Reporting to our condensed consolidated financial statements, we evaluate segment performance and allocate resources based on operating companies income, which we define as operating income, excluding general corporate expenses and amortization of intangibles, plus equity (income)/loss in unconsolidated subsidiaries, net. We believe it is appropriate to disclose this measure to help investors analyze the business performance and trends of our various business segments.

References to total international cigarette market, total cigarette market, total market and market shares throughout this "Discussion and Analysis" reflect our best estimates based on a number of internal and external sources.

- 37--------------------------------------------------------------------------------- Table of Contents Consolidated Operating Results for the Three Months Ended March 31, 2014 The following discussion compares our consolidated operating results for the three months ended March 31, 2014, with the three months ended March 31, 2013.

Our cigarette shipment volume of 196.0 billion units decreased by 9.0 billion units (4.4%), due principally to: • the European Union, mainly reflecting lower total markets, partially offset by market share growth; • EEMA, due mainly to a lower total market in Russia and unfavorable estimated inventory movements across various markets within the Region, partially offset by Turkey; • Asia, mainly reflecting a lower market share in Indonesia, lower market share and the adverse timing of our shipments in Japan, partially offset by the total market growth driven by retail trade and consumer purchasing in anticipation of the April 1, 2014, consumption tax increase, and lower share in Pakistan, partially offset by the Philippines; and, • Latin America & Canada, principally due to the timing of estimated trade inventory movements in Mexico.

Excluding the unfavorable impact of estimated inventory movements in the quarter, our cigarette shipment volume decreased by approximately 2.0%.

Our market share increased in a number of key markets, including Algeria, Argentina, Austria, Belgium, Brazil, Canada, France, Germany, Greece, Korea, Poland, Russia, Saudi Arabia, Spain, Thailand, the United Kingdom and Vietnam.

Total cigarette shipments of Marlboro of 65.9 billion units decreased by 4.1%, due primarily to unfavorable estimated inventory movements in EEMA and Japan, lower share in Japan, and a lower total market in the European Union and Mexico, partially offset by the Philippines.

Total cigarette shipments of L&M of 21.0 billion units decreased by 5.8%, driven notably by Algeria, Egypt and Saudi Arabia, partially offset by Germany. Total cigarette shipments of Bond Street of 9.3 billion units decreased by 6.3%, due predominantly to Hungary, Kazakhstan and Russia. Total cigarette shipments of Parliament of 9.9 billion units increased by 1.2%, driven mainly by Turkey, partially offset by Japan and Russia. Total cigarette shipments of Philip Morris of 8.0 billion units decreased by 5.4%, due primarily to the morphing to Lark in Japan, partially offset by Argentina. Total cigarette shipments of Chesterfield of 8.8 billion units increased by 14.3%, due primarily to Italy, Poland and Turkey, partially offset by Russia and Ukraine. Total cigarette shipments of Lark of 6.8 billion units decreased by 0.3%, due predominantly to Turkey, partially offset by Japan reflecting the morphing from Philip Morris.

Our other tobacco products ("OTP") primarily include tobacco for roll-your-own and make-your-own cigarettes, pipe tobacco, cigars and cigarillos. Total shipment volume of OTP, in cigarette equivalent units, decreased by 1.1% to 8.0 billion cigarette equivalent units, mainly due to declines in the pipe tobacco and snuff categories in Southern Africa that offset slight growth in the fine cut category principally in Europe.

Total shipment volume for cigarettes and OTP, in cigarette equivalent units, decreased by 4.3%.

Our net revenues and excise taxes on products were as follows: For the Three Months Ended March 31, (in millions) 2014 2013 Variance % Net revenues $ 17,779 $ 18,527 $ (748 ) (4.0 )% Excise taxes on products 10,862 10,943 (81 ) (0.7 )% Net revenues, excluding excise taxes on products $ 6,917 $ 7,584 $ (667 ) (8.8 )% Currency movements decreased net revenues by $1.3 billion and net revenues, excluding excise taxes on products, by $542 million. The $542 million decrease was due primarily to the Argentine peso, Australian dollar, Indonesian rupiah, Japanese yen, Russian ruble, and Turkish lira, partially offset by the Euro.

Net revenues shown in the table above include $470 million in 2014 and $450 million in 2013 related to sales of OTP. These net revenue amounts include excise taxes billed to customers. Excluding excises taxes, net revenues for OTP were $177 million in 2014 and $179 million in 2013.

- 38--------------------------------------------------------------------------------- Table of Contents Net revenues, which include excise taxes billed to customers, decreased by $748 million (4.0)%. Excluding excise taxes, net revenues decreased by $667 million (8.8)% to $6.9 billion. This decrease was due to: • unfavorable currency ($542 million) and • unfavorable volume/mix ($531 million), partly offset by • price increases ($406 million).

Excise taxes on products decreased by $81 million (0.7)%, due to: • favorable currency ($780 million) and • volume/mix ($374 million), partly offset by • higher excise taxes resulting from changes in retail prices and tax rates ($1.1 billion).

Governments have consistently increased excise taxes in most of the markets in which we operate. As discussed under the caption "Business Environment," we expect excise taxes to continue to increase.

Our cost of sales; marketing, administration and research costs; and operating income were as follows: For the Three Months Ended March 31, (in millions) 2014 2013 Variance % Cost of sales $ 2,374 $ 2,489 $ (115 ) (4.6 )% Marketing, administration and research costs 1,547 1,677 (130 ) (7.8 )% Operating income 2,951 3,391 (440 ) (13.0 )% Cost of sales decreased by $115 million (4.6%), due to: • favorable currency ($116 million) and • volume/mix ($93 million), partly offset by • higher manufacturing costs ($94 million, principally in Egypt due to the impact of the change in our new business structure).

With regard to tobacco leaf prices, we continue to expect modest increases going forward as the market has now stabilized. However, we anticipate some manufacturing cost increases in 2014, driven in large measure by historical leaf tobacco price changes that will continue to affect our product costs in the current year, higher prices for cloves and higher prices for a number of other direct materials we use in the production of our brands.

Marketing, administration and research costs decreased by $130 million (7.8%), due to: • favorable currency ($108 million) and • lower expenses ($22 million, primarily lower corporate expenses).

Operating income decreased by $440 million (13.0)%, due primarily to: • unfavorable volume/mix ($438 million), • unfavorable currency ($317 million), • higher manufacturing costs ($94 million) and • higher pre-tax charges for asset impairment and exit costs ($20 million), partly offset by • price increases ($406 million) and • lower marketing, administration and research costs ($22 million).

Interest expense, net, of $268 million increased $32 million, due primarily to higher average debt levels, partially offset by lower average interest rates on debt.

- 39--------------------------------------------------------------------------------- Table of Contents Our effective tax rate decreased by 0.7 percentage points to 28.9%. The effective tax rate is based on our full-year geographic earnings mix and cash repatriation plans. The effective tax rate for the three months ended March 31, 2013, was unfavorably impacted by the additional expense associated with the enactment of the American Taxpayer Relief Act of 2012 ($17 million). The effective tax rate is based on our full-year geographic earnings mix and cash repatriation plans. Changes in our cash repatriation plans could have an impact on the effective tax rate, which we monitor each quarter. Significant judgment is required in determining income tax provisions and in evaluating tax positions.

We are regularly examined by tax authorities around the world, and we are currently under examination in a number of jurisdictions. It is reasonably possible that within the next twelve months certain tax examinations will close, which could result in a change in unrecognized tax benefits along with related interest and penalties. An estimate of any possible charge cannot be made at this time.

Net earnings attributable to PMI of $1.9 billion decreased by $250 million (11.8%). This decrease was due primarily to an unfavorable currency impact on operating income and higher interest expense, net, partially offset by a lower effective tax rate. Diluted and basic EPS of $1.18 decreased by 7.8%. Excluding an unfavorable currency impact of $0.16, diluted EPS increased by 4.7%.

Operating Results by Business Segment Business Environment Taxes, Legislation, Regulation and Other Matters Regarding the Manufacture, Marketing, Sale and Use of Tobacco Products The tobacco industry and our business face a number of challenges that may adversely affect our business, volume, results of operations, cash flows and financial position. These challenges, which are discussed below and in "Cautionary Factors That May Affect Future Results," include: • fiscal challenges, such as excise tax increases and discriminatory tax structures; • actual and proposed extreme regulatory requirements, including regulation of the packaging, marketing and sale of tobacco products, as well as the products themselves, that may reduce our competitiveness, eliminate our ability to communicate with adult smokers, ban certain of our products, limit our ability to differentiate our products from those of our competitors, and interfere with our intellectual property rights; • illicit trade in cigarettes and other tobacco products, including counterfeit, contraband and so-called "illicit whites"; • intense competition, including from non-tax paid volume by local manufacturers; • pending and threatened litigation as discussed in Note 10. Contingencies; and • governmental investigations.

FCTC: The World Health Organization's ("WHO") Framework Convention on Tobacco Control ("FCTC"), an international public health treaty with the objective of reducing tobacco use, drives much of the regulation that shapes the business environment in which we operate. The treaty, to which 177 countries and the European Union are Parties, requires Parties to have in place various tobacco control measures and recommends others.

We support many of the FCTC regulatory policies, including measures that strictly prohibit the sale of tobacco products to minors, limit public smoking, require health warnings on tobacco packaging, regulate product content to prevent increased adverse health effects of smoking and establish a regulatory framework for reduced-risk products. We also support the use of tax and price policies to achieve public health objectives, as long as tax increases are not excessive, disruptive or discriminatory and do not result in increased illicit trade.

However, the FCTC governing body, the Conference of the Parties ("CoP"), has adopted non-binding guidelines and policy recommendations to certain articles of the FCTC, some of which we strongly oppose, including such extreme measures as point-of-sale display bans, plain packaging, bans on all forms of communications with adult smokers and ingredient restrictions or bans based on the concepts of palatability or attractiveness. Among other things, these measures would limit our ability to differentiate our products and disrupt competition, are not based on sound evidence of a public health benefit, are likely to lead to adverse - 40--------------------------------------------------------------------------------- Table of Contents consequences, such as increased illicit trade and, in some cases, result in the expropriation of our trademarks and violate international treaties.

It is not possible to predict whether or to what extent measures recommended in the FCTC guidelines will be implemented. In some instances where these extreme measures have been adopted by national governments, we have commenced legal proceedings challenging them.

Excise Taxes: Excessive and disruptive tax increases and discriminatory tax structures are expected to continue to have an adverse impact on our sales of cigarettes, due to lower consumption and consumer down-trading from premium to non-premium, discount, other low-price or low-taxed tobacco products, such as fine cut tobacco and illicit products. In addition, in certain jurisdictions, our products are subject to tax structures that discriminate against premium-price products and manufactured cigarettes. We oppose such extreme tax measures. We believe that they undermine public health by encouraging consumers to turn to the illicit trade for cheaper tobacco products and ultimately undercut government revenue objectives, disrupt the competitive environment and encourage criminal activity.

EU Tobacco Products Directive: In December 2013, the European Commission, the Council of Ministers and the European Parliament reached a preliminary agreement on the text of a significantly revised EU Tobacco Products Directive that provides for: • health warnings covering 65% of the front and back panels of packs with specific health warning dimensions that will in effect prohibit certain pack formats, such as smaller packs for slim cigarettes, even though the agreed text does not ban slim cigarettes. Member States would also have the option to further standardize tobacco packaging, including, under certain conditions, by introducing plain packaging; • a ban on packs of fewer than 20 cigarettes; • a ban on some characterizing flavors in tobacco products with a six-year transition period for menthol from the date the revised Directive enters into force; • tracking and tracing measures requiring tracking at pack level down to retail, which we believe will provide no incremental benefit in the fight against illicit trade; and • a framework for the regulation of e-cigarettes and novel tobacco products (except for those found to be medicines or medical devices), including requirements for health warnings and information leaflets, prohibiting product packaging text related to reduced risk, and introducing notification requirements in advance of commercialization.

The revised Directive has been formally adopted by the European Parliament and the Council of the European Union, and is expected to enter into force in May 2014. Thereafter, Member States will have 24 months to implement the Directive.

Plain Packaging: Australia's plain packaging regulation, which came into force in December 2012, bans the use of branding, logos and colors on packaging of all tobacco products other than the brand name and variant, which may be printed only in specified locations and in a uniform font. The remainder of the pack is reserved for health warnings and government messages about cessation. The branding of individual cigarettes is also prohibited under this regulation.

To date, only Australia has implemented plain packaging, although a few other countries are considering it. For example, the U.K. Parliament passed legislation that allows the Secretary of State for Health to implement plain packaging via regulations if he determines it may contribute to reducing the risk of harm or promoting the health or welfare of people. Following the April 2014 release of the most recent government-commissioned review of the plain packaging evidence base, the government has indicated that it is "minded to proceed with regulations" although any final decision on regulation will follow further public consultation on draft regulations, which have not yet been proposed. In February 2014, draft plain packaging legislation in New Zealand had its first reading in Parliament and is now being considered by a Parliamentary Health Committee, although the government has indicated that the legislation is unlikely to be passed until the legal challenges to Australia's plain packaging law are resolved. In Ireland, the government has announced its intention to formally introduce plain packaging legislation. It is not possible to predict whether other plain packaging legislation will be enacted.

Australia's plain packaging legislation triggered three legal challenges. First, major tobacco manufacturers, including our Australian subsidiary, challenged the legislation's constitutionality in the High Court of Australia. Although the High Court found the legislation constitutional, a majority of the Justices concluded that plain packaging deprives tobacco manufacturers of their property, raising serious questions about the legality of similar proposals in other jurisdictions. Second, our Hong Kong subsidiary has initiated arbitration proceedings against the Australian government pursuant to the Hong Kong-Australia Bilateral Investment - 41--------------------------------------------------------------------------------- Table of Contents Treaty and is seeking substantial compensation for the deprivation of its investments in Australia. Third, several countries have initiated World Trade Organization ("WTO") dispute settlement proceedings against Australia. The ongoing legal challenges may take several years to complete, and it is not possible to predict their outcome.

We oppose plain packaging because it expropriates our valuable intellectual property by taking away our trademarks and moves the industry much closer to a commodity business where there is no distinction between brands and, therefore, the ability to compete for adult smoker market share is greatly reduced. Early data from Australia appear to confirm that with plain packaging, adult smokers down-trade to lower price and lower margin brands and illicit products but do not quit or smoke less. According to recent industry-commissioned studies, illicit trade in Australia has increased since the implementation of plain packaging, with a significant shift towards branded illicit products (away from unbranded loose tobacco), while the data show no impact on smoking prevalence among adults or youth.

Restrictions and Bans on the Use of Ingredients: Currently, the WHO and some others in the public health community recommend restrictions or total bans on the use of some or all ingredients in tobacco products, including menthol. Some regulators have considered and rejected such proposals, while others have proposed and, in a few cases, adopted restrictions or bans. In particular, as mentioned above, the European Union has adopted a ban of characterizing flavors in tobacco products, subject to a six-year transition period for menthol, while sweeping ingredient bans have been adopted only by Canada (with an exemption for menthol) and Brazil.

However, the Brazil ingredients ban, which, as originally drafted, would prohibit the use of virtually all ingredients with flavoring or aromatic properties, is not in force due to a legal challenge by a tobacco industry union, of which our Brazilian subsidiary is a member. It is not possible to predict the outcome of this legal proceeding.

Broad restrictions and bans on the use of ingredients would require us to reformulate our American Blend tobacco products and could reduce our ability to differentiate these products in the market in the long term. Menthol bans would eliminate the entire product category. We oppose broad bans or sweeping restrictions on the use of ingredients, as they are often based on the subjective and scientifically unsupported notion that ingredients make tobacco products more "attractive" or "palatable" and therefore could encourage tobacco consumption, and also because prohibiting entire categories of cigarettes, such as menthol, will lead to a massive increase in illicit trade.

Many countries have enacted or proposed legislation or regulations that require cigarette manufacturers to disclose to governments and to the public the ingredients used in the manufacture of tobacco products and, in certain cases, to provide toxicological information about those ingredients. We have made, and will continue to make, full disclosures where adequate assurances of trade secret protection are provided.

Bans on Display of Tobacco Products at Retail: In a few of our markets, governments have banned or propose to ban the display of tobacco products at the point of retail sale. Other countries have rejected display ban proposals. We oppose display bans because they restrict competition by favoring established brands and encourage illicit trade, while not reducing smoking or otherwise benefiting public health. In some markets, our subsidiaries and, in some cases, individual retailers have commenced legal proceedings to overturn display bans.

Health Warning Requirements: In most countries, governments require large and often graphic health warnings covering at least 30% of the front and back of cigarette packs (the size mandated by the FCTC). A growing number of countries require warnings covering 50% of the front and back of the pack, and a small number of countries require larger warnings, such as Australia (75% front and 90% back), Mexico (30% front and 100% back), Uruguay (80% front and back) and Canada (75% front and back).

Most recently, the Ministry of Public Health in Thailand mandated health warnings covering 85% of the front and back of cigarette packs. Currently, this requirement is suspended pending the outcome of legal challenges by two of our affiliates. It is not possible to predict the outcome of these proceedings.

We support health warning requirements designed to inform consumers of the risks of smoking. In fact, where health warnings are not required, we place them on packaging voluntarily in the official language or languages of the country. We defer to governments on the content of warnings except for content that vilifies tobacco companies or does not fairly represent the actual effects of smoking.

However, we oppose excessively large health warnings, i.e., larger than 50%. The data show that disproportionately increasing the size of health warnings does not effectively reduce tobacco consumption. Yet, such health warnings impede our ability to compete in the market by leaving insufficient space for our distinctive trademarks and pack designs.

Other Packaging Restrictions: Some governments have passed, or are seeking to pass, restrictions on packaging and labeling, including standardizing the shape, format and lay-out of packaging, as well as imposing broad restrictions on how the space left - 42--------------------------------------------------------------------------------- Table of Contents for branding and product descriptions can be used. Examples include prohibitions on (1) the use of colors that are alleged to suggest that one brand is less harmful than others, (2) specific descriptive phrases deemed to be misleading, including, for example, "premium," "full flavor," "international," "gold," "silver," and "menthol" and (3) in one country, all but one pack variation per brand. We oppose broad packaging restrictions because they unnecessarily limit brand and product differentiation, are anticompetitive, prevent us from providing consumers with information about our products, unduly restrict our intellectual property rights, and violate international trade agreements. In some instances, we have commenced litigation challenging such regulations. It is not possible to predict the outcome of these proceedings.

Bans and Restrictions on Advertising, Marketing, Promotions and Sponsorships: For many years, the FCTC has called for, and countries have imposed, partial or total bans on tobacco advertising, marketing, promotions and sponsorships, including bans and restrictions on advertising on radio and television, in print and on the Internet. The FCTC also requires disclosure of expenditures on advertising, promotion and sponsorship where such activities are not prohibited.

The CoP guidelines recommend that governments adopt extreme and sweeping prohibitions, including all forms of communications to adult smokers. Where restrictions on advertising prevent us from communicating directly and effectively with adult smokers, they impede our ability to compete in the market. For this reason and because we believe that the available evidence does not show that marketing restrictions effectively reduce smoking, we oppose complete bans on advertising and communications that do not allow manufacturers to communicate directly and effectively with adult smokers.

Restrictions on Product Design: Tobacco control advocates and some regulators are calling for the further standardization of tobacco products by, for example, requiring that cigarettes have a certain minimum diameter, which amounts to a ban on slim cigarettes, or requiring the use of standardized filter and cigarette paper designs. We oppose such restrictions because they limit our ability to differentiate our products and because we believe that there is no correlation, let alone a causal link, between product design variations and smoking rates, nor is there any scientific evidence that these restrictions would improve public health.

Reduced cigarette ignition propensity standards are recommended by the FCTC guidelines, have been adopted in several of our markets (e.g., Australia, Canada, Korea and the EU) and are being considered in several others. We believe that due to the costs to manufacturers of implementing such standards, their effectiveness at reducing the risk of cigarette-ignited fires in countries where they have been implemented should be examined before additional countries consider them.

Restrictions on Public Smoking: The pace and scope of public smoking restrictions have increased significantly in most of our markets. Many countries around the world have adopted or are likely to adopt regulations that restrict or ban smoking in public and/or work places, restaurants, bars and nightclubs.

Some public health groups have called for, and some regional governments and municipalities have adopted or proposed, bans on smoking in outdoor places, as well as bans on smoking in cars (typically when minors are present) and private homes. The FCTC requires Parties to adopt restrictions on public smoking, and the guidelines call for broad bans in all indoor public places but limit their recommendations on private place smoking, such as in cars and homes, to increased education on the risk of exposure to environmental tobacco smoke.

While we believe outright bans are appropriate in many public places, such as schools, playgrounds, youth facilities, and many indoor public places, governments can and should seek a balance between the desire to protect non-smokers from environmental tobacco smoke and allowing adults who choose to smoke to do so. Owners of restaurants, bars, cafes, and other entertainment establishments should have the flexibility to permit, restrict, or prohibit smoking, and workplaces should be permitted to provide designated smoking rooms for adult smokers. Finally, we oppose bans on smoking outdoors (beyond places and facilities for children) and in private places.

Other Regulatory Issues: Encouraged by the public health community, some regulators are considering, or in some cases have adopted, regulatory measures designed to reduce the supply of tobacco. These include regulations intended to reduce the number of retailers selling tobacco by, for example, reducing the overall number of tobacco retail licenses available or banning the sale of tobacco within arbitrary distances of certain public facilities. We oppose such measures because they stimulate illicit trade and could arbitrarily deprive business owners and their employees of their livelihood with no indication that such restrictions would improve public health.

Regulators in some countries have also called for the exclusion of tobacco from free trade agreements, such as the Trans-Pacific Partnership Agreement, which is under negotiation. This could limit our ability to protect investments and intellectual property through these treaties. We oppose such measures because they unfairly discriminate against a legal industry and are at odds with fundamental principles of global trade.

In a limited number of markets, most notably Japan, we are dependent on governmental approvals that may limit our pricing flexibility.

- 43--------------------------------------------------------------------------------- Table of Contents Illicit Trade: Illicit tobacco trade creates a cheap and unregulated source of tobacco products, undermines efforts to reduce smoking, especially among youth, damages legitimate businesses, stimulates organized crime and increases corruption and lost tax revenue. Illicit trade may account for as much as 10% of global cigarette consumption; this includes counterfeit, contraband and the growing problem of "illicit whites," which are unique cigarette brands manufactured predominantly for smuggling. We estimate that illicit trade in the European Union accounted for more than 10% of total cigarette consumption in 2011 and for approximately 11% of total cigarette consumption in 2012.

A number of jurisdictions are considering regulatory measures and government action to prevent illicit trade. In November 2012, the CoP adopted the Protocol to Eliminate Illicit Trade in Tobacco Products (the "Protocol"), which includes supply chain control measures, such as licensing of manufacturers and distributors, enforcement in free trade zones, controls on duty free and Internet sales and the implementation of tracking and tracing technologies. The Protocol will come into force once the 40th country ratifies it, after which countries must implement its measures via national legislation. To date, one country -- Nicaragua -- has ratified the Protocol. It is not possible to predict whether or when other countries will do so.

Additionally, we and our subsidiaries have entered into cooperation agreements with governments and authorities to support their anti-illicit trade efforts.

For example, in 2004 we entered into a 12-year cooperation agreement with the EU and its member states (except Croatia) that provides for cooperation with European law enforcement agencies on anti-contraband and on anti-counterfeit efforts. Under the terms of this agreement we make financial contributions of approximately $75 million per year (recorded as an expense in cost of sales when product is shipped) to support these efforts. We are also required to pay the excise taxes, VAT and customs duties in qualifying seizures of up to 90 million genuine PMI products in the EU in a given year, and five times the applicable taxes and duties if seizures exceed 90 million cigarettes in a given year. To date, our payments for product seizures have been immaterial.

In 2009, our Colombian subsidiaries entered into an Investment and Cooperation Agreement with the national and regional governments of Colombia to promote investment in, and cooperation on, anti-contraband and anti-counterfeit efforts.

The agreement provides $200 million in funding over a 20-year period to address issues such as combating the illegal cigarette trade and increasing the quality and quantity of locally grown tobacco.

In June 2012, we committed €15 million to INTERPOL over a three-year period to support the agency's global initiative to combat trans-border crime involving illicit goods, including tobacco products. This initiative funds the coordination of information gathering, training programs for law enforcement officials, development of product authentication standards and public information campaigns.

Reduced-Risk Products: One of our strategic priorities is to develop, assess and commercialize a portfolio of innovative products with the potential to reduce the risk of smoking-related diseases in comparison to cigarettes. We refer to these as reduced-risk products ("RRPs"). The use of this term applies to tobacco-containing products and other nicotine-containing products that have the potential to reduce individual risk and population harm. We draw upon a team of world-class scientists from a broad spectrum of scientific disciplines and our efforts are guided by the following three key objectives: • to develop RRPs that provide adult smokers the taste, sensory experience, nicotine delivery profile and ritual characteristics that are similar to those currently provided by cigarettes; • to substantiate the reduction of risk for the individual adult smoker and the reduction of harm to the population as a whole, based on robust scientific evidence derived from well-established assessment processes; and • to advocate for the development of science-based regulatory frameworks for the approval and commercialization of RRPs, including the communication of substantiated health benefits to adult smokers.

Our product development is based on the elimination of combustion via tobacco heating and other innovative systems for aerosol generation, which we believe is the most promising path to reduce risk.

Our approach to individual risk assessment is to use cessation as the benchmark, because the short-term and long-term effects of smoking cessation are well known, and the closer the clinical data derived from adult smokers who switch to an RRP resemble the data from those who quit, the more confident one can be that the product reduces risk.

Four RRP platforms are being developed and are in various stages of commercialization readiness: • Platform 1 uses a precisely controlled heating device into which a specially designed tobacco product is inserted to generate an aerosol.

Eight clinical trials for Platform 1 were initiated in 2013, and we will have the results in 2014.

- 44--------------------------------------------------------------------------------- Table of Contents • Platform 2 also uses a controlled heating mechanism to generate an aerosol via the heating of tobacco and has the format and ritual of a cigarette.

This platform is in the pre-clinical testing phase and early stages of industrial scale-up. We estimate that the launch of Platform 2 will start approximately one year after that of Platform 1.

• Platform 3 is based on technology we acquired from Professor Jed Rose of Duke University and other co-inventors in May 2011. It uses a chemical reaction to generate a nicotine-containing aerosol. This platform is currently in the product development phase and early stages of pre-clinical assessment.

• Platform 4 covers e-vapor products - battery powered devices that produce an aerosol by vaporizing a liquid nicotine solution. Our e-vapor products comprise devices using current generation technology, and we are working on developing the next generation of e-vapor technologies.

In December 2013, we established a strategic framework with Altria Group, Inc.

("Altria") under which Altria will make available its e-vapor products exclusively to us for commercialization outside the United States, and we will make available two of our candidate reduced-risk tobacco products exclusively to Altria for commercialization in the United States. The agreements also provide for cooperation on the scientific assessment of these products and for the sharing of improvements to the existing generation of RRPs.

We are also developing other potential platforms.

We are proceeding with the commercialization of RRPs. In January 2014, we announced an investment of up to €500 million in our first manufacturing facility in the European Union and an associated pilot plant near Bologna, Italy, to produce our RRPs. We plan for the factory to initially manufacture Platform 1 and, when fully operational by 2016, and together with the pilot plant, to reach an annual production capacity of up to 30 billion units.

In the United States an established regulatory framework for assessing "Modified Risk Tobacco Products" ("MRTPs") exists under the jurisdiction of the Food and Drug Administration ("FDA"). We expect that future FDA actions are likely to influence the regulatory approach of other interested governments. Our assessment approach and the studies conducted to date reflect the rigorous evidentiary standards set forth in the FDA's Draft Guidance. We have shared our approach and studies with the FDA's Center for Tobacco Products. In parallel, we are engaging with regulators in several EU member countries, as well as in a number of other countries.

On April 25, 2014, the FDA issued a notice of a proposed rule deeming e-cigarettes (including e-vapor products) and certain other tobacco products to be "tobacco products" subject to its jurisdiction under the Family Smoking Prevention and Tobacco Control Act. Once finalized, the rule would subject e-cigarettes to the following provisions: (1) enforcement action against products determined to be adulterated and misbranded; (2) reporting of ingredients and harmful and potentially harmful constituents; (3) registration and product listing; (4) prohibition against the use of descriptors such as "lights" and claims of modified risk unless approved by the FDA; (5) prohibition of free samples; and (6) premarket review. The proposed rule would not prohibit the use of characterizing flavors in e-cigarettes, but it would ban their sale to minors and require health warnings. The FDA is seeking public comment on the proposed rule.

We expect to launch RRPs (including tobacco-based and e-vapor products) with several commercial pilot city tests in the second half of 2014 and the first national launch in 2015. There can be no assurance that we will succeed in our efforts or that regulators will permit the marketing of our RRPs with substantiated claims of reduced exposure, risk or harm.

Other Legislation, Regulation or Governmental Action: In Argentina, the National Commission for the Defense of Competition issued a resolution in May 2010, in which it found that our affiliate's establishment in 1997 of a system of exclusive zonified distributors ("EZDs") in Buenos Aires city and region was anticompetitive, despite having issued two prior decisions (in 1997 and 2000) in which it had found the establishment of the EZD system was not anticompetitive.

The resolution is not a final decision, and our Argentinean affiliate has opposed the resolution and submitted additional evidence.

In Germany, in October 2013, the Administrative District Office Munich, acting under the policy supervision of the Bavarian Ministry of Health and Environment, sent our German affiliate an order alleging that certain components of its Marlboro advertising campaign do not comply with the applicable tobacco advertising law, which required our affiliate to stop this particular campaign throughout Germany and remove all outdoor advertisements within one month from the effective date of the order and point-of-sale materials within three months.

Our affiliate does not believe the allegations properly reflect the facts and the law and filed a challenge in the Munich Administrative Court against the order. At a hearing held in April 2014, at the Bavarian Higher - 45--------------------------------------------------------------------------------- Table of Contents Administrative Court, the parties agreed that our affiliate can continue the campaign with certain limitations on image visuals and text slogans for the duration of the court proceedings.

It is not possible to predict what, if any, additional legislation, regulation or other governmental action will be enacted or implemented relating to the manufacturing, advertising, sale or use of tobacco products, or the tobacco industry generally. It is possible, however, that legislation, regulation or other governmental action could be enacted or implemented that might materially affect our business, volume, results of operations, cash flows and financial position.

Governmental Investigations From time to time, we are subject to governmental investigations on a range of matters. As part of an investigation by the Department of Special Investigations ("DSI") of the government of Thailand into alleged under declaration of import prices by Thai cigarette importers, the DSI proposed to bring charges against our subsidiary, Philip Morris (Thailand) Limited, Thailand Branch ("PM Thailand") for alleged underpayment of customs duties and excise taxes of approximately $2 billion covering the period from July 28, 2003, to February 20, 2007 ("2003-2007 Investigation"). In September 2009, the DSI submitted the case file to the Public Prosecutor for review. The DSI also commenced an informal inquiry alleging underpayment by PM Thailand of customs duties and excise taxes of approximately $1.8 billion, covering the period 2000-2003. In early 2011, the Public Prosecutor's office issued a non-prosecution order in the 2003-2007 Investigation. In August 2011, the Director-General of DSI publicly announced that he disagreed with the non-prosecution order. Thus, the matter was referred for resolution to the Attorney General, whose deputy subsequently stated that the Attorney General has made a ruling to proceed with a prosecution order.

Based on available information, it is probable that criminal charges will be filed. PM Thailand has been cooperating with the Thai authorities and believes that its declared import prices are in compliance with the Customs Valuation Agreement of the WTO and Thai law.

Additionally, in November 2010, a WTO panel issued its decision in a dispute relating to facts that arose from August 2006 between the Philippines and Thailand concerning a series of Thai customs and tax measures affecting cigarettes imported by PM Thailand into Thailand from the Philippines. The WTO panel decision, which was upheld by the WTO Appellate Body, concluded that Thailand had no basis to find that PM Thailand's declared customs values and taxes paid were too low, as alleged by the DSI in 2009. The decision also created obligations for Thailand to revise its laws, regulations, or practices affecting the customs valuation and tax treatment of future cigarette imports.

Thailand agreed in September 2011 to comply with the decision by October 2012.

Although the Philippines contends that to date Thailand has not fully complied, the parties remain engaged in consultations to address the outstanding issues.

At WTO meetings, the Philippines has repeatedly expressed concerns with ongoing investigations by Thailand of PM Thailand, noting that these investigations appear to be based on grounds not supported by WTO customs valuation rules and inconsistent with several decisions already taken by Thai Customs and other Thai governmental agencies.

Acquisitions and Other Business Arrangements In the fourth quarter of 2013, as part of our initiative to enhance profitability and growth in North African and Middle Eastern markets, we decided to restructure our business in Egypt. The new business model entails a new contract manufacturing agreement with our long-standing, strategic business partner, Eastern Company S.A.E., the creation of a new PMI affiliate in Egypt and a new distribution agreement with Trans Business for Trading and Distribution LLC. To accomplish this restructuring and to ensure a smooth transition to the new model, we recorded, in the fourth quarter of 2013, a charge to our 2013 full-year reported diluted EPS of approximately $0.10 to reflect the discontinuation of existing contractual arrangements.

In May 2013, we announced that Grupo Carso, S.A.B. de C.V. ("Grupo Carso") would sell to us its remaining 20% interest in our Mexican tobacco business. The sale was completed on September 30, 2013 for $703 million. As a result, we now own 100% of the Mexican tobacco business. A director of PMI has an affiliation with Grupo Carso. The final purchase price is subject to a potential adjustment based on the actual performance of the Mexican tobacco business over the three-year period ending two fiscal years after the closing of the purchase. In addition, upon declaration, we agreed to pay a dividend of approximately $38 million to Grupo Carso related to the earnings of the Mexican tobacco business for the nine months ended September 30, 2013. In March 2014, the dividend was declared and paid. The purchase of the remaining 20% interest resulted in a decrease to our additional paid in capital of $672 million.

- 46--------------------------------------------------------------------------------- Table of Contents Investments in Unconsolidated Subsidiaries On September 30, 2013, we acquired a 49% equity interest in United Arab Emirates-based Arab Investors-TA (FZC) ("AITA") for approximately $625 million.

As a result of this transaction, we hold an approximate 25% economic interest in Société des Tabacs Algéro-Emiratie ("STAEM"), an Algerian joint venture which is 51% owned by AITA and 49% by the Algerian state-owned enterprise Société Nationale des Tabacs et Allumettes SpA. STAEM manufactures and distributes under license some of our brands. The initial investment in AITA was recorded at cost and is included in investments in unconsolidated subsidiaries on the condensed consolidated balance sheets.

On December 12, 2013, we acquired from Megapolis Investment BV a 20% equity interest in Megapolis Distribution BV, the holding company of CJSC TK Megapolis ("Megapolis"), our distributor in Russia, for a purchase price of $750 million.

An additional payment of up to $100 million, which is contingent on Megapolis's operational performance over the four fiscal years following the closing of the transaction, will also be made by us if the performance criteria are satisfied.

We have also agreed to provide Megapolis Investment BV with a $100 million interest-bearing loan. We and Megapolis Investment BV have agreed to set off any future contingent payments owed by us against the future repayments due under the loan agreement. Any loan repayments in excess of the contingent consideration earned by the performance of Megapolis are due to be repaid, in cash, to us on March 31, 2017. At December 31, 2013, we recorded a $100 million asset related to the loan receivable and a discounted liability of $86 million related to the contingent consideration. The initial investment in Megapolis was recorded at cost and is included in investments in unconsolidated subsidiaries on the condensed consolidated balance sheets.

Trade Policy We are subject to various trade restrictions imposed by the United States and countries in which we do business ("Trade Sanctions"), including the trade and economic sanctions administered by the U.S. Department of the Treasury's Office of Foreign Assets Control ("OFAC") and the U.S. Department of State. It is our policy to fully comply with these Trade Sanctions.

Tobacco products are agricultural products under U.S. law and are not technological or strategic in nature. From time to time we make sales in countries subject to Trade Sanctions, pursuant to either exemptions or licenses granted under the applicable Trade Sanctions.

A subsidiary sells products to distributors that in turn sell those products to duty free customers that supply U.N. peacekeeping forces around the world, including those in the Republic of the Sudan. We do not believe that these exempt sales of our products for ultimate resale in the Republic of the Sudan, which are de minimis in volume and value, present a material risk to our shareholders, our reputation or the value of our shares. We have no employees, operations or assets in the Republic of Sudan.

We do not sell products in Cuba, Iran and Syria.

To our knowledge, none of our commercial arrangements result in the governments of any country identified by the U.S. government as a state sponsor of terrorism, nor entities controlled by those governments, receiving cash or acting as intermediaries in violation of U.S. laws.

Certain states within the U.S. have enacted legislation permitting state pension funds to divest or abstain from future investment in stocks of companies that do business with certain countries that are sanctioned by the U.S. We do not believe such legislation has had a material effect on the price of our shares.

- 47--------------------------------------------------------------------------------- Table of Contents Operating Results - Three Months Ended March 31, 2014 The following discussion compares operating results within each of our reportable segments for the three months ended March 31, 2014, with the three months ended March 31, 2013.

European Union. Net revenues, which include excise taxes billed to customers, increased by $96 million (1.5%). Excluding excise taxes, net revenues increased by $43 million (2.2%) to $2.0 billion. This increase was due to: • price increases ($52 million) and • favorable currency ($51 million), partly offset by • unfavorable volume/mix ($60 million).

The net revenues of the European Union segment include $387 million in 2014 and $366 million in 2013 related to sales of OTP. Excluding excise taxes, OTP net revenues for the European Union segment were $134 million in 2014 and $129 million in 2013.

Operating companies income of $978 million increased by $40 million (4.3%). This increase was due to: • price increases ($52 million), • favorable currency ($28 million) and • lower marketing, administration and research costs ($19 million), partly offset by • unfavorable volume/mix ($59 million).

The total cigarette market in the European Union of 106.3 billion units decreased by 5.6%, due primarily to the impact of tax-driven price increases, the unfavorable economic and employment environment and the prevalence of non-duty paid products. Although our cigarette shipment volume of 41.7 billion units decreased by 2.9%, predominantly reflecting a lower total market, our market share increased by 0.9 share points to 38.9%. The total OTP market in the European Union of 38.4 billion cigarette equivalent units decreased by 1.0%, principally reflecting a lower total fine cut market, down by 0.9% to 33.6 billion cigarette equivalent units.

While shipment volume of Marlboro of 20.2 billion units decreased by 3.8%, mainly due to a lower total market, market share increased by 0.4 share points to 19.1%, driven notably by Italy and Spain. Shipment volume of L&M increased by 1.0% to 7.4 billion units and market share increased by 0.3 share points to 6.9%, driven notably by Germany. Shipment volume of Chesterfield of 5.4 billion units increased by 26.9% and market share increased by 0.6 share points to 4.9%, driven notably by Italy and Poland. Shipment volume of Philip Morris of 2.4 billion units increased by 3.0% and market share increased by 0.1 share point to 2.1%, driven notably by Italy.

Our shipments of OTP of 5.3 billion cigarette equivalent units increased by 1.9%, driven principally by higher share. Our OTP total market share was 13.8%, up by 1.0 share point, reflecting gains in the fine cut category, notably in Hungary, up by 10.3 share points to 18.3%, Italy, up by 10.7 share points to 41.2%, Poland, up by 16.2 share points to 32.7%, Portugal, up by 5.1 share points to 33.4%, and Spain, up by 2.3 share points to 15.7%.

In France, the total cigarette market of 10.5 billion units decreased by 8.9%, mainly reflecting the unfavorable impact of price increases in July 2013 and January 2014, and the growth of e-vapor products. While our shipments of 4.6 billion units decreased by 8.0%, our market share increased by 1.0 share point to 41.0%, mainly driven by Marlboro and Philip Morris, up by 0.5 and 0.2 share points to 25.0% and 9.4%, respectively. Market share of L&M increased by 0.1 share point to 2.6% and share of Chesterfield was flat at 3.4%. The total industry fine cut category of 3.2 billion cigarette equivalent units decreased by 6.3%. Our market share of the category decreased by 0.3 share points to 26.1%.

In Germany, the total cigarette market of 18.2 billion units decreased by 3.0%.

While our shipments of 6.7 billion units decreased by 0.7%, market share increased by 0.8 share points to 36.9%, driven by L&M and Chesterfield, up by 1.2 share points and 0.1 share point to 11.7% and 1.7%, respectively, partially offset by Marlboro, down by 0.3 share points to 22.0%, reflecting the brand's crossing the €5.00/pack price point in the second quarter of 2013. The total industry fine cut category of 9.8 billion cigarette equivalent units decreased by 0.9%. Our market share of the category was down by 1.8 share points to 13.1%.

In Italy, the total cigarette market of 16.8 billion units decreased by 0.5%, mainly reflecting a stabilization in the prevalence of illicit trade and a lower incidence of e-vapor and fine cut products. Our shipments of 9.1 billion units increased by 0.8%, including favorable estimated inventory movements. Excluding these trade inventory movements, our shipments declined by 0.8%. Our market share decreased by 0.2 share points to 53.0%, due primarily to: Diana in the low-price segment, down by 2.1 share points to 9.9%, impacted by the growth of the super-low price segment; partially offset by Philip Morris, up by 0.6 share points to 2.5%, - 48--------------------------------------------------------------------------------- Table of Contents and Chesterfield, up by 1.5 share point to 5.1%, benefiting from its repositioning in February 2014 into the €4.00/pack price segment. Market share of Marlboro was flat at 25.6%. While the total industry fine cut category of 1.4 billion cigarette equivalent units decreased by 2.2%, our market share of the category increased by 10.7 share points to 41.2%, driven by Marlboro following its launch in the first quarter of 2013.

In Poland, the total cigarette market of 10.5 billion units decreased by 10.6%, including the unfavorable impact of estimated trade inventory movements.

Excluding these trade inventory movements, the total cigarette market declined by an estimated 7.8%, partially reflecting the growth of the fine cut category and non-duty paid OTP products. Although our shipments of 3.7 billion units decreased by 6.0%, our market share increased by 1.7 share points to 35.1%, driven by Marlboro, up by 0.1 share point to 10.2%, L&M, up by 0.6 share points to 16.4%, and Chesterfield, up by 1.4 share points to 6.9%, benefiting from the morphing of Red & White in the fourth quarter of 2013. The total industry fine cut category of 1.0 billion cigarette equivalent units increased by 7.1%. Our market share of the category increased by 16.2 share points to 32.7%.

In Spain, the total cigarette market of 10.5 billion units decreased by 3.6%, mainly due to the impact of the unfavorable economic and employment environment.

Our shipments of 3.2 billion units increased by 3.0%, including favorable estimated trade inventory movements. Excluding these trade inventory movements, PMI's shipments decreased by 1.1%. Our market share increased by 0.8 share points to 31.2%, driven by higher share of Marlboro and Chesterfield, up by 1.0 and 0.1 share point to 15.1% and 9.3%, respectively, partially offset by L&M, down 0.2 share points to 6.2%. While the total industry fine cut category of 2.2 billion cigarette equivalent units decreased by 12.8%, partly reflecting the impact of tax-driven price harmonization with the cigarette category in July 2013, our market share of the fine cut category increased by 2.3 share points to 15.7%.

Eastern Europe, Middle East & Africa. Net revenues, which include excise taxes billed to customers, increased by $139 million (3.1%). Excluding excise taxes, net revenues decreased by $34 million (1.7%) to $2.0 billion. This decrease was due to: • unfavorable volume/mix ($142 million) and • unfavorable currency ($126 million), partly offset by • price increases ($234 million).

Operating companies income of $927 million decreased by $8 million (0.9%). This decrease was due primarily to: • unfavorable volume/mix ($105 million), • unfavorable currency ($80 million) and • higher manufacturing costs ($73 million, principally related to the impact of the change to our new business structure in Egypt), partly offset by • price increases ($234 million).

Our cigarette shipment volume in EEMA of 62.0 billion units decreased by 7.2%, mainly due to Kazakhstan, Russia, Serbia and Ukraine, partially offset by Turkey. Excluding the unfavorable impact of estimated inventory movements, our cigarette shipment volume decreased by 3.0%. Our cigarette shipment volume of premium brands decreased by 3.0%, due principally to Marlboro, down by 6.0% to 18.5 billion units, partially due to the aforementioned inventory movements, partially offset by Parliament, up by 4.5% to 7.2 billion units.

In North Africa, the total cigarette market increased by 2.2% to an estimated 34.0 billion units, driven mainly by Egypt. Our shipment volume of 8.6 billion units decreased by 3.5%, principally reflecting lower production of our products as part of the transition to the new business structure in Egypt. Our market share decreased by 1.3 share points to 25.4%, due to lower share in Egypt, partially offset by gains in the other four markets. Market share of Marlboro increased by 1.5 share points to 15.3%, while share of L&M decreased by 2.7 share points to 8.1%.

In Russia, the total cigarette market declined by 6.7% to an estimated 66.9 billion units, mainly due to the impact of the tax-driven price increases of June 2013 and January 2014 and the prevalence of illicit trade. Our shipment volume of 18.6 billion units decreased by 8.9%. Our market share of 26.7%, as measured by Nielsen, was up by 0.5 share points. Market share of Parliament, L&M and Bond Street increased by 0.2, 0.5 and 0.5 share points to 3.5%, 3.1% and 7.0%, respectively, partially offset by Marlboro and Chesterfield, down by 0.2 and 0.3 share points to 1.6% and 2.9%, respectively.

In Turkey, the total cigarette market increased by 1.3% to an estimated 18.8 billion units. Our shipment volume of 9.0 billion units increased by 9.7%, mainly reflecting a favorable comparison with the first quarter of 2013 in which shipments declined by 17.4% as a result of the reversal of estimated trade inventory movements in the fourth quarter of 2012 ahead of the January 2013 excise tax increase. Our market share, as measured by Nielsen, decreased by 0.3 share points to 44.4%, mainly due to Marlboro, - 49--------------------------------------------------------------------------------- Table of Contents mid-price Muratti and low-price L&M, down by 0.3, 0.6 and 1.0 share points to 8.6%, 6.2% and 6.6%, respectively, partially offset by premium Parliament, up by 1.2 share points to 10.5%.

In Ukraine, the total cigarette market decreased by 6.5% to an estimated of 15.2 billion units, mainly reflecting the impact of price increases in 2013, a worsening economy and the prevalence of illicit trade. Our shipment volume of 5.1 billion units decreased by 9.8%, principally due, in addition to the aforementioned factors, to a decrease in our market share, as measured by Nielsen, down by 1.0 share point to 32.9% as a result of price competition and down-trading, with Marlboro and Parliament down by 0.7 and 0.3 share points to 5.0% and 3.0%, respectively. The decrease in our market share was partially offset by growth from our low-price segment brands of Bond Street and President.

Asia. Net revenues, which include excise taxes billed to customers, decreased by $776 million (14.8%). Excluding excise taxes, net revenues decreased by $608 million (21.8%) to $2.2 billion. This decrease was due to: • unfavorable currency ($366 million) and • unfavorable volume/mix ($276 million), partly offset by • price increases ($34 million).

Operating companies income of $915 million decreased by $427 million (31.8%).

This decrease was due to: • unfavorable volume/mix ($226 million), • unfavorable currency ($215 million), • higher pre-tax charges for asset impairment and exit costs ($20 million, principally due to the announced factory closure in Australia) and • higher manufacturing costs ($13 million), partly offset by • price increases ($34 million) and • lower marketing, administration and research costs ($13 million).

Our cigarette shipment volume of 70.8 billion units decreased by 2.5%, due primarily to: a lower market share in Australia and Indonesia, lower market share and the adverse timing of shipments in Japan; and lower share in Pakistan; partially offset by the Philippines driven by a favorable comparison with the first quarter of 2013 which was significantly impacted by a disruptive excise tax increase. Excluding the unfavorable impact of estimated inventory movements, our cigarette shipment volume was essentially flat. Shipment volume of Marlboro of 18.9 billion units increased by 0.8%, driven by Indonesia and the Philippines, partially offset by Japan.

In Indonesia, the total cigarette market decreased by 1.0% to 73.8 billion units, mainly reflecting a weaker economy. The total cigarette market for the full-year of 2014 is estimated to increase by up to 1.0%. Our shipment volume of 25.5 billion units decreased by 5.5%, primarily due to lower market share, down by 1.6 share points to 34.6% as a result of: the share decline of hand-rolled Dji Sam Soe, which decreased by 2.1 share points to 4.2%, due to the continuing decline of the hand-rolled kretek segment, partially offset by the growth of machine-made Dji Sam Soe Magnum, and the fact that the brand crossed a critical price point ahead of competition; the withdrawal of our ultra-low price brands Trend Mild and Vegas Mild following the implementation of excise tax legislation relating to sister companies in the fourth quarter of 2013; and increased competition in the machine-made LTLN (low-tar, low-nicotine) segment. Market share of Sampoerna A, in the premium machine-made LTLN segment, increased by 0.1 share point to 14.4%, while mid-price U Mild, was up by 1.1 share points to 5.2%. Marlboro's market share increased by 0.3 share points to 5.3% and its share of the "white" cigarettes segment, representing 6.6% of the total cigarette market, increased by 5.9 share points to 80.4%.

In Japan, the total cigarette market increased by 9.6% to 49.4 billion units, mainly driven by retail trade and consumer purchasing ahead of the consumption tax-driven retail price increases of April 1, 2014. Excluding the favorable impact of these inventory movements, the total cigarette market is estimated to have declined by approximately 2.0%. For the full-year 2014, the total cigarette market is projected to decline by an estimated 3.0% to 3.5%. Our shipment volume in the quarter of 13.5 billion units decreased by 9.1%, principally due to the adverse timing of our shipments and lower market share. Our market share decreased by 2.0 share points to 25.5%, with share of Marlboro, Lark, Philip Morris and Virginia S. down by 0.4, 0.8, 0.2 and 0.3 share points to 11.9%, 7.5%, 2.0% and 1.9%, respectively.

In Korea, the total cigarette market decreased by 5.4% to 19.4 billion units, mainly due to an unfavorable comparison with the first quarter of 2013 resulting from trade inventory movements ahead of an anticipated excise tax increase in 2013 that did not materialize. Although our shipment volume of 3.8 billion units decreased by 3.3%, market share increased by 0.7 share points - 50--------------------------------------------------------------------------------- Table of Contents to 19.9%, with share of Marlboro, up by 0.3 share points to 7.9%, Parliament, up by 0.3 share points to 7.1%, driven by Parliament Hybrid 5mg and the launch in October 2013 of Parliament Hybrid 1mg, and Virginia S., flat at 4.1%.

In the Philippines, the total tax-paid industry cigarette volume increased by 25.9% to an estimated 19.3 billion units, primarily reflecting a favorable comparison with the first quarter of 2013 which was significantly impacted by a disruptive excise tax increase in January and a surge in the prevalence of domestic non-duty paid products. Our shipment volume of 16.2 billion units increased by 19.6%. Our market share of 83.7% was down by 4.4 share points.

Marlboro's market share decreased by 2.8 share points to 18.8% in the first quarter of 2014. Share of Fortune decreased by 11.4 share points to 32.3%, more than offset by gains from our other local brands.

Latin America & Canada. Net revenues, which include excise taxes billed to customers, decreased by $207 million (8.9%). Excluding excise taxes, net revenues decreased by $68 million (8.7%) to $713 million. This decrease was due to: • unfavorable currency ($101 million) and • unfavorable volume/mix ($53 million), partly offset by • price increases ($86 million).

Operating companies income of $202 million decreased by $52 million (20.5%).

This decrease was due primarily to: • unfavorable currency ($52 million), • unfavorable volume/mix ($48 million), • higher marketing, administration and research costs ($29 million) and • higher manufacturing costs ($8 million), partly offset by • price increases ($86 million).

Our cigarette shipment volume in Latin America & Canada of 21.4 billion units decreased by 4.8%, principally due to the timing of estimated trade inventory movements in Mexico. Shipment volume of Marlboro of 8.2 billion units decreased by 10.5%.

In Argentina, the total cigarette market decreased by 0.9% to 10.7 billion units. Our cigarette shipment volume of 8.3 billion units increased by 2.2% and market share increased by 2.5 share points to 77.1%, driven by mid-price Philip Morris, up by 3.2 share points to 43.3%, reflecting the positive impact of its capsule variants, partially offset by low-price Next, down by 0.6 share points to 2.2%. Share of Marlboro was up by 0.1 share point to 24.1%.

In Canada, the total cigarette market decreased by 7.5% to 5.8 billion units, mainly due to the depletion of estimated trade inventory levels and the unfavorable impact of price increases. Excluding the impact of these inventory movements, the total market is estimated to have declined by 4.0%. While our cigarette shipment volume of 2.2 billion units decreased by 2.7%, market share increased by 2.4 share points to 38.5%, with premium brands Benson & Hedges flat at 2.3% and Belmont up by 0.4 share points to 2.8%. Market share of mid-price Canadian Classics was up by 0.9 share points to 10.9%. Market share of low-price brand Next was up by 1.6 share points to 10.8%, partially offset by mid-price Number 7 and low-price Accord, down by 0.1 share point and 0.3 share points to 4.2% and 2.7%, respectively.

In Mexico, the total cigarette market decreased by 11.3% to 7.2 billion units, mainly due to the depletion of estimated trade inventory levels built up ahead of our price increase in December 2013. Excluding these trade inventory movements, the total cigarette market declined by 2.0%. Our cigarette shipment volume of 4.9 billion units decreased by 18.3%. Our market share decreased by 5.8 share points to 67.7%, or by 1.7 share points to 71.3%, excluding the impact of trade inventory movements. While market share of Marlboro was down by 6.2 share points to 47.0%, or down by 2.8 share points to 50.4% excluding the impact of the trade inventory movements, and share of Benson & Hedges was down by 0.6 share points to 5.2%, reflecting consumer down-trading and the timing of price increases by our principal competitor, our share of the premium price segment was up by 1.3 share points to 91.2%. Market share of Delicados, the second best-selling brand in the market, increased by 0.2 share points to 10.7%.

Financial Review Net Cash Provided by Operating Activities Net cash provided by operating activities of $715 million during the first three months of 2014 decreased by $648 million from the comparable 2013 period. The decrease was due primarily to higher cash payments related to exit costs, an increase in our working capital requirements and lower net earnings.

- 51--------------------------------------------------------------------------------- Table of Contents The unfavorable movements in working capital were due primarily to the following: • more cash used for accrued liabilities and other current assets ($871 million), largely due to the timing of payments for excise taxes; partially offset by • more cash provided by accounts receivable ($462 million), primarily due to the timing of collections; and • more cash provided by inventories ($280 million), primarily related to the timing of finished goods inventory purchases by the trade.

Net Cash Used in Investing Activities Net cash used in investing activities of $208 million during the first three months of 2014 decreased by $14 million from the comparable 2013 period, due primarily to higher cash proceeds from the sale of fixed assets, partially offset by higher capital expenditures.

Our capital expenditures were $256 million and $240 million during the three months ended March 31, 2014 and 2013, respectively. The 2014 expenditures were primarily related to investments in productivity-enhancing programs, equipment for new products and the expansion of our capacity in Indonesia for machine-made kretek.

Net Cash Used in Financing Activities During the first three months of 2014, net cash used in financing activities was $805 million, compared with net cash used in financing activities of $53 million during the first three months of 2013. During the first three months of 2014, we used a total of $4.4 billion to repurchase our common stock, pay dividends and repay debt. These uses were partially offset by proceeds from our debt offerings and short-term borrowings in 2014 of $3.8 billion. During the first three months of 2013, we used a total of $4.6 billion to repurchase our common stock, pay dividends and repay debt. These uses were more than offset by proceeds from our debt offerings and short-term borrowings in 2013 of $4.7 billion.

Dividends paid in the first three months of 2014 and 2013 were $1.5 billion and $1.4 billion, respectively. The increase reflects a higher dividend rate in 2014, partially offset by lower shares outstanding as a result of our share repurchase program.

Debt and Liquidity We define cash and cash equivalents as short-term, highly liquid investments, readily convertible to known amounts of cash that mature within a maximum of three months and have an insignificant risk of change in value due to interest rate or credit risk changes. As a policy, we do not hold any investments in structured or equity-linked products. Our cash and cash equivalents are predominantly held in short-term bank deposits with institutions having a long-term rating of A- or better.

Credit Ratings - The cost and terms of our financing arrangements as well as our access to commercial paper markets may be affected by applicable credit ratings.

At March 31, 2014, our credit ratings and outlook by major credit rating agencies were as follows: Short-term Long-term Outlook Moody's P-1 A2 Stable Standard & Poor's A-1 A Stable Fitch F1 A Stable - 52--------------------------------------------------------------------------------- Table of Contents Credit Facilities - On January 31, 2014, we extended the term of our existing $2.0 billion 364-day revolving credit facility until February 10, 2015. On February 28, 2014, we replaced our $2.5 billion multi-year revolving credit facility, expiring March 31, 2015, with a new $2.5 billion multi-year credit facility, expiring on February 28, 2019. At March 31, 2014, our committed credit facilities and commercial paper outstanding were as follows: (in billions) Committed Credit Commercial Type Facilities Paper364-day revolving credit, expiring February 10, 2015 $ 2.0 Multi-year revolving credit, expiring February 28, 2019 2.5 Multi-year revolving credit, expiring October 25, 2016 3.5 Total facilities $ 8.0 Commercial paper outstanding $ 2.6 At March 31, 2014, there were no borrowings under the committed credit facilities, and the entire committed amounts were available for borrowing.

All banks participating in our committed credit facilities have an investment-grade long-term credit rating from the credit rating agencies. We continuously monitor the credit quality of our banking group, and at this time we are not aware of any potential non-performing credit provider.

Each of these facilities requires us to maintain a ratio of consolidated earnings before interest, taxes, depreciation and amortization ("consolidated EBITDA") to consolidated interest expense of not less than 3.5 to 1.0 on a rolling four-quarter basis. At March 31, 2014, our ratio calculated in accordance with the agreements was 13.8 to 1.0. These facilities do not include any credit rating triggers, material adverse change clauses or any provisions that could require us to post collateral. We expect to continue to meet our covenants. The terms "consolidated EBITDA" and "consolidated interest expense," both of which include certain adjustments, are defined in the facility agreements previously filed with the U.S. Securities and Exchange Commission.

In addition to the committed credit facilities discussed above, certain of our subsidiaries maintain short-term credit arrangements to meet their respective working capital needs. These credit arrangements, which amounted to approximately $2.5 billion at March 31, 2014 and $2.4 billion at December 31, 2013, are for the sole use of our subsidiaries. Borrowings under these arrangements amounted to $717 million at March 31, 2014, and $1.0 billion at December 31, 2013.

Commercial Paper Program - We have commercial paper programs in place in the U.S. and in Europe. At March 31, 2014 and December 31, 2013, we had $2.6 billion and $1.4 billion, respectively, of commercial paper outstanding.

Effective April 19, 2013, our commercial paper program in the U.S. was increased by $2.0 billion. As a result, our commercial paper programs in place in the U.S.

and in Europe currently have an aggregate issuance capacity of $8.0 billion.

The existence of the commercial paper program and the committed credit facilities, coupled with our operating cash flows, will enable us to meet our liquidity requirements.

Debt - Our total debt was $29.7 billion at March 31, 2014 and $27.7 billion at December 31, 2013.

On February 21, 2014, we filed a new shelf registration statement with the U.S.

Securities and Exchange Commission, under which we may from time to time sell debt securities and/or warrants to purchase debt securities over a three-year period.

Our debt offerings in the first quarter of 2014 were as follows: (in millions) Type Face Value Interest Rate Issuance Maturity €750 (approximately EURO notes (a) $1,029) 1.875 % March2014 March 2021 €1,000 (approximately EURO notes (a) $1,372) 2.875 % March 2014 March 2026 - 53--------------------------------------------------------------------------------- Table of Contents (a) Interest on these notes is payable annually in arrears beginning in March 2015. U.S. dollar equivalents for foreign currency notes were calculated based on exchange rates on the date of issuance.

The net proceeds from the sale of the securities listed in the table above will be used for general corporate purposes.

In April 2014, we launched and priced two bond offerings in the amount of CHF 275 million (approximately $311 million) and CHF 250 million (approximately $283 million). The CHF 275 million bond will have a fixed interest rate of 0.750% and a maturity date of December 2019. The CHF 250 million bond will have a fixed interest rate of 1.625% and a maturity date of May 2024. These transactions are scheduled to close in May 2014.

Guarantees - At March 31, 2014, we were contingently liable for $0.8 billion of guarantees of our own performance, which were primarily related to excise taxes on the shipment of our products. There is no liability in the condensed consolidated financial statements associated with these guarantees. At March 31, 2014, our third-party guarantees were insignificant.

Equity and Dividends As discussed in Note 3. Stock Plans to our condensed consolidated financial statements, during the three months ended March 31, 2014, we granted 2.4 million shares of deferred stock awards to eligible employees at a weighted-average grant date fair value of $77.74 per share. Equity awards generally vest three or more years after the date of the award, subject to earlier vesting on death or disability or normal retirement, or separation from employment by mutual agreement after reaching age 58.

In May 2012, our stockholders approved the Philip Morris International Inc. 2012 Performance Incentive Plan (the "2012 Plan"). The 2012 Plan replaced the 2008 Performance Incentive Plan (the "2008 Plan") and, as a result, there will be no additional grants under the 2008 Plan. Under the 2012 Plan, we may grant to eligible employees restricted stock, restricted stock units and deferred stock units, performance-based cash incentive awards and performance-based equity awards. Up to 30 million shares of our common stock may be issued under the 2012 Plan. At March 31, 2014, shares available for grant under the 2012 Plan were 24,800,140.

On August 1, 2012, we began repurchasing shares under a three-year $18.0 billion share repurchase program that was authorized by our Board of Directors in June 2012. From August 1, 2012 through March 31, 2014, we repurchased 114.8 million shares of our common stock at a cost of $10.1 billion under this repurchase program. During the first three months of 2014, we repurchased 15.4 million shares at a cost of $1.2 billion. During the first quarter of 2013, we repurchased 16.7 million shares at a cost of $1.5 billion.

As previously announced on February 6, 2014, we have a share repurchase target amount for 2014 of $4.0 billion.

Dividends paid in the first three months of 2014 were $1.5 billion. During the third quarter of 2013, our Board of Directors approved a 10.6% increase in the quarterly dividend to $0.94 per common share. As a result, the present annualized dividend rate is $3.76 per common share.

Market Risk Counterparty Risk - We predominantly work with financial institutions with strong short- and long-term credit ratings as assigned by Standard & Poor's and Moody's. These banks are also part of a defined group of relationship banks.

Non-investment grade institutions are only used in certain emerging markets to the extent required by local business needs. We have a conservative approach when it comes to choosing financial counterparties and financial instruments. As such we do not invest or hold investments in any structured or equity-linked products. The majority of our cash and cash equivalents is currently invested in bank deposits maturing within less than 30 days.

We continuously monitor and assess the credit worthiness of all our counterparties.

Derivative Financial Instruments - We operate in markets outside of the United States, with manufacturing and sales facilities in various locations throughout the world. Consequently, we use certain financial instruments to manage our foreign currency and interest rate exposure. We use derivative financial instruments principally to reduce our exposure to market risks resulting from fluctuations in foreign exchange rates by creating offsetting exposures. We are not a party to leveraged derivatives and, by policy, do not use derivative financial instruments for speculative purposes.

See Note 6. Financial Instruments, Note 13. Fair Value Measurements, and Note 15. Balance Sheet Offsetting to our condensed consolidated financial statements for further details on our derivative financial instruments and the related collateral arrangements.

- 54--------------------------------------------------------------------------------- Table of Contents Contingencies See Note 10. Contingencies to our condensed consolidated financial statements for a discussion of contingencies.

Cautionary Factors That May Affect Future Results Forward-Looking and Cautionary Statements We may from time to time make written or oral forward-looking statements, including statements contained in filings with the SEC, in reports to stockholders and in press releases and investor webcasts. You can identify these forward-looking statements by use of words such as "strategy," "expects," "continues," "plans," "anticipates," "believes," "will," "estimates," "intends," "projects," "goals," "targets" and other words of similar meaning. You can also identify them by the fact that they do not relate strictly to historical or current facts.

We cannot guarantee that any forward-looking statement will be realized, although we believe we have been prudent in our plans and assumptions.

Achievement of future results is subject to risks, uncertainties and inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from those anticipated, estimated or projected. Investors should bear this in mind as they consider forward-looking statements and whether to invest in or remain invested in our securities. In connection with the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995, we are identifying important factors that, individually or in the aggregate, could cause actual results and outcomes to differ materially from those contained in any forward-looking statements made by us; any such statement is qualified by reference to the following cautionary statements. We elaborate on these and other risks we face throughout this document, particularly in the "Business Environment" section. You should understand that it is not possible to predict or identify all risk factors. Consequently, you should not consider the following to be a complete discussion of all potential risks or uncertainties.

We do not undertake to update any forward-looking statement that we may make from time to time except in the normal course of our public disclosure obligations.

Risks Related to Our Business and Industry Cigarettes are subject to substantial taxes. Significant increases in cigarette-related taxes have been proposed or enacted and are likely to continue to be proposed or enacted in numerous jurisdictions. These tax increases may disproportionately affect our profitability and make us less competitive versus certain of our competitors.

Tax regimes, including excise taxes, sales taxes and import duties, can disproportionately affect the retail price of manufactured cigarettes versus other tobacco products, or disproportionately affect the relative retail price of our manufactured cigarette brands versus cigarette brands manufactured by certain of our competitors. Because our portfolio is weighted toward the premium-price manufactured cigarette category, tax regimes based on sales price can place us at a competitive disadvantage in certain markets. As a result, our volume and profitability may be adversely affected in these markets.

Increases in cigarette taxes are expected to continue to have an adverse impact on our sales of cigarettes, due to resulting lower consumption levels, a shift in sales from manufactured cigarettes to other tobacco products and from the premium-price to the mid-price or low-price cigarette categories, where we may be under-represented, from local sales to legal cross-border purchases of lower price products, or to illicit products such as contraband, counterfeit and "illicit whites." Our business faces significant governmental action aimed at increasing regulatory requirements with the goal of reducing or preventing the use of tobacco products.

Governmental actions, combined with the diminishing social acceptance of smoking and private actions to restrict smoking, have resulted in reduced industry volume in many of our markets, and we expect that such factors will continue to reduce consumption levels and will increase down-trading and the risk of counterfeiting, contraband, "illicit whites" and cross-border purchases.

Significant regulatory developments will take place over the next few years in most of our markets, driven principally by the World Health Organization's Framework Convention on Tobacco Control ("FCTC"). The FCTC is the first international public health treaty on tobacco, and its objective is to establish a global agenda for tobacco regulation. The FCTC has led to increased efforts by tobacco control advocates and public health organizations to reduce the palatability and attractiveness of tobacco products to adult smokers. Regulatory initiatives that have been proposed, introduced or enacted include: • restrictions on or licensing of outlets permitted to sell cigarettes; • the levying of substantial and increasing tax and duty charges; • restrictions or bans on advertising, marketing and sponsorship; - 55--------------------------------------------------------------------------------- Table of Contents • the display of larger health warnings, graphic health warnings and other labeling requirements; • restrictions on packaging design, including the use of colors, and plain packaging; • restrictions on packaging and cigarette formats and dimensions; • restrictions or bans on the display of tobacco product packaging at the point of sale and restrictions or bans on cigarette vending machines; • requirements regarding testing, disclosure and performance standards for tar, nicotine, carbon monoxide and other smoke constituents; • disclosure, restrictions, or bans of tobacco product ingredients; • increased restrictions on smoking in public and work places and, in some instances, in private places and outdoors; • elimination of duty free sales and duty free allowances for travelers; and • encouraging litigation against tobacco companies.

Our operating income could be significantly affected by regulatory initiatives resulting in a significant decrease in demand for our brands, in particular requirements that lead to a commoditization of tobacco products, as well as any significant increase in the cost of complying with new regulatory requirements.

Litigation related to tobacco use and exposure to environmental tobacco smoke ("ETS") could substantially reduce our profitability and could severely impair our liquidity.

There is litigation related to tobacco products pending in certain jurisdictions. Damages claimed in some tobacco-related litigation are significant and, in certain cases in Brazil, Canada, Israel and Nigeria, range into the billions of U.S. dollars. We anticipate that new cases will continue to be filed. The FCTC encourages litigation against tobacco product manufacturers.

It is possible that our consolidated results of operations, cash flows or financial position could be materially affected in a particular fiscal quarter or fiscal year by an unfavorable outcome or settlement of certain pending litigation. Please see Note 10. Contingencies to our condensed consolidated financial statements for a discussion of tobacco-related litigation.

We face intense competition, and our failure to compete effectively could have a material adverse effect on our profitability and results of operations.

We compete primarily on the basis of product quality, brand recognition, brand loyalty, taste, innovation, packaging, service, marketing, advertising and price. We are subject to highly competitive conditions in all aspects of our business. The competitive environment and our competitive position can be significantly influenced by weak economic conditions, erosion of consumer confidence, competitors' introduction of lower-price products or innovative products, higher tobacco product taxes, higher absolute prices and larger gaps between retail price categories, and product regulation that diminishes the ability to differentiate tobacco products. Competitors include three large international tobacco companies and several regional and local tobacco companies and, in some instances, state-owned tobacco enterprises, principally in Algeria, China, Egypt, Taiwan, Thailand and Vietnam. Industry consolidation and privatizations of state-owned enterprises have led to an overall increase in competitive pressures. Some competitors have different profit and volume objectives and some international competitors are susceptible to changes in different currency exchange rates.

Because we have operations in numerous countries, our results may be influenced by economic, regulatory and political developments or natural disasters in many countries.

Some of the countries in which we operate face the threat of civil unrest and can be subject to regime changes. In others, nationalization, terrorism, conflict and the threat of war may have a significant impact on the business environment. Economic, political, regulatory or other developments or natural disasters could disrupt our supply chain, manufacturing capabilities or our distribution capabilities. In addition, such developments could lead to loss of property or equipment that are critical to our business in certain markets and difficulty in staffing and managing our operations, which could reduce our volumes, revenues and net earnings. In certain markets, we are dependent on governmental approvals of various actions such as price changes.

In addition, despite our high ethical standards and rigorous control and compliance procedures aimed at preventing and detecting unlawful conduct, given the breadth and scope of our international operations, we may not be able to detect all potential improper or unlawful conduct by our employees and international partners.

- 56--------------------------------------------------------------------------------- Table of Contents We may be unable to anticipate changes in consumer preferences or to respond to consumer behavior influenced by economic downturns.

Our tobacco business is subject to changes in consumer preferences, which may be influenced by local economic conditions. To be successful, we must: • promote brand equity successfully; • anticipate and respond to new consumer trends; • develop new products and markets and broaden brand portfolios; • improve productivity; and • be able to protect or enhance margins through price increases.

In periods of economic uncertainty, consumers may tend to purchase lower-price brands, and the volume of our premium-price and mid-price brands and our profitability could suffer accordingly. Such down-trading trends may be reinforced by regulation that limits branding, communication and product differentiation.

We lose revenues as a result of counterfeiting, contraband, cross-border purchases and non-tax paid volume by local manufacturers.

Large quantities of counterfeit cigarettes are sold in the international market.

We believe that Marlboro is the most heavily counterfeited international cigarette brand, although we cannot quantify the revenues we lose as a result of this activity. In addition, our revenues are reduced by contraband, legal cross-border purchases and non-tax paid volume by local manufacturers.

From time to time, we are subject to governmental investigations on a range of matters.

Investigations include allegations of contraband shipments of cigarettes, allegations of unlawful pricing activities within certain markets, allegations of underpayment of customs duties and/or excise taxes, allegations of false and misleading usage of descriptors and allegations of unlawful advertising. We cannot predict the outcome of those investigations or whether additional investigations may be commenced, and it is possible that our business could be materially affected by an unfavorable outcome of pending or future investigations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Operating Results by Business Segment-Business Environment-Governmental Investigations" for a description of certain governmental investigations to which we are subject.

We may be unsuccessful in our attempts to produce products with the potential to reduce the risk of smoking-related diseases compared to cigarettes.

We continue to seek ways to develop commercially viable new product technologies that may reduce the risk of smoking-related diseases in comparison to cigarettes. Our goal is to develop products whose potential for exposure, risk and harm reduction can be substantiated and provide adult smokers the taste, sensory experience, nicotine delivery profile and ritual characteristics that are similar to those currently provided by cigarettes. We may not succeed in these efforts. If we do not succeed, but others do, we may be at a competitive disadvantage. Furthermore, we cannot predict whether regulators will permit the marketing of tobacco products with claims of reduced exposure, risk or harm, which could significantly undermine the commercial viability of these products.

Our reported results could be adversely affected by unfavorable currency exchange rates, and currency devaluations could impair our competitiveness.

We conduct our business primarily in local currency and, for purposes of financial reporting, the local currency results are translated into U.S. dollars based on average exchange rates prevailing during a reporting period. During times of a strengthening U.S. dollar, our reported net revenues and operating income will be reduced because the local currency translates into fewer U.S.

dollars. During periods of local economic crises, foreign currencies may be devalued significantly against the U.S. dollar, reducing our margins. Actions to recover margins may result in lower volume and a weaker competitive position.

The repatriation of our foreign earnings, changes in the earnings mix, and changes in U.S. tax laws may increase our effective tax rate. Our ability to receive payments from foreign subsidiaries or to repatriate royalties and dividends could be restricted by local country currency exchange controls.

Because we are a U.S. holding company, our most significant source of funds is distributions from our non-U.S. subsidiaries. Under current U.S. tax law, in general we do not pay U.S. taxes on our foreign earnings until they are repatriated to the U.S. as - 57--------------------------------------------------------------------------------- Table of Contents distributions from our non-U.S. subsidiaries. These distributions may result in a residual U.S. tax cost. It may be advantageous to us in certain circumstances to significantly increase the amount of such distributions, which could result in a material increase in our overall effective tax rate. Additionally, the Obama Administration has indicated that it favors changes in U.S. tax law that would fundamentally change how our earnings are taxed in the U.S. If enacted and depending upon its precise terms, such legislation could increase our overall effective tax rate. Certain countries in which we operate have adopted or could institute currency exchange controls that limit or prohibit our local subsidiaries' ability to make payments outside the country.

Our ability to grow may be limited by our inability to introduce new products, enter new markets or to improve our margins through higher pricing and improvements in our brand and geographic mix.

Our profitability may suffer if we are unable to introduce new products or enter new markets successfully, to raise prices or maintain an acceptable proportion of our sales of higher margin products and sales in higher margin geographies.

We may be unable to expand our brand portfolio through successful acquisitions or the development of strategic business relationships.

One element of our growth strategy is to strengthen our brand portfolio and market positions through selective acquisitions and the development of strategic business relationships. Acquisition and strategic business development opportunities are limited and present risks of failing to achieve efficient and effective integration, strategic objectives and anticipated revenue improvements and cost savings. There is no assurance that we will be able to acquire attractive businesses on favorable terms, or that future acquisitions or strategic business developments will be accretive to earnings.

Government mandated prices, production control programs, shifts in crops driven by economic conditions and the impact of climate change may increase the cost or reduce the quality of the tobacco and other agricultural products used to manufacture our products.

As with other agricultural commodities, the price of tobacco leaf and cloves can be influenced by imbalances in supply and demand, and crop quality can be influenced by variations in weather patterns, including those caused by climate change. Tobacco production in certain countries is subject to a variety of controls, including government mandated prices and production control programs.

Changes in the patterns of demand for agricultural products could cause farmers to plant less tobacco. Any significant change in tobacco leaf and clove prices, quality and quantity could affect our profitability and our business.

Our ability to implement our strategy of attracting and retaining the best global talent may be impaired by the decreasing social acceptance of cigarette smoking.

The tobacco industry competes for talent with consumer products and other companies that enjoy greater societal acceptance. As a result, we may be unable to attract and retain the best global talent.

The failure of our information systems to function as intended or their penetration by outside parties with the intent to corrupt them could result in business disruption, loss of revenue, assets or personal or other sensitive data.

We use information systems to help manage business processes, collect and interpret business data and communicate internally and externally with employees, suppliers, customers and others. Some of these information systems are managed by third-party service providers. We have backup systems and business continuity plans in place, and we take care to protect our systems and data from unauthorized access. Nevertheless, failure of our systems to function as intended, or penetration of our systems by outside parties intent on extracting or corrupting information or otherwise disrupting business processes, could result in loss of revenue, assets or personal or other sensitive data, cause damage to our reputation and that of our brands and result in significant remediation and other costs to us.

We may be required to replace third-party contract manufacturers or service providers with our own resources.

In certain instances, we contract with third parties to manufacture some of our products or product parts or to provide other services. We may be unable to renew these agreements on satisfactory terms for numerous reasons, including government regulations. Accordingly, our costs may increase significantly if we must replace such third parties with our own resources.

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