Philip Morris International: Smoke Screen

By Larry Barrett Print this article Print

Your distribution network is vast. You sell your product to distributors. You have no way to track what happens after that. So how can you be held accountable for how your cartons and packages hit the stores—or the street? A $1.25 billion settlemen

Philip Morris "can't keep track of every single pack of cigarettes as it makes its way through distributors and retailers," U.S. compliance VP Jack Holleran says.

A $1.25 billion settlement in Europe says the global manufacturer has no other choice.

The DHL express freight plane rolled to a stop on the runway at New York's John F. Kennedy International Airport on the morning of Nov. 16, 2004, and was immediately surrounded by agents from the U.S. Department of Justice's Bureau of Alcohol, Tobacco, Firearms and Explosives.

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Its cargo of 82,000 bootleg cartons of cigarettes, valued at more than $1.1 million, was earmarked for customers in the United States who had placed orders with Otamedia, an online tobacco retailer based in Switzerland.

The majority of the cartons were Marlboro and Marlboro Lights, the top-selling brands made by the world's largest tobacco manufacturer, Altria Group, through two subsidiaries, Philip Morris International (PMI) and Philip Morris USA.

It's illegal under current U.S. laws, including the Lanham Act and the Imported Cigarette Compliance Act, to import cigarettes into the U.S. without paying appropriate taxes and import duties. And the Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF) is still investigating exactly how all those cigarettes—untaxed, in addressed packages and ready for delivery—ended up on the DHL cargo plane.

Early media reports suggested the cigarettes were made in Europe by PMI, which is based in Lausanne, Switzerland, purchased by Otamedia from PMI and then rerouted by the distributor to the U.S. to fill orders made over the Web by Americans looking for a cheaper cigarette.

International duties as well as state and federal excise taxes in the United States can drive the price of a carton of Marlboros at a grocery store on this side of the Atlantic Ocean to $50. Otamedia's Internet customers were paying as little as $13.95 a carton, plus an additional $5 or so in shipping, to have their smokes delivered right to their door in an oversized manila envelope.

If you ask Philip Morris, these cartons are being shipped by an unauthorized distributor, and the company has taken Otamedia to court to stop its illicit supply chain in its tracks.

But regulators in Europe are now saying that doesn't matter: It's the responsibility of a manufacturer to control its supply chain from start to finish, regardless of who puts its products in the hands of consumers. In fact, the European Union (EU) last July reached a $1.25 billion settlement with the $33.4 billion-a-year cigarette maker and ordered it to implement information systems that track and trace its cigarettes all the way from the manufacturing line to the retail shelf.

Philip Morris protests that a manufacturer can have its hands full just keeping track of its authorized distributors, much less gray-market operators or other illicit supply chains. "It's a vast distribution network," says Jack Holleran, PM USA's vice president of compliance and brand integrity. "We can't keep track of every single pack of cigarettes as it makes its way through distributors and retailers."

But government regulators in Europe have had enough—and could raise the hurt if Philip Morris doesn't comply. The settlement is almost pocket change for Philip Morris, payable over 12 years by its parent, Altria, which generated $9.2 billion of net income in 2003 on revenue of $60.7 billion.

Indeed, the EU's ruling could have far-reaching implications. The 25-nation EU is, in effect, ordering the cigarette maker to implement a supply chain system that will keep track of every Marlboro, Bond Street and Parliament carton—as well as Philip Morris' other brands—from the time the cigarettes are packaged to the time they're sold by anybody, anywhere, in the world.

It's a demand that the EU could easily impose on manufacturers of liquor, apparel, pharmaceuticals, hazardous materials or other products that want to do business in its surging $12 trillion-a-year common market. And other governments—particularly those facing financial deficits, like the U.S.—could be easily motivated to follow along with their own actions.

Leaks in the distribution of cigarettes conservatively cost national, state and local governments more than $30 billion a year in tax revenue, according to the World Health Organization. Smokes are not the only trade of unauthorized distributors. Illicit supply chains move more than $500 billion a year in smuggled and counterfeit goods, from pocketbooks to steel, says the U.S. Government Accountability Office.

"This is just the beginning for manufacturers in many industries," says Kara Romanow, an analyst with AMR Research. "Either by force of regulation or from a large customer such as Wal-Mart, companies are being forced to get their supply chains under better control."

So watch closely how Altria reacts. PMI now has a team of experts from its packaging, research and development, information-technology and brand integrity departments meeting monthly to evaluate new technologies that could tighten up supply chains, according to Holleran.

Altria says it will take a pre-tax charge of $500 million in the next three years as part of the payment plan established by the settlement, and, according to Philip Morris officials, PMI will invest at least $10 million to $20 million in the new information systems needed to put the proper tracking systems in place. One option under consideration is Radio Frequency Identification (RFID) technology, which allows manufacturers to attach tags with antennas and computer chips on goods and track their movement through radio signals.

Altria refused to talk in detail about any of its plans. Yet experts say RFID may be too expensive for Philip Morris to use in tracking individual cigarette packages.

Romanow says it costs companies of Altria's size between $1 million and $3 million just to set up a basic RFID pilot system. The readers, tags and accompanying software will run a large corporation $13 million to $23 million for a full-scale installation—well within the amount now being invested by PMI.

But that's a typical cost of a supply chain in which RFID tags are attached to pallets of goods. Product labels with embedded RFID tags can easily run 50 cents apiece. In 2003, PMI and PM USA combined sold 4.5 billion cartons of cigarettes. If the company put an RFID attachment on each of those boxes, it could have cost $2.25 billion for the tags alone.

While Philip Morris figures out how to respond, it may be cheaper and easier for the company to just pay the settlement. The first payment on the $1.25 billion deal it signed with the EU is $250 million, which penalizes PMI less than 2.5% of its 2004 operating profit.

And customers may end up footing the bill anyway. Both PMI and PM USA announced on Dec. 10 that they were bumping up wholesale prices to all customers by about $1 a carton. That could bring billions of dollars into company coffers next year.

Indeed, looking at Altria's current and past supply chain strategies—and seeing how RFID would fit into its existing product tracking and reporting system—shows just how difficult it is for any consumer products manufacturer to track its wares from plant floor to retail shelf, and how tough it is for regulators to demand such intensive monitoring from global manufacturers.

This article was originally published on 2005-02-01
Senior Writer
Larry, of San Carlos, Calif., was a senior writer and editor at CNet, writing analysis, breaking news and opinion stories. He was technology reporter at the San Jose Business Journal from 1996-1997. He graduated with a B.A. from San Jose State University where he was also executive editor of the daily student newspaper.
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