subsidiaries to meet their obligations under the MSA, to fund their capital

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expenditures and to make payments to RJR that, combined with RJR's cash balance, will enable RJR to make its required debt-service payments and to pay dividends to RJR's stockholders. The negative impact, if any, on the sources of liquidity that could result from a decrease in demand for products due to short-term inventory adjustments by wholesale and retail distributors, changes in competitive pricing, or accelerated declines in consumption, cannot be predicted. RJR cannot predict its cash requirements or those of its subsidiaries related to any future settlements or judgments, including cash required to be held in escrow or to bond any appeals, if necessary, and RJR makes no assurance that it or its subsidiaries will be able to meet all of those requirements. Under the class-action settlement agreement with tobacco growers, RJR Tobacco has agreed to annually purchase a minimum of 35 million combined pounds of domestic green leaf flue cured and burley tobacco in each of the next 10 years, beginning with the 2004 crop year. RJR Tobacco believes that this commitment, at market prices, will not be incremental to its previously anticipated leaf purchase needs. For further discussion of the tobacco growers' settlement, see note 7 to condensed consolidated financial statements. Table of Contents Cash Flows Net cash flows used in operating activities were $88 million in the first three months of 2004, compared with a use of $79 million in the first three months of 2003. This change is primarily due to the increased operating income as a result of decreased promotional expenses, partially offset by lower volume and lower interest income. Additionally, combined with lower tobacco settlement and related expenses in 2004, cash payments during 2004, based on 2003 expenses, resulted in an $86 million comparatively smaller decrease in the accrual for tobacco settlement and related expenses. Net cash flows used in investing activities were $8 million in the first three months of 2004, compared with $21 million in the prior year. This change is primarily due to distributions from equity investees in the first quarter of 2004, versus investments in equity investees in the first quarter of 2003. Net cash flows used in financing activities were $79 million in the first quarter of 2004, compared with $152 million in the prior-year quarter. This change is due to decreased repurchases of common stock and, to a lesser extent, proceeds from the exercise of stock options. Stock Repurchases The following tables summarize stock repurchases from November 1999 through March 31, 2004. These repurchases were made under programs authorized by RJR's board of directors and funded through cash provided by operating activities and from RJR Acquisition Corp., utilizing the cash proceeds of the NGH acquisition. In April 2003, to increase financial flexibility, RJR indefinitely suspended repurchases under its $1.0 billion repurchase program authorized by the board of directors in February 2002. RJR continues to repurchase shares forfeited with respect to the tax liability associated with certain option exercises and restricted stock vesting under its 1999 Long Term Incentive Plan, referred to as the 1999 LTIP. Shares held by RJR through repurchase, in addition to shares forfeited pursuant to employee stock plans, are included in treasury stock in RJR's condensed consolidated balance sheets. Repurchases ?2004 Shares Cost -------------------------------- ----------- ----------------- (in millions) 1999 LTIP tax withholding: January 99,057 $ 6 February 23,041 1 March 1,174 ? ------- ---- Total through March 31, 2004 123,272 $ 7 ------- ---- Cumulative Period Completed Shares Cost ---------------------------- ------------------------------------------------------------ -------------------- --------------- Programs completed November 1999 to February 2002 21,570,739 $ 875 $1 billion approved February 6, 2002 Suspended ?$530 million remaining 9,187,160 470 1999 LTIP tax withholding Ongoing 590,760 29 ---------- ----- Total as of March 31, 2004 31,348,659 $ 1,374 ---------- ----- Dividends On February 4, 2004, RJR's board of directors declared a quarterly cash dividend of $0.95 per common share. The dividend was paid on April 1, 2004 to stockholders of record as of March 10, 2004. On May 5, 2004, RJR's board of directors declared a quarterly cash dividend of $0.95 per common share. The dividend is payable July 1, 2004 to stockholders of record as of June 10, 2004. On an annualized basis, the dividend rate is $3.80 per common share. Table of Contents Capital Expenditures RJR Tobacco's capital expenditures were $10 million for the first three months of 2004 compared with $8 million for the first three months of 2003. RJR Tobacco plans to spend $55 million to $65 million for capital expenditures during 2004, funded primarily by cash flows from operations. RJR Tobacco's capital expenditure program is expected to continue at a level sufficient to support its strategic and operating needs. There were no material long-term commitments for capital expenditures as of March 31, 2004. Debt RJR's revolving credit facility with a syndicate of banks was amended and restated on May 10, 2002, and has a committed amount of $531 million through November 2004. The facility was further amended on September 25, 2003, primarily to modify certain definitions of terms related to negative covenants. RJR can use the full facility to obtain loans or letters of credit, at its option. RJR's material subsidiaries, including RJR Tobacco and Santa Fe, have guaranteed RJR's obligations under the revolving credit facility and have pledged all of their assets to secure their obligations under the facility. Moody's rating of RJR's guaranteed, secured notes is Ba2, stable outlook, and Standard & Poor's rating is BB+, negative outlook. Concerns about, or further lowering of, the ratings of RJR's guaranteed, secured notes by Standard & Poor's or Moody's could have an adverse impact on RJR's ability to access the debt markets. However, given that RJR has significant cash balances, RJR's management believes that such concerns about, or further lowering of, such ratings would not have a material adverse impact on RJR's cash flows. RJR is not required to maintain compensating balances; however, RJR pays commitment fees of 1.5% per annum of the revolving credit facility committed amount. Borrowings under the revolving credit facility bear interest at rates that vary with the prime rate or LIBOR. The credit facility also limits RJR's ability to pay dividends, repurchase stock, incur indebtedness, engage in transactions with affiliates, create liens, acquire, sell or dispose of specific assets and engage in specified mergers or consolidations. Under the credit facility, cumulative dividends and share repurchases generally may not exceed the sum of $500 million plus 50% of cumulative adjusted cash net income. Despite this general restriction, however, the credit facility further provides that up to an additional $500 million in dividends and share repurchases may be made. Stock repurchases also are limited to the extent that a stated minimum level of net worth must be maintained. At March 31, 2004, RJR had $19 million in letters of credit outstanding under the facility. No borrowings were outstanding, and the remaining $512 million of the facility was available for borrowing. RJR has a $30 million uncommitted, unsecured line of credit with one bank. No borrowings were outstanding on this line of credit at March 31, 2004. RJR's $1.45 billion guaranteed, secured notes, unlike RJR's $195 million of other non-bank debt, are guaranteed by RJR's material subsidiaries, including RJR Tobacco and Santa Fe. Because RJR and the guarantors have pledged their assets to secure their obligations under the revolving credit facility, as amended and restated, certain of the guarantors, which are considered restricted subsidiaries under the guaranteed, secured notes, also have pledged certain of their assets to secure these notes. Excluded from the pledge to secure these notes are intellectual property, inventory, accounts receivable, cash and certain other assets. Generally, the terms of these notes restrict the issuance of guarantees by subsidiaries, the pledge of collateral, sale/leaseback transactions and the transfer of all or substantially all of the assets of RJR and its subsidiaries. RJR uses interest rate swaps to manage interest rate risk on a portion of its debt obligations. As long as RJR's secured debt rating remains either one level below BBB- by Standard & Poor's or Baa3 by Moody's, any fair value that results in a liability position of the interest rate swaps, will require full collateralization with cash or securities. In addition, because RJR and the guarantors have pledged their. Table of Contents assets to secure their obligations under RJR's revolving credit facility, as amended and restated, such pledge also has secured their obligations under these interest rate swap agreements. RJR was in compliance with all covenants and restrictions imposed by its indebtedness at March 31, 2004. Litigation and Settlements Various legal actions, proceedings and claims, including legal actions claiming that lung cancer and other diseases, as well as addiction, have resulted from the use of, or exposure to, RJR's operating subsidiaries' products, are pending or may be instituted against RJR Tobacco or its affiliates, including RJR, or indemnitees. In July 2000, a jury in the Florida state court case Engle v. R. J. Reynolds Tobacco Co. rendered a punitive damages verdict in favor of the "Florida class" of plaintiffs of approximately $145 billion, with approximately $36.3 billion being assigned to RJR Tobacco. RJR Tobacco and the other defendants appealed the verdict. On May 21, 2003, Florida's Third District Court of Appeal reversed the trial court's final judgment and remanded the case to the Dade County Circuit Court with instructions to decertify the class and dismiss the individual cases. Plaintiffs filed a motion for rehearing on July 16, 2003. The appellate court denied that motion on September 22, 2003, and issued its mandate on October 8, 2003 (which officially concluded proceedings before that court). The class filed its notice of intent to seek discretionary review by the Florida Supreme Court on October 22, 2003. Although RJR Tobacco remains confident in its bases for appeal in this case, RJR Tobacco cannot predict the final outcome of the appellate process. For further discussion of the Engle case and other litigation and legal proceedings pending against RJR or its affiliates or indemnitees, see "?Governmental Activity" and note 7 to condensed consolidated financial statements. Even though RJR's management continues to conclude that the loss of any particular smoking and health tobacco litigation claim against RJR Tobacco or its affiliates, when viewed on an individual basis, is not probable, the possibility of material losses related to tobacco litigation is more than remote. However, RJR's management is unable to predict the outcome of such litigation or to reasonably estimate the amount or range of any possible loss. Moreover, notwithstanding the quality of defenses available to it and its affiliates in tobacco-related litigation matters, it is possible that RJR's financial condition, results of operations or cash flows could be materially adversely affected by the ultimate outcome of certain pending or future litigation matters. In November 1998, RJR Tobacco and the other major U.S. cigarette manufacturers entered into the MSA with attorneys general representing most U.S. states, territories and possessions. As described in note 7 to condensed consolidated financial statements, the MSA imposes a stream of future payment obligations on RJR Tobacco and the other major U.S. cigarette manufacturers and places significant restrictions on their ability to market and sell cigarettes in the future. The cash payments made by RJR Tobacco under the MSA and the other state settlement agreements were $530 billion and $608 billion during the three-month periods ended March 31, 2004 and March 31, 2003, respectively, and were $1.8 billion, $2.5 billion and $2.4 billion in 2003, 2002 and 2001, respectively. RJR Tobacco estimates these payments will exceed $1.8 billion in 2004 and each year thereafter. However, these payments will be subject to adjustments for, among other things, the volume of cigarettes sold by RJR Tobacco, RJR Tobacco's market share and inflation. RJR Tobacco records its allocation of ongoing settlement charges as products are shipped. RJR Tobacco cannot predict the impact on its business, competitive position or results of operations of the MSA and the other state settlement agreements, the business activity restrictions to which it is subject under these agreements or the price increases that it may be required to make as a result of these agreements. Table of Contents Governmental Activity The marketing, sale, taxation and use of cigarettes have been subject to substantial regulation by government and health officials for many years. Various state governments have adopted or are considering, among other things, legislation and regulations that would: ? increase their excise taxes on cigarettes; ? restrict displays and advertising of tobacco products; ? establish ignition propensity standards for cigarettes; ? raise the minimum age to possess or purchase tobacco products; ? require the disclosure of ingredients used in the manufacture of tobacco products; ? impose restrictions on smoking in public and private areas; and ? restrict the sale of tobacco products directly to consumers or other unlicensed recipients, including over the Internet. In addition, in the remainder of 2004, the U.S. Congress may consider legislation regarding: ? further increases in the federal excise tax; ? regulation of cigarette manufacturing and sale by the U.S. Food and Drug Administration; ? amendments to the Federal Cigarette Labeling and Advertising Act to require additional warnings; ? implementation of a national standard for "fire-safe" cigarettes; ? regulation of the retail sale of cigarettes over the Internet and in other non-face-to-face retail transactions, such as by mail order and telephone; ? banning of the delivery of cigarettes by the U.S. Postal Service; and ? changes to the tobacco price support program. Together with manufacturers' price increases in recent years and substantial increases in state and federal excise taxes on cigarettes, these developments have had and will likely continue to have an adverse effect on cigarette sales. Cigarettes are subject to substantial excise taxes in the United States. The federal excise tax per pack of 20 cigarettes is $0.39. All states and the District of Columbia currently impose excise taxes at levels ranging from $.025 per pack in Virginia to $2.05 per pack in New Jersey. During 2003, 15 states increased their excise taxes. When fully implemented, these increases will raise the weighted average state cigarette excise tax per pack from $0.62 at the beginning of 2003 to $0.70. Although no states have increased cigarette excise taxes this year, a number of states have pending legislation proposing additional excise tax increases. RJR Tobacco expects some state excise taxes to increase in 2004. In December 2003, the California Environmental Protection Agency Air Resources Board issued a "Proposed Identification of Environmental Tobacco Smoke as a Toxic Air Contaminant" for public review. If environmental tobacco smoke is identified as a "toxic air contaminant," the Air Resources Board is required to prepare a report assessing the need and appropriate degree of control of environmental tobacco smoke. RJR Tobacco cannot predict the form any future California regulation may take. Several states have enacted or have proposed legislation or regulations that would require cigarette manufacturers to disclose the ingredients used in the manufacture of cigarettes. In September 2003, the Massachusetts Department of Public Health announced its intention to hold public hearings on amendments to its tobacco regulations. The proposed regulations would delete any ingredients-reporting requirement. (The U.S. Court of Appeals for the Second Circuit previously affirmed a ruling that the Massachusetts ingredient-reporting law was unconstitutional.) MDPH has proposed to inaugurate extensive changes to its regulations requiring tobacco companies to report nicotine yield ratings for cigarettes. Table of Contents according to methods prescribed by MDPH. Because MDPH withdrew its notice for a public hearing in November 2003, it is impossible to predict the final form any new regulations will take or the effect they will have on the business or results of operations of RJR Tobacco. In June 2000, the New York State legislature passed legislation charging the state's Office of Fire Prevention and Control with developing standards for "fire-safe" or self-extinguishing cigarettes. On December 31, 2003, OFPC issued a final standard with accompanying regulations that will require all cigarettes offered for sale in New York State after June 28, 2004 to achieve specified test results when placed on ten layers of filter paper in controlled laboratory conditions. Certain design and manufacturing changes will be necessary for cigarettes manufactured for sale in New York to comply with the standard. There may be an adverse impact on the sale of cigarettes in New York due to reduced consumer acceptance of the changes in cigarettes made necessary to meet the standard. Inventories of cigarettes existing in the wholesale and retail trade as of June 28, 2004 that do not comply with the standard may continue to be sold, provided New York tax stamps have been affixed and such inventories have been purchased in comparable quantities in the same period in the previous year. Similar legislation is being considered in other states. Varying standards from state to state could have an adverse effect on the business or results of operations of RJR Tobacco. A price differential exists between cigarettes manufactured for sale abroad and cigarettes manufactured for U.S. sale. Consequently, a domestic "gray market" has developed in cigarettes manufactured for sale abroad. These cigarettes compete with the cigarettes RJR Tobacco manufactures for domestic sale. The U.S. federal government and all states, except Massachusetts, have enacted legislation prohibiting the sale and distribution of gray market cigarettes. In addition, RJR Tobacco has taken legal action against certain distributors and retailers who engage in such practices. Forty-four states have passed, and various other states are considering, legislation to ensure nonparticipating manufacturers, referred to as NPMs, under the MSA are making required escrow payments. Under this legislation, a state would only permit distribution of brands by manufacturers who are deemed by the states to be MSA-compliant. Failure to make escrow payments could result in the loss of a nonparticipating manufacturer's ability to sell tobacco products in a respective state. Early efforts to enact legislation, from 2001 to early 2002, resulted in a range of NPM laws, some containing only minimal requirements. However, once the National Association of Attorneys General, referred to as NAAG, became involved in the legislative initiative, model "complementary" NPM language was developed and introduced in the states where either no NPM laws existed or where existing laws needed to be amended to bring them in line with the model language. Additionally, 30 states have enacted, and several other states are considering, legislation that closes a loophole in the MSA. The loophole allows nonparticipating manufacturers to recover most of the funds from their escrow accounts. To obtain the refunds, the manufacturers must establish that their escrow deposit was greater than the amount the state would have received had the manufacturer been a "subsequent participating manufacturer" under the MSA. NAAG has endorsed adoption of these legislative efforts. Finally, three states have enacted "equity assessments" on NPMs' products, a legislative initiative that has not been endorsed by NAAG. Collectively, these forms of NPM legislation attempt to address some of the competitive inequities in the domestic cigarette market that benefit cigarette manufacturers that are not parties to the MSA. Thirty states have passed, and several additional states are considering, statutes limiting the amount of the bonds required to file an appeal of an adverse judgment in state court. The limitation on the amount of such bonds generally ranges from $25 million to $150 million. Such bonding statutes allow defendants that are subject to large adverse judgments, such as cigarette manufacturers, to reasonably bond such judgments and pursue the appellate process. Tobacco leaf is an agricultural product subject to U.S. Government production controls and price supports that can affect market prices substantially. The tobacco leaf price support program is subject to. Table of Contents congressional review and may be changed at any time. Post-MSA cigarette volume declines have dictated significant reductions in tobacco marketing quotas, which in turn have led many farmers to support legislation eliminating the current tobacco quota program with compensation for the lost value of their quotas. Such "quota buyout" legislation, funded by a tax on manufacturers and importers, has been introduced and could be considered during this session of Congress. Because of the importance of tobacco leaf as a raw material for RJR Tobacco's products, substantial changes in the legislative or regulatory environment applicable to tobacco leaf could have a material effect on RJR Tobacco's results of operations and cash flows. On May 21, 2003, the World Health Organization adopted a broad tobacco-control treaty. The treaty recommends and requires enactment of legislation establishing specific actions to prevent youth smoking, restrict and gradually eliminate tobacco products marketing, provide greater regulation and disclosure of ingredients, increase the size and scope of package warning labels to cover at least 30% of each package and include graphic pictures on packages. Although the United States delegate to the World Health Organization Assembly voted for the treaty, it is not known whether the treaty will be signed by the President and sent to the United States Senate for ratification. Ratification of the treaty by the United States Senate could lead to broader regulation of the industry. It is not possible to determine what additional federal, state or local legislation or regulations relating to smoking or cigarettes will be enacted or to predict the effect of new legislation or regulations on RJR Tobacco or the cigarette industry in general, but any new legislation or regulations could have an adverse effect on RJR Tobacco or the cigarette industry in general. For further discussion of litigation and legal proceedings pending against RJR, its affiliates, including RJR Tobacco, or indemnitees, see "?Litigation Affecting the Cigarette Industry," "?ERISA Litigation" and "?Environmental Matters" in note 7 to condensed consolidated financial statements. Environmental Matters RJR and its subsidiaries are subject to federal, state and local environmental laws and regulations concerning the discharge, storage, handling and disposal of hazardous or toxic substances. RJR and its subsidiaries have been engaged in a continuing program to assure compliance with these environmental laws and regulations. Although it is difficult to identify precisely the portion of capital expenditures or other costs attributable to compliance with environmental laws and regulations, RJR does not expect such expenditures or other costs to have a material adverse effect on the business or financial condition of RJR or its subsidiaries. For further discussion of environmental matters, see "?Environmental Matters" in note 7 to condensed consolidated financial statements. Other Contingencies Until the acquisition by merger by Philip Morris Companies, Inc. of Nabisco from NGH on December 11, 2000, NGH and Nabisco were members of the consolidated group of NGH for U.S. federal income tax purposes. Each member of a consolidated group is jointly and severally liable for the U.S. federal income tax liability of other members of the group as well as for pension and funding liabilities of the other group members. NGH, now known as RJR Acquisition Corp., continues to be jointly and severally liable for these Nabisco liabilities prior to December 11, 2000. In connection with Philip Morris's acquisition by merger of Nabisco and RJR's subsequent acquisition by merger of NGH, Philip Morris, Nabisco and NGH entered into a voting and indemnity agreement that generally seeks to allocate tax liabilities ratably based upon NGH's taxable income and that of Nabisco, had the parties been separate taxpayers. If Philip Morris and Nabisco are unable to satisfy their obligations under this agreement, NGH would be responsible for satisfying them. Table of Contents In connection with the sale of the international tobacco business to Japan Tobacco Inc. on May 12, 1999, RJR and RJR Tobacco agreed to indemnify Japan Tobacco against ? any liabilities, costs and expenses arising out of the imposition or assessment of any tax with respect to the international tobacco business arising prior to the sale, other than as reflected on the closing balance sheet; ? any liabilities, costs and expenses that Japan Tobacco or any of its affiliates, including the acquired entities, may incur after the sale with respect of any of RJR's or RJR Tobacco's employee benefit and welfare plans; and ? any liabilities, costs and expenses incurred by Japan Tobacco or any of its affiliates arising out of certain activities of Northern Brands. Although it is impossible to predict the outcome of the Northern Brands litigation or the amount of liabilities, costs and expenses, a significant adverse outcome regarding any of these items could have an adverse effect on either or both of RJR and RJR Tobacco. RJR Tobacco and Santa Fe have entered into agreements to indemnify certain distributors and retailers from liability and related defense costs arising out of the sale or distribution of their products. Additionally, Santa Fe has entered into an agreement to indemnify a supplier from liability and related defense costs arising out of the sale or use of Santa Fe's products. The cost of such defense indemnification has been, and is expected to be, insignificant. RJR Tobacco and Santa Fe believe that the indemnified claims are substantially similar in nature and extent to the claims that they are already exposed to by virtue of having manufactured those products. For further information related to these guarantees, including probability and estimates of loss, see note 7 to condensed consolidated financial statements. As long as RJR's secured debt rating remains either one level below BBB-by Standard & Poor's or Baa3 by Moody's, any fair value that results in a liability position of the interest rate swaps will require full collateralization with cash or securities. Cautionary Information Regarding Forward-Looking Statements Statements included in "Management's Discussion and Analysis of Financial Condition and Results of Operations" that are not historical in nature are forward-looking statements made pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements regarding RJR's future performance and financial results inherently are subject to a variety of risks and uncertainties, described in the forward-looking statements. These risks include: ? the substantial and increasing regulation and taxation of the cigarette industry; ? various legal actions, proceedings and claims relating to the sale, distribution, manufacture, development, advertising, marketing and claimed health effects of cigarettes that are pending or may be instituted against RJR or its subsidiaries; ? the substantial payment obligations and limitations on the advertising and marketing of cigarettes under various litigation settlement agreements; ? the continuing decline in volume in the domestic cigarette industry; ? competition from other cigarette manufacturers, including increased promotional activities and the growth of deep-discount brands; ? the success or failure of new product innovations and acquisitions; ? the responsiveness of both the trade and consumers to new products and marketing and promotional programs; Table of Contents ? any potential costs or savings associated with realigning the cost structure of RJR and its subsidiaries; ? the ability to achieve efficiencies in manufacturing and distribution operations without negatively affecting sales; ? the cost of tobacco leaf and other raw materials and other commodities used in products; ? the effect of market conditions on the performance of pension assets, foreign currency exchange rate risk, interest rate risk and the return on corporate cash; and ? the rating of RJR's securities. In addition, RJR can give no assurance that the proposed formation of Reynolds American, the combination of RJR Tobacco and the U.S. assets, liabilities and operations of B&W, and the related combination transactions, will be consummated, or if consummated, that any expectations relating thereto will be realized. Factors that could affect whether these transactions are consummated include obtaining approvals from U.S. and European regulatory authorities and RJR stockholders, the receipt of satisfactory IRS rulings and the satisfaction or waiver of certain other conditions. Due to these uncertainties and risks, you are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. Except as provided by federal securities laws, RJR is not required to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. Enditem