Chapter 22, Part 2

By Frank Tursi, Susan E. White, Steve McQuilkin and Ken Otterbourg
JOURNAL REPORTERS
© 1999 Winston-Salem Journal

In trying to explain the company's slide at the time, Reynolds executives found an easy scapegoat: big government.

The R.J. Reynolds Tobacco Co. was once the largest cigarette company in the United States with a powerhouse of best-selling brands: Winston, Salem and Camel. But times changed, and as the case against smoking became more pronounced in the 1960s, RJR failed to adapt to the marketplace. Its rivals would eventually rush past it, and RJR's efforts to catch up would have a profound impact on the company and the cigarette industry.

Cigarettes had been an easy tax target for years, but the recession of the early 1980s made them even more inviting. Legislators were looking for new revenue sources to help ease the pressure on their budgets, squeezed by unemployment and inflation.

Unlike other industries, tobacco's power base wasn't spread through the country. It was concentrated in three states: Kentucky, North Carolina and Virginia. Politicians elsewhere could tax a product that created few jobs in their districts. Half the states increased their excise taxes between 1980 and 1984. Compounding the problem was the federal government, which doubled its per-pack tax from 8 cents to 16 cents, beginning Jan. 1, 1983.

The tobacco companies themselves had never been reluctant to raise prices. One key to the industry's enormous profitability was the willingness of smokers to swallow price increases year in and year out. The government had figured this out as well. But there were too many big bites at once. Together, they were pushing the price of a pack close to a dollar.

''We're used to predicting in November what the year's sales would be and the outlook for the next, but now we're faced with wild ranges -- that's revolutionary for us,'' James Morgan, the executive vice president for sales at Philip Morris, said in December 1982. (Business Week footnote; quotes from James Morgan.)

Americans had bought 624 billion cigarettes in 1982, the most ever. Consumption dropped in 1983 by nearly 30 billion cigarettes, to 596 billion cigarettes. But the pain wasn't equally spread. Philip Morris and Lorillard made modest gains. Reynolds took the biggest hit. It shipped 188 billion cigarettes in 1983, down 10 percent from 1982.

Speaking to stock analysts in early 1984, Jerry Long, the president of Reynolds Tobacco, called the plunge part of an aberration and simply a distribution problem. ''By taking the necessary price increases in two stages,'' he said, ''we made our brands very attractive to wholesalers and retailers at the end of 1982. Consequently, the pipeline remained loaded with our brands well into 1983.'' It was that simple.

Or was it?

Cigarettes, like most products, are sold through wholesalers. The companies' market shares are based on shipments to these middlemen. As the pressure on RJR to hold its market share increased in the early 1980s, the company began pushing wholesalers to buy more cigarettes than they needed, a tactic known as trade-loading. When the cigarettes didn't sell, the wholesalers returned them for credit. As long as RJR was willing to eat the returns, it got to record the shipment.

Cigarette companies had been engaged in these sorts of tricks on a smaller scale for years, but the hefty tax increases of 1982 and 1983 would make it a way of life for Reynolds, which was looking for any way to keep pace with Philip Morris.

''What we were having was an inordinate level of returns,'' said John Dowdle, the treasurer of R.J. Reynolds Industries in the early 1980s. ''You throw those cigarettes out there and run a trade promotion to get the retailers to buy it and it inflates your numbers, so it makes your market share look great, and then they come back. And if you're going to not show your share going down, you have to keep putting them out and putting them out and putting them out. It's a treadmill that you never want to get on, because you can't get off without showing a drop in sales.''

Long and Ed Horrigan, the chairman of the tobacco company, had made the call to push extra cigarettes on wholesalers. They knew the risks and costs and believed that they were worth taking. It would be years before the mess was straightened out. Among the casualties would be Jim Johnston, Long's right-hand man for sales and marketing and another go-getter from international. He opposed trade-loading and left RJR in 1984 after he couldn't get Horrigan and Long to stop the practice.

''Maintaining a 32 percent share was a very, very primary objective,'' Long said in 1989. ''Nobody worried whether it was artificial.'' (Fortune footnote; account of trade-loading practices at R.J. Reynolds Tobacco Co.)

Cheap Smokes

As the recession gnawed at America, changes were under way at Liggett & Myers Tobacco Co. of Durham. In the 1930s, Liggett had been a contender, with its Chesterfield one of the big three brands, along with Lucky Strike and Camel. But since World War II, it had been on a slow and steady drop to the bottom of the heap. By 1981, it had 2.5 percent of the market. With little to lose, Liggett took dead aim at the industry's cherished notion that image was more important than price.

Liggett's gambit was the generic cigarette, the anti-brand. The pack was white with black lettering that said simply ''Filtered cigarettes'' with the bluntness usually reserved for the warning label. There was no advertising campaign, no good-looking models playing cards or hunkering down over a campfire.

They were cheap and they sold, finding a market with smokers hurt by the recession and bothered by the soaring price of regular cigarettes. In 1983, when the industry in general and Reynolds in particular were getting stung, little Liggett sold 10 billion more cigarettes than in the previous year. Generics had jumped to being the 12th-largest brand and were closing in on the top 10, near Lorillard's Newport and RJR's Vantage. (Business Week footnote; discussion of the introduction of generic cigarettes.)

Discount brands posed a problem for Reynolds and the other majors. On one hand, introducing their own low-priced brands would have customers questioning whether the more-expensive smokes were worth the money. But many of Liggett's new smokers had likely come from Reynolds. Even if the profits on discounts weren't as high as on Winston, half a loaf was better than none.

To battle the generics, RJR's first weapon was Century, which offered 25 cigarettes priced the same as a 20-cigarette pack. It produced modest success at first but then began sliding down.

The next tack appeared even odder. It was geared around a lackluster brand called Doral that had been introduced in 1969 as a low-tar cigarette. It had gone nowhere, eclipsed by Vantage, which came out in 1971. By 1983, it had only about .3 percent of the domestic market.

Even if smokers hadn't bought Doral the first time around, they knew the name. And there was ample evidence that the right advertising could change a brand's image. Philip Morris had done it with Marlboro, after all.

RJR's marketing department began working on a redesign to move Doral from its current position as a low-tar brand aimed at women to a discount brand. To keep the profit margins, the manufacturing side had to engineer a cigarette that was cheaper to make, and they relied on increasing the amount of reconstituted tobacco in each cigarette.

Long brought his research to the World Headquarters building in early 1984, where he made his pitch to J. Tylee Wilson, the chairman of Reynolds Industries.

''You're out of your mind,'' Wilson said after listening to the presentation. ''You're taking a brand name and you're killing it.''

Long's response was that Doral's market share was so tiny that maybe killing it was more humane. Reynolds had to get into this area -- the so-called ''savings segment'' -- before Philip Morris did. Wilson still didn't bite.

Long returned later with Horrigan and made another pitch. ''Jerry, you're right most of the time,'' Wilson said after listening again, ''but you're sure as hell wrong on this one.''

Wilson wouldn't stop Long, but cautioned him to do a small test market. Sales took off. When Doral went national with an advertising campaign in the summer of 1984, Liggett's bluff had been called. The growth in generics stalled. Doral was a bona fide success, a confidence booster for a company looking for a way to make a comeback.

''Why buy this black and white package that looks like hell when you can buy this very attractive package?'' Long said. ''It was a recycled brand that turned out to be a great success.''

Out With the Old

J. Paul Sticht is now 82, a wealthy man, but a man with regrets. Chief among them is his firm belief that he got old too soon.

''Well, I just didn't have the time to carry out the whole program that I started, that is what I meant by that,'' he said. ''And I had to turn it over to people who obviously didn't have the same feelings about it that I did. But you know, that's their prerogative.''

In late 1983 and into 1984, Wilson began taking apart the Reynolds Industries he had inherited. Sea-Land went first. Still unable to find a buyer, Reynolds spun the company off to RJR shareholders in a separate offering. As part of the deal, Sea-Land paid Reynolds $400 million to settle part of its massive debt to its parent company. In early 1984, RJR began working on a deal to sell its Aminoil subsidiary. Phillips Petroleum bought the company in October 1984 for $1.7 billion, giving RJR $275 million in profit.

''We were kind of returning to our roots,'' Wilson said. ''We wanted to be a consumer products powerhouse with significant critical mass.''

Wall Street's securities analysts took notice. ''A lot of them had negative perceptions because they never really understood the company,'' Wilson said.

''The first guy got up and talked about tobacco. Then the next guy would get up and talk about natural gas and the Texas oil fields. These weren't energy analysts. And the next guy would talk about containerships. And yet we're sitting with a bunch of consumer-packaged-goods security analysts. A lot of those people who were very critical of us through the years suddenly became great fans.''

On June 4, 1984, Wilson landed on the cover of Business Week, complete with a photo and a splashy headline that read: ''The Consumer is King Again.'' Sticht barely got a mention, but the magazine gushed over Wilson's efforts to remake RJR into a lean, focused company.

Sticht fumed. By his reckoning, according to associates, Wilson was getting credit for programs that were already in the works or that Sticht would have done anyway if his age hadn't caught up with him.

''He obviously didn't like some of the things I was doing, or rather it brought to me and to the company accolades for things which should have been done a long time ago,'' Wilson said.

Sticht declines to discuss Wilson's tenure as chairman and chief executive. ''You haven't heard me say anything about Ty Wilson,'' he said.

Chunking the oil and shipping businesses did more than help boost RJR's stock price. It also gave the company a huge pile of spending money. Reynolds had $960 million in cash and short-term investments at the end of 1984, up from $117 million the previous year.

It was time to go shopping. Reynolds started Project Alphabet, and its corporate planners began tracking large consumer-products companies for performance and fit within the RJR system. The group included Campbell Soup, Kraft Foods, Quaker Oats, even what became Sara Lee Corp.

At the head of every list was Nabisco Brands. Its high-flying chief executive, F. Ross Johnson, would teach Wilson and his buddies a thing or two about office politics.

• Coming Sunday: In the Belly of the Beast