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Business Context and Reporting Period

This Form 10-Q covers the quarterly period ended June 30, 2010, for Altria Group, Inc., a Virginia corporation. The company operates primarily through its wholly-owned subsidiaries: Philip Morris USA Inc. (cigarettes and smokeless products), UST LLC (smokeless products and wine), and John Middleton Co. (cigars and pipe tobacco). Additionally, Altria holds a 27.2% economic and voting interest in SABMiller plc. The financial statements are unaudited and reflect the consolidation of UST, acquired in January 2009.

Key Financial Metrics

Material Changes vs. Prior Period

• Revenue Growth: Net revenues increased 7.0% year-over-year, driven primarily by higher pricing related to the April 2009 federal excise tax increase, partially offset by lower cigarette volumes.
• Profitability: Net earnings increased 16.0% to $1.855 billion. This was driven by higher operating income, a lower effective tax rate (29.5% vs. 37.7%), and lower interest expense, partially offset by lower earnings from the SABMiller investment.
• Segment Performance:
  • Cigarettes: Operating income increased 4.3% despite a 5.9% decline in shipment volume, due to price increases and cost reductions.
  • Smokeless Products: Operating income doubled (100%+ increase) due to volume growth and significantly lower exit/integration costs compared to 2009.
  • Financial Services: Operating income declined 70.4% due to lower gains on asset sales compared to the prior year.
• One-Time Items: The company recorded a $169 million reduction in tax-related receivables from Kraft Foods and Philip Morris International, which was fully offset by a corresponding tax benefit. Asset impairment and exit costs were $28 million in 2010 compared to $166 million in 2009.

Guidance, Outlook, and Risks

• 2010 Guidance: In July 2010, Altria raised its full-year 2010 diluted EPS guidance to a range of $1.81 to $1.85 (previously $1.78 to $1.82). This reflects higher projected earnings from operations and net tax benefits. Adjusted diluted EPS is forecast to grow 7% to 9% over 2009.
• Dividends: The quarterly dividend was increased to $0.35 per share (2.9% increase), with an annualized rate of $1.40. The target payout ratio was raised to approximately 80% of adjusted diluted EPS.
• Key Risks and Contingencies:
  • Litigation: Significant tobacco-related litigation remains pending, including "Engle progeny" cases in Florida and "Lights/Ultra Lights" class actions. Management believes an unfavorable outcome is not probable for pending tobacco cases but notes the uncertainty of litigation.
  • Regulation: The company faces ongoing regulatory challenges from the FDA under the Family Smoking Prevention and Tobacco Control Act (FSPTCA), including marketing restrictions and potential new product standards.
  • Tax Matters: The IRS has challenged tax benefits related to PMCC leveraged lease transactions. Altria intends to file a claim for a refund of approximately $945 million related to these transactions; if disallowed, it could materially affect earnings.
  • Excise Taxes: Continued state and federal tax increases are expected to adversely impact sales volumes.

Investor Verification Checklist

• Verify the impact of the $169 million reduction in Kraft/PMI tax receivables and the corresponding tax benefit on net earnings.
• Monitor the status of the IRS challenge regarding PMCC leveraged lease tax benefits and the anticipated $945 million refund claim.
• Review the progress of "Engle progeny" litigation in Florida and the potential for adverse verdicts or settlements.
• Assess the impact of FDA regulations (FSPTCA) on marketing costs and product launch capabilities.
• Confirm the sustainability of cigarette volume declines versus price increases in the core Cigarettes segment.
• Track the integration cost savings from the UST acquisition against the projected $300 million target by end of 2011.