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A cautious outlook from tobacco giant

Philip Morris

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sent its shares tumbling 13% Tuesday and dragged down the entire sector as worries mounted about an influx of cheap and illegal cigarettes.

In a conference with investors Tuesday, Philip Morris reaffirmed its 2002 earnings growth estimates but said it couldn't confirm 2003 projections because of soft volume in the domestic tobacco industry.

Shares of the New York-based company plunged $5.74, or 13%, to $37.24 on the news while rival

R.J. Reynolds

( RJR) skidded 11% to $37.73.

Loews Corp.

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slid 12% to $17.69.

Kraft Foods

( KFT), in which Philip Morris has an 84% stake, fell 5% to $37.55.

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Investors had expected Philip Morris to produce earnings growth of between 8% and 10% next year, but CFO Dinyar Devitre said the company could not affirm that guidance, citing a flood of both cheap imported cigarettes and counterfeit cigarettes.

He did note, however, that the company still intends to generate between 3% and 5% earnings-per-share growth in 2002 due to strong performances in its international tobacco business and worldwide food business.

In September, Philip Morris slashed its full-year outlook amid weak demand for its premium-priced brands. The firm had originally forecast earnings growth of between 9% and 11% this year.

David Kathman, an analyst at Morningstar, said earnings growth could fall to around 5% next year.

"This is a continuation of the issues that have been going on since the middle of this year," he said. "It's been dragging on longer than they thought but they're not going to cut prices."

Although Philip Morris is expected to spend money on promotions and temporarily lower cigarette costs, Kathman doesn't believe there will be any longer-lasting price reductions.

"I think some of this is a question of enforcement but the authorities have started to crack down," he said, referring to the illegal sale of cheap cigarettes on the Internet and elsewhere.

Higher taxes and greater spending on anti-smoking campaigns mandated by a 1998 state tobacco settlement have forced Philip Morris to raise prices sharply in recent years. But with the economy slowing down, consumers have become increasingly price-conscious.

Philip Morris derives around 90% of its sales from premium brand cigarettes like Malboro and only about 10% from discount brands, according to Kathman. R.J. Reynolds, on the other hand, receives about 60% of its revenues from premium brands and the rest from discount names.

Kathman noted that brand-loyalty among cigarette smokers tends to be strong and he believes discounters are more likely to be hurt by the influx of cheaper cigarettes. For that reason, he feels that R.J. Reynolds is more at risk than Philip Morris.

"Malboro smokers are more loyal and are less likely to switch to a no-name brand," he said.

Adding to Philip Morris' recent woes is a California jury ruling that ordered it to pay $28 billion to a woman with lung cancer for failing to warn her of the dangers of smoking. The company has appealed the verdict, and most experts believe the penalty should be drastically reduced.

Philip Morris expects to provide guidance for the full-year 2003 when it reports fourth-quarter and full-year 2002 results in late January.