Smoke Screen; 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.

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.

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.

SUPPLY CHAIN REACTION

But the bar code is primarily used to scan each carton or pack of cigarettes when it is sold by a legitimate retailer. If a pack has fallen into the hands of an illicit distributor, Philip Morris won't be notified.

Indeed, the bar code doesn't even tell either the retailer or the manufacturer how the pack ended up at the point of sale. Right now, it tells Philip Morris only that a product has been sold and at what price, but not with much specificity. It's merely a "Marlboro carton" or a "Marlboro pocket box" or "Marlboro wraparound soft box."

No carton or pack has a unique identity. "There's precious little information that can come from the bar codes," Holleran says.

What happens between the time the cigarettes are packaged and shipped to distributors and when a customer plunks down $5 at the 7-Eleven store for a pack of smokes is the enormous gap Philip Morris must fill if it wants to avoid paying heavy fines in Europe.

PMI and PM USA each has more than 1,000 distribution partners scattered throughout the globe. Philip Morris brands can be found at just about any supermarket, drugstore or sundry shop in the world.

"We don't have perfect traceability right now," Holleran explains. "After a point, the shipments between retail locations get lost and the system falls apart. It's a similar situation at Philip Morris International. At some point, we can't track them all."

At this point, aside from UPC bar codes, PMI and PM USA in the past decade have done little in concert to improve the traceability of products in their supply chains.

Some factories do apply an ink-based code to the exterior of cartons that can tell Philip Morris where and when the cigarettes were manufactured, Holleran says. However, that's mainly a quality-control feature that helps track down the source of inferior cigarettes after customers complain about the product's taste or freshness.

The system the EU wants PMI to put in place would require an overhaul of the supply chain overseen by the tobacco company. The mandate requires PMI to identify the date and place of manufacture of every pack of its cigarettes with embossed markings on the packaging. The information on the packages - both cartons and individual packs - must be able to identify the manufacturing facility, the individual machine used and the production shift.

The settlement also requires PMI to identify the country of intended destination on each pack. PMI must also build and maintain a database of all pack information for the European anti-fraud investigating organization, OLAF, to identify products found in any seizure - and their last known purchasers. This data, which would allow investigators to identify exactly which distributors have received Philip Morris shipments, must be available online 24/7.

During the 12 years of the settlement, PMI is required to carry out research and supply a yearly report on new technologies to improve the tracking and tracing of its cigarettes.

The settlement does not include a specific deadline by which this new system would have to be installed. However, intermediate deadlines have been imposed on associated projects to help fight cigarette smuggling. Thus far, though, it appears PMI has failed to meet these basic requirements.

A database containing the names, addresses, phone numbers and contacts of all PMI distributors was to be made available to OLAF by Oct. 9, 2004. But according to the European anti-fraud office, PMI has yet to deliver this first-purchaser database.

The agreement also requires PMI to develop a database of second purchasers - those who buy cigarettes from the first level of distributors - and provide quarterly reports to OLAF on second-layer tracking. That would include the names, addresses, phone numbers and contact information of retailers or other distributors who buy PMI cigarettes from the first-purchaser distributors. No deadline was set for the second-purchaser database.

Company executives declined to comment on the status of the first- and second-purchaser databases. However, a former Philip Morris executive who didn't want to be identified said that the company has all of the first-purchaser information, including distributor names, addresses, and phone numbers, in a database. That database, he told Baseline, is connected to the SAP business software applications that Philip Morris uses to manage its distribution network.

MAKING THE CASE FOR RFID

While still unproven on a large scale in distribution of consumer packaged goods, the technology is widely used to track the movement of cars going through toll booths, and in similar applications where radio tag readers can be fixed in place.

Using it to track a pack of cigarettes from factory to sales outlets on seven continents to each individual customer raises a host of issues. Even if the tags could be produced at a cost similar to that of the cellophane wrap on a package, how many readers would be needed and where would they be put to maintain control of the supply chain?

Still, more data can be encoded on an RFID chip than in a standard bar-code strip, making it possible to track every pack. Compared with a 12-digit standard UPC, the 28-digit Electronic Product Code (EPC) being promoted for use with RFID has much more information-carrying capacity. An EPC can contain the same company and product information as a UPC and still have room left over for a serial number that uniquely identifies an individual object. In a track-and-trace scenario, that serial number could be used to identify a product shipped for sale in Switzerland that is turning up in New York instead.

According to Holleran, Philip Morris in the U.S. and in Europe has spent millions to examine how RFID technology could be implemented into its supply chain.

Philip Morris, however, isn't providing details. "We don't talk about it at all for security reasons, but we are monitoring all options that pertain to tracking and tracing our products," Holleran says. "But at this point, we haven't implemented anything beyond the standard bar codes that are applied to all our products."

One of the first decision a company like Philip Morris would have to make about RFID would be how to track cigarettes by the carton.

Attaching tags to each box is time-consuming. Holleran says PM production lines can crank out more than 14,000 a minute. Thus far, all tracking and tracing systems tested by the company slow down production.

How fast is not fast enough?

"We can't comment on how much these various systems would slow production," Holleran says. "But it's significant."

The tags would assign each carton a unique identity that would include its location of manufacture, date and time of production, intended sales destination and price.

After a tag was affixed to each carton, the carton would then be scanned by a reader at the end of the production line and the data would be entered into the company's supply chain database. The cartons would then be shipped or flown to authorized distributors in, say, Germany or South Dakota, where they would again be scanned to ensure the right products and quantities were ready for distribution.

RFID readers would then need to be installed at each distribution location. So when that shipment of 50,000 cartons of Marlboro cigarettes manufactured in Switzerland arrived at the port in Antwerp, Belgium, the distributor and customs officers could scan each carton as it arrived or spot-check cartons in the large "igloo" containers to ensure they were sent directly from the PMI manufacturing site.

Once the authenticity of the cartons was validated by the readers, the cartons would then be assigned their appropriate tax and import duty fees before being distributed to second-tier distributors or directly to retail locations.

Eventually, RFID scanners could be found at receiving docks at each retail location and, ultimately, checkout lanes.

This station-by-station data collection, from one distributor to another and possibly another before arriving at a retail location, could be fed into PMI's enterprise resource planning and customer relationship management software systems. This would give Philip Morris greater insight into where and when products are being sold and resold - and help it better gauge demand and the impact of marketing efforts in various regions.

With such a system, local and national law enforcement agents could theoretically take any carton of Philip Morris cigarettes and scan it with a handheld reader to determine when and where the carton came from and whether it had been taxed appropriately. Rather than manually wave a scanner across each item, as is necessary with bar codes, they could verify the identify of products high up on shelves, using radio signals from across the room.

SAP, Altria's primary business software vendor, is participating in the movement toward RFID by partnering with RFID hardware makers, working with Altria's customers to figure out the implications of the technology, and adding capabilities for tracking RFID-generated data to its software platform.

But Amar Singh, SAP's vice president of global RFID and business development, says even the early adopters are still figuring out where RFID makes sense. "RFID is theoretically better than bar codes in every respect. If cost were no object, RFID would win hands-down," he says.

But, of course, cost is an issue, as is the broad deployment of RFID readers. In addition to costing $500 to $1,000 each, RFID readers need to be tuned for the places in which they operate. For example, a reader at a receiving dock door must be tuned so it doesn't accidentally retrieve codes from products arriving at an adjacent door.

Tags remain an even more fundamental hurdle. Where applying a bar code might cost a fraction of a cent, an RFID tag and the label to contain it can cost 40 or 50 cents - or more - even in volume (see Gotcha! p.44).

"I can't think of any company that in the next few years is going to go 100% RFID," Singh says. "In some cases, bar codes are still going to be more practical and more effective for a long time to come."

Which is why even Wal-Mart isn't demanding that its suppliers apply RFID tags to individual packages at this point. According to Singh: "In most cases, because the cost of the tags is so high, they're looking at it more for the case level or the pallet level."

On the other hand, the pharmaceutical industry is seriously looking at RFID tracking of individual bottles of pills, particularly controlled substances, Singh says.

The U.S. Food and Drug Administration (FDA) gave its blessing to leading drug makers early last year to invest in RFID systems for tracking and tracing drugs to prevent counterfeit medications from entering the supply chain. The FDA says the adoption and common use of RFID to track and trace a variety of products through the supply chain will be "feasible" by 2007.

Take the addictive painkiller OxyContin, which began being illegally "diverted" to drug dealers in the late '90s. Its maker, Purdue Pharma of Stamford, Conn., started shipping 100-pill bottles, with RFID-enabled tags, to Wal-Mart and wholesaler H.D. Smith in mid-November. Purdue also plans to tag bottles of its new painkiller, Palladone. New York-based Pfizer plans to use tags to track its erectile dysfunction medication, Viagra, and GlaxoSmithKline of London says it will begin tagging various drugs within the next year.

The FDA's reach has also extended to the food-services supply chain to ensure meat, fish and agricultural products are safe as part of the Bioterrorism Act of 2002. And in Europe, the EU Food Safety Law, scheduled to take effect this year, requires the traceability of food, livestock and any substance incorporated into them through all stages of production and distribution, including records detailing to whom the products were sold or distributed.

"It's not overkill for pharmaceutical products," Singh points out. "But obviously if you were going to put a 30-cent tag on a $1 retail item, that's a 30% increase in cost."

A breakthrough in manufacturing, such as making tags from organic polymers rather than silicon, could dramatically lower cost and broaden use of RFID, Singh says.

When a tag is a penny a pack or so, RFID technology could be used to help cigarette makers and other manufacturers prevent counterfeiting. If a maker or distributor loses track of a known pack with a known ID, it can trace where the item left the supply chain and close the leak. If cartons or cases with duplicate codes pop up, that should set off alarms that counterfeiting is taking place. If a pack with a code assigned to a specific country shows up in another, that would be a sign of smuggling.

ALWAYS LOOKING, NEVER DOING

Altria has been reluctant in the past to move to more advanced and expensive technologies, say experts such as Wolfgang Partsch, co-author of the book Supercharging Supply Chains, and John Thorpe, former managing director of the product security division of Swiss security firm SICPA.

Philip Morris and other tobacco firms previously investigated another, arguably simpler, technology for tracking cigarettes that uses special ink markings on packages. The state of California is planning to implement the system this year to uniquely identify every pack of cigarettes that enters the state legally, which will help authorities combat the smuggling of cigarettes to avoid state taxes. California will use the high-tech ink to replace the standard adhesive stamps, which smugglers find easy to duplicate.

SICPA, a producer of anti-counterfeiting inks for currencies including the U.S. dollar, offers a variation on that technology that places unique markings on the packaging of high-value or highly controlled products. Tobacco and alcohol were among the first markets it targeted, says Thorpe, who set up SICPA's product-security division in the U.S. eight years ago.

"Any company that makes anything that is high tax, and therefore the target of criminals, is a potential good customer for us," Thorpe says. Initially, he saw the opportunity as preventing interstate smuggling within the U.S. Tobacco companies were also interested because they thought they might be required to implement a track-and-trace system to combat smuggling as part of the class-action lawsuit settlement they were negotiating with state authorities. But when the settlement, announced in 1998, didn't include that requirement, their interest cooled, he says.

Originally dubbed Project Hawkeye and later named SICPATrace, this system uses a form of bar code covertly printed on product packaging with inks that are invisible to the naked eye. It has a sophisticated matrix of dark and light squares, placed in a crossword puzzle-like pattern. Like an RFID tag, this printed code is capable of storing far more information than a standard bar code. But unlike an RFID tag, it requires no electronic components - just ink.

With SICPA's approach, a Pocket PC-based scanner can read thousands of codes at a time, storing the identifiers in the handheld computer's memory. But although the codes are machine-readable, this technology doesn't have the range of RFID - the scanner needs to be held within about 6 inches of each product to read its code.

Yet Thorpe argues this would be an economical and practical option for spot-checking merchandise - potentially down to individual cigarette packs. A serial number encoded on each item, and recorded in a database along with sales and tax history data, would provide track-and-trace capability.

Even with a limited selection of products scanned, Philip Morris employees and government officials would be able to use the absence of the code as a clue to possible counterfeits. If the code were present, a search of Philip Morris' database could detect smuggling - products turning up in New York or London that were recorded as sold for distribution to some low-tax area.

Philip Morris got as far as testing SICPA technology on simulated production lines in the U.S. and at PMI headquarters in Switzerland. The company later stated in a letter to the International Conference on Illicit Tobacco Trade, which met in New York in summer 2002, that the package-marking technology would not function at the speed of its production lines.

"Typically, modern cigarette packing equipment operates at between 450 and 700 packs per minute," the company wrote. "Accordingly, the development of a reliable marking system at such speeds is technically quite challenging. As far as the costs of such systems are concerned, clearly any discussion is academic until a feasible system is developed."

Philip Morris USA's Holleran says the implementation of SICPA technology or any other plan to improve the tracking of cigarettes would not be used if it slowed down production.

But Thorpe insists it would have worked. "We achieved all of the requirements that were set out for the system," he says. "They would have done anything to discredit the system at that point."

What it suggests to him is that the tobacco companies aren't really interested in solving the smuggling problem, preferring to remain ignorant of what happens to its products once they leave the warehouse.

After retiring from SICPA in 2000, Thorpe was approached by anti-tobacco groups such as Europe's ASH (Action on Smoking and Health) and agreed to speak publicly about his experience with the tobacco companies. His point was simply to counter the tobacco industry's argument that there is no practical, affordable technology that can cover the entire supply chain.

He suspects Philip Morris would rather fiddle with RFID for a few more years. With SICPATrace, he claims, "You could track and trace every single pack of cigarettes in the world today, and it would cost about one penny a pack."

THROUGH THE SMOKE

Meanwhile, in the six months that have passed since the EU settlement was signed, Ian Walton-George, head of the customs unit for the European Anti-Fraud Office, says little has changed.

"We're still seizing thousands of cigarettes every day somewhere in Europe," he says. "We've seen a slight decline in the amount of genuine cigarettes smuggled, but it's still a major problem."

As for the landmark pact between the EU and Altria, Walton-George says, thus far, it's been all talk and no action.

"To my knowledge, we have not been presented with a database of first-purchaser customers from Philip Morris International," he says. "Whatever improvements they've said they'll make in tracking and tracing cigarettes, we don't know anything about them yet.

"We're just hoping this agreement will be a first step to improving tracking and tracing," he adds. "I know they're talking about RFID, but so far no one has seen anything. In the past, we didn't even talk to Philip Morris. At least we're talking now."

Thus far, PMI is the only cigarette manufacturer to hammer out a deal with the EU. Other tobacco makers such as Reynolds International are still subject to civil litigation in the U.S. and in Europe for allegedly conspiring with known cigarette smugglers to sell more cigarettes into international markets.

Even the best information system can only protect a supply chain so much, say fraud trackers such as Walton-George. But that doesn't remove responsibility from Altria or any other cigarette manufacturer.

"It comes down to aiding and abetting," says John Boatright, professor of business ethics at Loyola University in Chicago. "Generally, it comes down to who knows what and when. Philip Morris controls its supply chain and is aware of its sales, so it can't say it's ignorant to what's going on."

Back at Kennedy Airport, ATF senior special agent Joe Green and roughly 100 colleagues spent the better part of two weeks stacking and recording hundreds of thousands of Philip Morris cigarettes. Each of the 100,000-plus customers who were expecting an oversized manila envelope stuffed with two cartons of Marlboro cigarettes would instead receive a letter from the U.S. Customs Service informing them that their order had been seized.

"These smugglers are stuffing these igloos, these huge containers, full of thousands of white bags with dozens of manila envelopes inside them and flying them in from Europe every day," Green says. "You have to see it to believe it."