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Criticism by Republican leaders that McCain's bill is too onerous and will lead to a black market, combined with Senator Nickles intent to offer a "skinny" youth drug/tobacco bill with modest tax increase and no liability protections, will likely cause Senator McCain to water down his tobacco bill. Potential changes: Payments that are volume-adjusted; elimination of international provisions; partial credit for $6.5 billion liability fund; and explicit language that liability be contained within domestic tobacco.

The current McCain bill remains unworkable, largely because the five-year price increase needed (our estimate $2.78/pack) is far more than was originally projected by Treasury officials ($1.21/pack, both in constant dollars). We see an average retail price after five years of $5.06/pack, vs. Treasury's estimate of $3.21/pack. Major differences:Treasury omitted lookback penalties (adds $.44/pack), liability costs ($.50/pack), licensing fees ($.14/pack), and volume declines from outside factors ($.48/pack).

Second flaw:Treasury estimates a 29% reduction in teen prevalenceresulting from a 60% price hike, but only a 25% reduction in adult consumption-- prevalence plus quantity -- from the same 60% price increase. With adults 2 - 3x as sensitive to price increases as teens, either Treasury's estimates of teen smoking reductions are too high, or estimates of adult declines too low.

Mainstream Republicans continue to gravitate to the Gingrich/Nickles idea to embed tobacco within an overall teen drug and tobacco plan. Key elements: $.60-$.75/pack excise tax increase; raising the minimum age to buy cigarettes from 18 to 21; tough sweeping retail restrictions; narrowly-tailored ad restrictions; limited FDA jurisdiction; and no liability protections. We have also heard that Nickles, Gingrich, and apparently McCain are considering provisions that teens caught buying cigarettes pay fines.

President Clinton appears to have three options over the next few weeks:1) Endorse as his own the Nickles teen drug/tobacco bill with modest excise tax hike and no liability protections;2) Threaten to veto the skinny Nickles or Gingrich bills, allowing Democrats to tout the lack of progress on tobacco as a political weapon in the Fall elections;or 3) Back a scaled-down McCain bill, and pressure House leaders and the industry to accept a true $516 billion deal, with fewer liability protections than June 20.

We put very high odds on a favorable resolution in the Minnesota Medicaid case -- specifically, a $5 billion settlement ($1.7 billion present value) within the next 48 hours, plus $600 million in attorneys' fees based on actual hours worked to get around most-favored nations' clauses in other state settlements. We believe MN Attorney General Humphrey will accept the industry's demands that towns and cities not be able to bring claims. We see cigarette prices rising by $.03- $.04/pack to fund the deal.

We rate Philip Morris (price target $60), RJR Nabisco ($40), and UST ($40) outperforms. A $5.5 billion settlement in Minnesota, combined with a less onerous McCain bill with an explicit provision that limits liability to domestic tobacco, could dramatically improve sentiment toward stocks. New Wilner trial (Maddox vs. B&W) begins next week in Florida (3-4 weeks).

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The information set forth has been obtained from sources we believe to be reliable but is not guaranteed by us and may be incomplete. Such information and any views or opinions expressed herein are not to be considered as representations by us or as a prospectus or offer to buy or sell any security. Investment information supporting a recommendation of a specific security or materials upon which a projection or prediction are based are available upon request. Sanford C. Bernstein & Co., Inc. (the "Corporation") or one or more of its clients, officers, directors, stockholders, affiliates or employees may at any time hold, increase or decrease positions in securities of any company mentioned herein. The Corporation may provide investment management or other services for such companies or employees of such companies or their pension or profit sharing plans. Detailed

sides, we have reworked our industry volume and profit analysis of the McCain bill to distinguish between the endogenous effects (those arising from the bill itself) and the exogenous effects (those that occur whether or not there is a bill).

We agree with the Treasury economists that one should consider only the incremental, or endogenous effects on pricein costing out the McCain bill. Our analysis of the price rise needed to pay for the McCain bill now excludes ongoing state and federal excise tax increases, trade markup trends, and normal industry price increases -- all which would occur with or without a deal. But even excluding these outside factors, we estimate the industry will have to increase list prices by $2.78/packin constant dollars over five years to cover all the incremental provisions in the McCain bill. This, we believe, would trigger a massive black market unlike anything we have seen in this country, given current prices in Mexico of $1.00/pack, and average gray market Marlboros and other U.S.-made cigarettes sold on Indian reservations for $1.20/pack. Within five years, we estimate the average real price of a pack of cigarettes will be $5.06/pack-- up from the $2.00/pack benchmark at the end of 1998 used by Treasury. In contrast, Treasury economists estimate that the price increase in constant dollars over five years will be $1.21/pack, and that the average price for a pack of cigarettes in five years will be $3.21 -- a $1.85/pack difference vs. our estimates.

We have summarized the apparent differences between our analysis and Treasury's analysis in the following table. We cannot be 100% certain of the differences between our model and Treasury's, because Treasury officials, despite three months of pleading, refuse to provide us with anything more than a one-page "model" that contains five lines of summary information.

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Lookback penalties.Treasury omits from its pricing analysis the $3.5 billion annual lookback penalty under the theory that the industry can take appropriate actions to achieve the youth lookback targets. We, on the other hand, have 100% certainty that the industry will not achieve the youth lookback targets set by the McCain bill, and therefore include the $3.5 billion lookback caps as additional fees. In reality, the lookback penalties will likely be converted to excise tax surcharges that kick in if society (rather than the industry) misses its youth lookback targets, because constitutionally, manufacturers cannot be held responsible for illegal actions of retailers (Anheuser-Bush could not be fined if a liquor store sells beer to a 17-year old). Why won't the McCain bill reduce teen smoking? One, recent empirical research out of Cornell shows that raising price has virtually no impact on teen smoking rates. Two, smoking has become very cool again among youths, due in large part, ironically, to the government's efforts to get kids not to smoke. We strongly believe that if the industry stopped advertising

its products, and shut down in cigarette manufacturing operations in America, teen smoking rates would not fall. Under McCain's bill, the industry would be subject to a $2.4 billion per year penalty if teen smoking rates don't fall by at least 15% in 3 years, and an additional penalty of $3.5 billion if teen smoking rates don't fall by at least 20% thereafter (penalty capped at $3.5 billion/year once industry misses targets by 20pp). Because penalties are not tax-deductible, the actual pricing needed per year to cover the $3.5 billion in non-deductible payments is $5.8 billion, assuming a 40% tax rate. On estimated packs of cigarettes to be sold in Year 5, this would add $.44/pack to the per pack price.

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Liability cap. In addition to the $21 billion in base payments, the industry would have to provide funding for its $6.5 billion liability cap. Similar to the June 20 agreement, the McCain cap is more a liability fund than a cap, since the "unused amounts roll over" to the following year, according to the March 29 summary of the Chairman's mark. But unlike the June 20 agreement, the $6.5 billion liability cap would be in addition to the $21 billion in base payments. On the other hand, the June 20 settlement gave the industry a credit equal to 80% of the $5 billion liability cap, to be used for judgments or settlements for individual suits, which were not banned. The incremental cost of the cap in the McCain bill is $6.5 billion, vs. an incremental cost of the June 20 cap of $1 billion (20% x $5.0 billion). The chances of the McCain cap being busted are much higher than the June 20 agreement, since class actions, consolidations, third-party payer claims, and punitive damages would all be permitted under the McCain legislation. Under June 20, only actual individual damages would go against the cap.

iii).Licensing fees.The McCain bill imposes industry licensing fees of $1/thousand ($.02/pack) on volumes shipped or sold overseas. These fees are to be paid on domestic volumes as well, but the domestic fees would be credited against federal excise taxes. With the industry currently selling some 1.5 trillion cigarettes, or 75 billion packs of cigarettes overseas, this would impose additional costs of $1.5 billion per year, which rises to $1.8 billion in constant dollars by 2003 (year 5). Since foreign competitors would not be required to pay this $.02/pack upcharge, and since the U.S. manufacturers have little control over foreign pricing, the chance of recovering this increase in fees on volume sold overseas is very low. Therefore, we think it fair to assume that this fee would have be recovered in the U.S. market, where there is far more power over pricing, and all competitors are more or less in the same boat.

iv).Volume declines.As we said up front, it seems correct to ignore the exogenous cost factors that would occur anyway in totaling the overall price impact brought about by the McCain deal. However, that does not mean that one can ignore the underlying volume declines caused by those exogenous factors, since these exogenous factors would have an impact on the price per pack increase that would be needed to recover the incremental costs of the McCain bill. And yet, the Treasury analysis appears to ignore volume declines caused by all factors other than base payments -- which severely understates the price per pack increase needed to recover the incremental costs in the McCain bill. In assessing the real world risk of whether a black market will develop, or whether the industry will go bankrupt, one has to consider whether 17.7 billion packs of cigarettes will be sold in five years (Treasury estimate based on view that only volume declines from base payments should be considered), or 13.1 billion packs are sold (Bernstein estimate based on view that volume declines from all factors should be incorporated) -- otherwise the price per pack increase computed could be off by as much as 35%. Treasury also incorrectly calculates that cigarettes will account for 93% of payments, vs our estimate of a 98.3% proportion that would be allocated to cigarettes, based on the algorithm for adjusted units shown in S1415, Title IV, Subtitle A, Section 403. The use of incorrect volumes and incorrect mix together explain another $.48/pack difference between our numbers and Treasury's.

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On April 1, Senator McCain's tobacco bill was voted out of his Senate Commerce Committee 19-1. To get a bill out of Senate Commerce with a supermajority vote, McCain needed the support of the left -- particularly Senators Wyden and Kerry -- as well as the public health groups. To get this support, McCain had to include in his bill several items -- stronger lookback provisions, the requirement that any liability payments be incremental to the base payments, and a $1.00/thousand licensing fee on volumes shipped abroad -- all which served to push the list price increase needed even higher than the $1.10/pack increase supporting the $65 billion in new spending ($87 billion pre-offset) sought by President Clinton. But, the thinking went, as long as the industry got its liability protections, they would be able to stomach the final bill.

During the final 48 hours before the public unveiling of the McCain bill -- Saturday, March 28 to Monday, March 30 -- the tobacco settlement unraveled. The liability protections that had been so carefully crafted and were included in the bill as late as Friday -- bans on class actions for past behavior, consolidations limited to 5-10 persons, bans on third-party payer claims, no protections for individual punitives but a punitives sub-cap of $1.5 billion, a maximum award for individuals in any year of $1.0 million -- were stripped out, reportedly the casualty of two seemingly random events. First, House Speaker Gingrich was quoted in the Washington Post saying that he would not let President Clinton get to the left of Gingrich on tobacco. This, we believe, may have caused Senator McCain (who, like Gingrich, is rumored to be running for President in 2000) to conclude that neither Clinton nor Gingrich should get to the left of McCain on tobacco. Second, Dr. Kessler apparently called Senator McCain on Monday 3/30, and reportedly warned that if class action protections were included in the McCain bill, the health community would withdraw its support. On Monday afternoon, the liability protections were tossed overboard -- despite the fact that the original $368.5 billion settlement was, in effect, structured as a settlement of the industry's liability claims ($196.5 billion for third-party claims;$60 billion for punitive damage claims;$112billion for class actions and other liability protections) We believe Senator McCain's original intent was to get the bill out of the Senate Commerce Committee with the left and the Administration firmly on board, and then try to water it down sufficiently to pick up the industry's support before the bill reached the Senate floor. In hindsight, this appears to have failed because the terms of the deal as advertised-- $516 billion in payments over 25 years and limited liability protections -- were false. The McCain bill as structured would require payments and penalties of some $861 billion over 25 years:$516 billion in base payments, $120 billion in pretax equivalent lookback penalties, $163 billion in incremental liability funds, and $63 billion in licensing fees. These payments, penalties and fees would give the industry almost no liability protections:1) Settlement ofthe state AG cases, but only where states don't exercise their opt-out options (Note: If all 50 states opted out, the $861 billion in payments and penalties would not change);the industry would get no protections from other third-party claims;2) Settlement ofthe Castano addiction class actions;here, the same lawyers could turn around and file lung cancer, heart disease, and second-hand smoke class actions in the same states; and 3) A $6.5 billion liability cap, which could be lifted if the industry missed its youth lookback targets by 20% or more. Because the unused portion

of the $6.5 billion rolls over every years -- i.e. industry does not get this money back even if not used, the cap operates more like a liability fund that will encourage plaintiffs' attorneys to go out and round up claims. In our mind, the liability fund increases rather than reduces industry liability risks. We would prefer a straight $1.10/pack tax increase with no liability fund to McCain's bill.

Given the industry's anger and mistrust of the Washington political process, there is now almost no chance that the industry will return to negotiate with either McCain or the Administration on this specific bill. The only way to get a tobacco deal now may be to first kill the McCain bill, and then create an entirely new bill. This may come as a shock to Senate Commerce staffers who continue to try to water down the McCain bill as a way to bring the industry back to the table and bring mainstream Republicans on board. This suggests potentially two more bills being introduced on the Senate floor, depending on what President Clinton does. The first, if Clinton continues to keep his distance from the tobacco legislative process, would be the so-called skinny tobacco bill embedded in a comprehensive teen drug bill, to be championed by Assistant Senate Majority Leader Nickles. The second bill would look like the June 20 agreement but be more expensive and have fewer liability protections, and would probably come from Senator Hatch. This would fly only if President Clinton took the lead in suggesting that the industry be given limited liability protections. The liability protections would have to be similar to the McCain bill pre-Gingrich and Kessler warnings.

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Assuming Assistant Majority Leader Nickles introduces his skinny tobacco/drug bill, and Senator McCain waters down his comprehensive bill to try to get mainstream Republican support, President Clinton will have essentially three options:

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Embrace the skinny tobacco/drug bill that could be passed by the Senate, with modest excise tax increase, narrowly-tailored ad restrictions, limited FDA jurisdiction, and no liability protections. With Clinton's support, this should clear the House.

Threaten to veto the skinny tobacco/drug bill if passed by the Senate, and then blame the lack of progress on tobacco on Republicans. Democrats could then cast Republicans as more eager to protect Big Tobacco than protect kids' health.

Embrace the McCain II bill and try to convince mainstream Republicans to back it. If enough Republicans commit to backing McCain II, Clinton would likely call a tobacco summit to try to convince the industry to accept McCain II, which would be more expensive than June 20 and offer fewer liability protections. House leaders would be pressured to get on board.

Our view is that Clinton will choose Option #3. If McCain II doesn't make it out of the Senate, then Clinton can always embrace as his own the skinny Nickles bill (Option #1) that would probably pass in the House as well, even though it won't get Clinton his target $1.10/pack tobacco tax hike over five years. Option #2 has never made much sense to us -- i.e., using tobacco as a political issue against Republicans to try to take control of the House (226 Republicans, 204 Democrats, 1 Independents), although we hear that Democrats are ready to roll with advertisements that ridicule Republicans who have long accepted tobacco contributions. Our sense is that mainstream Republicans have found comfort in the results of the recent Wall Street Journal poll showing that combating teen-age tobacco use is far less important to the public than fighting teen drug use or alcohol use, and that the vast majority of Americans (70% to 20%) view the McCain bill as a big Washington money grab. In the end, the passive views of the public in the face of a tobacco feeding frenzy in Washington should give Republicans the cover they need to vote down a big government tax and spending bill such as McCain I or McCain II. And that, in turn, is likely to leave Clinton with no choice but to get behind the skinny tobacco legislation being championed by Nickles and Gingrich -- rather than get nothing. Either way, tobacco stocks should continue to rally from their 52-week relative lows reached last week.