(FORTUNE Magazine) – IT LOOKED LIKE just one more announcement in a year of many. In September, RJR Nabisco declared that it would end the practice in domestic cigarette distribution known as trade loading. A startling number was attached to this statement: The company, as a result, would forgo $340 million in operating profits this year. Even so, the news received only routine press coverage and could not have impressed most readers as having deep significance. But when you focus hard on what RJR has been doing over the past decade, it adds up to an earthshaker. Trade loading is a crazy, uneconomic, insidious practice through which manufacturers -- trying to show sales, profits, and market share they don't actually have -- induce their wholesale customers, known as the trade, to buy more product than they can promptly resell. RJR engaged in this practice aggressively enough over the past few years to overstate operating profits in its tobacco division by an estimated $250 million. The other five major U.S. cigarette producers were in this game also. In total the industry appears to have exaggerated operating profits by as much as $600 million. Unaware of this, shareholders were repeatedly misled. At least some outside directors had no idea that their companies were puffing up profits. One of the world's presumably savviest investors, Kohlberg Kravis Roberts, had only a fuzzy understanding of this problem when it agreed in late 1988 to buy RJR for a record-shattering $25 billion. And those who bought RJR's $4 billion junk bond offerings last spring were left in the dark. RJR executives do not deny that the practice of trade loading was misguided. That's why new management has stopped the game. Neither do they contest FORTUNE's estimate that the company added about $250 million to profits over the past few years. But RJR maintains firmly that the profits arose from legitimate sales, booked according to generally accepted accounting principles. The profits were spread across several years, executives point out, and were ''immaterial'' in relation to the huge operating income RJR was reporting -- $2.8 billion in 1988 alone. Besides, they add, trade loading is common in many industries, including food and beverages. As for last spring's bond issues, Robert Spatt, of Simpson Thacher & Bartlett, a law firm that represents KKR, says that disclosure of the trade loading was not called for. KKR was just then beginning to pin down the dimensions of the problem, he says, and had no notion it would culminate in a $340 million solution a few months later. Four of RJR's competitors -- Philip Morris, Brown & Williamson, Lorillard, and Liggett -- refuse to talk about trade loading, pleading antitrust problems, the confidentiality of their marketing strategies, and you name it. Philip Morris is the industry leader with about 40% of the market, and RJR is second, claiming it has upwards of 31%. Charles Mullen, the CEO of American Tobacco, the least active practitioner of loading, says he is glad to see this weed patch thinning out. The shame of trade loading is that so many businessmen, in and out of the tobacco industry, accept it as necessary if certain quarterly financial objectives are to be met or a particular picture painted for investors. But when a $340 million announcement like RJR's comes along, the practice is exposed for the gross deception it is. Whether this acute case of managed earnings amounts to a violation of the securities laws is another question. The management of earnings can be smelly but permissible -- or just plain illegal. The uncertainty in this instance brings to mind a Michael Kinsley line in the New Republic: ''When wrongdoing is exposed, the real scandal is what's legal.'' TRADE LOADING is a kind of economic treadmill. In the first step, manufacturers induce wholesalers to buy more cases of a product than they really need. The inducements -- price discounts, for example -- are called the ''push,'' and the wholesalers love them. Next comes the ''pull'' -- promotions at the retail level, also financed by the manufacturer, to help the wholesaler unload those mountains of boxes stacked on his floor. If you've ever seen $2-off stickers on a carton of cigarettes, you were looking at a pull. Pushes and pulls are costly enough for the manufacturer, but suppose he is trying to work this magic in a business like tobacco with certain troublesome characteristics. First, cigarette unit sales are declining in the U.S.; that makes the pull more difficult to pull off. Second, cigarette manufacturers must pay federal excise taxes of 16 cents a pack on the goods they ship to the wholesalers -- which means they automatically incur a sizable, up-front cost when they pad volume. Third, this industry has a full-return policy for cigarettes the manufacturer regards as too stale to sell, typically those that are six months old. When the bad stuff comes back, the manufacturer can at that point apply for an excise-tax credit. But in the meantime, of course, he has incurred the expenses of producing and inducing the sale of cigarettes destined to return to him. If he has managed this exercise well enough to show the bogus profits he is after, he will also be liable for income taxes he would otherwise not have to pay. Alas, this whole process is addictive to an extreme. If a manufacturer loads up the trade in the fourth quarter of year A and thereby inflates sales, profits, and unit shipments, he will, in the interests of continuing to look good, be powerfully tempted to repeat the exercise in the fourth quarter of year B. In an industry showing unit growth, he might settle for simply matching the first year's load. If the industry is declining, or if the manufacturer is losing ground to a despised competitor -- as RJR has been doing to Philip Morris -- he is apt to be seduced into increasing the load year after year. By this strategy he disguises the extent to which he is losing both his customer base and market share. Hearing about trade loading recently, Clifford Mullen, an excise-tax expert in the U.S. Treasury, sized up the facts and cut through the smoke: ''It's like getting in with a loan shark.'' The huge trade loading numbers that RJR disclosed on September 21 suggest that the company's tobacco managers had long been scrambling to avoid broken thumbs. For perspective, consider that the current management believes 4 1/2 days of stock at the wholesale level, or about two billion cigarettes, to be ideal. But at the start of 1989, RJR had an excess of 18.5 billion cigarettes sitting in customer warehouses, or close to six weeks of surplus supply. Through a combination of forces -- the normal runoff of trade inventories, some reduction in shipments by RJR, and more returned cigarettes than usual -- the excess had been cut to about one billion cigarettes by the day of the company's announcement. But had the company followed its past practice of loading up the trade at the end of both the third and fourth quarters and of repeatedly upping the ante, by early 1990 the excess inventories would have been back up to a high number, perhaps even more than 18.5 billion. Enough! the new management decided. We will not ship this load. Thus, it quit cold turkey. These facts illuminate the financial equation: If not shipping 18.5 billion cigarettes this year is going to both eliminate the excess load and deprive RJR of $340 million in earnings, it follows inexorably that shipping that many excess units in prior years produced millions in earnings that were essentially artificial. Because these profits were realized when cigarette prices were lower than they are today, an estimate of $250 million for misbegotten past earnings seems reasonable. RJR does not disagree with the figure, although it hardly accepts the characterization. The company concedes, and wholesalers confirm, that RJR was the biggest perpetrator among the six big U.S. manufacturers. A reasonable estimate for its competitors' trade load might be close to four weeks of goods, or nearly 30 billion excess cigarettes. FORTUNE estimates that these companies recorded at least $350 million in bogus operating profits as the load was piling up. Put these two chunks together and you have a $600 million tobacco scam. It is hard to say how many more dollars might have been added to that pot had not new management come in at RJR and new priorities taken over. As a heavily indebted company, RJR needs cash flow more than reported earnings. In the management change, KKR installed Louis V. Gerstner Jr. as chief executive last April, and one of his first steps was to bring back James W. Johnston to run the U.S. tobacco division. Johnston, 43, a former RJR marketing executive, left in 1984 for a job at Citicorp. A TALL, outgoing smoker -- he dispatched nine Salem Lights during a two-hour interview -- Johnston had not liked trade loading when he was originally at RJR. Though ''management disagreements'' was the official explanation for his departure, a colleague who quit soon after -- ''I said, jeez, if somebody that good is leaving, I'd better get out of here too'' -- reports that the disagreements included trade loading, which Johnston unsuccessfully opposed. He liked the practice even less when he came back last June, and this time he was in a position to stop it. If the current management at RJR knows the exact speed at which the trade load grew, it is not telling, but the popularity of the sport clearly accelerated in 1982. At that time RJR was obsessed with preventing Philip Morris from overtaking it in market share, and the cigarette industry was hitting its watershed in the U.S., with unit sales starting to decline. The companies were also faced with a doubling of federal excise taxes to 16 cents a pack in January 1983. Wholesalers loaded up on inventory in 1982 trying to beat the tax, and so did retailers and smokers. Thus a sort of trade loading bogey was set for future years. The industry then settled into a pricing pattern that all but institutionalized the load. Before 1983 the manufacturers had raised prices periodically but on no fixed schedule. In that year, however, they posted an increase in June and another in December, and they have never budged from that timing since. The wholesalers quickly caught on, loading up like gangbusters before each increase so they could resell the cigarettes to retailers at the new, higher prices. Now addicted themselves, the wholesalers even began to build these increases into their budgets. By orchestrating this smokefest, the manufacturers were condoning and encouraging the load, willingly sharing their profits with the distributors in return for this nice, big ''trade-driven'' fix in the June and December quarters. That left the March and September periods to be managed. For these the producers devised ''manufacturer-driven'' loads, induced by special price discounts and favorable payment terms. The overall result: alpine shipping peaks toward the end of the second and fourth quarters, smaller peaks at the conclusion of the first and third (see chart). The two men calling the shots at RJR tobacco were Edward A. Horrigan Jr., who under various titles ran the business from 1980 to early this year, and his next in command, Gerald H. Long, who retired in 1988. Long, 61 and chatty in retirement, ventures that RJR's distributor inventories were at five billion cigarettes by 1984. But he also says that as the trade load grew, the company lost a handle on how big it was, becoming uncertain as to how many packs were piling up in wholesale warehouses, as opposed to ''selling through'' at retail. His comments relate to an industry mystery: the actual level of retail sales, in total and by brand. Definitive figures simply don't exist because so many cigarettes are bought at mom and pop shops and newsstands where there is no scanner technology for counting sales. Nonetheless, the tobacco companies speak authoritatively about market share, typically without conceding the haziness of the consumption statistics. Or they use manufacturers' shipments to wholesalers -- which is a known figure -- as their base. The absurdity of that statistic when trade inventories are becoming gigantic is obvious. In its statements to shareholders between 1984 and 1987, RJR was cheerily chronicling market share, pointing out how it rose from 31.5% in 1983 to 32.5% in 1987. In the back of some annual reports, though not all, shareholders learned those percentages were based on manufacturers' shipments. Trade loading was never mentioned as a reason for the share increase. Spacing out his words, Jerry Long says, ''Maintaining a 32% market share was a very, very primary objective.'' Why? ''Because then our comment could be that we had approximately one-third of the market,'' he explains. That figure was important to retailers, he says, in deciding how much display space to award a manufacturer, and it was important to Wall Street analysts. ''Nobody worried whether it was artificial,'' Long says, adding that analysts never poked into the percentage, questioning whether a share point or two might be trade loading. Despite his brand loyalty to 32%, Long says he and Horrigan did from time to time discuss reducing the trade load, which was becoming exhaustingly expensive to carry. It created production peaks and valleys as RJR went into overtime to make its quarterly loads, and then slackened off. The push and pull expenses were enormous in the face of declining unit sales, and returns, always costly to handle, grew. Horrigan and Long understood the pathology of the load problem, but like smokers planning to quit, they could never find the right day. Then in 1987, Ross Johnson, a tiger for cost control, replaced Tylee Wilson as CEO. Rather than confronting this burning issue, Johnson seems not even to have noticed the blaze. He says that for more than a year after becoming boss, he did not know there was a trade loading problem. Long believes Johnson's attention was fixed elsewhere: ''My friend Ross said, 'Jerry, you have one great big major objective, and that's producing over $300 million a quarter in operating profits.' '' Doing that, according to Long, was not consistent with reducing trade loading. Nor, it can be noted, would reducing the load have allowed RJR's executives to make the most of the company's generous incentive compensation schemes. WHEN LONG RETIRED in early 1988, he still hadn't found the right day. But Horrigan, ready to seize the moment, asked Long's successor, Dolph W. von Arx, to get the monkey off RJR's back. Von Arx had come from Thomas J. Lipton, where tea was trade loaded. But RJR's cigarette business presented him with what he called a double whammy: declining unit sales in the overall market and slippage in RJR's market share. He had apparently noticed that the 32.5% share was not a solid figure. Though he didn't have a precise count, von Arx believes RJR's excess load at the beginning of 1988 might have been around 14 billion, a choking number. So in the first quarter he constructed a three-year plan for gradually bringing it down. Shipments would necessarily be cut, but the higher prices that the industry was constantly imposing on smokers would keep sales and earnings rising.

Von Arx presented his plan to Johnson and Horrigan, and they, he says, ''bought in.'' The RJR board of directors heard about the program, getting their first intimation, it seems, that trade inventories were too high. Treading delicately, the company told Wall Street to expect some reductions in shipments -- though not, Horrigan pointed out, any cuts in retail market share. With that, von Arx put distributors on allocation in the second quarter, so that they could not load up heavily in advance of the June price increase. They howled. But by the end of the quarter, von Arx had the trade load down to perhaps ten billion units. Soon after, his three-year plan was derailed by the biggest buyout in history. On October 20, Ross Johnson and a management group that included Horrigan announced their offer to buy the company and sent KKR and a host of other prospective purchasers scrambling. By December von Arx had left the tobacco division to become CEO of another RJR operation, Planters LifeSavers. Horrigan, meanwhile, was maneuvering to keep his job in a KKR regime. The load problem was neglected. RJR did not put the trade on tight allocation in the fourth quarter, and as 1989 began, the load was up to 18.5 billion units. NONE of the prospective buyers of RJR grasped the dimensions of the trade loading, and some plainly didn't have a clue. Says one investment banker today who played a leading role in the buyout: ''Trade loading? I don't know what that is.'' Another key investment banker checked with his staff and found out that it had examined the issue in the due diligence process. Management told the banker's staff that loading was probably a $100 million problem, no more. Von Arx says he thinks the best-informed shopper was Brian Little, of the buyout firm Forstmann Little. Little, whose firm eventually withdrew from the bidding, recalls today that he came to think of trade loading as a ''troubling, nagging, but known element,'' defended by management as necessary. He adds, ''I'd say we knew there were several hundred millions of dollars out in the field that one could say weren't really sales.'' And what about the special committee of RJR directors set up to do its own due diligence and assess the buyout proposals? Says one of the committee's five members, who asks for anonymity: ''I don't recall trade loading coming out.'' Did he think that 18 billion cigarettes in trade inventories, quarterly make-your-numbers loads, and efforts to maintain market share artificially should have been subjects for the board's audit committee at some time? No, he says, ''that wasn't an audit committee matter. It was a board matter. That's something that smacks of manipulation.'' Ernst & Young, which was RJR's auditor until March 1989, when KKR moved the account to the firm it usually engages, Deloitte Haskins & Sells, declined to be interviewed on grounds that it does not discuss any client's affairs.

As for KKR, Simpson Thacher's Robert Spatt says that when KKR went into the buyout negotiations, it knew from articles in the press that wholesalers loaded up on cigarettes before price and excise-tax increases and that RJR indulged in the practice. The firm learned more in the due diligence discussions, in which RJR's managers took the position that this ''accumulated load'' was something they were going to deal with. Says Spatt: ''I don't think KKR -- and quite frankly, I don't think the company at that time -- really knew the precise number. I think everyone knew that it was a big number, a big problem. But I don't think the perception was that it was quite as large as the company ultimately reported.'' In any case, he says, KKR did not regard this issue as something that affected its opinions about the fundamental value of RJR. Immediately after KKR completed the first stage of its buyout in February 1989, it again heard about trade loading. Word came not from Horrigan, who was unsuccessful at impressing the KKR crew and had retired, but from RJR's chief - financial officer, Edward J. Robinson, who has since taken the same job at Avon. Said Robinson to a KKR representative: ''What do you want to do about trade loading?'' Spatt says the KKR man responded, ''We're not in any position to tell you what to do. We are not tobacco operators. We need to get a management team in place, and when we do, we'll make a decision how to deal with this.'' On April 3, Lou Gerstner's first day on the job, he met with his tobacco managers in Winston-Salem to talk over problems and issues. First on the list was whether to kill Premier, the smokeless cigarette that Horrigan and Ross Johnson had backed -- and that tasted so bad, according to the joke, that nobody would even steal it. Gerstner pronounced the death sentence and moved on to the other problems, which included trade loading. It didn't seem like a big deal to him, Gerstner now says -- ''it still doesn't, in fact'' -- but it hung in his mind as he went forth to recruit the man he really wanted to run his domestic tobacco business. That was Jim Johnston, who found the RJR challenge ''irresistible.'' A component of the challenge, the two men agreed as they talked, was trade loading. Arriving at RJR on June 1, Johnston got reports of three- and five-year plans to bring down the load and thought even three years was too slow. By July 1 he had the wholesalers on allocation. He also tried immediately to determine how big the load was, but found the job difficult. Some sales and marketing people were telling Johnston it was 13 billion, others 15 billion. Johnston then sent salesmen into every customer's warehouse, he says, to count cases with hand-held calculators. Hearing reports that some wholesalers had run out of room in their own warehouses and rented space elsewhere, the salesmen tried to track down that merchandise as well. When the roundup was finished, there was that numbing number of what Shakespeare called ''thou weed! who art so lovely fair and smell'st so sweet,'' which is not exactly the odor Johnston detected. By this time Johnston was coming to grips with statistics on returned cigarettes. In 1988, a year in which RJR shipped 177 billion smokes, about 2.5 billion, or 1.4%, were shipped back by wholesalers. This year, says the company, the percentage will be higher, though it declines to give figures. A spot check of a big smoking state, Texas, reveals that RJR, with its ''one- third of the market,'' accounted for 43% of returns from June 1988 to June 1989. ^ The worst problem about returns is what they imply about cigarettes that have not been returned. Inevitably the warehousing of smokes for long periods leads to confusion about which block of inventory came in first and must be sold first so that it won't get stale. Johnston says that RJR has had problems with stale goods hitting the market and irritating smokers. The staleness quotient was on his mind as he deliberated how to deal with the load. Johnston first decreed that it would have to be eliminated by no later than the end of 1990. Then, lying awake one night, he thought, ''We've got to get on with this.'' Early next morning -- the date was Wednesday, September 13 -- he called Gerstner and said he was considering axing the load ''right now,'' assuming the management group agreed that sudden action was feasible. By Friday morning, when Gerstner arrived in Winston-Salem for a previously scheduled meeting, the group's conclusion was yes. Gerstner had KKR's approval by that time and he gave his own. ''It was not,'' Gerstner says, ''a hard decision.'' ONE THING making it relatively easy was Johnston's discovery that the effect on 1989 cash flow will be ''slightly positive'' -- or something under $20 million -- because of the cost savings that can be realized, for example, from smoothing production schedules and reducing push expenses. Post-buyout, RJR is a prodigiously leveraged company whose interest costs will prevent the showing of earnings for some time but whose needs for cash are intense. So in theory the disappearance of $340 million in reported earnings matters less to it than the unlocking of a chunk of cash. The move to forgo that much all at once also has the look of a big bath. Reducing the load over time would have strung out the financial effects, creating a drag on sales and earnings and perhaps dismaying creditors. Not that they appear totally thrilled today: Many RJR bonds, afflicted by junk bond disease, have recently skidded. The decision to kick the loading habit has cleared Jim Johnston's agenda of a huge distraction and allowed him to reorder his spending. Money that used to go to the trade in the push will now be allocated directly to consumer promotions; time that RJR's salesmen used to spend stroking wholesalers will now be lavished on retailers. His organization, says Johnston, can sense the benefits ahead. He talks like a man from whom a huge load has been lifted, no kidding: ''What we have done is a real statement of change in emphasis and direction. There's probably no single thing I could have done that would have energized the place as much as I think this has.'' Johnston's move has given the rest of the tobacco trade a nicotine fit. RJR's announcement on September 21 came too late to affect the third-quarter load programs of its competitors. On that very day Philip Morris notified wholesalers of a price promotion. By now, however, the other five companies have played follow-the-leader, putting the wholesalers on allocation. That implies they too will be renouncing the load or at least cutting it back. If they stick to that intention, their fourth-quarter tobacco earnings will suffer. Lorillard, controlled by the cost-conscious Tisch family, has indicated to Wall Street that a decrease is an acceptable trade-off for being suddenly freed from a type of peer pressure it never liked. Philip Morris cannot be as pleased, since it needs reported earnings from its tobacco side to offset the goodwill write-offs arising from its Kraft merger. But the real pain may fall on Brown & Williamson, a division of British-American Tobacco, the company under attack from Sir James Goldsmith. From BAT's standpoint, this is hardly a convenient time for B&W to stop padding its earnings. But how can it do otherwise, when the realities of trade loading are now in public view? The truly excruciating withdrawal pains are falling on the distributors. They have treasured trade loading -- ''grown accustomed to its charms,'' says one. Many, in fact, would be breakeven operations or money losers if they did not get a quarterly surge from the load. Says Peter Strauss, a New York distributor and industry leader: ''Take those profits away without giving us something in their place and you've got blood in the streets.'' Some drops are already visible. Word is around that a troubled LBO company, Southland, owner of the 7-Eleven convenience stores and five distributors that serve them, is having poor luck selling off its distributors because their profits depend so heavily on trade loading. For RJR, trade relations are apt to be an immense problem, and Johnston agrees that some fence mending will be required. But he hopes to announce by December an innovative trade program that will reward wholesalers in new and acceptable ways. THE MORE CRITICAL issue for RJR may be convincing some close readers of its filings with the SEC that they have not been misled. From March 1989 until * September, RJR published one 10-K annual report, two 10-Q quarterly reports, one merger proxy, and three bond prospectuses. In the quarterlies, RJR noted that ''a program to reduce field inventories'' had contributed to lower unit volume in 1989 but said nothing else about trade loading. The other documents described 1988 results and included just one sentence on trade loading. It said one reason cigarette volume fell during the year was a program ''to realign trade inventories.'' Would not a reader assume from that explanation that trade inventories had fallen, instead of rising to 18.5 billion cigarettes? The proxy and prospectuses also repeated that 32% market share figure, as in ''domestic market share for 1987, measured on manufacturers' shipment basis, increased to 32.5%.'' Spatt, KKR's lawyer, defends the wording totally: ''The market share figure is correctly stated and so is the comment about trade inventories. Without the 1988 program to bring these down, the year's shipments would have been higher and the load at the end of the year would have been greater than it was.'' Jim Johnston talks about market share figures these days too, but with extreme care. He says RJR believes its share of sales at the retail level is about 31.6%. Next year, assuming that the damned spot called trade loading has been rubbed from RJR's smoking jacket, cigarette shipments and sales will be roughly equal -- and then perhaps we will know who has or hasn't got a third of the market.

CHART: NOT AVAILABLE CREDIT: SOURCE: THE TOBACCO INSTITUTE CAPTION: A NICOTINE FIX EVERY QUARTER This information is derived from the number of packs on which distributors pay state revenue tax. The pattern shows how they load up at the end of each quarter.