By Philip Gorham
After taking control of tobacco regulation in 2009, the U.S. Food and Drug Administration (FDA) is investigating the use of menthol in cigarettes. Its tobacco panel, the Tobacco Products Scientific Advisory Committee (TPSAC) is due to report its findings by March 23, 2011, and the FDA will issue a binding ruling after that. We envision three ultimate outcomes: menthol is banned (6% probability); no action is taken against menthol (16% probability); no ban, but tighter regulation (78% probability).
With a ban on menthol a potential outcome, investors have reason to harbor concerns about the future of Lorillard (NYSE:LO), the maker of Newport menthol cigarettes.However, based on our conversations with anti-smoking lobbyists, FDA officials, tobacco executives [including Altria (NYSE:MO) CEO Mike Szymanczyk and Lorillard CFO David Taylor], and representatives of smokers' rights groups, we think a ban is unlikely for the following reasons: The scientific evidence being considered by TPSAC is ambiguous; A black market for menthol cigarettes could emerge, limiting the FDA's ability to oversee the category; Tax revenues for governments at all levels would be impacted; Eighty percent of African-American smokers consume menthol products, so this issue has a racial component.
On the other hand, the anti-tobacco lobby is vociferous, and with the TPSAC being stacked in favor of individuals with anti-smoking positions, we view the status quo as a very unlikely outcome as well.
To exploit the uncertainty in the menthol category, we've outlined three investment strategies across multiple securities and risk thresholds:
- Debt: Buy Lorillard bonds. The credit market appears to be pricing in a worse scenario than the equity market, even though we think a bankruptcy scenario is highly unlikely.
- Equity: Wait for headline risk to provide an entry point. A negative TPSAC report could provide an attractive entry point to Lorillard's equity, which appears to be valued on a probability-weighted basis.
- Paired equity trade: Buy Lorillard, sell Reynolds American (NYSE:RAI) stock. Lorillard's stock should rally harder in the absence of Draconian measures, while a short position in Reynolds should cushion the blow in the event of a ban because we think it will not be able to retain the majority of its revenue from Kool menthol cigarettes.
Setting the Stage: The FDA Investigation Into the Use of Menthol in Tobacco
The FDA assumed regulatory control of the tobacco industry after the passing of the Family Smoking Prevention and Tobacco Control Act (FSPTCA) of June 2009, and immediately stamped its authority on the industry by writing legislation. One of the agency's first targets has been the menthol category, which represents around 30% of the U.S. cigarette industry. The Tobacco Products Scientific Advisory Committee TPSAC, a subcommittee under the FDA, is expected to report its findings from an ongoing investigation into the use of menthol in tobacco products on or before March 23, 2011.
TPSAC is investigating the public health impact of menthol cigarettes. Its final report will summarize its conclusions into the scientific evidence behind some of the accusations made about menthol from opponents. These include the physiological effects of menthol use in tobacco; patterns of menthol smoking in the United States; the marketing of menthol products and its impact on initiation, addiction and cessation; and the effects of menthol on smoking-related diseases.
FSPTCA gives the FDA wide-ranging authority to control the components of tobacco products, to ban categories of tobacco products (but not to ban tobacco outright), and to impose stricter marketing restrictions. However, the recommendation on the regulation of menthol from TPSAC will be nonbinding. If the TPSAC report concludes that menthol causes additional damage to public health above that caused by non-menthol products, the FDA may draw upon these conclusions to restrict the use and sale of menthol products. However, the final decision on what, if any, sanctions should be imposed on the menthol category lies with the FDA, and the agency could, in theory, choose to ignore TPSAC's recommendations. The FDA faces no time deadlines for implementing any measures following the TPSAC announcement.
Lorillard has the most to lose from a menthol ban, which would have minimal impact on our valuation of Altria and Reynolds. Based on company disclosures and recent trends, we estimate that the menthol category represented exactly 30% of the total U.S. cigarette retail volume in 2010. Of that, we estimate that Lorillard accounted for 36% (with Newport representing 35% of the category), Altria had a retail share of around 18%, and Reynolds American 12%. At over 90%, Lorillard has by far the most exposure as a proportion of revenue to menthol of any of the leading manufactures. In fact, while a menthol ban would be very disruptive for Lorillard, we calculate that such an outcome would have a minimal impact on Altria and Reynolds, particularly if menthol smokers switch to non-menthol products within the same brand family. Imperial Tobacco (NYSE:IMT) holds a very small market share in the U.S. and British American Tobacco (NYSEMKT:BTI) has an investment in Reynolds, but neither firm has enough exposure to the U.S. menthol category to move the needle on our fair value estimates in the event of a menthol ban.
Assessing Potential Outcomes: We Expect Manageable Restrictions
The ultimate fate of the menthol category will be decided by a two-stage decision process within the FDA. First, TPSAC will make its recommendation to the FDA in March, and we anticipate several potential outcomes from the TPSAC panel findings. The panel could recommend a ban, recommend less severe measures, ask for more time to investigate, or recommend no further measures against the menthol category. Then, the FDA will make a final decision that may not necessarily be in line with TPSAC's recommendation. We expect middle-of-the-road measures, such as controls over the composition of cigarettes. This would allow the FDA to be seen as taking steps against an activity that is harmful to public health, while avoiding the creation of a black market and hurting government revenues. In short, we anticipate three potential outcomes from FDA regulation.
Outcome 1: Menthol Is Banned
We view an outright ban as a low-probability outcome. TPSAC could cause a stir by making a recommendation that leaves the door open for the FDA to impose some Draconian measures, but ultimately, we think the issue is too politically sensitive for the agency to impose a ban.
The scientific evidence is ambiguous, making a ban difficult to justify. Conflicting evidence has been presented to TPSAC relating to the impact of menthol on the initiation, dependence, and cessation of smoking. Nonnemaker et al (2010) presented evidence that youth smokers who initiated smoking with a menthol product were both more likely to become daily smokers and demonstrated a higher level of dependence than those who initiated through non-menthol cigarettes. Hersey et al (2010) found that the smoking of menthol cigarettes was associated with "significantly higher" nicotine dependence. With regard to cessation, Delnevo and Gundersen (2010) concluded that menthol smokers are "significantly less likely" to quit than smokers of non-menthol products. On the other hand, Muscat (2010) found no difference in the levels of cotinine (an alkaloid found in tobacco that can be used as a measure of exposure to tobacco smoke) and lung cancer risk between mentholated and non-mentholated cigarettes. Unger, Cruz and Allen (2010) discovered no significant differences in the plans or ability to quit of smokers of menthol versus non-menthol cigarettes. If the validity of the tobacco companies' evidence is upheld, we think it would be difficult for the FDA to justify a ban on menthol given that the scientific evidence is unclear.
A black market likely would emerge if menthol were banned, along with some adverse consequences for public health. Cigarettes are addictive because they contain nicotine, so smokers find it difficult to quit, even in the face of rising prices. According to the American Council on Science and Health, 70% of smokers want to quit, 40% make a serious effort each year to do so, but only 5% succeed. There is a close correlation between retail cigarette prices and U.S. industry demand, and we estimate the R2 to be 0.98 (98% of the total drop in demand is explained by price increases). We calculate the price elasticity of demand to have been negative-0.35 in the U.S. since 1978, which indicates an inelastic demand curve.
With these statistics in mind, we doubt that demand for menthol cigarettes in the event of a ban would evaporate; the mentholation process is likely to go underground. Smokers could buy regular cigarettes and add menthol either in crystallized or liquid form. Worse still, black market traders could create menthol cigarettes using a similar process on a large scale. This could have two important unintended consequences:
- The FDA would lose control over the cigarette black market. The regulation of the content of tobacco products was one of the primary reasons the agency was given regulatory authority over the industry in the first place. Nonregulated suppliers would have the ability to adjust the levels of addictive substances in illicit cigarettes.
- Youth smoking rates could increase. Evidence from Canada, where high excise taxes have led to a large black market (around one in three cigarettes in Canada was smuggled into the country from the U.S.) suggests that unregulated markets increase the ability of young smokers to access cigarettes through the nonregulated black market.
Regardless of TPSAC's recommendation, there are political components that will prevent the FDA from issuing a ban. The head of the FDA, Margaret Hamburg, was an appointee of President Obama, and we suspect she will come under political pressure not to alienate a key voting bloc for Democrats, particularly with the Presidential election looming in 2012. This is also a racially-charged issue, as menthol is popular among African-American smokers. According to the U.S. government's 2008 National Survey on Drug Use and Health, 80% of African-American smokers favor menthol products. We think the FDA will come under political pressure from the Obama administration not to implement a ban in order to avoid alienating a core voting bloc.
And governments would lose a significant amount of tax revenue. We estimate that taxes from menthol cigarettes contributed around $13.5 billion to federal, state, and municipal government revenues in 2010. The loss of this revenue would be a painful blow to governments struggling with fiscal deficits. It also will be impractical to ban one third of the cigarette market. Menthol represents around 30% of the total U.S. cigarette industry. It is a $23 billion dollar annual business, and a ban would impact around 14 million American smokers.
Finally, a ban would provoke resistance from convenience store chains. Cigarettes represent around one third of sales at convenience stores in value terms, more than any other product in the store, and about two thirds of tobacco sales are made at convenience stores. If some menthol sales are lost to illegally imported products through the black market, convenience store sales will decline, and lower traffic could increase the impact of a ban. We expect the National Association of Convenience Stores to lobby hard against a ban.
Therefore, we think much more benign measures are the most likely outcome when the FDA makes a final decision. Such sanctions could include tighter marketing restrictions and reduced menthol and/or nicotine levels.
Outcome 2: No Action Against Menthol
We do not expect the menthol category to escape without any form of sanctions. The composition of TPSAC is heavily skewed toward members with anti-smoking backgrounds, including chairperson Jonathan Samet, a tobacco control expert. The tobacco industry is represented by only three of the 12 panel members. We suspect that both TPSAC and the FDA will wish to be perceived as taking measures to clamp down on smoking for public health reasons, so we think some measures against menthol are likely. We give the outcome of no action against menthol just a 5% probability of occurring, as we've outlined in our decision tree later in this report.
There are many anti-tobacco lobbying groups, many of which lobby for an outright smoking ban. We spoke to Joel Spivak at the Campaign for Tobacco-Free Kids, who told us that his organization would attempt to steer the debate over menthol toward the public health impact of the marketing of menthol products to youth and minority groups. We believe this is a question that goes beyond the arguments over science, and muddies the waters when it comes to the impact of menthol. We expect TPSAC to leverage the attempts by this vociferous organization to highlight marketing malpractices as justification to recommend stiff measures against the tobacco industry. In turn, we think the FDA will find it difficult to ignore the social issues.
Outcome 3: No Ban, but Tighter Regulation
Potential sanctions could be focused on reducing addiction. The levels of nicotine and/or menthol could be reduced, particularly if TPSAC finds that menthol increases the likelihood of commencement, or the difficulty in cessation, of smoking. The financial impact of such measures on manufacturers is difficult to forecast, but we would be likely to materially lower our medium-term volume forecasts in the event of any regulations that reduced the addictiveness of menthol cigarettes.
Greater marketing restrictions are another potential outcome. This would be particularly likely, in our view, if the panel concludes that menthol is an additive used to attract youth smokers. In June 2010, the FDA enacted new requirements relating to the sale and distribution of all tobacco products, including the prohibition of both free samples and the sale of cigarettes through vending machines. We think it is likely that the FDA will pursue similar regulations for menthol products, and potential sanctions could include the prohibition of menthol tobacco sales within certain distances from schools. This, in our opinion, would slightly lower the long-term volume growth of manufacturers, and potentially bring forward the tipping point in the industry when manufacturers are no longer able to raise prices at a rate faster than volumes fall. However, in the medium term, we think it would have a very limited impact on volumes.
A reduction in nicotine and/or menthol levels is another feasible outcome. The FDA has the authority to write regulations to control the content of tobacco products. Any reduction in nicotine levels in menthol cigarettes likely would reduce the addictiveness of those products, and we may lower our longer-term assumptions for all U.S. manufacturers as a result. A reduction in menthol levels won't have a material impact, in our opinion, as it is not likely to encourage smokers to quit.
TPSAC could recommend further studies into the effects of menthol. Given the conflicting evidence the panel has been presented with so far, this is a realistic outcome. This, in theory, would leave the threat of a ban still on the table, and we would expect the sword of Damocles that has been hanging over the menthol category since the FDA announced its investigation to remain in place. Lorillard's equity could continue to trade at lower multiples than it would without the looming threat of a ban, but we would not change our assumptions.
The impact of these outcomes are the most difficult to quantify. We assume that revenue growth from menthol products slows to a low- to mid-single-digit rate from 2012 under these circumstances, although we may adjust these forecasts depending on what actions are recommended by TPSAC and on the time frame for implementation
Investment Strategies to Exploit Menthol's Uncertainty
We believe there are ways for investors to capitalize on the uncertainty over menthol by utilizing several strategies involving Lorillard securities. We expect even the most severe of outcomes to have little impact on the financial performance of both Altria and Reynolds, with 13% and 12% of revenue derived from menthol cigarettes, respectively. Both firms derive most of their menthol revenue from brands that are better known for their non-menthol products -- Altria with Marlboro and Reynolds with Camel -- and we expect a significant number of smokers of Marlboro and Camel menthol to switch to the non-menthol lines of their preferred brands. For Lorillard, however, the range of outcomes is wider, and we think the bond market is pricing in an outcome that's too disruptive. We've outlined three investment strategies across multiple securities and risk thresholds:
Investment Strategy 1: Buy Lorillard Bonds
Lorillard's senior notes look cheap enough to buy now. Lorillard’s credit metrics are the strongest of the tobacco companies, and in fact the credit metrics are stronger than those typically associated with an average BBB issuer. Both our Cash Flow Cushion and solvency scores are comparably rated due to the firm's strong interest coverage and low debt leverage. However, based on the investigation and wide range of possible outcomes, the rating is constrained until the outcome is known. This uncertainty has led to the notes trading at the widest credit spreads within the sector.
Based on our outlook for a relatively benign outcome, we think the risk/reward profile is attractive on a probability-weighted basis. For example, the 6.875% senior notes maturing 2020 currently trade at plus-310 basis points, well above Altria's at 9.25% 2019 senior notes at plus-182 and Philip Morris International's (NYSE:PM) 4.50% 2020 senior notes at plus-77. If TPSAC recommends anything less than an outright ban, we think the bonds could tighten over 100 basis points to plus-200 which is an 8.5 point gain. In the event the TPSAC recommendation is more severe than we expect, based on our downside scenario, the bonds could widen to plus-400, which is behind where BB bonds currently trade, resulting in a 5.25 point loss. With the risk/return profile currently being skewed toward upside potential, we recommend buying the senior notes today. In the event that the uncertainty is dragged out and TPSAC requests more time, we do not anticipate downside on the bonds.
Investment Strategy 2: Wait for Headline Risk to Provide an Entry Point
Relatively benign restrictions are likely to have little impact on our fair value estimate of Lorillard's equity. We expect the final outcome from the FDA's investigation into menthol to be relatively benign, because of the political pressure we think the FDA will face. Marketing and input restrictions are likely outcomes, in our opinion, and while these would probably impact long-term volumes, depending on the extent to which they limit addiction or marketing, they should allow Lorillard to continue to function in its current form. It is plausible, however, that TPSAC will recommend a ban. This would, in our view, send the stock tumbling, presenting a buying opportunity for investors who do not believe a ban ultimately will be implemented. We think the probable creation of a black market and the damage caused to government tax revenues will be enough to dissuade the FDA from implementing a ban, regardless of TPSAC's recommendation. Therefore, we are sticking with our $88 per share fair value estimate, which assumes a steeper decline in revenue and a quicker contraction in operating margin in the outer years of our explicit forecast period than in our upside scenario, in which no sanctions are taken against menthol.
It appears that the market is currently baking in a realistic probability-weighted valuation. As the following decision tree shows, the current market value of $78 per share approximately reflects what we consider to be a reasonable probability-weighted valuation of the company's stock. Based on our belief that fairly mediocre sanctions ultimately will be taken, this implies upside of around 15% from current levels. However, we recommend that investors keep some powder dry in the event of a negative TPSAC recommendation.
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Investment Strategy 3: Buy Lorillard Equity, Sell Reynolds American Stock
A paired trade idea: Buy Lorillard and sell Reynolds American. If our thesis of a fairly benign outcome from the menthol investigation plays out, Lorillard's equity should rally. With over 90% of its revenue dependent on Newport menthol, Lorillard clearly has the most to gain from the avoidance of a ban on the additive. We think the stock is slightly undervalued, and an upside catalyst from our fair value estimate of $88 per share would be that TPSAC recommends that no action be taken, albeit a highly unlikely scenario. In our expected scenario, we expect no impact to either Altria's or Reynolds American's market value, as menthol is a much smaller proportion of their revenue and income, and their broader product portfolios give the bigger players more opportunities to keep former menthol smokers within their brands. Even in our upside scenario, we do not expect the two larger firms' market values to be materially impacted. However, with the stock trading at 13 times our 2011 earnings per share and almost 1.2 times our fair value estimate, we think Reynolds has much less upside potential than either Lorillard (undervalued) or Altria (fairly valued). Reynolds derives just 12% of its revenue from menthol cigarettes, the least of the three largest manufacturers, so in theory, has the least to gain from a benign outcome. Therefore, we recommend Reynolds as the short position in a paired trade with Lorillard.
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