2 New Developments That Could Push Big Tobacco Much Higher

 |  Includes: LO, MO, RAI
by: The Independent Investor

Another day, another series of legal challenges for the tobacco companies. Is their any industry other than the tobacco industry where the legal and regulatory environment has been more treacherous over the last several decades?

While the big three, Altria (NYSE:MO), Reynolds (NYSE:RAI), Lorillard (NYSE:LO), faced their biggest legal challenges in the 1990s, the onslaught of constant civil litigation against these companies has continued. While the S&P 500 (NYSEARCA:SPY) has outperfomred most tobacco and other consumer staple names this year, most major U.S. tobacco companies have outperformed major index funds by a large margin over the last several decades.

While big tobacco settled with 48 of the fifty states in what is known as a master settlement agreement, and the federal government recently lost their attempt to seek large financial damages against big tobacco, challenges remain. As an attorney who follows markets and companies in this industry closely, I think it is interesting to look at how these latest legal developments may affect big tobacco.

The biggest regulatory challenge that big tobacco faces today is new and more intrusive regulation resulting from the 2009 Tobacco Control Act. The most significant final legal challenge that these companies face is small scale civil litigation from individual planitiffs seeking large punitive judgments. These cases have collectively been referred to as the "Engle cases." While it was not a big story in the press, big tobacco scored two huge wins on the regulatory and legal front over the past two weeks.

The first big victory big tobacco scored was winning the first Engle case at the federal level since the recent Florida ruling limiting pre-jury instructions on big tobacco's market and advertising policies. Over the last decades, individual plaintiffs have had an exceptionally easy time bringing and winning cases against big tobacco. Since the Florida courts had held several years that since big tobacco was found liable of false marketing and advertising, juries were to presume fraud on the part of these companies before the trial even begin.

This very favorable pretrial instruction emboldened many plaintiffs and their attorneys to bring low-cost litigation against the tobacco companies seeking large punitive damages. However, recently, in 2006, a Florida court reversed this finding, and found that plaintiffs who were not a part of the original class action suit against big tobacco would have to prove their case individually. Since this new, more industry-favorable ruling, big tobacco has won or had reversed about two thirds of the Engle cases that have been brought by plaintiffs.

These legal developments also make the latest Engle case extra important. The latest Engle case brought against big tobacco, which was the first time plaintiffs tried a case in federal court since the 2010 ruling, resulted in a big win for big tobacco. What is important about this ruling is the big tobacco has already been winning at the state level since the recent industry favorable ruling occurred in 2010. The latest federal ruling shows that the final wave of litigation being brought by individual plaintiffs may be coming to an end.

But what about regulation? Here, despite the legal successes big tobacco has had in recent years, there have been a number of setbacks. Under the recently passed Tobacco Control Act, the regulatory authority has been centralized with the FDA. While the FDA has been slow to put new rules into effect, they have sought some potentially negative new regulations, like mandating graphic warnings on tobacco products.

Here again, tough, big tobacco was able to win a big victory against the FDA at the federal level. Most federal and state regulation of tobacco companies and their products has been allowed by state and federal court because it has been seen as being done for the health and welfare of the general public. What is interesting about the recent big tobacco victory over the FDA on the question of graphic warnings is that it may signal a change in the way courts look at regulations of tobacco products.

Tobacco companies have always attracted a significant amount of attention from state and federal authorities because of the high number of health related illnesses related to the overuse of their products. Because of the health problems resulting from the use of tobacco products, state and federal authorities have sought to treat these companies specially.

While all companies, including alcohol and other producers of potentially harmful products, have had to disclose health risks to their products, even producers of some of the most unhealthy products, like alcohol and fast food, are not required to put special labels on the their products.

If big tobacco had been forced to put graphic labels on their products it would have signaled that a special set of rules applied to cigarette and tobacco products. The fact that the recent finding by federal courts that the FDA cannot compel speech by forcing the tobacco companies to put special labels on their products shows that courts will not allow the government to regulate the tobacco industry significantly different than other areas of the economy.

So, what does all this mean for investors and why is it bullish for the tobacco industry? If you look at the primary appeal of tobacco stocks, it is the company's dividends. While even the biggest of the big three tobacco companies, Altria, is growing its revenues, revenue growth has slowed to the single digits for all three of the these companies. With the U.S. tobacco market stabile but not growing, big tobacco has relied more on prices increases and cost cutting measure to continue to grow their revenue and raise their dividends.

These more favorable legal and regulatory findings for the industry have the potential to significantly lower the borrowing costs for the industry. While, obviously, big tobacco doesn't face the same legal and regulatory issues the industry faced in the nineties, the bonds of Altria, for example, are trading at 8-10% going out five years. A significant change in the legal and regulatory environment has the potential to moderately to significantly lower these costs. Altria's cost of capital to acquire UST just a couple years ago was nearly paid 8-10%.

To conclude, while investors traditionally value a stock using PEs, REIT and tobacco stocks are primarily about cash flow since their payouts are the most important reason most investors choose these companies. If the cost of capital continues to come down, it should give these companies the ability to refinance at lower rates and make it easer to borrow cheaper for new acquisitions, continue buybacks, and potential future dividend raises. These companies still significant litigation costs should come down as well.

While no industry has faced bigger regulatory and legal challenges than big tobacco over the last several decades, these latest developments could signal that the tide is starting to turn towards big tobacco. With state governments cash strapped the federal government looking for new revenue, these latest developments may be welcomed by others as well.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.