Gary Black: Vuja De -- Industry Moving Ahead With Plan B. Raising Estimates. Outperforms MO, RN, UST.


TOBACCO

Vuja De -- Industry Moving Ahead With Plan B. Raising Estimates. Outperforms MO, RN, UST.

Gary Black (212) 756-4197
Jon Rooney (212) 756-4504

July 9, 1998

HIGHLIGHTS

  1. Sources on both sides indicate that the industry will soon announce the settlement of all remaining state attorneys general claims, at a cost of $180-$200 billion over 25 years, and requiring an approximate $.35/pack price increase over five years. We believe the industry will convince at least 40 of the remaining 46 states to buy into the program, which could be announced by August.
  2. The new state settlement, which would contain the youth access and marketing provisions found in the Minnesota settlement, would give Republicans political cover to say that the teen smoking problem is being addressed by the states -- hence, federal actions (i.e., excise tax increases) are not needed. Rather than fight it, we believe President Clinton would take credit for the deal.
  3. A comprehensive mult-state settlement, combined with continued favorable rulings by federal and state courts banning class actions in tobacco cases, would, according to lawyers involved, permit the separation of domestic tobacco from non domestic tobacco assets. This would reduce bankruptcy discounts on tobacco, and permit sum-of-the-parts valuations on parents’ assets.
  4. One major challenge that appears to have been overcome involves new entrant risks. The AGs would agree to release from legal risks only retailers who sold product by parties to the protocol; carrying non-protocol product could subject the retailer to new lawsuits by the state. In its state settlements, Liggett Group has agreed to match any price increase required by a national deal.
  5. One big loser in a state-only settlement would be the FDA, which would get no jurisdiction, and cause the health community to cry foul. We expect the conservative 4th Circuit panel that heard the FDA re-arguments in June to toss the FDA issue back to Congress -- i.e., if Congress wants the FDA to regulate nicotine as a drug, then Congress should modify the 1938 FD&C Act.
  6. We believe the timing on the announcement of a state only settlement has been accelerated to give the state AGs some bragging rights for their own reelections in November. Incentives for the AGs to sign up: 1) Money offered is 3-5x the actual amount of state claims; 2) Industry will stop advertising and merchandising voluntarily, via consent decree, 3) Price of cigarettes will rise by $.35/pack only in states that take the money and the agreement; and 4) 41 of these state AGs backed the original June 20 accord.
  7. We are raising 1999 and 2000 estimates (MO: 1999 +$.05/share, 2000 +$.10/share; RN 1999 and 2000 +$.10/share; UST no change) to reflect the lower settlement-related price increase ($.35/pack) in the state-only scenario, vs. prior forecasts ($.60/pack over five years). We have trimmed 1998 estimates (MO -$.03/share, RN -$.05/share) to reflect a smaller inventory load in 1998.
  8. UST is likely to participate in a state-only settlement to the tune of $.03-$.05/can over five years, but not have to pay any portion of the up-front costs (likely $10 billion out of total $180 - $190 billion, spread over 5 years), since it was not in most AG claims.

INVESTMENT CONCLUSIONS

We reiterate outperform ratings on Philip Morris, RJR Nabisco, and UST. With odds of onerous tobacco legislation essentially dead for this year, and with prospects for an improving litigation environment -- clearly-defined precedent banning class actions likely; new evidence that appellate courts will uphold statute of limitations and preemption rights; much easier state Medicaid trials ahead even if there is no state-only settlement -- we believe valuations will return to normal ranges, which implies an 80% relative multiple on MO, 70% relative on UST, and a 60% relative multiple on RJR. The announcement of a 50-state settlement, combined with continued favorable precedent on class actions, should permit separation of domestic tobacco and non-tobacco assets, which would permit much higher sum-of-the-parts type valuations. Our 6-12 month price targets remain Philip Morris $60, RJR $40, and UST $40.

ADDITIONAL DETAILS
  1. Ready or not, here comes Plan B. Based on discussions we have had with counsel on both sides, the industry appears to be moving full speed ahead with plans to announce a state-only settlement to eliminate all remaining state AG actions, at an all-in cost of approximately $180-$200 billion over 25 years. We now expect this announcement to come sometime late this Summer, after Congress adjourns for its August recess (August 7), but well before the November elections to both give the attorneys general up for reelection bragging rights, and to give Republicans political cover that efforts to reduce teen smoking are being pushed to the state level; and hence, no federal action is needed. We expect to hear more about this plan in the coming weeks.

The total cost of this deal, excluding new funds needed to settle AG claims with the remaining 47 states, $36 billion in costs already agreed to in MS, FL, TX, and MN, and the $6 billion in additional funds we estimate are needed under most-favored nations (MFN) clauses in MS, FL, and TX based on Minnesota’s settlement (Mississippi announced Tuesday that it would get $550 million more upfront; based on Minnesota’s up-front amount), would be in the $180 - $200 billion range over 25 years, which would be fully volume adjusted. On a cents per pack basis, the industry would have to raise prices by $.35/pack over five years to pay for the state-only settlement (probably an additional $.20/pack, since the industry has already taken $.15/pack in settlement related pricing). We expect the upfront piece of this new program to be $6-$7 billion.

Industry and outside lawyers with whom we have talked about this deal perceive that if the industry can get: 1) something close to a 50-state settlement that eliminates AG actions and makes it highly unlikely that there will be other government actions; and 2) a paper trail of state court rulings that class actions are not appropriate in tobacco cases, following the precedent of four federal courts and one state court (federal courts in Missouri, Puerto Rico, Pennsylvania, 5th Circuit in New Orleans; state court in D.C.), the industry would have the flexibility to separate domestic tobacco from other assets. We point out that BAT’s demerger of tobacco and insurance has not received a single fraudulent conveyance challenge. This scenario of new AG settlement and favorable rulings on the class action front, of course, would a) reduce bankruptcy discounts; and b) permits sum-of-the parts valuations.

While details are still far from resolved, the following concepts appear to have been tentatively resolved:
    • The four states that have settled (MS/FL/TX/MN) already would not be affected. Florida and Texas would receive another $5 billion or so over five years in "up-front" money (these two states received $1.3 billion in up-front funds) to adjust for MFN clauses that were triggered by the MN settlement (Mississippi’s adjustment announced on Tuesday). The total costs over 25 years for the four states having settled would be a revised $42 billion over 25 years (up from $26 billion over 25 years). These up-front costs have been treated so far as below-the-line (non-recurring) charges by the companies and investors.
    • The other 46 states, which account for 83% of Medicaid expenses for smoking-related diseases, would be offered their shares of the June 20 agreement that was to go to the states - their share of $10 billion in upfront money, and $186.5 billion in ongoing payments over 25 years. This would imply total additional payments, if all states took the money, of $165 billion (83% x $196.5) over 25 years. There would be some additional funds allocated to make all states perceive they were getting favorable terms. The ongoing payments for all 50 states, which go into operating company P&Ls, would begin at around $4.0 billion in 1999, and ramp up to $8.0 billion within five years. This would require a $.175/pack increase in 1999 -- most of which has already been taken -- rising to $.35/pack by year 2004.. The total settlement fund would be revised down for states who choose not to participate (for example, the $8.0 billion steady-state payment would fall to $7.2 billion if states with 10% of Medicaid population decline to settle).
    • All payments would be volume adjusted. There would be no lookback penalties or FDA regulation. The marketing restrictions would likely be those from the Minnesota agreement -- no billboards, no in-store merchandising, no branded merchandiser, no sponsorships. Trademarks such as Marlboro Man and the Camel would still be permitted in ads.

When we first heard of the concept of a state-only settlement, the biggest concerns we had about a state only-settlement were: a) absence of a renegade provision preventing new entrants or those who choose not be part of the settlement from selling cigarettes at $.35/pack less than those involved in the settlement; and b) how to prevent the counties and states from suing the tobacco companies.

To dissuade new entrants, the AGs would agree that retailers who carry products by non-protocol manufacturers -- those who don’t agree to the advertising restrictions or other terms of the settlement -- could still be sued, as would the non-protocol manufacturers themselves. Retailers who believe they could be sued for carrying non-protocol product might think twice before carrying a non-protocol product. Second, payments in every settling state would be based on company market share, and so, if the five who settle lose 20% share to an upstart, even if the market stays flat, the participants’ payments would be reduced by 20%. For states that decide not to settle, the manufacturers could have the option of holding their prices at $.35/pack less (since there would be no payments in those states). Liggett is not really a risk in this regard, since LeBow’s agreement with the 41 states with whom he has settled calls for Liggett to raise prices in line with other manufacturers if there is a national settlement, such as a 45-state AG settlement.

To offset the risks of counties and towns bringing claims, there will be a provision that any judgments earned by the towns and counties would be offset against the states’’ payments.

We estimate the industry could sign up at least 40 of the remaining 46 states. The industry has three weapons to convince Rambo-type attorneys general to sign up: 1) May be difficult to turn down the money (alternative is to go to trial to collect, or raise excise taxes, which would be difficult, since the states who are most anti-tobacco and most likely to turn down the money are those with the highest excise taxes already, such as MA, CT, and MI); 2) Voluntary consent decrees on advertising; which means industry would not agree to take down advertisements without a court fight in states that didn’t sign up; and 3) In states that don’t take the settlement, industry might forego the $.35/pack price increase, since absent a deal that puts risks on retailer for carrying non-protocol product, retailers would carry new entrants’ products at $.35/pack cheaper than those who have a deal. Obviously, these states that don’t take the deal would likely pass excise tax hikes (and hence, only threat is that advertising continues).

UST’s share of costs would be minimal, since it is really not a defendant in the AG cases. Our best guess is that if cigarette prices went up by $.35/pack over 5 years, the allocation to smokeless might be $.03- $.05/can over five years. We cannot see UST agreeing to pay any share of the upfront costs (hasn’t in any settlement to date).

Timing on this announcement is now likely to come before the Washington Medicaid trial, which was to start September 22, but, according to sources on the plaintiffs’ side, is now likely to slip until January. This would make the next state trial Oklahoma (January) or Massachusetts (February). There are many in the industry who believe the plan could be unveiled in August to give Republicans cover to pass only a narrow bill or nothing this year. The logic: Republicans can say that teen smoking issue is being addressed at state level, so there is no need for Congress to address it. The risk to moving before Congress adjourns on October 9 is that the FDA would have no jurisdiction under a state only plan; which may convince some in Congress to address giving the FDA jurisdiction before it adjourns. We believe the benefits to moving early outweigh the risks.


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