Gary Black: Settlement Talks: Industry Holding Its Ground. Philip Morris Takes Another Price Hike

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

August 3, 1998

1. Our sources close to the settlement talks indicate that we are still 3-4 weeks from a deal. The major issues to be worked out are, in order: 1) renegade provisions; 2) extent of marketing restrictions; 3) industry distribution concessions, and 4) money. FDA jurisdiction and look-back provisions are non-starter issues. The industry will reject a deal unless at least 40 (of 46) states opt in.

2. We view Philip Morris’ $.06/pack price increase taken Friday (+5.4%, fifth price increase totaling +27.8% since September) as a sign of confidence there will be a new settlement agreement. The settlement on the table -- $180 - $200 billion for the remaining 46 states; $220 - $240 billion for all 50 states — translates to a $.35/pack increase over five years. Including Friday’s pricing, the industry has taken $.25/pack in pricing since last September, vs. ongoing costs of $.11 by year 5 in the four states settled to date.
3. Two of the participants — RJR and B&W — have indicated that they will not sign any deal unless the renegade provision has some teeth. While the AGs are not opposed to keeping cigarette prices high, some AGs seem resistant to some of the ideas being floated — such as states getting much lower payments if non-signatory discount volume rose above a certain level. Another idea, but one which few feel will work, is for the AGs to take an openly hostile stance toward retailers who sell non-protocol product.
4. The industry seems unwilling to concede marketing restrictions beyond those found in the Minnesota settlement, applied under MFN clauses to MS, FL, and TX. The industry will eliminate tobacco billboards, branded merchandise, and movie placements, but does not appear likely, contrary to our initial thinking, to agree to eliminate in-store signage or continuity programs.
5. The industry seems to be bargaining from a far stronger position than in the prior settlement, following the Indiana judge’s ruling dismissing that state’s claim in entirety; the Washington judge’s ruling that the industry could introduce as evidence excise taxes collected by the state, and the trial calendar. The weak Washington case, with a pro-tobacco judge, goes to trial September 14. The industry could easily walk away from this deal, try the Washington case, and negotiate better terms after winning that trial.

6. The House leadership announced on Friday that they would not bring tobacco legislation before adjourning for the summer, which effectively kills any chance of tobacco legislation this year. We continue to expect President Clinton to take credit for any agreement reached between the industry and AGs, and then push again for FDA jurisdiction in the next session of Congress.

We reiterate outperform ratings on Philip Morris, RJR, and UST. We perceive that the sentiment on the tobacco group is now turning quickly, driven by the following factors: 1) The new AG settlement talks, with likely resolution that requires neither an act of Congress or a single vote by any legislature; 2) Favorable class action ruling in New York (dismissing five NY state class actions); 3) Favorable state Medicaid ruling in Indiana (dismissing that state’s entire Medicaid claim); 4) Favorable ruling overturning the Carter loss by B&W, which suggests that the Widdick verdict will similarly be overturned, given the same appellate court and same trial strategy by Wilner; 5) The now official pronouncements by both the House and Senate that there will be no tobacco legislation this year; 6) High-profile earnings disappointments, combined with lack of pricing flexibility in other names in the consumer non-durables sector (K, GS, MCD); 7) The prospect of Philip Morris coming back into the market to buy in its stock with nearly $5 billion in cash after an almost 18-month hiatus. We caution that neither side has yet walked from the table in these settlement talks, which we assure you will happen, given the politics and egos involved. When settlement talks collapse and stocks fall, we would be strong buyers; conversely, just as the deal is announced, we would be cutting back somewhat on positions. Our price targets are Philip Morris $60 (75% relative), RJR $40 (sum of the parts, with tobacco at 5x cash EPS), and UST $40 (65% relative).

1. Biggest obstacle -- Renegade provisions with teeth. On Friday, after negotiations had adjourned for the week (talks are scheduled to resume today), we spoke with representatives from three of the four manufacturers at the bargaining table. At the margin, three messages rang through loud and clear: One, getting the AGs to commit to renegade provisions "with teeth" are the key to this deal. Two, each of the four players has come to the table with a different set of needs and wants, and that for better or worse, each will have equal veto power to nix the deal when the time comes to sign on the bottom line. Three, the industry will take its time to get the deal it wants, given the perception that time is now on its side, given the weakness of the Washington Medicaid suit, which goes off first on September 14, and is not likely be delayed unless the industry agrees.

2. Marketing restrictions - industry not giving an inch. Our sources suggest that if the industry could get acceptable renegade provisions, it would be more inclined to cede some of the marketing restrictions sought by the states. For now, the baseline restrictions remain Minnesota’s deal, where the industry agreed to remove billboards and transit signs, all branded merchandise, and agreed not to pay for movie placements. The AGs appear to have asked for a ban on all outdoor advertisi9ng, including signs outside retail locations, or which point outside. The AGs also want bans on non-branded merchandise that smokers get with multiple purchase of cigarettes, such as through the Marlboro Gear program. To date, the industry has held its ground.