Tobacco.org

Gary Black: New AG Deal Likely Next Week -- Game of Corporate Chicken Continues. Outperforms.

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

September 4, 1998

1. Sources close to negotiations between the eight AGs, Philip Morris, and Lorillard suggest that a new AG settlement could be announced by end of next week. Terms are likely as follows -- Payments at high end of expected $180-$200 billion range; marketing restrictions similar to Minnesota, with additional bans on sponsorships and cartoons; renegade multiplier of 3x with credits split by market share. The industry will not cede authority to the FDA or be subject to youth lookback penalties.
2. Our sense is that RJR and BAT – the latter which has been given the green light by a UK court to separate tobacco from non-tobacco – will continue their game of chicken with Philip Morris until after the state opt-in period closes, but ultimately embrace the new deal. RJR’s Board and institutional shareholders are highly unlikely to bet the company on trials in Washington or Massachusetts to get a few market share points – particularly if Philip Morris’ stock price is flying, and theirs isn’t.
3. RJR and B&W continue to insist that renegade credits be split up among those who lose share, rather than be split evenly by overall share. Philip Morris cannot accept a deal whereby those who lose share get rewarded with a rebate that could exacerbate any bout of pricing instability. It is one thing for renegade players with a collective 1% share to have a $.40/pack price advantage; it is another for RJR’s #2 Doral or B&W’s #3 GPC brands to roll up company renegade credits to produce a $.40/pack discount.
4. We believe that virtually all of the 46 states will opt in to the new PM/Lorillard agreement Having the industry split actually increases odds of all states opting in, since it allows the AGs to receive more than half their money from PM and Lorillard, and still talk tough in demanding that RJR & B&W comply with the public health provisions agreed to by the others – or go to trial.
5. Two other events should help bring all the states in: 1) The Idaho ruling essentially gutted that state’s case, on the heels of the Indiana ruling dismissing Indiana’s AG claims last month; 2) We have heard talk that Republicans may try to clarify statutory language to effectively disallow the federal government from recovering their share of Medicaid damages received by the states.
6. BAT’s spinoff should give investors renewed confidence that U.S. courts would similarly reject challenges by plaintiffs that the distribution of corporate assets represents a fraudulent conveyance by the tobacco companies. To succeed, plaintiffs must show:

• Tobacco subsidiaries cannot satisfy all current and unmatured claims – which seems remote with an AG deal, in light of the growing paper trail by courts dismissing personal injury class actions, and the industry’s still perfect track record at trial;
• Assuming these claims succeed, tobacco subs cannot take pricing to offset these claims, which is inconsistent with the record
• The parent is an "alter ego" of the sub, and therefore, the parent’s assets can be used to satisfy the judgments against the sub. This requires a showing of various veil-piercing tests -- same Board, common use of facilities, sub has inadequate capital, etc.

We reiterate outperform ratings on Philip Morris, RJR, and UST. We expect tobacco stocks to continue to outperform going into the new AG settlement (relative performance since McCain bill died 6/16: MO +26%, UST +17%, BATS +15%, LTR +8%, RN +3%). This reflects the sharp favorable turn in the litigation landscape, and the general perception that tobacco stocks, with their non-cyclical businesses, depressed multiples, and rich relative yields, will hold up well in this bear market. We expect investors to bid up tobacco multiples in anticipation of a new deal, and then, as occurred last June, sell off once the deal is announced. This may be even more true here, with a likely 30-day opt-in period for all states to decide whether to embrace the deal, and the uncertainty associated with RJR and B&W not being at the table. Key events: Resumption of Philip Morris’ buyback and UST’s recap (October); announcement of new proxy fight by Icahn/LeBow against RJR (end of October); Congressional elections (valuations increase if Republicans pick up seats); Maryland class action ruling (any day); Engle Phase I finding of fact (year-end). We expect spinoffs of corporate assets to begin by mid-next year, after the Florida Supreme Court overturns Engle. UST remains a prime takeout candidate by MO or LTR.

1. New deal next week. By the end of next week, we expect a new AG settlement to be announced along the lines of what we have articulated for two months ($180 - $200 billion in payments, Minnesota marketing restrictions, plus ban on sponsorships and cartoons, renegade multiplier of 3x on the share lost to discount players, no FDA or lookback provisions). We had hoped that RJR and B&W would be back at the table for the finale, but now expect they will wait until the close of the state opt-in period before choosing to end their game with Philip Morris to negotiate better terms on renegade credits and the upfront payment (see our piece dated 8/28/98 "The Renegade Rift: Why RJR and B&W Will Come Back To The Table.").

• Payments: Closer to high end of $180-$200 billion range over 25 years for remaining 46 states; this would require an additional price increase of about $.35- $.40/pack over five years.
• Marketing restrictions: Minnesota terms (bans on billboards, branded merchandise and product placements in movies) plus concessions for brand sponsorships, and cartoons in ads. We doubt PM or Lorillard conceded human images in ads or outdoor signage at retail; the latter is important for gas and convenience chains’ efforts to use premium cigarettes to draw traffic – which will help the Big 4 in their efforts to limit renegade share growth.
• Renegade provisions: The industry will get a credit for share lost to non-signatories, equal to the % share lost, multiplied by some factor, which we believe will be 3x (example: 5pp share loss to renegades, with a 3x multiplier, would reduce industry payments that year by 15%, split by market share). The AGs may also agree on a best efforts basis to pursue claims against manufacturers who do not consent to the deal, and pursue actions against retailers who carry product made by non-signatories.
• MFN clauses: PM and Lorillard will get MFN clauses (most favored nations clauses) that if RJR and B&W negotiate more favorable terms, Philip Morris and BAT would get the same deal. Politically, it would be impossible for the AGs to give better terms to RJR/BAT, since they would then have to match those terms for MO/Lorillard. In addition, there are likely to be affiliate provisions in the agreement to prevent RJR or B&W from spinning off discount brands as separate companies, etc.
• Access, FDA, lookback penalties: Industry unlikely to give any concessions on these issues.

1. Will Philip Morris and Lorillard sign even if RJR and B&W won’t? We believe that RJR and B&W misjudged their positions in walking away from the talks over how to split up renegade credits. Philip Morris cannot allow RJR, with a 24% share, and B&W with a 16% share, to arm themselves with a $.10- $.15/pack corporate cost advantage (much higher if rolled up against a single brand) simply because they lose share in a given year. We believe RJR and B&W would use those funds to recoup their share losses -- which might have occurred anyway – which would further disrupt pricing . We point out that Liggett and Commonwealth, with 2.2% of the total 3.0% renegade share, have always followed the Big 4’s price increases. The other 0.8% share held by renegades is highly unlikely to change much no matter how aggressively the renegades price, given spotty broker distribution networks, weak balance sheets with the exception of Japan Tobacco, and the vast sums of program money given to the trade to encourage both wholesalers and retailers to push big 4 brands. We believe that the mindset of "let’s-win-in-Washington-so-that-we-can-get-a-better-AG-deal-later" is short-sighted; the AGs certainly aren’t going to negotiate a deal after they lose Washington (late-December timing); but instead wait until after the Massachusetts trial, where they may have some leverage. Finally, we ponder this: Del Webb, who represents Philip Morris, was supposed to run the Washington trial for the industry. Two weeks before the trial, is RJR really willing to change quarterbacks in a trial that could result in a multi-billion dollar loss? \
2. Tobacco stocks as defensive plays. While we expect continued improvement on the litigation front to drive litigation discounts down further, investors can also view Philip Morris’ stock as a good hedge during this period of high market turbulence. On average, Philip Morris has outperformed the market by +13pp annualized during periods recognized as bear markets (market down at least 20% from peak). All tobacco stocks offer yields that add 2.5-6.0pp to their relative performance:

Search News

News Briefs

Top Resources