Gary Black:Settlement Update: Timing Slips Again -- Deal Complexity Increasing. The Waning Days Of Congress

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

October 9, 1998

1. Anticipated timing of the new AG settlement has slipped to the week of 10/26. This was said to be due to a prior scheduling conflict by lead AG Gregoire, but may reflect additional time needed to get a critical mass of AGs behind the deal prior to its announcement. Or, it may reflect the industry needing time to digest what has become a very complex set of renegade provisions.
2. Our biggest fear is not the renegade issue (which the industry has overblown), or that states won't sign up (they want the money), but that after the deal is consummated, state legislators will pass legislation that imposes licensing fees -- but fail to give credits to companies who signed the accord. This would effectively raise taxes twice on deal signatories, and once on non-signatories. We don't believe the AG settlement can be voided, for instance, if a state passed a licensing law at odds with the spirit of the deal.
3. Washington update: Before Congress adjourns Monday, we could see efforts to attach two tobacco-related riders to the omnibus appropriations bill (which effectively allows the government to avoid shutting down in the absence of formal appropriations bills):

• One rider sponsored by senators from Florida and Texas allows states to keep all of their tobacco settlement proceeds, rather than give the federal government its share under HCFA. This would increase the appeal of the new AG deal to the states.

• Second rider clarifies a 1960s statute that the federal government can bring a Medicare recovery action against the tobacco industry. Given no appetite by Republicans to bring new claims against the industry, odds of this passing are very low.

4. We reiterate outperform ratings on Philip Morris, RJR, and UST. While timing on this deal remains slippery, which naturally fuels investor uncertainty, we believe 1) there will be a new AG deal that will be supported by a critical mass of AGs announced within a few weeks; 2) Virtually all states will ultimately embrace the deal, given overall weakness of AG cases, and few suitable alternatives with which to put new regulations on the tobacco companies. Our expectation now is that stocks will not trade off when the deal is announced, given the short (7-14 day) opt-in period

1. Settlement update: Below, we have clarified some outstanding issues about which we have been asked on the new settlement:

• Cost -- The cost to settle with the remaining 47 states (including Puerto Rico) will be about $180 billion. This would bring the total cost of the deal to $220 billion -- in line with our expectations, but higher than some analysts are predicting.

• Renegade credits -- The exact mechanism by which renegade credits are allocated appears to be more of a compromise between PM and RJR than we had indicated in our note last week. Credits would be allocated to those who actually lose share, but only to a certain threshold. Once that threshold is crossed, the credits get divided based on market share.

• Marketing restrictions -- The industry would agree to ban billboards and transit signs, product placements in movies, branded merchandise, and all but one sponsorship per manufacturer. Size limits would be imposed on outdoor signage at retail and on signage that faces out of retail locations (14 sq. feet). Cartoons would be banned in advertising, but not humans or animals.

• Licensing fees -- The industry's goal is to get all of the states to pass licensing fees for manufacturers who do not sign onto this accord. We believe the vehicle used would be that each state would impose licensing fees for all manufacturers, but exempt manufacturers who sign the new accord. This, combined with the provision that smaller manufacturers (under 3% share) be a part of this agreement at no cost as long as they don't grow share, makes it difficult to see why smaller players wouldn't sign this deal. If a renegade joins, and holds share, he pays nothing. If a renegade doesn't join, and the state passes a licensing fee, the renegade will have to pay on all units sold, and not just those above last year's share.

• State licensing incentives -- States that pass tobacco licensing laws, with credits for those who sign the accord, would be exempted from having to contribute to the renegade credit pool back to the industry if overall renegade share increases. The As more states adopt licensing provisions, the pressure grows for the remaining states to do the same -- or they will have to give back more of the payments. Example: If 30 states pass licensing provisions, the remaining 20 states would split the costs of the renegade credits. If 40 states pass licensing provisions, 10 states split the same costs of the renegade credits. If all 50 states pass licensing laws, there would be no renegade credit. There would also be no renegade credit if share merely shifted from one of the signatories to another signatory (i.e., Philip Morris takes share from RJR).

• Liggett -- We believe that Liggett (1.4% share) could void his agreements with most of the 47 states involved in the new deal under most favored nations provisions in the old deals. This new deal, which allows Liggett to be covered at essentially no cost (for smaller players, any volume below last year's share is grandfathered in free), is better than Liggett's old deal, which compels Liggett to pay on average 27.5-30% of pretax profits to the 42 states with whom Liggett has settled.

2. Bye, bye Congress. Congress is now expected to adjourn on Monday. Given the ongoing impeachment inquiry, the House will be adjourned subject to the call of the Speaker, which means House members will likely return for impeachment hearings after the Election. The Senate is effectively gone until January, beginning Monday.

• Provision that allows states to keep all their Medicaid winnings. Senators from three of the four states that have settled with the industry (Bilirakis from FL, Bailey from TX, Lott from MS) have proposed a rider to be attached to the omnibus appropriations bill (to keep the government running) that would preclude the federal government from taking any percentage of funds that states receive from tobacco settlements. Under federal statutes governing Medicaid (Title 19 of Social Security Act), the federal government is entitled to reclaim its Medicaid % contribution (on average, federal government pays 60% of each state's Medicaid bills, percentages vary from 50% - 80%) from states that get Medicaid reimbursement from third parties. We put high odds on this rider passing, given Lott's involvement. Clinton is unlikely to insist that the rider be struck. If passed, this will give a hostile state a further incentive to embrace the AG settlement, since they would get to keep their entire settlement amount, but have to give back the federal share if the state won a judgment at trial.

• Provision that clarifies that federal government can sue the tobacco industry. Separately, anti-tobacco senators, egged on by plaintiff counsel Richard Scruggs, want to include a rider in this omnibus appropriations bill clarifying the federal government's authority to bring a direct action for Medicare recovery under statutes that govern Medicare (Title 18 of Social Security Act). Remember, Scruggs' plan was to get the federal government to bring a federal recovery claim, and then get the industry to settle with the federal government for $150 - $175 billion, with offsets for settlements or judgments for class actions, punitive damages, consolidations, and other exposures not covered by the AG settlement, but which were included in the original June 20 accord. Scruggs' incentive, of course, is probably higher fees for Scruggs. We put low odds on Richard Scruggs convincing Republicans to include a rider in this omnibus bill clarifying that the federal government can sue the tobacco industry.