Gary Black: New AG Settlement: Critical Investment Question -- Not When, But How Many? Outperforms.

Gary Black (212) 756-4197
Jon Rooney (212) 756-4504
November 11, 1998

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1. Terms of the new AG settlement to be released Friday remain unchanged vs. prior expectations. For all 51 states, the deal could cost $230 billion ($190 billion incremental for 47 states), with approximately $5 billion in upfront money (total $10 billion over 5 years) and $4.5 billion in ongoing payments due in 1999. The ongoing payments level off at $8 billion per year in Year 5 (2003).
2. We believe at least 40 of the remaining 47 states (including Puerto Rico) will sign the accord, including both CA and NY. Potential holdout states will likely be MA, MD, MO, WI, and MI -- all who have 1999 trial dates. Our sources in California AG Dan Lungren's office have suggested they will brief AG-elect Lockyer by next week, but still sign the accord by the opt-in date.
3. We expect the industry to take $.15/pack in additional pricing between now and year-end -- including $.075/pack pricing as soon as Friday. Over the past year, average cigarette prices, net of promotions, have increased by $.21/pack (+12.4%). Philip Morris has already increased its average 4Q deal on Marlboro to $3.00/carton (from $2.50/carton) to cushion the impact of higher prices.
4. Marketing restrictions are largely those from Minnesota -- bans on billboards and transit signs, on promotional merchandise with brand logos, and on product placements in movies -- plus a new ban on cartoons in advertising; restricting each company to one sports sponsorship per year; and limiting the size of indoor and outdoor retail signage to 14 square feet.
5. The renegade provisions are largely those agreed to last month:

• Renegade multiplier: The industry would get a credit equal to 3x the share points lost to non-signatories, multiplied by the annual payment (e.g. $8 bill. payment; if non-signatory share grows to 7.5% from 2.5% now, credit = $1.2 billion).
• Renegade exemption: States that enact legislation forcing non-signatories to pay into trust (for fuure claims) the amount they would pay under the deal -- payments which would not be tax deductible -- would be exempted from any renegade credits.
• Renegade carve-out: Non-signatories to the deal will be granted a "carve out" for 1997 share. This effectively allows smaller players to be covered by the deal at no cost (but take prices up like everyone else) up to their 1997 share levels.
• Renegade civil litigation clause: States will agree on a best efforts basis to bring claims based on violation of consumer protection statutes against non-signatories to the deal, and possibly against retailers who carry non-signatory product.
• Renegade credit allocation: The compromise reached between PM, RJR, and B&W was that up to a certain level, credits would be awarded to those who actually lost share to non-signatories; beyond that level, it would allocated on market share.

6. Our expectation is that UST has reached a separate settlement with the AGs that requires no ongoing payments, and only nominal upfront payments (legal fees, and some upfront money for public health initiatives) but which commits UST and other smokeless makers to the same marketing concessions to which the cigarette manufacturers have agreed
7. We see little sentiment among Clinton's inner circle to push for a large federal excise tax increase on cigarettes in 1999. Republicans control both House and Senate; a $.15/pack tax increase ($.10/pack in 2000 and $.05/pack in 2002) has already been passed. Tobacco was a huge non-issue in the 1998 elections (defeats of AGs Humphrey and Harshbarger proof). The trial balloon in the WSJ may simply be a reminder to the states that the federal government could claim its share of the settlement under HCFA

Investment Conclusions: We reiterate outperform ratings on Philip Morris, RJR, and UST. With the announcement of the deal largely discounted, the catalyst now is any fresh evidence that substantially all 47 states will embrace the new deal within the 7-day opt-in period (e.g. public statement by California AG Dan Lungren that CA will sign). We look for buybacks at Philip Morris and UST to begin within two weeks; another large cigarette price hike within a week, and spinoffs to be announced by early-1999.