Gary Black: Can Senator Hatch Resurrect the June 20 Accord? Outperforms MO, RN, UST.


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

June 9, 1998

TOBACCO

Can Senator Hatch Resurrect the June 20 Accord? Outperforms MO, RN, UST.

"Democrats are going to have to make up their minds: Do they want to do something about teenage smoking and drug abuse, or do they want what they think will be a good political issue?" Senate Majority Leader Trent Lott 6/8/98

"It’s up to the Republicans to come to the realization that we’re going to do this ...the easy way or the hard way. The hard way is that we offer tobacco as an amendment to every bill that comes down the pike ... So it becomes a political issue." Senate Minority Leader Tom Daschle 6/8/98

HIGHLIGHTS
  1. Today’s failure by Senator Daschle to get cloture on the McCain bill, with voting along party lines (42 yea, 56 no; 60 yea votes needed for cloture) will likely lead Senator Lott to again withdraw the McCain bill, citing other legislative needs. We continue to believe that Senate Republicans will feel compelled to vote out some limited tobacco bill, given Senator Daschle’s threat to amend tobacco to every bill that hits the Senate floor this Summer. This, Senator Lott has concluded, could be a huge political liability.
  2. In place of McCain’s bill, we ultimately expect the Senate to pass a narrower drug/tobacco bill, with modest excise tax increase ($.50-$.75/pack increase over 5 years), limited FDA authority, tough retail restrictions, and no legal protections. Today’s vote on the Coverdell amendment, which allocates $10 billion of tobacco money over five years to fight the war on drugs, should pass overwhelmingly, since Democrats do not want to be perceived as pro-drug. This could form the base for a drug/tobacco bill.
  3. Our sources in Washington believe that Republicans now have the political cover to pass a narrow tobacco/drug bill focusing on youth access, and which avoids the estimated $2.75/pack tax hike, black market threat, and bankruptcy risks inherent in McCain’s bill. As Senator Lott points out, a Republican (McCain) championed the bill, Lott introduced it, and it was kicked around for three weeks. 70% of Americans view this bill as the government trying to get more revenue, 20% view this as a teen smoking bill.
  4. With McCain’s bill close to death, one thought is whether there is sufficient appetite on both sides to return to a June 20-type accord, as embodied by Senator Hatch’s tobacco bill ($398.3 billion payments, $175 billion in lookback penalties, all legal protections from June 20). We expect Hatch’s bill to be introduced on the Senate floor this week or next week. While Hatch doesn’t have the votes needed for passage, any indication by Clinton to support Hatch’s bill -- i.e., embrace the concept of industry legal protections in return for industry consent -- gives Republicans political cover to vote for Hatch’s bill.
  5. The uncertainty associated with the 4th Circuit rehearing on FDA jurisdiction could also help build support for a June 20-type bill, since the FDA would get only limited authority over tobacco if a narrow tobacco/drug bill passes. Emory Widener, a conservative appointed by President Nixon, was named to the 4th Circuit panel to replace Judge Russell, who passed away. A conservative panel, amid dimming prospects for a comprehensive bill, could boost support for Hatch’s bill, which gives the FDA full authority.

INVESTMENT CONCLUSIONS

We reiterate outperform ratings on Philip Morris, RJR, and UST. We believe tobacco stocks will continue to rebound off their all-time relative lows reached two weeks ago, as confidence builds that we get either a narrow/tobacco drug bill with modest excise tax increase, or that the June 20 accord can be resurrected in the form of Senator Hatch’s $600 billion tobacco bill, which contains all the legal protections of June 20. With Daschle’s vote on cloture failing by a wide margin (42-56) today, we expect investors to finally start to believe that the McCain bill will either never come to a vote as written, or be replaced by a narrower drug/tobacco bill by next week. The House will wait until the Senate completes its work to proceed with an even narrower drug/tobacco bill that eliminates deductibility of advertising, and has no excise tax increase. If Senator Hatch can convince Republicans or President Clinton to offer legal protections that permit the industry to spin off non tobacco assets without fraudulent conveyance risks, valuations could move sharply higher. Our price targets remain $60 on Philip Morris, $40 on RJR, and $40 on UST.

ADDITIONAL DETAILS

  1. Republican strategy appears to be shifting. With Senator Daschle’s first cloture vote now having failed by a wide margin (42-56), there should be no doubt in anyone’s mind that the McCain bill is dead. Partisan squabbling has erupted full force between Senate Majority Leader Lott and Senate Minority Leader Daschle. This morning, Senator Daschle filed a third motion for cloture, given the clear writing on the wall that the first vote would fail (second vote likely tomorrow; also likely to fall along party lines 55R, 45D). Cloture limits future debate to 30 hours, establishes a timetable for the amendments already on the floor, and forces the Senate to vote on the overall bill in a timely manner. Daschle has suggested that Republicans are trying to kill the McCain bill by not letting it come to a vote -- i.e., by running out the clock. Daschle: "Republicans continue to block and obfuscate and come up with a myriad of different ways with which to ensure that we make no progress on tobacco. That way they don’t have to vote to kill it." Lott puts the lack of progress on tobacco squarely back with Democrats, saying yesterday, "The bill has grown and grown and grown, and what has happened is that greed has just taken over, and it’s now way beyond things that are directly related to smoking." On the cloture motion, Lott said he believes he can keep Republicans in line to vote no on cloture, which would allow the debate to continue, and which allows for additional amendments to be introduced. A "no" vote on cloture serves to further chew up the clock, which is likely to convince Democrats and the Administration they may get nothing. We expect the full Senate to pass the Coverdell amendment, which allocates $10 billion of tobacco money over 5 years to the war on drugs.

While Senate Majority Lott has indicated he would withdraw the McCain bill if Daschle’s motions for cloture fail, technically, Lott would need 60 votes to end the Senate debate on tobacco legislation, which he doesn’t have. In addition, Lott takes seriously Daschle’s threat to try to amend every bill considered by the Senate this Summer with elements of the Conrad tobacco bill -- which is as onerous as the McCain tobacco bill -- to force Republicans to be on record repeatedly voting not to raise tobacco taxes, which Democrats will use in the Fall elections. As such, we expect Lott and McCain to choose either one of two paths outlined below, or try both in succession, if the Daschle vote on cloture fails, and McCain’s bill is again withdrawn.

If all of the Daschle motions for cloture fail, which seems likely, the first course of action may be for Republicans to next week offer a scaled down Nickles/Gramm combination drug tobacco bill, which could get 50 Republican votes as well as 2-3 Southern democratic senators’ votes> Such a bill would give Republicans the political cover to say they passed a bill that addresses the teen smoking issue. We believe that Lott’s comments yesterday that Congress should be able to get the job done on teen smoking for half the cost of the McCain bill suggests a $.50 - $.75/pack excise tax increase over five years, with limited FDA jurisdiction, narrowly-tailored advertising restrictions, and no legal protections. Since House Republicans are likely to propose a bill that is even narrower -- no excise tax increase, elimination of deductibility of marketing expenses (industry will redefine promotional spending, which is 80% of industry’s $5.1 billion marketing budget, as a pricing allowance, which is fully taxed), limited FDA jurisdiction, narrow advertising restrictions, and tough retail access restrictions, tough anti-drug provisions, and fines on teens caught buying cigarettes or drugs -- any final bill that comes out of House-Senate conference is likely to fall far short of President Clinton’s objectives spelled out last Fall. Still, we believe such a narrow tobacco/drug bill would give the Republicans the cover to say they took steps to address the teen smoking and drug problems, without raising taxes on 25% of Americans, which would have funded a half trillion dollars in new spending initiatives, and would have lead to a black market for cigarettes.

The second course of action -- which could either precede, coincide, or follow the first course of action -- may be to allow Senator Hatch to introduce his tobacco bill as a substitute for the failed McCain bill. Hatch’s bill offers the legal protections of June 20, but is more expensive ($600 billion all-in-cost vs. $434 billion all-in cost; would raise prices after five years by about $1.10, vs. $.80/pack increase under June 20; and vs. a $2.75/pack increase under McCain). From a theoretical standpoint, introducing Hatch’s bill now, after McCain’s bill is pulled, offers some appeal to the Administration, liberals, and the health community, who may conclude that they are getting very little other than a questionable political issue on which to run if a narrow tobacco/drug bill is passed instead. Still, Republicans cannot move first to give the industry the legal protections the industry seeks. The wild card remains the Administration, which is on record during the debate over the Gregg amendment to preserve the liability caps, but which has been unwilling to explicitly support the legal protections found in the June 20 accord (no class actions, no punitives, limits on individual awards per year, a $5 billion unconditional cap, all liability contained within domestic tobacco, etc.). While the idea of Clinton now supporting the Hatch amendment if the McCain bill is withdrawn offers some appeal, we can’t see Clinton offering legal protections to the industry just yet, given our view that some in the Administration appear to prefer that the tobacco debate continues as a political issue into the Fall elections.

We also speculate that there may be some differences in opinion on tobacco policy between President Clinton’s staff, who may want a solution to the teen smoking problem, and Vice President Gore’s staff, who we perceive may want tobacco to remain an issue that can be used in Gore’s run for the presidency in 2000. Our view remains that most Americans do not care about the teen smoking issue: Raising taxes to reduce the number of teen smokers ranked 9th out of 11 goals for the federal government in the WSJ/NBC poll taken in April. Nor do Americans believe that government can even do much about teen smoking: 73% agree with the statement that "the tobacco bill is not likely to reduce the levels of youth smoking." In the end, unfortunately, we believe politics will win the day, and that absent direct involvement by President Clinton, Hatch’s bill will not pass, and we will get a narrow bill that is not too onerous, but which will give the industry none of the legal protections found in the June 20 settlement.


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