Gary Black: Is There A Silver Lining In the Widdick Verdict? Outperforms MO, RN, UST


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

TOBACCO

Is There A Silver Lining In the Widdick Verdict? Outperforms MO, RN, UST.

HIGHLIGHTS

    1. We expect investors to shrug off yesterday’s first ever punitive damages award against the industry as having narrow rather than broad implications, and instead, re-focus on the McCain bill and whatever tobacco bill comes out of the House (late-July) and conference (September). We believe the Widdick verdict, combined with recent horsetrading of votes by McCain, increase odds that Congress will grant legal protections acceptable for the industry to return to the bargaining table, permitting spinoffs.
    2. The size of the Widdick award ($1.0 million), like the Carter verdict in 1996, is far too small to create a ground swell of new suits. Because RJR walked off with two easy victories in the same jurisdiction against the same plaintiff attorney and experts, this appears to be more a B&W problem than an industry problem. We believe B&W could have spent more time outlining efforts to make cigarettes safer, had senior executives explain the documents; and talked more about filtered vs. unfiltered cigarettes.
    3. We do not see a change in sentiment among the American public; nor do we believe the documents from Minnesota increase odds that juries will start awarding fistfuls of money to injured smokers. In an April WSJ/NBC poll, 90% of respondents said that people who smoke should not be able to sue, consistent with past polls. We believe the industry can maintain its traditional 70-80% win rate in court, which, combined with juries’ refusal to award large punitive damages, implies still low bankruptcy risks. In 41 of 50 states, plaintiffs who are 60-70% to blame for injuries -- as this jury said Maddox was -- cannot be awarded damages..
    4. We believe Philip Morris and RJR are somewhat insulated from what is logically the next wave of individual claims: That manufacturers should have withdrawn unfiltered cigarettes from the market. One, by 1969 (effective date of warning labels), only 4% of Philip Morris and 19% of RJR volumes were still unfiltered (American Tobacco, bought by B&W in 1994, still had 63% of volume in unfiltered). Two, every brand offers a filtered version; B&W simply did a poor job talking about consumer preferences.
    5. We believe this verdict will cause shareholders to put more pressure on managements to do whatever it takes to "ringwall" domestic tobacco, to distribute all excess equity possible, and incorporate legal risks in future pricing decisions. While nothing can happen before October, we believe the industry will strike a settlement with all 50 states, which, combined with continued favorable court opinions on class actions, may allow separation of domestic tobacco from other units even if Congress doesn’t act.
    6. We believe this verdict will work in the industry’s favor to get limited legal protections in the form of legal caps and parent asset protection from Washington: 1) The loss raises the specter of bankruptcy, which mainstream Washington does not want, since the strain on the courts and the inability to regulate new entrants could undermine efforts to control tobacco; 2) It gives Republicans cover to vote for liability caps and still say they didn’t give immunity, since smokers would still have all rights to sue.
    7. We have resurrected our doomsday scenario. Assuming 150,000 to 180,000 new lung cancer cases per year, a 50% propensity to sue within 5 years, a 2/3 plaintiff hit rate, and a $1.0 million average verdict, we calculate the industry present value of all after-tax individual damages at $64 billion. Philip Morris’ estimated 1/3 share of these damages equates to $21 billion present value -- 1/6 its current litigation discount of some $137 billion. RJR’s 1/3 share also equates to $21 billion -- whichis above its current litigation discount of $9.4 billion. This, however, ignores the industry’s ability to raise prices to cover increased legal costs.
    8. Three events will drive stocks near term: 1) Whether McCain/Clinton can convince conservatives to retain the $8.0 billion liability cap before final passage next week (5% upside); 2) Whether Gingrich can convince House Republicans to vote out a skinny drug/tobacco bill with no excise tax increase (5% upside); and 3) Engle Phase I class action trial, which begins July 6th in Florida.
    9. We reiterate our outperform ratings on Philip Morris ($60 price target), RJR ($40), and UST ($40).


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