Gary Black: Litigation Discounts Should Shrink As Tobacco Exits the National Spotlight. Outperforms


TOBACCO

Litigation Discounts Should Shrink As Tobacco Exits the National Spotlight. Outperforms.

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

July 6, 1998ax 6

HIGHLIGHTS

We expect relative multiples to expand over the next few months as investors conclude that:

  • State courts will follow their federal counterparts and ban tobacco class actions such as Engle;
  • The industry will negotiate a multi-state settlement with the AGs to settle most of the state Medicaid claims;
  • Congress will pass only a narrow youth access tobacco bill with no excise tax increase;
  • 4th Circuit panel likely to rule that absent new legislation, FDA does not have authority to regulate tobacco;
  • Industry will resume share buybacks and accelerate profit growth in domestic tobacco after Congress adjourns October 9.

INVESTMENT CONCLUSIONS

We reiterate outperform ratings on Philip Morris, RJR Nabsico, and UST. Wiith odds of comprehensive legislation all but dead for this year, and with prospects for an improving litigation environment (clearly-defined precedent banning class actions likely; new evidence that appellate courts will uphold statute of limitations and preemption rights; much easier state Medicaid trials ahead) we believe valuations will return to normalcy -- which implies an 80% relative multiple on MO, 70% relative on UST, and a 65% relative multiple on RJR. The one wild card remains whether the industry can craft a 50-state settlement that, combined with continued favorable precedent on class actions, permits separation of domestic tobacco and non-tobacco assets, which would permit much higher sum-of-the-parts type valuations. Our 6-12 month price targets remain Philip Morris $60, RJR $40, and UST $40.

ADDITIONAL DETAILS
  1. Engle class action unlikely to survive on appeal. While we are relatively certain that Judge Kaye will move forward with Phase I of the Engle class action once a jury is picked (actual trial likely to begin by August 1; could last 8 weeks) we expect investors to begin to conclude that state class actions such as Engle will ultimately be decertified as unmanageable and not superior to the alternative of trying claims one-by-one. From an investment standpoint, this would make any outcome in Engle relatively impotent. To date, three federal courts and one state court have already denied class action status to claims of injured smokers in PA, MO, Puerto Rico, and Washington D.C. We are currently awaiting class certification rulings by appellate courts in New York (Frosina, Hoskins class actions) and Maryland (Richardson class action). Investors should recall that in 1996, the U.S. Supreme Court in Amchem found that class action treatment was not appropriate for a national class of injured asbestos victims -- even where there was a settlement, which eliminated many of the individual issues that needed to be considered at trial. Two weeks ago, the U.S. Supreme Court accepted a certiorari petition to hear the Ahearn v Fibreboard case again after the 5th Circuit refused to decertify the settlement class action based on Amchem. As we have talked at length, the Engle class action involves some 100,000 - 200,000 Florida residents with smoking-related diseases, all whom equire separate trials to determine injury, legal cause of injury, and to evaluate comparative fault. We believe the Engle class action will be decertified as unmanageable after the Phase II trial (one trial for six representative class members, assuming the jury finds the industry liable in Phase I) under Castano and Amchem -- either by the Florida Supreme Court or the U.S. Supreme Court.
  1. State actions likely to be resolved by early-1999. We continue to believe the industry will negotiate a comprehensive settlement with as many of the 50 states as possible to eliminate the pending state AG and other government actions. We expect a settlement in the $150 - $200 billion range over 25 years, requiring a national price increase of $.30 - $.35/pack over five years, and which imposes a licensing fee on cigarettes in participating states for manufacturers who don’t settle. One strong incentive for states to sign up for a settlement is the commitment by the industry to sign consent decrees to end most advertising and merchandising activities. Complicating a state-only settlement scenario: A handful of states will refuse to take the industry’s money, but prices would go up in that state anyway by the same $.30-$.35/pack as in the states that did take the money; this might open the door for new entrants to sell cigarettes in those non-participating states at prices $.30-$.35/pack below the majors.

    2. We fully expect the industry to go to trial in the Washington state case (which begins September 22; trial likely to last 2 months) given the industry’s excellent prospects of winning (favorable judge, less engaged plaintiff attorneys, all claims but anti-trust, conspiracy and violation of consumer protection statute were dismissed). Judge George Finkle dismissed 3 claims back in November 1996 (violation of a special duty, unjust enrichment and restitution). The State is still pursuing its allegations of antitrust violations, conspiracy, and violations of the consumer protection laws prohibiting unfair marketing to minors and misrepresentations of material facts. The state is not seeking punitive damages, although Judge Finkle could award treble damages under the antitrust claim. The tobacco companies will likely seek summary judgment on those remaining claims during the summer, after discovery is complete. In addition to his decision to dismiss several of the state’s claims, some of the other pre-trial rulings have been favorable to the industry. Judge Finkle decided that the Minnesota judge’s ruling on the 39,000 documents did not automatically mean that those documents should be turned over to the state of Washington. Instead, Judge Finkle will evaluate the industry’s claims of privilege as to those documents.

  1. Republicans likely to pass narrow tobacco bill to get political cover. Next week, the House will start deliberating the narrowly focused drug/tobacco bill sponsored by Deborah Pryce (R-OH), and championed by Speaker Gingrich. At the core of the Republican bill are fines on retailers caught selling to minors, penalties on teens caught buying cigarettes, tougher youth access provisions, and little else (no excise tax increase). The Senate will likely follow the House, and pass something similar to the Pryce legislation before its Summer recess begins August 7th. We expect Clinton to embrace the narrow drug/tobacco bill as his own, rather than make tobacco a political issue in the Fall elections. Closure on legislation should allow investors to stop worrying about other more onerous tobacco legislation, such as the Hansen-Meehan-Waxman bill being kicked around in the House, which would raise excise taxes by $1.50/pack over three years, and be offered as a substitute to the Pryce bill. In the Senate, the Hatch-Feinstein bill, which looks like the June 20 accord, but would cost, all-in, $600 billion over 25 years, and raise prices by $1.50 over 10 years, does not have anywhere near the votes needed to pass; and hence, may not even come up for a vote.
  1. 4th Circuit panel unlikely to grant FDA authority to regulate tobacco. On June 9th, a panel of three 4th Circuit justices reheard arguments from the industry and FDA on the FDA’s intent to regulate nicotine as a drug under the 1938 Food Drug and Cosmetic Act. The 2 1/2 hour arguments focused on two key issues: (1) whether Congress clearly intended to withhold from the FDA jurisdiction to regulate tobacco; and, if not, then (2) whether the FDA’s claim of jurisdiction is based on a reasonable construction of the Food Drug and Cosmetic Act (FDCA). If the judges answer yes to the first question, then the FDA cannot regulate tobacco. If the judges answer no to the first question and yes to the second, the FDA can regulate tobacco, but the judges must also decide whether the FDA can restrict tobacco advertising.

The FDA has contended that Congress gave the FDA broad jurisdiction under the FDCA to regulate any substance intended to affect the structure or function of the body. According to the FDA, tobacco fits within that broad definition, as demonstrated by the tobacco industry’s own documents, which comment that nicotine is a powerful pharmacological agent, a sedative and a tranquilizer, and that cigarettes are a dispenser for a dose unit of nicotine. The FDA urged the court to look at the reasons consumers use tobacco products when deciding whether they are intended to affect the body. The FDA pointed to the fact that Congress did not expressly exempt tobacco from regulation under the FDCA. Therefore, the FDA argues, Congress did not clearly intend to withhold jurisdiction over tobacco from the FDA. The FDA urged the court to defer to its reasonable claim of jurisdiction. Despite its refusals over the past few decades to exercise jurisdiction over tobacco, the FDA now claims it has the right to change its position on the basis of new evidence: that the tobacco companies manipulated the nicotine content in cigarettes in order to cause and sustain addiction in smokers.

The industry argued that Congress has shown its clear intent, in the FDCA, the Cigarette Labeling Act and the Alcohol, Drug Abuse and Mental Health Reorganization Act, to withhold from the FDA jurisdiction to regulate tobacco. In the FDCA, Congress allowed the FDA to regulate food, drugs and cosmetics, but did not mention tobacco. The industry argued that tobacco does not qualify as a substance that is intended to affect the structure or function of the body because courts determine "intent" on the basis of the manufacturers’ representations. In the FCLAA and the ADAMHA, Congress gave power over tobacco to agencies other than the FDA. The industry focused on two purported dangers resulting from FDA regulation of tobacco: (1) the FDA would have to ban tobacco because the FDCA prohibits the sale of unsafe products; and (2) the FDA would have jurisdiction over every product that foreseeably affects the body, potentially including air conditioners and rollercoasters. According to the tobacco industry, none of the relevant facts have changed since 1980, when the FDA last decided that it did not have the authority to regulate tobacco. The FDA knew then about the addictiveness of nicotine and the potential health effects of tobacco. The FDA even knew that the tobacco companies were able to manipulate nicotine yields — they had to in order to label each brand of cigarette with the tar and nicotine content. After Judge Hall commented that the industry has recently changed its position to target youths, the industry noted that Congress delegated authority to the states and the FTC -- not the FDA -- to address this problem.
  1. Buybacks and earnings surprises can resume after Congress adjourns. Once Congress passes a narrow tobacco bill -- likely in late-September after the House-Senate conference to iron out differences between the House and Senate versions -- we expect the industry, led by Philip Morris to resume its stock buyback activity. We also believe the industry will be able to accelerate domestic tobacco profit growth, given the spending flurry this year to both build momentum prior to the industry going dark, and to avoid showing much operating profit growth in domestic tobacco -- by 1998/4Q. At a minimum, we expect Philip Morris to resume its $8 billion, 3-year program -- even if it reaches a settlement agreement with the states. We expect UST to take on significant debt (at least $1 billion over 3 years) to boost its valuation. RJR’s value unlocking action will likely take the form of either an IPO of RJR’s international business, or a joint-venture of RJR International with another tobacco company -- likely BAT.


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