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Gary Black: As Litigation Ills Mount, Industry Split On Whether To Embrace Settlement With Feds.

Gary Black (212) 756-4197
Jon Rooney (212) 756-4504
January 22, 1999

1. We sense a split in the industry over whether to embrace the concept of a new settlement with the federal government as a vehicle by which to bring closure to this litigation wave. Over the next few weeks, we expect industry CEOs and their lawyers to open discussions with plaintiff counsel Richard Scruggs and DOJ lawyers, to assess the pros and cons of a new federal settlement.
2. Given explicit language in the 1962 Medical Cost Recovery Act (MCRA) that the federal government has the statutory authority to "institute legal proceedings against third person[s] who [are] liable for injury or disease….either alone or in conjunction with the injured or diseased person…." we see little chance that a court would dismiss or rule in summary judgment against a fed claim.
3. There is confusion about the nature of the fed's lawsuit, which will seek recovery of federal spending on smoking-related diseases under Medicare, Veterans, and other federal programs. DOJ's lawsuit will not seek recovery for the fed's share of state Medicaid spending, which was the basis for the AG settlement. Some analysts have misinterpreted Janet Reno's 1997 quote that the federal government does not have authority to seek recovery as applying to Medicare, when, in fact, she was referring to Medicaid.
4. Conceptually, the federal settlement vehicle pitched by Scruggs, combined with the AG settlement, would get the industry close to the legal certainty envisioned by the June 20 accord. The industry would demand offsets (i.e. credits) for personal injury judgments (individual, consolidated, classes), international judgments, third party recovery judgments not in the AG settlement, and excise tax hikes for a finite number of years. New settlements might be granted only a partial offset, to encourage a defense.
5. We expect the industry to cede limited FDA jurisdiction -- which could be the hook that convinces the health community to get behind a new settlement. Last year, the 4^th Circuit rejected the Administration's en banc request to review the three-judge panel's ruling that the FDA had no authority to assert jurisdiction. The U.S. Supreme Court has been asked to review the matter.
6. The biggest obstacle to a new deal remains renegade pricing. The AG settlement gave the renegades a $.45/pack cost advantage as long as their share didn't exceed the higher of 125% x 1997 share, or 1998 share. A $150-$200 billion federal settlement ($7-$8 billion/year) would give the renegades an additional $.35/pack cost advantage. Because share caps would remain fixed, the practical volume upside for the renegades with an $.80/pack cost advantage is not that different than with a $.45/pack advantage.
7. A DOJ settlement would not require Congressional approval, and would likely be welcomed by Republicans who oppose both raising excise taxes and efforts by the Administration to take its average 60% share of the state AG settlements. Yesterday, Senators Gramm (R-FL) and Hutchison (R-TX) announced they would introduce legislation to block the Administration from taking any of the state Medicaid settlement proceeds. Risk: This could become a "Christmas tree" for other tobacco initiatives.

We rate Philip Morris, RJR, and UST outperform. We expect tobacco stocks to remain weak near-term, given the odds of losing at least one of the four trials ongoing in February (Henley in California; Engle Phase I in Florida; Newcombe/Karney in Memphis; Ohio Iron Workers). Over the next few months, however, we expect stocks to rally as investors start to discount that the industry will again attempt to bring closure to this seemingly endless spiral of litigation, by constructing a federal settlement vehicle that essentially caps the legal risks not covered in the new AG settlement. Our simple premise: Once the industry has decided to settle, it cannot suddenly change course and decide to fight. We also perceive that investors are overlooking two fundamental issues that could trigger positive revisions: One, the 1999 consumption declines associated with the $.45/packprice hike taken at the end of 1998 are likely to be about half the 10-12% declines predicted by management and other analysts. Second, BAT's purchase of Rothmans, which we expect will trigger a global consolidation wave, will improve global pricing, leverage distribution, and be accretive if funded with debt.

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