Gary Black: Williams Verdict: Industry Still In Denial. The Case for Higher Cigarette Prices.

TOBACCO

Williams Verdict: Industry Still In Denial. The Case for Higher Cigarette Prices.



Gary Black (212) 756-4197
April 1, 1999

HIGHLIGHTS

  1. While we are not changing our bearish outlook near term, we believe investors have grossly overreacted to a second outsized tobacco jury verdict. We believe both the Henley and Williams’s punitive awards will be sharply reduced, to more closely match the miniscule compensatory awards. More importantly, the back to back verdicts will likely cause industry leaders to alter both their settlement philosophies and pricing strategies.
  2. Senior management has to make a decision: Either embrace the idea of settling all tobacco claims -- not just the AG claims but the individual cases as well -- to bring closure to this litigation wave to facilitate restructuring actions (spin-offs, recapitalizations); or, it should dig its heels in the sand, fight the cases tooth and nail, and price the marginal costs of losing cases into each pack of cigarettes sold. Because management has done neither, investors have lost confidence in the company's ability to survive.
  3. Based on the U.S. Supreme Court's ruling in the 1996 BMW v. Gore case, we believe both the Oregon and California appellate courts will reduce the punitives awards ($79.5m and $50.0m, respectively) to more closely match the underlying compensatory awards ($1.2m and $1.5m, respectively). We believe there is a decent (25-50%) chance the Williams verdict will be overturned because the judge allowed the jury to consider company conduct prior to 1988, contrary to Oregon statute of repose law.
  4. We believe Philip Morris would need to raise prices by at least $.50/pack to show investors that it can cover the marginal costs of individual litigation risks, and reduce its bankruptcy discount (now 64%) to a more normal level of 20-30%. Math -- Assume the marginal smoker who consumes two packs of cigarettes per day for 40 years, has a 1 in 3 chance of getting lung cancer, a 1 in 10 propensity to bring a suit to trial, and a 1 in 10 chance of winning the trial and being awarded $5 million. This translates to an expected marginal litigation cost of $16,650 over lifelong consumption of 29,200 packs, or $.57/pack in marginal litigation costs.
  5. The next data point is now the Newcombe/Karney (Memphis) verdict in Tennessee, which should go to the jury the week of 4/19, and where a unanimous jury of at least 9 jurors (currently has 12) is needed for a verdict. Plaintiffs in that case (now only three following directed verdict in favor of industry on one plaintiff) are seeking $665 million each. Engle Phase I verdict due 5/15.

ADDITIONAL DETAILS

  • 1. Investors again overreacted? We are maintaining our view that until the industry articulates that it is interested in a new settlement to eliminate the risk posed by the individual claims (settlement with offsets with the federal government, or new state-only settlement class actions, one per state to get around Amchem) tobacco stocks are likely to remain questionable investments. In the interim, the only catalysts that would make investor sentiment improve is a change in pricing strategy to build the increased cost of litigation into every pack of cigarettes sold, or a marked shift in capital structure that increases the cash distributed to shareholders (higher dividends or share repurchases). We don't see either occurring anytime soon. The next data point is now the Memphis trial (Karney/Newcombe), which is expected to go to the jury the week of 4/21, and where plaintiffs seek $665 million for each of three plaintiffs. We may see a dead-cat bounce today as bottom fishers search the wreckage.
  • This $80.7 million verdict in Portland -- on the heels of the $51.5 million Henley verdict in San Francisco -- has got to serve as a wake-up call for the industry CEOs and Boards that the $206 billion AG settlement negotiated in November bought them no closure, and that the tide of jury sentiment has now turned against the industry. Our view remains that the flood of new documents, whistle blowers, and adverse publicity will increasingly convince juries to award punitive damages in tobacco cases. Ultimately, we believe this will cause the industry to rethink both its pricing and litigation strategies, but given huge debate within the industry now about how to proceed, we doubt the industry leaders will change course within the next few months.

    The specifics of Williams verdict were as follows: Negligence claim decided by 11-1 vote, jury split the blame 50/50%, awarded $821,485, which the jury reduced by 50% to $410,743. On the false representation claim (making false statements about the link between smoking and cancer), the vote was 9-3; since there were no modified comparative fault issues, the jury awarded the full $821,485, plus $79.5 million in punitives. It is interesting to note that the jury allocated the entire punitives award on the false representation claim, so as not to have to reduce the award by the amount of plaintiff's comparative fault. Most jurors quoted in the Oregon newspapers cited both old and new documents that showed the company has long been aware of the dangers of smoking, and made false statements that may have persuaded Mr. Williams that cigarettes wouldn't hurt him.

    The industry has lost 3 of its last 4 trials, and 4 of the past 8. Unlike the Henley verdict, which was pretty clean, we believe there is some chance an appellate court will overturn this verdict, given the decision by the judge to allow into evidence behavior by the industry pre-1988 -- which the industry will argue contradicts Oregon's statute of repose, which says that in tort claims, the jury can consider only products used by the plaintiff up to eight years prior to the claim filing date (1996). The judge allowed documents that outlined Philip Morris' behavior pre-1988, which we believe is probably allowable. Over 30 years of litigation, the industry has gone to trial in individual cases some 32 times, lost 5 (Horton 1985 - $0 damages, Cipollone 1988 - $400K overturned, Carter 1996 - $750K overturned, Widdick 1998 $1.0 million overturned, and Henley 1999 $51.5 million appeal pending).

    As in Henley, we expect the appellate courts to reduce the amount of punitives ($79.5 million to more closely match the compensatory award of $1.2 million). There are no limits on punitives in Oregon, and in Oregon, the court is given broad discretion to consider "amounts of previous judgments" -- i.e. Henley $50 million -- in deciding whether to reduce awards. About 20 states set limits on punitives (usually 2-3x compensatory damages; another 5 do not allow punitives at all. The controlling case is the U.S. Supreme Court's BMW v. Gore case (1996), which provides that punitives must bear a rational relationship to the amount of compensatory damages.

  • 2. Pricing in marginal litigation costs into every pack. Adverse judgments on lawsuits -- or settlements -- would not be a problem if the industry could demonstrate that it has the flexibility to increase prices to pay for the increased legal costs. This has not been the case this year, given Philip Morris' $.55/pack buydown in 1Q, which has raised pricing tensions. To put the Williams case in perspective, Jesse Williams smoked 3 packs per day for 42 years, or 46,000 packs over his life. At $81 million, this translates to an implicit cost of $1,761/pack in legal costs for every pack smoked by Mr. Williams.
  • Lets assume a normal verdict that results in a loss results in total damages including punitives of $5 million. Assume a normal 2-pack a day smoker has a 1 in 3 chance of getting lung cancer. Assume only 1 in 10 smokers with lung cancer brings a suit that makes it to trial. Assuming the industry loses 1 in 10 trials (perhaps low). This still implies expected legal costs of $.57/pack --

    Expected legal costs per smoker = $5 million x 1/3 x 1/10 x 1/10 = $16,650

    # Packs consumed by normal 2-pack a day smoker = 2 x 365 x 40 yrs = 29,200 packs

    Marginal cost of individual litigation per pack = $.57/pack

    The problem remains that the tobacco industry, like many industries, prices to recover average costs, as they are incurred or paid. Since no one in the industry we talk to even thinks like this, and because the renegades, who are not included in personal injury suits would surely not follow such an aggressive pricing posture, we view the odds of anywhere near a $.57/pack price hike anytime soon is nil. Still, if the industry winds up with another $250 billion settlement to eliminate individual and other claims, we are looking at another $.45/pack in pricing anyway.


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