Changes In Washington May Pressure U.S. Cigarette Makers
The changing of the guard in Washington is expected to translate into higher taxes and tougher regulation of the U.S. tobacco industry, which is already under pressure from steadily weakening cigarette sales.
Industry watchers widely expect Congress to enact legislation this year that will allow an increase in federal excise taxes on tobacco products to help fund an expansion in the State Children's Health Insurance Program. Also, likely to be on the agenda are measures that would allow the Food and Drug Administration to regulate the tobacco industry. The changes could pose fresh challenges for the three major U.S. cigarette makers, Altria Group Inc. (MO), Reynolds American Inc. (RAI) and Lorillard Inc. (LO). "It's a More adversarial environment for tobacco companies," says Stifel Nicolaus analyst Christopher Growe. Cigarette companies in the U.S. have seen volumes decline as they have been pushed to boost prices to offset higher federal and state taxes and to make annual payments under a 1998 settlement agreement with states. Bans on smoking in public places and More health-conscious consumers have also contributed to the slide in cigarette volumes. Fresh taxes on Cigarettes could put added pressure. Growe says that legislation related to the children's health-insurance program, or SCHIP, could translate into a tax increase of 61 cents a pack on Cigarettes. "It could have a meaningful effect on volume," he says. He estimates that such an increase could translate into an approximate 15% tax increase for the consumer and a possible 5% to 10% reduction in overall cigarette industry volumes. Andrew Parmentier, managing director of equity research at FBR Capital Markets Corp. in Arlington, Va.,says passage of the bill is likely to take place in the second quarter of 2009. "Investors will begin pricing the risk into the stock once they see legislation moving in the House early next year," he said. President Bush vetoed related legislation on SCHIP, but the incoming Obama administration is expected to see it through, Parmentier said. "Both the FDA bill and the SCHIP funded by tobacco tax have demonstrated bipartisan support and therefore present the new Congress and the new president with the opportunity for early victories," says Matthew Myers, president of the Campaign for Tobacco-Free Kids, an organization that works to reduce tobacco use. "This president and this Congress is likely to be More supportive to efforts to reduce tobacco use than any in history." Representatives for Altria and Reynolds said they wouldn't speculate on how much of an impact higher federal taxes might have on cigarette volumes. John Singleton, a spokesman for Reynolds American said that the regulatory downside of such a tax would be that cigarette sales could shift away from legal and regulated retailers to less regulated channels or possibly even illegal outlets as consumers seek to evade the taxes. Altria spokesman Bill Phelps said his company "believes that funding any expanding federal programs with a declining revenue source doesn't make sense" and Altria will "continue to oppose taxes that unfairly target adults who smoke." A Lorillard spokeswoman pointed to a recent regulatory filing in which the company said future tax increases, the amount of which can't be predicted, could result in further volume declines for the cigarette industry. Passage of broad-based FDA regulation of the tobacco industry could also happen in 2009, says Parmentier. A related bill already passed the House and he said it could easily pass the Senate. What FDA regulation of the tobacco industry will ultimately mean for the U.S. companies is a matter of some debate. "I call it a net negative to the industry," said Growe of FDA regulation. The bill could make it harder for new products to make it to market and there could be More aggressive control on marketing as well, he said. Tighter controls could help established companies like Altria, whose Marlboro cigarette brand already dominates the market, but Growe says the scale of that benefit may not be huge. The Altria spokesman said the company supports "tough and reasonable" regulation by the FDA partly because it would push all tobacco manufacturers to operate at the same standards and could provide a "framework" for companies to pursue alternative, less harmful tobacco products. The FDA bill could effectively offer a defense against litigation, especially for new low-risk products following FDA approval, Growe said. He added that the smokeless tobacco industry could effectively seek approval to claim that smokeless tobacco is less harmful than Cigarettes. That could be beneficial for smokeless tobacco maker UST (UST), which is soon to be acquired by Altria, and as well as other smokeless tobacco sellers. The Reynolds American spokesman said the company opposes FDA regulation as currently drawn, party because the company believes it would make it More difficult to introduce lower risk products. There is some uncertainty on how FDA regulation will impact the menthol cigarette category. A tougher stance from regulators on menthol could pressure Lorillard, which has the leading menthol cigarette brand, Newport. "There is some question going forward how menthol will be treated under the legislation and that is very important to a number of investors on Wall Street because Lorillard is the brand leader in menthol Cigarettes," Parmentier said. Lorillard says the FDA is overburdened and the wrong agency to carry out the regulation. Lorillard says scientific studies to date don't support a conclusion that menthol Cigarettes are More hazardous or addictive than non-menthol Cigarettes.