PARTIES TO TOBACCO PACT SEEK RESOLUTION
OF DIFFERENCES
The litigation environment surrounding tobacco has improved, and
the Master Settlement Agreement (MSA) between tobacco manufacturers
and states is firmly in place, although there are disagreements
over how well states have enforced the pact.
Those are some of the conclusions drawn from discussions with industry
insiders during our recent attendance at the Tobacco Merchants Association
annual meetings in New Jersey. The conference provided the opportunity
to talk with industry participants regarding some of the hot topics
facing the tobacco settlement bond segment. Our observations included
the following:
- Annual shipment declines appear to be consistent within the
expected ranges of 2% to 4% per year as envisioned in the structuring
assumptions of the $18.5 billion of tobacco settlement bonds issued
since the MSA was created.
- Both parties to the MSA generally agree that the states have
stepped up their efforts over the last two years to better enforce
the MSA, although more work needs to be done. As a result of new
legislation targeting the closing of loopholes in the MSA, it
is estimated that the market share of tobacco companies that do
not participate in the MSA has flattened and will likely decline
over time.
- Tobacco manufacturers who are part of the MSA are seeking credit
against future payments, through the NPM Adjustment (based on
market share lost to Non-Participating Manufacturers) for alleged
overpayments (plus treble penalties) for the years 2003-2004.
The companies say they lost market share due to the MSA agreement
itself, and the lack of adequate state enforcement during those
years.
The resolution process to determine over/under payments has
taken place only once so far, in 2002, and meetings are already
scheduled to work out differences for subsequent years. A neutral
party has been selected by both sides to determine market share
loss of participating manufacturers for 2003-2004 and to what
extent that loss was caused by the MSA itself. The time it will
take to reach a resolution by the parties is unknown, with estimates
ranging from a few months up to two years. Insiders tell us
that MSA implementation "ground rules" are still evolving,
with two questions having paramount importance:
First, both the states and manufacturers need to agree on the
size of the overall domestic cigarette market as a prelude to
determining each company's market share and gain/loss. This
has been the most hotly disputed issue by both sides of the
MSA. The states, which are responsible for reporting data each
year on shipments, have underestimated the non-participating
manufacturers market share, according to the companies who belong
to the MSA. If the companies are right, their market shares
would appear larger than if all non-participators, counterfeiters
and Internet sales were included. The problem is that in the
earlier years of the MSA, enforcement was more lax, and detection
of illegal shipments was less successful than it is today.
Second, once the parties reach agreement on market size, there
will need to be a determination that the MSA itself was the
cause of a participating manufacturer's market share loss. Further,
agreement will need to be reached whether such loss must be
determined on a state-by-state or national basis, in order for
the NPM Adjustment to be applied. As expected, the states support
a state-by-state approach, while the manufacturers find that
unwieldy and believe financial relief should be granted based
upon an overall nationally determined figure.
Although the NPM Adjustment issue has raised concern by holders
of tobacco settlement bonds, we believe that a concerted effort
by passionate advocates on both sides will result in a compromise.
Further, while there is some risk through 2007 that an NPM Adjustment
could affect cash flow to the states negatively, bond payments are
still expected to be made on time.
The longer term holds greater optimism. Stepped up enforcement
over the last two years has stopped the market share growth of non-participating
manufacturers, and many have sought to join the MSA rather than
compete from outside. If that trend continues, the market share
of companies outside the MSA will decline making future "Volume
Adjustments" and "NPM Adjustments" a smaller factor,
while the annual required "Inflation Adjustment" (minimum
of 3% or actual rate of inflation) should have an upward effect
on MSA payments.
Conclusion
With little success to date of class action suits against tobacco
companies, and the failure of the Department of Justice to gain
reinstatement of substantial financial penalties in its lawsuit
against the companies, litigation appears to have lessened as a
threat to tobacco bonds.
Additionally, the MSA is still in its early years. The agreement,
reached in 1998, is designed to last in perpetuity. The agreement
itself is highly complex and couldn't possibly account for every
"real world" twist and turn that would occur in the years
following its signing. At this point, the most contentious issue
within the industry surrounds the measurement of the actual size
of the cigarette market and each manufacturer's share of the market.
While resolution of this issue may provide a bumpy ride for bond
investors in the near term, market forces would seem to hold a promising
future in subsequent years.
ANALYST CERTIFICATION
SEC Regulation AC
I, Jay H. Abrams, hereby certify that the views expressed in this
research report accurately reflect my personal views about the subject
securities and issuers. I also certify that no part of my compensation
was, is, or will be, directly or indirectly, related to the specific
recommendations or view expressed in this report.
05/18/05
About Dr. Abrams
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