TOBACCO: THE UNFILTERED VIEW
We recently attended the annual Tobacco Merchants Association conference
and interviewed Standard & Poor's to better gauge the impact
that the Master Settlement Agreement (MSA) is having on the tobacco
industry and tobacco settlement bonds.
Our research indicates that industry analysts and bondholders are
primarily focused on litigation, shipment volumes and enforcement
of the master settlement agreement. However, due to a variety of
factors, bondholders can expect to see their principal and interest
payments continue as they have in the past.
Background
The 1998 agreement between the four largest tobacco companies and
50 states and territories requires the original tobacco companies,
plus 36 companies that signed on afterward, to pay approximately
$206 billion over 25 years to the states as repayment for health
costs borne by the states from smoking-related illness.
In return, the states agreed not to sue the tobacco companies who
are part of the agreement. Non-participating cigarette producers
that wish to ship their products must post escrow payments in the
states where they seek to do business as collateral against any
future state suits against them.
Litigation
Although numerous individual and class-action suits remain outstanding,
it appeared to most of the conference participants and tobacco industry
analysts that the litigation landscape for tobacco companies is
improving. For example, plaintiff attorneys have apparently concluded
that higher courts are not sustaining suits based on health claims.
Instead, plaintiff attorneys are asserting fraud, arguing that cigarette
producers misled the public into believing that "light"
cigarettes are healthier than regular smokes. In the Price case,
in Madison County, Illinois, the trial judge agreed with the plaintiffs
in their suit against Altria (parent of Philip Morris USA), but
his decision is expected to be overturned on appeal.
Most industry observers we have talked with believe suits of this
kind will not meet with success. Federal law prescribes the health
warning contained on cigarette packaging, and both cigarette makers
and the states are prohibited from overriding these disclosures.
Furthermore, limitations on punitive awards under the recent U.S.
Supreme Court State Farm decision may well reduce the size of potential
liability cigarette producers are faced with.
Shipment Volumes
An area of greater concern is the inordinately high excise taxes
that have been, and are likely to be, placed on the sale of cigarettes
by the states. Because of state budget shortfalls, eight states
have already passed tax hikes and 21 more are considering it. If
all such tax increases are passed, the tax bite would increase by
36% per pack. In addition to tax increases already enacted since
the MSA was signed, the increasing price gap between premium brand
and deep discount cigarettes has grown more stark.
As can be expected, consumers have moved from higher price brands
to generics as prices have risen. Market share has then shifted
to smaller producers, many of whom are MSA participants, and some
who are not. Market share is significant since it determines the
percentage each cigarette manufacturer is responsible for paying
under the MSA.
To the extent that the four original participating manufacturers
lose market share, it has weakened their bond ratings and, in turn,
the bond ratings of the tobacco settlement bonds. Also of concern
is the market share that could be slipping to non-participating
manufacturers who do not share in the obligation to make MSA payments.
Market share data are often conflicting and reliability is suspect,
making tracking industry trends difficult. Despite this, MSA participants
are still thought to control 85% - 90% of total industry shipments,
ensuring that sufficient MSA payments flow to the states and secure
outstanding bonds.
MSA Enforcement
Increased enforcement actions are underway against non-participating
manufacturers seeking to evade required escrow payments, counterfeit
cigarette makers and other illegal imports, and unregulated Internet
sales operations seeking unfair price advantages over MSA participants.
Legislation has been introduced to strengthen enforcement in approximately
half the states so far this year that would tighten compliance with
MSA requirements and reduce incentives for non-participating manufacturers
to remain outside of the MSA. Increased enforcement by the Federal
Bureau of Alcohol, Tobacco and Firearms (BATF) along with greater
vigilance by state attorneys general should work to reduce unaccounted
for shipments and decrease opportunities to undercut cigarette prices
charged by legitimate sales channels.
Conclusion
Current uncertainty surrounding the direction of the tobacco industry
is partially ameliorated by an improving litigation environment,
increased enforcement activities and efforts to better quantify
market share data. Tobacco settlement bonds have suffered downgrades
and remain on CreditWatch, but they are viewed by rating agencies
as stronger than tobacco company direct debt due to the strength
of the MSA payment mechanism and the likelihood it would be viewed
as an executory contract in a bankruptcy scenario. All this means
that with increased efforts to insure that the MSA continues to
work, bondholders can expect to see their principal and interest
payments continue as they have in the past.
05/20/03
About Dr. Abrams
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