Tobacco companies that provide the lion’s share of funding under the Master Settlement Agreement (MSA) have seen their market share stabilize over the last year.
Recent second-quarter earnings releases from Altria and Reynolds American (successor to RJR) have confirmed that the Original Participating Manufacturers (OPMs) of the MSA have seen their market share remain at 85% of total domestic cigarette shipments for much of the last year. This follows a period of erosion to cheaper brands as a result of higher state excise taxes.
Since the signing of the MSA in 1998, the economic downturn brought with it record state government deficits. Although the MSA promised more than $200 billion to the states over the MSA’s first 25 years, budget crises saw states raise tobacco excise taxes to record levels.
Predictably, the rising cost of cigarettes provided incentives for small startup cigarette producers, counterfeiters, importers, Internet sellers and other “back channel” lower-cost alternatives. Many of these Non Participating Manufacturers (NPMs) have not complied with MSA requirements that they escrow funds with states in a timely manner.
Manufacturers who do not participate in the MSA must escrow funds in states where they do business. These funds are equivalent to their potential MSA payment and serve as collateral against potential future state health-care claims. By failing to escrow funds, NPMs are able to price cigarettes significantly below the major brands. Additionally, many small producers failed to report shipments, as required by law, and exploited other MSA loopholes that allow rebates of some escrowed funds to NPMs whose business is heavily concentrated in a few states.
In all, these loopholes provided pricing advantages for non-participating manufacturers, which gradually cut into the market share of bigger cigarette makers.
States take action
States have not stood still. Over the last three years, 149 bills have passed tightening up enforcement of state laws governing implementation of the MSA. Much of this legislation sought to level the playing field between the generic and name-brand cigarette makers to ensure that the generics don’t exploit loopholes to compete on price.
While market share have stabilized for both OPMs and NPMs, statistics from Management Science Associates, the official data collector for the MSA, indicate that industry volume for the first half of 2004 was 194.2 billion units, down 2.4% over the same period in the prior year, and in line with expectations.
Although challenges to enforcement legislation (Freedom Holdings case) persist, the legal path is likely to be long. We still believe that such enforcement will continue to be successful and that efforts to retain unfair loopholes are unlikely to prevail. The good news is that stepped up enforcement efforts are working, which benefits MSA participants, states and bondholders alike.
