Debate and Issues Archive

draft settlement

Reading the Tobacco Leaves: How Long Will Smokers Keep It Up?
  Date: Jun 11, 1999
  By Daniel Kruger

  Bond Buyer NewsEdge Corporation : Cigarettes are addictive.

That fact alone will ensure continued existence of the tobacco industry for many years to come, securities analysts say.

But when it comes to analyzing what market conditions will move cigarette consumption up and down during the next 25 years, affecting the level of payments tobacco companies make to the states as part of their nationwide legal settlement, the picture becomes unclear.

Between the first issuance of tobacco-backed debt, which may happen later this year, and principal payments on final maturities of the settlement securitizations, analysts say the industry could undergo significant changes. They foresee many developments that may complicate how Americans use and view tobacco, including how changes in social mores and the emergence of black markets, business decisions and market conditions, developments in health and medicine, governmental agendas, and plain old human nature will also influence the industry.

While questions remain, there are a number of reasons that favor continued strong levels of tobacco use. In addition to cigarettes being addictive, there are few alternatives to them. Also, the companies that sell them operate in a brand- conscious market, where already-high barriers to entry are made harder by an agreement with the states that forecloses many traditional venues for marketing the product.

The cost of the habit to smokers is another factor influencing long-term survival of the industry.

As this year's decline in consumption indicates, "the demand of tobacco is fairly elastic," said Michael J. Schroeder, who follows the industry at Wasmer, Schroeder & Co., meaning that the price of the product does have an influence on demand.

To maintain their financial strength, cigarette companies have to "minimize negative impact of the necessary price increases, to the extent more are necessary," said Roy D. Burry, a tobacco analyst with Brown Brothers Harriman.

The companies have so far been successful in shifting the settlement's cost to consumers, according to Burry. "We had the big list price increases, but they were phased in over time," he said. He added that Philip Morris Inc., the largest U.S. tobacco company, is still discounting prices on brands and will probably ease out of that strategy by the end of the year.

But the added expense of the settlement has already slowed cigarette consumption by consumers, analysts say. With sharp price hikes of about 65 cents per pack this year, consumption is expected to fall between 6% and 10%, and analysts project in subsequent years that decline will probably slow annually to 1% to 3%.

A Unique Product
When prices are higher, there is a very disproportionately small decline in use, Schroeder said. "And you see that largely because there's no substitute. Tobacco is a very unique" product, he said.

Burry sees strength for the industry in a lack of new competition.

While the master settlement agreement between the participating tobacco companies and 46 states forbids many types of advertising and marketing, the industry was already protected from new competitors, he said.

"You haven't got the brand names, the production capacity, and all that stuff," Burry said. "The barriers to entry are formidable."

While the tobacco industry can clearly define market factors that work in their favor, assessing factors that work against them is trickier.

For example, there is no consensus regarding how consumers will react to programs aimed at decreasing smoking through price hikes in the form of the settlement or from taxes.

Emanuel Goldman, Merrill Lynch & Co.'s global tobacco analyst, said demand for cigarettes will remain essentially the same following settlement-related price hikes, but consumers will seek ways to minimize how much they pay to smoke.

Some smokers may smoke less, or look to black or gray markets to keep their costs of smoking as low as possible, Goldman said.

With large price increases due to the state settlements, and states like California adding to the cost of smoking by raising tobacco taxes, "what you have is people making their adjustments" to consumption, according to Goldman.

He points to the increased number of cigarettes sold through sharply discounted cigarette-only stores, up from 6% of sales five years ago to approximately 18% today. He also points out the British experience as they have jacked up the cost of cigarettes.

"Two things have happened as they've raised prices into the sky," Goldman said. "One is a real black market, because what it costs in Belgium is a fraction of the price in the U.K., same brand." The other is the rise of the market for loose tobacco for roll-your-own cigarettes. "If someone wants to smoke, they're going to smoke," he said.

More Regulation?
There are other issues over which analysts differ, such as the possibility of more regulation.

Schroeder is concerned with the potential by the federal Food and Drug Administration's attempt to regulate cigarettes as a drug, particularly if smoking becomes an issue in the 2000 national election cycle and the tobacco companies become political punching bags.

"If we see that happening, the purchase points and distribution methods will likely have to be altered," he said. "You'll see heavy restrictions on the use of vending machines, you'll see placement of the product in supermarkets and drug stores and other venues be more restrictive, and labeling will change, and advertising, and so on and so forth."

But Goldman disagrees. "Don't hold your breath on FDA regulation," he said, adding the U.S. Supreme Court is unlikely to go along with the idea.

Health-related concerns of individual smokers, more than price or any other factor, is responsible for making people smoke less, according to Goldman. "The lion's share of people who have given up smoking have not given it up because of price. I think it's the health aspects," he said.

Many analysts also point to the risk of litigation by individual smokers and their families, particularly after juries in California and Oregon awarded the families of smokers judgments of larger than $50 million each.

The risk from litigation is hard to quantify, however, in part because of the tobacco industry's strong record of winning cases brought by individuals and of successfully appealing the few they have lost. And currently, both judgments have been reduced by judges and are on appeal.

But the lawsuits may have an unintended negative consequence that has hurt tobacco companies over the years.

One of the largest reasons for negative stories about the tobacco industry has come from "internal documents that have found their way into the court system and in front of juries and the media," Schroeder said.

He suggested the industry may be happy with the settlement because it will end state lawsuits and the subsequent courtroom revelations. "I think, internally, the industry was not really very excited about having the whole world read these internal documents," he said. "And who knows how many more are out there that were amassed during years of research and management changes and so on."

Generation Next?
As time passes, analysts are unsure how the agreement restrictions on advertising and marketing will affect the behavior of teenagers, a demographic group the government most heavily targeted in its campaign to reduce smoking. The inability to advertise to this group could hurt financially because teen smokers are likely to continue the habit when they become adults.

The cigarette companies could face problems in establishing themselves with another generation of potential smokers as they come of age, Schroeder said.

Pointing out that social trends are very difficult things to predict, Schroeder said that with more smoking "restrictions in restaurants and other public places like airports, it will be frowned upon and (become) a socially unacceptable practice."

To the extent anti-smoking attitudes rub off on kids, he said, "that's a hurdle they're going to have to overcome somehow."

But Goldman disagrees with the idea that ads and marketing have much to do with teenagers or young adults taking up smoking.

Having friends or parents who smoke is a stronger pull for kids and teens than any advertisement, Goldman said.

"It's not because of a Joe Camel," he said, referring to a cartoon character used to sell Camel cigarettes, but now banished from billboards. "It's the peer thing."

Money spent on anti-tobacco ads will also reach a similarly small audience, Goldman said.

"Just throwing money against the wall isn't going to help," he said. "If you had targeted programs, maybe it might help, but I happen to believe that most of the kids know all about smoking anyway."

Uncle Sam's Role
While the potential effects of governmental attempts to curb smoking among American youth have yet to be seen, analysts are agreed that the behavior of governments - national, state, and local - will have a large impact on future cigarette consumption.

With the settlement payments falling or rising based on tobacco consumption levels, Schroeder sees "a conflict of interest" for state and local governments that with one hand are establishing programs to halt teenaged smoking and on the other are now planning on receiving those settlement payments over time or issuing bonds against that money.

Schroeder said that though states may take the position that "when you're settling with somebody, you've got to come up with some kind of formula. So we had to separate those issues from this particular business decision that we had to make - what's best for the people of our state. Well, what's best for which people in the state? The kids you don't want to smoke?"

If kids stop smoking entirely, "eventually the tobacco companies will be out of business, and there goes your 25 years of big windfall money, and how are you going to pay off the tobacco bonds you're securitizing?" he asked.

"They're all in business together," Schroeder said, "like it or not."