Along with taxes, the report also dissects the other major issues currently facing the tobacco industry.
SCHIP
The current federal authorization of the State Children's Health Insurance Program (SCHIP), which was funded by a 15-cent increase in the federal excise tax on cigarettes in 1997, expires in March of 2009. An expansion of the program, which was to be funded by a 61-cent increase in the federal excise tax raising it to $1 per pack of cigarettes, was passed by congress in 2007 but was vetoed by President Bush. Given President-elect Obama's healthcare priorities, it is likely expansion of SCHIP, and consequently an increase in the federal excise tax, will be authorized early next year.
FDA Regulation
On June 30, 2008, the U.S. House of Representatives passed H.R. 1108/S. 625, the Family Smoking Prevention & Tobacco Control Act, with an overwhelming majority, but the bill has yet to be brought to a vote in the Senate due to a filibuster by Republicans. With Democrats enlarging their majority in both houses of Congress, it remains to be seen whether the Senate Republicans can maintain their filibuster. Although the bill will need to be re-introduced in the next Congress, the bill is unlikely to change drastically due to compromises made in drafting the bill to make it acceptable to various constituencies.
Adding further momentum to passage of the bill, Senator Ted Kennedy (D-Mass.) is the senate sponsor of the bill, and the senator is likely to lead Democratic-party legislative initiatives on healthcare. While it was unlikely President Bush would have signed the bill had it passed congress, President-elect Obama is a co-sponsor of the legislation and is likely to sign the bill into law if a version of the current bill passes congress.
Immediately following passage of Food & Drug Administration (FDA) regulation, the tobacco industry will likely operate much as it does today. The provisions allowing the continued sale of tobacco products to adults in retail outlets, along with legislation grandfathering today's tobacco products, will essentially ensure the continued operation of the industry in its current form in the near term. The ban on flavored cigarettes may stifle future industry innovation in tobacco taste preferences, but the exclusion of menthol as a banned flavor is important to all industry players and especially to Lorillard, considering the company's menthol brand Newport comprises more than 90% of its volume. Menthol cigarettes as a segment have experienced minimal growth to modest declines over the past few years, in contrast to mid-single-digit cigarette volume declines for the overall industry.
With the exceptions of banning tobacco products, eliminating nicotine content in tobacco and prohibiting the retail sale of tobacco products, the current draft of the legislation gives the secretary of the Department of Health & Human Services (HHS), as the Cabinet-level head of the FDA, wide-ranging authority to impose regulations. Fitch said it anticipates further advertising and sale restrictions would lessen the competitive forces between industry participants, benefiting those tobacco companies with substantial market shares. Furthermore, the legislation proposes a process for approval of modified-risk tobacco products, providing another impetus for industry change. If modified-risk products gain consumer acceptance, Fitch said it expects they could drastically change the competitive landscape of the industry in favor of early industry innovators.
Litigation
This fall, the U.S. Supreme Court heard oral arguments in Altria v. Good. The court's ruling should clarify a split in the appellate courts as to whether claims under state consumer fraud laws alleging fraud with regard to "light" and "lower tar and nicotine" labels are pre-empted under the Federal Cigarette Labeling and Advertising Act of 1965. Given the line of questioning pursued by the justices during oral arguments, Fitch said it expects a ruling in favor of Altria; a ruling in favor of Altria will further reduce the potential for adverse legal judgments against tobacco companies, it said.
On Oct. 14, 2008, a three-judge panel for the Federal Court of Appeals of the D.C. Circuit heard arguments against a 2006 Federal Court ruling in USA v. Philip Morris USA et al. Both the Department of Justice and the defendants have significant issues with the 2006 ruling finding tobacco companies guilty of racketeering but awarding no monetary damages to fund a multi-billion dollar smoking cessation program sought by the Justice Department. The 2006 ruling found the use of "light" and 'low-tar" descriptors as misleading and barred their continued use. The ruling was stayed on appeal, and the Supreme Court's ruling in Altria v. Good could have significant impacts in this case. It is likely the panel will wait to rule until after the Altria v. Good judgment.
Moist Tobacco
While the total moist smokeless tobacco category is quite a bit smaller than the cigarette market, accounting for approximately $3 billion in annual sales in 2007, the moist smokeless tobacco category growth has been between 5% and 6% annually during the past few years. Furthermore, the category is expected to continue to grow mid-single digits for the next several years, contrasting with U.S. cigarette volumes, which are expected to continue to decline. Additionally, operating margins are significant. UST posted a 56% operating margin in smokeless tobacco for the first nine months of 2008. This makes the market very attractive for cigarette manufacturers and accounts for Reynolds American Inc.'s purchase of Conwood in 2006 and Altria's bid to acquire UST.
Despite having over 57% market share, UST has been steadily losing share in the moist smokeless tobacco category to Conwood, since an adverse antitrust ruling. Conwood's value brand Grizzly has been outgrowing the overall category for several quarters, and the brand is expected to continue to grow as it benefits from trade down from premium brands such as UST's Skoal and Copenhagen. Weakness in spending at convenience and gas outlets in 2008, which has prompted the tradedown from premium smokeless tobacco brands to value brands, is expected to continue in 2009 as consumers pare back travel and discretionary spending.
With Altria's acquisition of UST expected to close in early January 2009, changes in price structure and promotion are anticipated in the moist smokeless tobacco category. Altria is likely to implement its marketing strategies in the smokeless tobacco category in an attempt to shore up share positions and capture some of the growth value brands have enjoyed. Altria's acquisition of UST is part of its strategy to diversify within domestic tobacco to offset declining cigarette volumes.
Dissolvable Tobacco
Separately, a recent Kraft/CSP Daily News poll asked, "Do you think that dissolvable tobacco products will eventually replace losses from declines in cigarette demand?" Of approximately 150 responses, nearly 57% said "no," more than 33% said "some, but not entirely," 8.5% said "yes, but a lot of education will have to take place" and about 1.5% said "yes."
Fitch said it expects ratings for U.S. tobacco companies to remain stable in 2009. This outlook is supported by the companies' significant liquidity positions and by their ability to continue to generate sizeable free cash flow as a result of their high operating margins.
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