The act gives the FDA control over the manufacturing, labeling, marketing and sale tobacco products. (Click here for details and previous CSP Daily News coverage.)
"Although the new policies may, in our view, alter the competitive environment in the industry by hindering new product development, putting up barriers to entry and raising the overall cost of doing business, we don't expect the regulations to have an immediate rating impact on the rated tobacco manufacturers," said S&P's credit analyst Mark Salierno.
These manufacturers include the three largest companies by market share: Richmond, Va.-based Altria Group Inc., parent of Philip Morris USA Inc.; Winston-Salem, N.C.-based Reynolds American Inc., parent of R.J. Reynolds Tobacco Co. and subsidiaries; and Greensboro, N.C.-based Lorillard Inc., parent of Lorillard Tobacco Co.
"We believe that these manufacturers' strong cash flow generation, solid margins and respective market positions provide support to the current ratings and partly offset the risks associated with FDA regulation, in addition to ongoing litigation risk and contraction in the domestic cigarette industry," Salierno said. "However, our negative outlook on Lorillard reflects greater uncertainty about the impact FDA regulation may have on the menthol cigarette category, given the company's greater exposure and leading position in this category."
Meanwhile, S&P's said it does not expect the bill to have an immediate impact on its ratings or outlook on tobacco settlement-backed securitizations, which are structured transactions secured by payments from participating manufacturers under the 1998 Master Settlement Agreement (MSA).
S&P's credit analyst Elena Serdyuk said, "Our ratings on all such securitizations already have negative outlooks or are on CreditWatch negative, reflecting our view of continued risks."
Moreover, at this time, S&P's does not expect to make changes to its current criteria assumptions for tobacco settlement-backed securitizations as a result of the legislation, it said.
"Two of the key assumptions we use to project cash flows for tobacco securitizations are the volume of cigarette sales and the market share of the tobacco industry participants, and overall, we believe our current assumptions for volume declines in cigarette consumption and market share address the continued risk of further declines," Serdyuk said.
S&P also said that it believes the new legislation will not substantially change the current level of overall litigation risk for the tobacco industry and settlement-backed bonds. "Our negative outlook on tobacco settlement-backed bonds reflects our belief that significant industry and litigation event risks will likely be present for five years or more," Serdyuk said. "It also acknowledges the continued risk of further volume declines, which could lead to downgrades in the future."
The report added, "We also believe the regulations may pose risks to the domestic tobacco industry as a whole over an intermediate to long-term time frame.... We believe the legislation has the potential to change the competitive landscape in the industry. Specifically, the marketing and sales restrictions may make it more difficult for manufacturers to introduce new products or establish brand names. The FDA approval process can itself delay the launch of new products and the FDA will also be able to limit or ban the use of harmful ingredients in both existing and new tobacco products, which could alter their flavor and potentially reduce consumer acceptance of these products."
"In addition, under the new legislation, the FDA will establish a Tobacco Scientific Advisory Panel that will evaluate issues surrounding the use of menthol as a flavoring agent or ingredient in cigarettes. Although we think an outright ban on menthol products is unlikely, we believe any future restrictions or prohibitions could hurt cigarette volumes in the menthol category, which accounts for approximately 30% of overall cigarette volumes."
"Moreover we believe that companies seeking to strengthen market share through innovationincluding smaller companies that may try to launch new brands or productscould have a harder time pursuing their competitive strategies under the new legislation. The bill also prohibits smokeless-tobacco manufacturers from implying in their marketing campaigns that smokeless products are safer or healthier than regular cigarettes."
"We also think the increased regulatory scrutiny and the costs associated with brand development and launching new products might discourage some market participants from competing on innovation, forcing them to compete primarily on price. The restrictions would also, in our opinion, make it more difficult for tobacco companies to target smokers who might be interested in switching tobacco brands or trying new products. This in turn could help established tobacco productsmany of which are produced by the PMs [participating manufacturers]to maintain market share."
"We expect the FDA regulations to increase the costs of doing business for all manufacturers in the tobacco industry in two ways. First, the legislation imposes user fees directly on the tobacco companies to fund the new FDA regulatory entity. Various public sources estimate that the fees, which would be phased in over 10 years, could range between $0.01 and $0.02 per pack initially and increase up to $0.06 cents over the longer term. Second, the tobacco manufacturers will need to make changes in their marketing, advertising, and manufacturing practices to comply with the FDA rules, which, in our view, could prove more costly than the user fees."
"We believe the increase in costs may be more burdensome to the smaller industry players, which don't benefit from the economies of scale that could help the larger manufacturers cope with implementing the new processes. Moreover, the PMs already have some of these practices in place and may not need to make significant changes to their marketing and sales programs."
Click herefor more from the report, "FDA Regulation Likely to Have Broad Effects on the Tobacco Industry, But Little Immediate Rating Impact on Settlement-Backed Securitizations."
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