CHICAGO - Fitch Ratings expects U.S. tobacco corporate ratings to remain stable in 2010 as the companies continue to generate sizeable free cash flow as a result of high operating margins. The ratings are further supported by the companies’ significant liquidity positions with respect to manageable upcoming long-term debt maturities.
“Due to the sizable cash flow generated by industry participants, past credit rating changes have mostly been precipitated by events, such as adverse legal judgments and merger and acquisition activity,” said Christopher Collins, Associate Director at Fitch. “Fitch believes that the risk of an event being material enough to cause a change in existing tobacco company ratings in 2010 is nominal.”
The following is Fitch’s review of events with the greatest ability to adversely affect ratings and the expected likelihood of those events occurring.
Menthol Exemption - Much Talk, Little Action Expected:
The Family Smoking Prevention and Tobacco Control Act was signed into law June 22, 2009 by President Barak Obama and provides the Food and Drug Administration (FDA) with authority to oversee the tobacco industry. Additionally, the law bans flavored cigarettes, with the exception of menthol, the most popular cigarette flavoring in the U.S. During the passage of the bill, the exemption proved controversial due to disproportionate use of menthol cigarettes by minorities. As a compromise, the FDA is tasked with developing a report on the risks of menthol flavoring and issuing a recommendation based on its findings. The report is currently scheduled to be published in August 2010, but the group tasked with producing the report, the Tobacco Products Scientific Advisory Committee, is still in the process of being staffed, potentially delaying the report and therefore any enforcement action. The report will be a review of studies already conducted. Fitch expects that the committee’s recommendation will be one of three options: 1) complete ban; 2) phased ban, based on menthol levels; or 3) status quo.
Fitch does not believe the Committee will recommend an outright complete ban due to the several predictable adverse consequences. Approximately 29% of cigarettes sold in the U.S. are mentholated. State budgets, already devastated by unemployment and reduced tax collections, would suffer further reduced tax collections. States took in more than $16 billion from state cigarette excise taxes in 2008. Taking the most extreme case, if menthol cigarette users all seek illegal cigarette replacements, states would lose approximately $5 billion in revenue. The expansion of the State Children’s Health Insurance Program (SCHIP) financed by an increase in the federal excise tax in April 2009 would require funding from other sources. The Master Settlement Agreement (MSA) payments, which totaled $8.8 billion in 2009, would be subject to a sharp downward revision due to volume provisions. Bootlegging of menthol cigarettes would increase exponentially. Resources would have to be tasked to stop the illicit trade, further straining federal and state budgets. Outside of fiscal effects, the health effects of contraband and bootleg cigarettes are unknown.
Clearly, Lorillard, Inc. (Lorillard) is the most dependent upon menthol cigarette sales and would be the most hurt by any type of menthol ban. Lorillard’s Newport brand, a mentholated cigarette line, accounts for over 85% of the company’s cigarette volume and over 90% of its net sales. Approximately 35% of menthol cigarette sales are Newport brand cigarettes. However, Altria Group, Inc.’s (Altria) Philip Morris USA and Reynolds American Inc.’s (RAI) R.J. Reynolds units would also suffer materially. Philip Morris USA’s Marlboro brand has the second largest menthol market share, and R.J. Reynolds’ Camel, Kool, and Salem brands garner significant menthol share. Menthol cigarettes have been gaining share, and prior to the passage of SCHIP and the increase in the federal excise tax, had been growing in volume in contrast to overall cigarette volumes, which have been experiencing a secular decline in the low- to mid-single digits.
Acquisitions - Lorillard, an Appealing Target, but Difficult to Acquire for U.S. Manufacturers:
Under the assumption menthol is not banned, Lorillard is an attractive acquisition. The company has industry-leading operating margins, the second best-selling cigarette brand in Newport, and leading market share in menthol. However, Lorillard’s larger domestic competitors face significant hurdles to acquire the leading menthol cigarette manufacturer. Altria’s approximately 50% cigarette market share likely precludes it from being an acquirer on an anti-trust basis. Fitch believes from an anti-trust standpoint, RAI would also have a difficult time getting an acquisition of Lorillard approved. Altria, RAI, and Lorillard together account for roughly 90% of the U.S. cigarette market. Additionally, if RAI were to keep its current brands, it would have over 50% market share in menthol in a combination with Lorillard. From a financial standpoint, the acquisition would also be challenging for RAI. An all cash offer would be near impossible given its balance sheet and earnings. With the need to raise over $12 billion (Lorillard’s bonds have a change of control provision), assuming no deal premium, the combined entity would have a pro forma leverage of almost 4 times (x). With leverage that high, the debt would certainly be high yield. Tobacco companies already pay an interest premium due to the limited pool of market participants. High yield tobacco debt is likely to have even fewer participants leading to very high interest costs, thus making a cash offer cost prohibitive. With a stock offer, British American Tobacco plc’s (BAT) 42% stake in RAI presents control issues. In an all stock offer, Lorillard shareholders would have a plurality of control, making a takeover unattractive to RAI’s management. An acquisition of Lorillard by RAI would be very complex due to the need to acquire regulatory approval as well as to strike the right balance between control, interest costs of debt-financed cash, and a premium for Lorillard’s shareholders.
Litigation - Outside of DOJ case, No Major Decisions Expected:
After the U.S. Court of Appeals for the District of Columbia upheld most of the findings of the U.S. District Court for the District of Columbia in United States v. Philip Morris at al (the DOJ Case), the tobacco companies are expected to file a petition for a writ of certiorari with U.S. Supreme Court. While the remedies required under the 2006 ruling of U.S. District Court in the DOJ Case are financially negligible, the findings have implications for cases pursued by consumer plaintiffs under state consumer fraud laws in various jurisdictions. A favorable Supreme Court ruling in the DOJ case would prevent consumer plaintiffs’ from citing the U.S. District Court’s ruling finding tobacco companies violated civil RICO laws. The tobacco companies have strong defenses in the consumer fraud cases, including arguments against class certification.
The Engle cases may continue to grab headlines with multi-million dollar damages awarded to plaintiffs, but Fitch anticipates resolution of the Engle cases will take many years as the jury trials are subject to post-trial motions and appeals. The Engle cases are a result of the decertification of the Engle class action suit by the Florida Supreme Court. In conjunction with the decertification, the court allowed consumer plaintiffs to file individual cases against tobacco companies using certain findings of fact established by the court such as smoking causes various diseases among others. Fitch expects tobacco companies to continue to fully litigate all cases. Given the time intensive nature of tobacco litigation, Fitch does not foresee undue risk of an adverse judgment in the near to intermediate term.
Operationally, 2010 will likely be a more typical year than 2009. The industry will lap the significant federal tobacco excise tax increase enacted April 1, 2009, which led to substantially higher retail prices and consequently considerably elevated volume declines.
Cigarette Prices - Nowhere to Go but Up Due to Expected State Excise Tax Increases:
Fitch expects state excise taxes to increase at an above-average rate due to the continuing strain on state budgets. The Center for Budget and Policy Priorities (CBPP) estimates that 48 states face budget shortfalls in fiscal 2010 of a combined total of approximately $180 billion. Increased tobacco excise taxes will obviously not make up for that entire shortfall as states only collected $16.2 billion in cigarette excise taxes in 2008, but so-called sin-taxes, excise taxes on tobacco and liquor, meet with little political resistance, allowing governments to somewhat offset revenue shortfalls. Additionally, as a result of the federal excise tax increase, volumes are expected to decline in the high single to low double digit range in 2009, cutting into state excise tax revenue. This will gives states additionally impetus to increase their excise taxes, many of which are dedicated to fund specific programs. Nine states have increased their cigarette excise taxes year-to-date, slightly above the annual median from 2000-2008. Twenty states increased cigarette excise taxes in 2002 following the prior year recession; consequently, an above average number of states are expected to raise their excise taxes in 2010.
The economic environment combined with significant price increases led to a trade down to value brands. With increases in state excise taxes and no substantial improvement in unemployment, Fitch expects the trend to continue. As of the third quarter of 2009, discount share of cigarettes grew to 29.5% from 27.3% for 2008. Among the large cigarette manufacturers, RAI, with its large percentage of value brand volume, is poised to continue to benefit from the consumer trade down. Its large value brand Pall Mall had a 5% share in the third quarter, up from 2.8% in the year earlier period. Lorillard has also benefited; shipments of its value brand Maverick were up almost 52% in the third quarter from the prior year period.
Cash Flow and Uses of Cash:
The industry’s cash flow from operations has historically been, and is expected to continue to be, significant and robust. This has allowed industry participants to return substantial amounts of cash to shareholders through high dividend payout ratios (Altria, RAI and Lorillard have payout ratios of 70% to 75%) and sizable share repurchase programs. However, in 2009, neither Altria nor RAI engaged in share repurchases. Altria conserved cash to pay down debt after its January acquisition of UST, and RAI used its cash to improve its liquidity position and reduce debt. While neither has current plans for share repurchases in 2010, Fitch expects both companies to be conservative if either chooses to return cash to shareholders via stock buybacks. RAI has traditionally engaged in only moderate share repurchases due to the 42% ownership stake of BAT, and Altria faces cash outlays as a result of adverse IRS audits. On July 9, 2009, a jury ruled unanimously in favor of the IRS’ disallowing tax benefits from certain Sale-In/Lease-Out (SILO) and Lease-In/Lease-Out (LILO) transactions of Philip Morris Capital Corp. (PMCC), a subsidiary of Altria. Tax benefits of SILO/LILO leases from 1996-1999 disallowed by the IRS totaled approximately $150 million, including related interest. The company anticipates that tax benefits, totaling $1 billion including related interest, from 2000?2003 will be disallowed by the IRS by early next year and it may need to post $1 billion in escrow to challenge the anticipated ruling, which Fitch expects would need to be financed at least short-term. However, a rating action is unlikely as credit measures have continued to improve after the $11.7 billion acquisition of UST.
Additionally, Fitch notes that Altria continues to hold a large stake in SABMiller plc, valued at over $10 billion, which could potentially be monetized. PMCC did not engage in any disputed transactions after 2003, but Altria will continue to face exposure to IRS audits, as it claimed SILO/LILO related tax benefits totaling $900 million including related interest from 2004 through 2009. In contrast to RAI and Altria, Lorillard is expected to continue to repurchase shares as it adds debt to its capital structure. Lorillard is targeting leverage of 1.5x total debt-to-EBITDA, and for the LTM period, the company’s total debt-to-EBITDA was 0.5x with total debt of $750 million.
The following is a list of Fitch-rated issuers and their current Issuer Default Ratings (IDRs):
— Altria Group, Inc. (‘BBB+’; Outlook Stable);
— Reynolds American Inc. (‘BBB-‘; Outlook Stable).
Additional information is available at ‘www.fitchratings.com’.