Is This Sector Going Up in Smoke?

FDA-approved cigarettes, anyone? They sound almost as exciting as Soviet-era cars.

With last week’s House and Senate approval of the Family Smoking Prevention and Tobacco Control Act, it’s all over but the crying for U.S. tobacco companies, as the bill looks to become law shortly. The new legislation will allow the FDA to have a hand in tobacco product standards and advertising guidelines. Big Tobacco will also have to ante up to pay for the tighter regulation ($85 million up front and up to $700 million annually within 10 years, according to The New York Times).

As we’ve discussed before, Altria (NYSE: MO  ) actually supported this legislation, which is funny because if the new regulation prevents folks from smoking, then wouldn’t that halt the growth of Altria’s primary business? Well, no, since Altria is already the leader in a declining market with legislation that would regulate development of new products. That’s why Altria's competition was strongly against the bill.

Big Tobacco is looking out for you
You can’t say the tobacco companies (other than Altria) didn’t try to thwart this legislation. Take the advertisement that Lorillard (NYSE: LO  ) placed in The Wall Street Journal two weeks ago. The company states that FDA regulation of what it calls an “inherently dangerous product” doesn’t align with the objective of keeping you, the consumer, safe. But in the next gasping breath, Lorillard claims the legislation could lead to black-market tobacco smuggling and potentially prohibition, not to mention the stifling of “safer” tobacco product development.

One reason for Lorillard’s concern is the potential for the FDA to eliminate menthol-flavored products, a move that would tear into the firm's Newport brand. The brand is the lifeblood of Lorillard’s business, making up more than 93% of the company’s 2008 sales. Although the legislation does allow such a move, the FDA is initially prohibited from banning menthol. 

Reynolds American (NYSE: RAI  ) , parent of R. J. Reynolds Tobacco Company, has been fairly vocal about its disapproval of the FDA regulation for a variety of factors, including stalled “product innovation.” With President Obama committed to signing the bill, Reynolds has said that it will continue to vie for new business and emphasized that this legislation has been years in the making, so the company is not unprepared for the changes.

British American Tobacco (NYSE: BTI  ) and Vector Group (NYSE: VGR  ) , while against the legislation, have been more quiet in their disapproval. Vector’s development of lower-nicotine products could position it well in this new FDA-regulated world, although the legislation could, of course, make it harder for new products to be approved. British American could also face issues with marketing its smokeless “snus” (now sold only outside the U.S.) in light of the new legislation.

Burnt-out investment opportunities?
FDA regulation of the tobacco industry is only a small piece of the puzzle when it comes to forecasting the potential of tobacco stocks. To me, the growing cigarette tax on consumers is the biggest barrier for stock growth in this industry. With a pack of cigarettes costing $5 or more in some states, the price of smoking continues to increase in an economy where job losses are near the double digits and the future financial picture is uncertain at best. And cigarette taxes are proven to decrease cigarette use: In New York State, the number of smokers declined by 12% in one year after a near-doubling of state tobacco taxes.

Tobacco companies can’t complain that they’re being singled out for tax increases and government intervention. Possibilities for sin taxes abound in this struggling economy, with potential tax increases in the pipeline for brewers and spirit manufacturers, such as Boston Beer Company (NYSE: SAM  ) (the maker of Sam Adams) and Diageo (NYSE: DEO  ) .

Will that make sin stocks less attractive? Solid dividends, such as those from tobacco firms, can help investors stomach struggling sales for awhile, and those who are addicted probably don’t care how much cigarettes cost. With that said, however, these taxes do motivate people to cut back on their consumption and prevent younger folks from getting started in the first place.

We know that the true effects of regulation can be different from what is intended, so it will be interesting to see if Altria’s market leadership position gives it the competitive advantage that its competition believes it will gain with heightened government intervention. We’ve seen that FDA leadership hasn’t been a huge factor in drug approvals, but that doesn’t mean that FDA chief Margaret Hamburg’s past toughness on smoking won’t hurt the industry as well.

In any case, the combination of increased taxes and FDA regulation of tobacco products certainly won’t help the industry’s future growth prospects in the United States.

For related Foolishness:

Diageo is a Motley Fool Income Investor pick. Looking for more advice in a topsy-turvy market? Give The Motley Fool’s newsletters a try via the 30-day free trial.

Fool contributor Colleen Paulson does not hold positions in any of the stocks mentioned above and gives a shout out to Penguins fans from the City of Champions. The Fool’s disclosure policy never burns out.


Read/Post Comments (9) | Recommend This Article (14)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 15, 2009, at 4:24 PM, madmilker wrote:

    when times get hard....people drink and smoke MO!

  • Report this Comment On June 15, 2009, at 4:30 PM, zooman53 wrote:

    Perhaps the real issue is not whether or not these companies make money. They shouldn't at the cost of lost lives and the disease that they cause to individuals who are addicted to their product. We don't permit companies to legally sell cocaine. Why should we support and encourage companies to make money off the suffering and pain of others? If you want to look at the issue as strictly and dollars and cents issue, then add up the costs to all of us in health care and insurance. Tax and regulate all these companies out of business!!

  • Report this Comment On June 15, 2009, at 5:07 PM, CIVILWAR1 wrote:

    This country is kept afloat by these outragous "sin" taxes and if anyone of these industries goes away this country will go under. This country has been stealing private enterprises money in the form of taxes and penalties for years without fixing the hole in the side of the Titanic. Believe me if the government could somehow find a moral reason to legalize all of the drugs that it tries to stop coming into this country, spending billions to stop maybe 10% of the traffic and tax it, our politicians would do it in a heart beat. We all make choices, some good some bad, but they are our choices in a free country. I wouldn't want it anyother way. Remember we threw the British out a few years back for imposing some taxes on us without representation. I think taxation with representation is alot worse.

  • Report this Comment On June 15, 2009, at 9:34 PM, mcdiv wrote:

    zooman53,

    If tobacco is truly responsible for a large portion of increased health care costs, then why haven't costs decelerated as the proportion of smokers halved over the past 30-40 years?

  • Report this Comment On June 15, 2009, at 11:28 PM, zooman53 wrote:

    Free choice comes at a cost and that cost is a burden that you and I carry in the indirect costs we carry for other's "sin". Frankly, I don't want lung cancer, nor do I wish to pay a smoker's hospital bill.

    mcdiv, the answer to your question is quite simple --- health care costs are influenced by many other factors than just the incidence of smoking. If there are ten factors pushing up the costs of health care and one pushing it down, guess which direction the costs are going to go.

  • Report this Comment On June 16, 2009, at 3:18 AM, tgauchat wrote:

    In response to CIVILWAR1, thanks...

    The government should have _nothing_ to do with "morality", and should just support equality and efficiency.

    The drug war is tremendously inefficient. The black market it causes leads to horrendous crime, murders, and extremely high enforcement costs (investigations, prosecution, and prisons), not to mention unfair application of the related laws and the affected families and communities.

    Legalization and taxation of substances which have a societal cost (i.e., all drugs) would permit the system to become efficient (i.e., enforcement and black market costs would be reduced, and taxation revenues can be partially allocated for treatment, education, etc., as is done with cigarettes).

    Our government is securely controlled by bribes of the drug lords who need to avoid legalization at all costs.

  • Report this Comment On June 16, 2009, at 10:23 AM, dwarrend39 wrote:

    I'm a current shareholder of MO (Altria) and don't think government intervention is necessarily a bad thing. What prevents them from simply changing their packaging to reflect "Not FDA approved" like the so many labels found in the GNC's so called nutrition stores across the country? Nicotine has been tested and proven in clinical tests to alleviate symptoms of schizophrenia, why not market and sale nicotine as an herb based product in those very chains that claim nutrition from natural herbs, vitamins, and lotions? The product could be marked up even higher and then the proceeds wouldn't be tagged with a "sin" tax.

  • Report this Comment On June 16, 2009, at 4:33 PM, billbk75 wrote:

    Not a word about Altria's recent acquisition of US Smokeless Tobacco. I don't know how the FDA regulation will effect Copenhagen, Skoal, and Husky but I do know that smokeless is the future of tobacco. It might not be the same on the coasts, but here in the middle of the country many more young men use smokeless than smoke. I'm one of them (not proud of it). I like to invest in companies that my money goes to.

  • Report this Comment On June 17, 2009, at 12:36 PM, CatWhisperer wrote:

    To the extent that when you buy (or short) a company, you buy (or short) a 'story', this is a very interesting set of developments for MO and the others. The whole story surrounding this legislation, is clearly yet to be told. I have not read the legislation but with tongue firmly in cheek, I have to ask, "What ghost writer might have assisted in drawing it up?" Any wild guesses?

    I too have to wonder if very stiff 'sin taxes' and regulation might prompt lower usership or (perish the thought) a more robust black market. Either way, tax revenue suffers. As was mentioned above by CIVILWAR1, the tax revenue from sin is very important at this moment in history, like it or not. With the gov't just as addicted to this sector as We the People are, the extent of taxation and regulation becomes a real balancing act. In making a wild assumption that a ghost writer had a hand in the authorship of this legislation, I think these cats are going to do OK on the regulation front; but no, this is not a real growth sector in it's current state.

    Great, article. Thanks for following this story. For those investors that choose to interact with companies in this sector, thoughtful and complete coverage of these developments is important, not to mention repleat with ethical and philosophical questions for those that enjoy bearing witness to the human condition.

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