Does Lorillard's (NYSE:LO) exposure to the highly scrutinized menthol-cigarette market pose a problem?

This is the question that many investors have been asking for some time and it seems as if they are going to get an answer very soon.

The menthol debate has been raging for some years now, but the U.S. Food and Drug Administration finally decided to make a stand this year, starting a 60-day public comment period back in July, which was intended to help inform the rule-making decision. However, the agency received requests that 60 days was not long enough to make an informed decision, so this deadline was extended to Nov. 22. Now that this period has ended, the FDA needs to make up its mind. 

Unfortunately, Lorillard's future is dependent upon the FDA's decision, as, according to Citi analyst Vivien Azer, about 90% of Lorillard's sales volume comes from menthol cigarettes. 

Meanwhile, Altria Group (NYSE:MO) sells menthol versions of Marlboro and Reynolds American' (NYSE:RAI) menthol offering is Camel, Kool, and Salem. Still, Reynolds' and Altria's exposure to the menthol market is nowhere near as troubling as that of Lorillard's. Specifically, Altria's menthol Marlboro's only account for around 20% of total sales and Reynolds' menthol brands only account for 30% of the company's overall sales.

So what are the two sides to the argument?

The argument against
Tobacco is usually a touchy subject when it comes to ethics, but when taking about menthol, the situation becomes extremely complicated. Not only are menthol cigarettes blamed for converting youngsters to the habit of smoking, but they are also popular among African-American smokers, which has fired up the race debate. In particular, 83% of African-American smokers use menthol cigarettes; by comparison, just 24% of white smokers use menthol cigarettes. Furthermore, there are some claims that three-quarters of African-American children and more than half of Asian and Hispanic children smoke menthol cigarettes. 

But perhaps the strongest argument against menthol cigarettes is the revelation that younger smokers prefer the 'softer' menthol flavor. So, with 88% of adult smokers claiming that they started smoking before the age of 18, menthol products become a big target in the war against tobacco.

What's more, Congress has already banned the addition of flavorings to cigarettes; they did this back in 2009 with the sole exemption of menthol. So why should it be exempt? In addition, the European Parliament recently introduced a law banning the sale of menthol cigarettes from 2022 -- this increases pressure on the United States to act.

All in all, there is some solid reasoning behind the FDA's prospective menthol ban.

The argument for menthol
However, every debate always has two sides and in this case, the argument to keep menthol products is supported by law enforcement agencies.

In particular, recent comments made by law enforcement agencies against the regulation of menthol products have started to sway the balance in favor of big tobacco. Specifically, law enforcement agencies are concerned that a ban on menthol cigarettes could lead to a rise in organized crime and black-market activity.

Previously, similar claims by big tobacco have been rejected by the FDA as a ploy and scare tactic to limit regulation. However, these new remarks come from Paul Carey III, chief of enforcement for the Northern Virginia Cigarette Tax Board, and others such as the 1,000-member Alabama State Troopers Association, a former supervisory U.S. Marshal from North Carolina, and Michael Robertson, former director of the North Carolina Alcohol Law Enforcement Agency, according to CNBC.

All of this makes me think that the FDA might start taking these comments seriously. Remarks from law enforcement agencies all suggest that cigarette smuggling is an ongoing problem and is linked to violent crime; comments like this could make the FDA reconsider regulation.

This makes me think that a complete ban on menthol products may not come into force.

Judgment day
Whatever the outcome, judgment day is getting closer. With the FDA's public consultation period on the matter closed, the agency needs to make a decision soon.

Overall, I feel a complete ban on menthol products is unlikely, as although they cause problems, the risk of black-market activity is a greater risk to society. That said, the FDA could restrict menthol products in some way, perhaps dulling down the menthol flavor so they weren't so appealing. This could impact sales of Reynolds, Altria, and Lorillard. Of these three companies, Altria is least likely to be affected, so for me Altria is currently my tobacco-sector investment of choice.

 

Fool contributor Rupert Hargreaves owns shares of Altria Group. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.