The Courts Rule Against Tobacco Again, How Much Will It Hurt This Time?

Altria, Reynolds American, and Lorillard have been reprimanded for misleading American consumers, and their punishment is harsh.

Jan 19, 2014 at 11:17AM

At the end of last week, the United States' largest domestic tobacco companies, Altria (NYSE:MO), Reynolds American (NYSE:RAI), and Lorillard (NYSE:LO), reached an agreement with the Department of Justice over allegations that the companies had lied about the dangers of smoking to their customers and the American public.

The final agreement is still to be approved by the U.S. District Court in Washington, D.C. and concludes several years of talks that followed the ruling by U.S. District Judge Gladys Kessler back in 2006, which inferred that the nation's largest cigarette makers concealed the dangers of smoking for decades.

What's the punishment?
So, there are basically two factors that are likely to impact Altria, Reynolds, and Lorillard as a result of this ruling. Firstly, their marketing costs will rise.

Under the ruling, Altria, Reynolds, and Lorillard must publish ads in the Sunday editions of 35 newspapers and on newspaper websites, as well as buy prime-time advertising space on CBS, ABC, or NBC five times per week for a year -- not a cheap undertaking. In addition, all three companies concerned must publish 'corrective' statements on their websites and affix them to a certain number of cigarette packs, three times per year, for two years. Again, none of this is likely to be cheap.

Can we estimate how much it will cost? Not really, although according to data from 2011 the average cost of a prime time TV spot is around $110,000. An ad for one prime time sport, five times a week for a year then will cost around just shy of $29 million per annum. In comparison, Lorillard spent $30 million to advertise its Blu e-cig product last year. So, financially, this judgement is not likely to damage the income of big tobacco significantly.

Nonetheless, the advertisements, or corrective statements as they have been referred to, are damning and they have been described as:

"...shameful and humiliating..."

The statements are designed to make up for years of misleading information that these companies have given. Under the agreement, every statement should be prefaced by a statement that conveys to readers the fact that:

"...a federal court has concluded that the defendant deliberately deceived the American public..."

This statement must then be followed by one of a list of corrective statements approved by the court, including but not limited to:

"Philip Morris USA, R.J. Reynolds Tobacco, Lorillard, and Altria intentionally designed cigarettes to make them more addictive."

"There is no safe level of exposure to secondhand smoke."

"When you smoke, the nicotine actually changes the brain — that's why quitting is so hard."

Impact on sales
These negative statements lead me to conclude that the ruling will have an effect on sales. Effectively, these tobacco companies are paying to tell consumers to stop using their products. Fortunately, it is possible to estimate what effect this will have on sales.

Specifically, a study entitled Can anti-smoking television advertising affect smoking behaviour? Controlled trial of the Health Education Authority for England's anti-smoking TV campaign, designed to evaluate the effectiveness of the Health Education Authority for England's anti-smoking television advertising campaign, concluded that an 18-month anti-smoking campaign would reduce smoking prevalence by around 1.2%.

In summary
So, it remains to be seen just how much this ruling will impact tobacco companies. Marketing costs incurred by this ruling are not really likely to impact the profits of Altria significantly, although Reynolds and Lorillard might be more effected.

Indeed, an additional $100 million a year in advertising spending (this is a complete guess but based on the $30 million per year in TV advertising covered above, it seems appropriate) will impact Altria's net profit by 2%, based on 2012 numbers. The impacts on Reynolds and Lorillard are likely to be slightly more damaging, but not catastrophic.

Nevertheless, the most pressing issue here is the impact that these advertisements will have on sales. Although the study from Britain suggests that the impact could be minimal, it's hard to tell how things will work out.

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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.

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