Altria and Reynolds Are Set to Profit From the Expiration of This Little-Known Law

When the FETRA legislation expires this year Altria and Reynolds will report big gains.

May 12, 2014 at 3:43PM

Big tobacco is used to the consistent stream of lawsuits levied on the industry and the settlement costs that follow as a result. However, one settlement, or to give it its correct name, buyout, is about to expire, and this is great news for both Altria (NYSE:MO) and Reynolds American (NYSE:RAI).

Buying out of quotas
Back during October 2004, the Fair and Equitable Tobacco Reform Act -- FETRA -- was signed into law.

FETRA was part of the American Jobs Creation Act and it eliminated the federal tobacco quota and price-support program, which was put into place by the Agricultural Adjustment Act back during 1938.

The main element of FETRA was an industry-funded buyout of tobacco growers and quota holders. The cost of the 10-year buyout, which should end this year, was $9.5 billion and it was paid by manufacturers and importers of tobacco products. Payments under FETRA are determined by factors such as volume and market share, although payments were capped at $500 million per year.

Individual contributions
As the US' largest domestic cigarette company, Altria and its subsidiary Philip Morris USA have been paying the maximum allowed, $500 million per annum, toward the buyout.

Now, as covered above, FETRA was supposed to last for 10 years and the last payments will be made at the end of this year, which means that Altria should report a $500 million gain to its bottom line as of next year.

Meanwhile, estimates place annual expenses for Reynolds subsidiaries under FETRA for 2014 at approximately $165 million. Reynolds' management has estimated that the company's overall share of the buyout will be approximately $2.5 billion.

With the 10-year buyout period up, both Reynolds and Altria will benefit as their cash flows jump by the amounts that their FETRA contributions used to consume. An additional $165 million should boost Reynolds' cash flow from operations by 13%, and Altria should report an 11% jump in cash flow from operations.

Nevertheless, while one set of legal constraints on tobacco finishes, yet another is rearing its ugly head.

More lawsuits
Altria has come under fire during the past week or so from shareholders after the reinstatement of a $10.1 billion verdict against its subsidiary Philip Morris USA. The original suit accused Altria of misleading consumers about the risks of smoking "light" cigarettes. The case was originally brought against Philip Morris USA at the turn of the century but the courts ruled in favor of Philip Morris back during 2005.

The lawsuit had accused Philip Morris USA of defrauding consumers into believing that "light" or "low tar" cigarettes were safer than regular cigarettes.

Of course, Altria has immediately appealed the reinstatement of this case, which has postponed any court action. Nevertheless, any appeals process is likely to be lengthy and the case could end up in the United States Supreme Court. What's more, due to the size of the settlement Altria will likely have to post a $250 million bond while the proceedings take place. As a result, this is likely to immediately mitigate the benefits from the FETRA expiration.

Still, Reynolds is likely to report a boost to earnings as the FETRA payments end.

Foolish summary
So, as FETRA payments end both Reynolds and Altria should post increases in their bottom lines. For Reynolds this will be great news as a gain of $100 million per annum will give the company more cash to return to investors. On the other hand, Altria's gain from the expiration of FETRA is likely to be almost immediately taken away as the company is forced to post a bond for yet another lawsuit. 

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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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