Judge's New Menthol Ruling Could Help Lift Tobacco Merger

Source: Wikimedia Commons

As part of making the $27 billion megamerger between tobacco giants Lorillard (NYSE: LO  ) and Reynolds American (NYSE: RAI  ) work, the two agreed to calve off a number of cigarette brands to Imperial Tobacco Group (NASDAQOTH: ITYBY  ) in a separate $7 billion deal. Among them were two popular menthol cigarette brands, Kool and Salem, part of Reynolds' support brands that receive only marginal marketing backing.

Although Imperial protected itself from financial devastation by having the two giants include an indemnity clause for any litigation that was tied to the brands, one of the things it couldn't protect against was additional government regulation.

It's been the FDA's position that menthol cigarettes were of special concern as it flexed its newfound muscle over tobacco regulation. Last summer, as it was releasing for public comment its proposed rules for the minty smokes, the FDA included a 2011 "scientific evaluation" that found that although menthol cigarettes created no greater health hazards than regular ones, they increased the likelihood of someone starting smoking while deepening their dependence, and made it harder to quit. In particular, kids were more susceptible to start smoking because of menthol cigarettes, which was why the FDA also banned certain flavored cigarettes.

The tobacco companies had previously filed a lawsuit over the scientific study contending the FDA findings were not only flawed, but were compiled by a cabal of participants who had an ax to grind. One-third of the nine-member committee were doctors who had actually served as paid expert witnesses for lawyers suing the tobacco companies or had financial ties to pharmaceutical companies making smoking-cessation products. Not exactly fair and balanced representation.

In a ruling handed down on Monday, a U.S. District Court judge in Washington essentially said the tobacco companies were correct in their assessment of the panel and the regulatory agency was barred from relying upon its findings in making decisions about menthol cigarettes. He also ordered the agency to reconstitute the panel.

That will be key for Imperial Tobacco going forward, but also for the newly merged tobacco giant, which retained for itself the premier menthol cigarette Newport. Reynolds' top minty cigarette is also the second-biggest-selling smoke behind Altria's Marlboro brand and accounts for 85% of the tobacco company's total revenues. It owns more than 37% of the menthol cigarette market and has a better than 12% share of the entire cigarette market (Marlboro owns more than half.)

Although the agency says it's conducted independent research into the question and reached many of the same conclusions, and will fund even more research into menthol's impact on smoking cessation and attempts to quit, as well as looking at the levels of menthol in cigarettes, with the flawed study tossed and the agency barred from relying upon it, it could be harder to defend imposing restrictions in the future. Considering this judge has sided with tobacco companies in the past, such as on mandating graphic image warnings labels, a lawsuit landing before him over new rules targeted specifically at menthol cigarettes might find him equally sympathetic.

That means Imperial can probably breathe easier that its investments in the menthol cigarettes now won't become undone later, and the new Reynolds-Lorillard company can focus on its Newport brand without additional angst that a key driver of revenues will be snuffed out. Investors in all the related parties can also relax knowing that at least this part of the merger likely won't have a monkey wrench thrown into the works.

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