Fool Plate Special: Justice Department Ready to Sue Tobacco

An Investment Opinion

Justice Department Ready To Sue Tobacco

By Warren Gump (TMF Gump)
September 22, 1999

The Justice Department will soon file a massive civil suit against the tobacco industry, attempting to recover the billions of dollars it spends on health expenses related to cigarette smoking. The dollar amounts being thrown about are huge, totaling about $25 billion in annual claims when including all groups receiving government benefits -- military personnel, federal employees, veterans, and Medicare claimants, among others.

The lawsuit reportedly claims that the tobacco companies engaged in consumer fraud by conspiring to conceal the risks of cigarette smoking from the public. Making the matter more serious, the government will try to show that tobacco companies violated racketeering laws, which would triple damages if successfully proven. All of the major cigarette makers, including Philip Morris (NYSE: MO), R. J. Reynolds Tobacco Co. (NYSE: RJR), and Loews (NYSE: LTR) fell in morning trading.

It's way too early to tell whether there is any legal merit to the case being brought by the government. In the past, eye-catching cases have been filed with little or no ultimate outcome. Already, before the case has been filed, the tobacco companies have started their rhetorical defenses. An R.J. Reynolds representative stated that, "We are going to vigorously defend the lawsuit. We are not going to settle this lawsuit... the law is going to find that the Justice Department doesn't have a valid case against the tobacco industry."

A battle has been fought for years among value investors debating whether cigarette companies offer attractive value. Proponents point to the fact that the companies are prolific cash flow generators, trading at extraordinarily low multiples of earnings that discount any reasonable estimates of litigation settlements. You can pick up RJR for less than 8x this year's estimated earnings, while Philip Morris, which owns Kraft and Miller Brewing in addition to its tobacco operations, trades for only 10x 1999 earnings. (The Standard and Poor's 500 index is trading at about 26x estimates for the year.) Considering the addictive nature of tobacco, the bulls argue, it is highly unlikely that these earnings will fall dramatically. In addition, the highly political nature of the topic means that a settlement should be reached that won't put these companies out of business.

Those staying away from the stocks say that that current estimates of litigation risk aren't adequate because the litigation risk isn't really calculable. Last year, investors thought that the companies received a reprieve from litigation after the tobacco companies reached a $240 billion settlement with states over their health care costs. Since then, however, verdicts in individual cases have raised concern about how much liability the company's might have. Today's new federal case raises the liability risk even higher. On top of all that, governments in other countries might see the multibillion recoveries in the U.S. and decide that they want a piece of the pie. Beyond litigation risk, overall smoking in America seems to be declining slightly, with higher prices and increased awareness of the health risks stalling consumption.

As a diehard value investor, I found stocks of tobacco companies very appealing for several years in the mid-1990s -- my favorite was Philip Morris, with its dominant cigarette brands and tremendous food operations. Over the past few years, however, I have learned from this stock and others that it is often better to wait for concrete signs of improving company fundamentals before buying into a beaten down stock. While this strategy means that I'll never get a stock at its lowest price (it will undoubtedly have rebounded somewhat prior to concrete evidence of a turnaround), it also dramatically improves my chances of not watching one of my investments fall steadily for several years. Until the litigation risk of these tobacco companies has subsided, you're going to find me on the sideline of these stocks.