It appears that the FDA has finally decided to make a move on the tobacco industry, and this could be really bad news for Lorillard (UNKNOWN:LO.DL), Altria (NYSE:MO), and Reynolds American (NYSE:RAI).
For some time now, there has been speculation that the FDA will ban menthol cigarettes. Things started moving last year when the administration initiated a 60-day public comment period during July which was intended to help inform the rule-making decision. The agency received requests which claimed that 60 days was not enough time to make an informed decision, so it extended the deadline to Nov. 22. Now that this period has ended, the FDA needs to make up its mind .
Since November, both consumers and investors have been kept waiting for the FDA's decision on the matter, although the agency has been quiet since the public comment period. However, it appears that the FDA is finally starting to flex its muscles, as it recently (on Feb. 21) issued orders to stop the further sale and distribution of four particular Bidis products which entered the market during a a grace period set up in the Tobacco Control Act.
Bidis, or hand-rolled cigarettes from India, have been sold within the US for decades but they have been found to contain high levels of nicotine and tar, and they also produce more carbon monoxide than traditional cigarettes. The FDA's decision to stop further distribution of these four products is really important because this is the first time the agency has made a move like this regarding a tobacco product since the introduction of the 2009 Family Smoking Prevention and Tobacco Control Act, which gave the agency expanded powers to regulate tobacco.
So, is a menthol ban likely to follow?
The FDA's view
Tobacco is usually a touchy subject when it comes to ethics, but when it comes to menthol the situation becomes extremely complicated. Not only are menthol cigarettes blamed for converting youngsters to the habit of smoking, 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.
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 became 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 menthol be exempt? In addition, the European Parliament recently introduced a law which will ban the sale of menthol cigarettes from 2022 -- this increases the pressure on the United States to act.
All in all, there is some solid reasoning behind the FDA's prospective menthol ban.
On the other side of the fence
Every debate always has two sides, and in this case the argument to keep menthol products legal is supported by law enforcement agencies.
In particular, comments made by law enforcement agencies which oppose 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 ploys and scare tactics to limit regulation. However, these new remarks came from Paul Carey III, chief of enforcement for the Northern Virginia Cigarette Tax Board, and others such as a former supervisory U.S. Marshal from North Carolina, the 1,000-member Alabama State Troopers Association, and former director of the North Carolina Alcohol Law Enforcement Agency Michael Robertson, 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 the practice is linked to violent crime; comments like these could make the FDA reconsider regulation.
This makes me think that a complete ban on menthol products may not come into force.
Whatever the outcome, judgment day is getting closer and now that the FDA's public consultation period on the matter has been closed for months, the agency needs to make a decision soon.
Unfortunately, Lorillard's future depends upon the FDA's decision, as according to Citi (part of Citigroup) analyst Vivien Azer about 90% of Lorillard's sales volume comes from menthol cigarettes.
Meanwhile, Altria Group sells Marlboro-branded menthol cigarettes and Reynolds American's menthol offerings include products from Camel, Kool, and Salem. Still, Reynolds' and Altria's exposures to the menthol market are nowhere near as troubling as that of Lorillard. Specifically, Altria's menthol Marlboros only account for around 20% of its total sales and Reynolds' menthol brands only account for 30% of the company's overall sales.
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 by having tobacco companies dull down the menthol flavor so these products aren't as appealing. This could impact the 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.
Rupert Hargreaves owns shares of Altria Group. The Motley Fool owns shares of Citigroup. 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.