FDA Announces Plan to Ban Menthol

Altria's MO in line first-quarter results were overshadowed by the Food and Drug Administration's announcement that it is to seek a ban on menthol cigarettes. Although the risk of a menthol ban has been a long-term overhang and one of the ESG risks we have identified, we did not include it in our base-case assumptions because we felt the legal burden of proof for implementing a ban--which required the FDA to prove that a ban would be a net public health benefit--was fairly high. Following the FDA's announcement, however, we believe the probability of a ban has now increased because the FDA clearly believes it has met that burden of proof. We still believe a ban will take years to implement, and we are lowering our stage II growth rate assumptions for the cigarette makers with exposure to the menthol category in the U.S. We are lowering our fair value estimates of Altria to $52 per share from $54, of British American Tobacco to GBX 4,000 from 4,300, and of Imperial Brands to GBX 2,900 from GBX 3,000. We believe the tobacco group remains undervalued, and our picks remain Philip Morris International, whose exposure to the U.S. is limited to a revenue share of its market-leading reduced risk portfolio, and Imperial Brands, which trades at under 10 times forward earnings and pays a dividend yield of 9%. Altria's first-quarter revenue net of excise taxes fell by 3.3%, slightly worse than our forecast due to a steep 12% decline in cigarette volume. We do not think that the underlying volume trend of a roughly 4% decline rate has changed much, however, and with management reiterating full-year guidance, it is likely that trade inventory movements drove volumes lower and that the impact of inventory level changes will reverse throughout the remainder of the year. Nevertheless, we expect the gradual easing of social distancing measures to slow volumes in the coming quarters. We retain our full-year estimates at the high end of management's EPS guidance of $4.49 to $4.62.

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